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Executive summary: 

• Companies that experienced a growth boom in the past decade are now transitioning to a new phase of their lifecycle.
• Investors are rightfully beginning to wonder what the long-term economics of these businesses will look like.
• Successful companies will be those that can strike the right mix between visionary and optimizer leadership.

By 1850, observers assumed that Cincinnati would be the future metropolis of the Midwest. Indeed, Horace Greeley of the New York Tribune envisioned at the time: “It requires no keenness of observation to perceive that Cincinnati is destined to become the focus and mart for the grandest circle of manufacturing thrift on this continent.”

Thanks to its advantageous location on the Ohio River and the introduction of canals and steamboats, Cincinnati’s economy and population boomed in the first half of the 19^th century, rapidly becoming the sixth-largest city in the young United States.

Source: Boston University, Brookline Connect, Wikipedia, Author’s calculations

Within a decade, however, the city’s growth trajectory flattened out. The impacts of the Civil War, the railroad revolution, and further westward expansion took opportunity elsewhere in the country.

It was a painful transition for the city leaders to acknowledge. Still, they pivoted from a boundless growth mindset to promoting civic pride, including building art museums, music halls, and urban parks. These efforts were critical in maintaining the city’s relevance in the subsequent 150 years.

A similar transition is happening at some high-profile companies that experienced a growth boom in the past decade. As growth slows, investors rightfully begin to wonder what the long-term economics of the business will look like.

In previous posts, we’ve shown how an investor’s assumptions about a company’s terminal value, or steady-state growth and profitability profile, account for at least 75% of its intrinsic value. Naturally, previous growth rates have no impact on current market valuations. What matters is how confident investors are in the company’s long-term economics.

To illustrate, consider the following two sets of companies:

Source: Bloomberg, as of 5/22/23

The “old school” group of companies trade with similar, or in some cases higher, multiples to the “new school” group that grew far more rapidly in recent years.

Why might this be?

The answer can take many paths, but ultimately what matters is what the economics of each of these businesses looks like in 10+ years and how confident investors are that they’ll achieve those figures.

With these selected “old school” companies, there’s a track record of execution. They’ve all been through various growth stages and cycles and have even stumbled multiple times, but they have come through the other side.

On the other hand, the “new school” companies have established themselves as forces to be reckoned with. Still, it remains to be seen what their margins and incremental returns on invested capital profiles look like when growth slows.

To this point, three sell-side analysts – Scott Davis, Carter Copeland, and Rob Wertheimer – wrote the book Lessons from the Titans. The trio covered industrial conglomerates and drew lessons from the successes and failures of these companies that they argue can be applied to many of today’s tech companies transitioning from high-growth periods.

The authors note that industrial companies were the “original tech” a few generations ago and once “had seemingly magical market positions, but most of them squandered that advantage. Arrogance led to wasteful investment decisions, poor labor relations, and countless scandals.”

The successful industrials they studied had “three common drivers: a relentless discipline on costs, cash flow, and capital deployment,” that they used to widen their moats.

Headlines about tech layoffs have increased as companies have started the painful transition from boundless growth to sustainable growth. Such changes require different skills from management and an adjustment to corporate culture. With a blueprint for success established, the new school companies need less visionary and more optimizer leadership.

Striking the right mix between visionary and optimizer will be critical to the outcomes of new school companies during this transitionary period. They must retain the cultural spark that drove talented employees to their company while doing so in a more economical manner.

Of course, it’s much easier to see with hindsight where companies should be on the Visionary-Optimizer spectrum, but in the moment, it’s unclear. Take Alphabet (Google), for example, which already boasts generous 30%+ EBITDA margins and attractive returns on invested capital. Figures any Optimizer would applaud. Nevertheless, the company has announced cost-cutting initiatives including eliminating 6% of its workforce and cutting back on office supplies and some of its famous employee perks.

All of those efforts are firmly in the Optimizer camp. Yet, Alphabet simultaneously faces an acute challenge in the form of rapidly advancing artificial intelligence (AI) technology, which will require a Visionary mindset.

Investors calling on Google to rein in spending, increase buybacks, and become more operationally efficient make reasonable points. However, if Google management takes that advice too far and becomes a complete Optimizer, its relevance in the next generation of technology could be at risk. Imagine if Google listened too intently to the investor complaints about investing in unprofitable growth initiatives like YouTube or DeepMind years ago. We believe Alphabet management is taking the appropriate steps to navigate this challenge thus far.

We have a mix of old and new school companies in our portfolio and are confident in all their long-term economic potential. Each group has its own set of risks and opportunities. With the old school names, we’re primarily focused on low growth risks and their reinvestment runways. With the new school names, we’re watching how they balance growth and innovation with more financial discipline.

No company is a static asset, and they either get stronger or weaker each day – and they will be materially different a decade from now. Whether they are old school or new school companies, how they address new challenges and transitions is what matters. The best companies come through stronger on the other side and[…]

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Like everyone else, we have been thinking a lot about the history of investing over the past year and specifically the relationship between the stock market, interest rates, inflation, and earnings. The chart below is a good visualization of the levels of inflation we are experiencing today in the context of the last 60 years, including two different measures, overall CPI (yellow solid line in lower panel) and core CPI (red dashed line, excludes volatile food and energy price changes). As result we see the Fed’s interest rate reactions (green dashed line) as well as the market’s overall expectations captured in the rate path of the 10-year Treasury yield (white line).

Source: ECM and Bloomberg

As we discussed in a previous post, there were reasons why inflation took off in the 1970s, and there are also well discussed reasons as to why it took off this time around. Both involve the growth of money supply driven by the Fed, policy actions by Government, aggregate demand running in excess of aggregate supply, and unanticipated macro and geopolitical events that happened to hit when the economy was vulnerable to inflation.

This next chart illustrates the long-term relationship between corporate earnings, the value of the stock market and its price to earnings ratio.

Source: ECM and Bloomberg

What’s most interesting about the long-term perspective is that over time earnings have grown (dashed blue line) which has underpinned market appreciation (white line). The relationship between the market level and underlying earnings is the Price to Earnings multiple (or P/E ratio) captured by the cyclical orange line.

The calculated P/E ratio captures the expected value of future cash earnings available to shareholders discounted back to current value. Since companies are expected to operate for decades into the future with various prospects for growth and reinvestment needed to support the growth, it is these future discounted cashflows that comprise the value of a stock. Please refer to our previous post about valuing these cashflows  for a more in-depth study.

However, the market’s discount rate — the rate of return that investors require as compensation for taking on investment risk– and its expectations for the level and duration of future earnings growth fluctuates over time. This impacts the multiple on earnings it ends up attributing to stocks.

When current events look bad or interest rates are higher, investors require a higher rate of return for the uncertainty of future earnings, translating to a lower P/E multiple. When things are looking bright, investors generally look to the future prospects of companies with greater optimism and certainty, they require a lower rate of return, resulting in a higher P/E multiple.

Similarly, when they can earn a high-risk free rate of return by holding treasuries, the rate of return net of an equity risk premium will require a higher rate of return to bear the uncertainty of equity risk (lower P/E multiple, higher earnings yield E/P) and vice versa. Earlier this year, we offered  an in-depth examination of the relationship between long term risk, perceived risk, and the equity risk premium.

As inflation rates took off in 2021 and 2022, the prospects of materially higher interest rates and the negative impact on economic growth increased, causing the market to sell off. It drove higher risk-free returns in treasuries while also creating greater uncertainty for the economy in the future as the Fed raised rates and drew down liquidity (Quantitative Tightening) to slow inflation. This will eventually result in a “soft” landing in the economy, with low to moderately negative growth and employment scenario, or a “hard” landing, with a steeper negative growth and employment scenario.

Nearly all of the decline in the S&P 500 in 2022 was due to the P/E multiple declining from about 25x to 18x as future confidence declined and required rates of return increased. In the 1970s, P/E multiples declined from 20x to 7x as short-term Fed Funds rate went from 3.5% to 13% and ultimately as high as 20% under Fed Chair Paul Volcker in the 1980s. That was quite a rough economic period!

The chart below shows the same metrics that were presented above, but zoomed in on the 1970-1989 period.

Source: ECM and Bloomberg

But while the PE multiple compressed sharply in the 1970s, S&P 500 earnings increased from about $5 in 1970 to $8 in 1974 and then further to over $15 by 1980. The market, while experiencing a lot of volatility in the 1970s including a 50% drawdown from the 1973 peak of 120 to 1974 trough of 63, roughly held flat from 1970 to 1980 in the 90-110 level. Of course, that outcome was no consolation for equity holders during that period, but fundamental earnings tripled! (Note: Real earnings adjusted for the high levels of inflation in the period grew a cumulative 27%, while S&P 500 total return inclusive of reinvested dividends was actually about 5.5% per year).

We know that in the period after inflation was finally brought under control after some false dawns, the P/E multiple increased like a coiled spring from 7x to 15x from 1980 to 1990 (including a brief flirtation with 25x before the 1987 crash) while earnings continued to increase (at a subpar annual rate of ~5%) from $15 to $24 resulting in the S&P 500 increasing from about 110 to 360. So, the decade of pain was rewarded with a decade of good returns of about 12.6% per year.

And we all know there was a lot more reward in the next decade culminating in the 2000 Dotcom bubble peak over 1500 on the S&P 500 (~15.5% CAGR), PE of 30x, and earnings of $55. But then that peak was followed by 13 years of painful volatility with essentially no progress in the market as P/Es trended lower even as earnings doubled, inclusive of the Great Financial Crisis that rattled the global financial system. Finally, the past decade was a good one, with market return averaging ~10%, inclusive of the drawdown from the S&P 500’s 4800 peak to today’s roughly 4100 level.

Source: ECM and Bloomberg

Of course, an extraordinary macro investment manager could have done really well trading among asset classes based on changing economic trends. This is the kind of environment when some such strategies have posted extraordinary results, though very few have consistently performed well. Since the economy has emergent complex system characteristics, it is much harder to forecast than company fundamental data[…]

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Read Part I of this post here.

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns… even if you originally buy it at a huge discount.” – Charlie Munger

In Part I of this series, we wrote about the way that the starting cash flow yield that an investor pays for a stock combines with the growth rate in cash flow that the company generates over the long term to drive the investor’s rate of return. And we argued that “value” is best understood not as stocks with high starting cash flow yields (ie. low starting valuations based on current results) but rather as stocks that trade at a “value” price such that the combination of their cash flow yield and forecasted growth offers an attractive rate of return.

In this post, we are going to examine Warren Buffett’s investment in Coca-Cola to show that when investors hold stocks for long periods of time, elevated returns must be driven by elevated growth. Buffett himself made note of the way that it was Coke’s elevated growth that drove the success of his investment in his recently released annual letter.

Buffett writes:

“We own publicly-traded stocks based on our expectations about their long-term business performance, not because we view them as vehicles for adroit purchases and sales. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”

He then used Coca-Cola as an example to highlight what he called the “secret sauce” of his investment approach and highlighted the long term growth in cash production the company had achieved.

“The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.”

This focus on businesses that generate long term growth in cash flow was not always Buffett’s focus. Early in his career, he pursued a more classic version of value investing that he learned from the father of value investing Benjamin Graham. This more classic version of value investing emphasizes buying stocks that have a high starting cash flow yield or that sell for a discount to the value of the assets owned by the company.

Investors who focus on a high starting distributable cash flow yield (Y) or a high growth rate (G) (see our last post for context) when seeking to generate strong rates of return, need to recognize that these distinct approaches are consistent with different time horizons. In general, the more an investor emphasizes a high starting Y, the shorter their average holding period should be. Indeed, truly deep value approaches are inconsistent with long holding periods and thus are incompatible with Warren Buffett’s favorite holding period of “forever.” In other words, as Buffett’s partner Charlie Munger puts it in the opening quote, over the long term it is the fundamental returns of the business, its return on invested capital and its rate of growth, that drive investment returns.

Let’s walk through a Y + G based analysis of Buffett’s investment in Coca-Cola, a company that most investors would agree is considered prototypical of Buffett’s investment approach. Indeed, it is one of the investments that Buffett is most highly associated with. We’re going to use reported free cash flow as a proxy for distributable cash flow. While these are not identical measures, in Coke’s case over the time period in question, the growth rates of these two cash flow measures is approximately the same.

Warren Buffett first bought Coca-Cola near the end of 1988 at a PE ratio of about 15x or a distributable cash flow yield of about 4.0%. This PE ratio and distributable cash flow yield are approximately the same as the long term average valuation of the S&P 500, which has returned 9% a year.  How then did Coca-Cola go on to produce an 12.2% rate of return over the subsequent 34 years?

Coca-Cola was a Growth stock.

It is true that Coca-Cola is a slow growing company today. But when Buffett bought the stock, Coca-Cola was embarking on a long period of elevated growth. Over the first ten years after Buffett first invested, the company grew distributable cash flow at a 15.4% rate. And it didn’t stop there. Over the next nine years, Coca-Cola continued to grow at an 8.0% rate.

Over the first 19 years Coca-Cola generated a growth rate of distributable cash flow of 11.7% a year. Buffett had crushed it. He had bought Coca-Cola with a starting Y of 4.0% and captured 11.7% growth (G) that lasted for 19 years.

As we showed in our last post, Y + G = Rate of Return. Or in the case of Coke, 4.0% + 11.7% = 15.7% and that’s indeed the return generated by the stock over that 19 year time period.

The fact is that the elevated returns that Buffett achieved by buying Coca-Cola came exclusively from the elevated growth and Buffett’s willingness to hold the stock for 19 years as the growth compounded. All 6.7% in excess returns over the 9% average return of the stock market came from elevated growth (G). The stock began and ended this 19 year period with the same valuation, which was also the average valuation of the S&P 500. So none of the excess return came from an elevated cash flow yield (Y).

Does that mean that the price Buffett paid for Coke was irrelevant? No, of course not. Investment returns are driven by a combination of the starting cash flow yield and growth, so both are important.

By paying a 4.0% starting cash flow yield for the stock, Coke only needed to grow at the average 5% rate of corporate America to generate the average 9% return that the US equity market has offered over time. If Buffett had paid twice as much for Coke, a 30x PE or a 2% distributable cash flow yield, he would have required elevated growth just to earn 9%. But because in fact Coke grew at an 11.7% growth rate, Buffett could have bought the stock at a PE ratio of as much as 46.5x or a distributable cash flow yield of as little as 1.3% and still earned a 9% rate of return.

But once Coke’s elevated growth came to an end, Buffett’s investment returns ever since have been quite pedestrian. Over the past 15 years, Coca-Cola has only grown distributable cash flow at a 4.0% rate. So, with a starting Y for this 15 year period of 4.0% and only 4.0% growth (G), the stock has returned[…]

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Yesterday, Ensemble CIO Sean Stannard-Stockton appeared on CNBC to discuss recession risk, our market outlook, thoughts about Fed policy and some of our favorite investment ideas. In the clip below, Sean discussed both the home builder NVR and payroll processing company Paychex.

On NVR and the large homebuilders more generally, Sean talked about the surprising strength in the stocks and how this is being driven by likely large market share gains. With so many existing homes owned with a 3% mortgage homeowners are unlikely to want to sell, so a larger than normal portion of total home sales in the years ahead will need to be made up of new homes. And the largest builders, with low debt and high cash levels, are well positioned to take share from smaller builders.

On Paychex and payroll processing more generally, these businesses are more defensive than most investors appreciate. For instance, in the Great Financial Crisis of 2008-09, Paychex revenue only fell 4%. While a 2%-3% rise in the unemployment rate is common even during mild recession, this only represents about a low single digit decline in employment levels and thus a mild headwind to Paychex’s revenue growth.

If you are reading this post via an email subscription, you can click here to watch the interview.

As DR Horton surges on Q2 earnings beat, Sean Stannard-Stockton is bullish on US home builders including $NVR. What’s your take on the housing market in US? $DHI $LEN $PAYX@TanvirGill2 @WillKoulouris @IntrinsicInv pic.twitter.com/fe97UpMn5h

— CNBC’s Street Signs (@StreetSignsCNBC) April 21, 2023

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During our first quarter 2023 investment update, Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton addressed our long-time holding in First Republic Bank (FRC) and the broader impact of the banking crisis on the economy and financial markets. The performance of other portfolio holdings was also discussed.  The webinar concluded with a live Q&A session with the team.

Below is a replay of the full webinar as well as a link to Ensemble Capital’s QUARTERLY LETTER.