On October 3rd, Fed chairman Jerome Powell told PBS’s Judy Woodruff:

“We’re a long way from neutral at this point… probably”

And since then, financials markets have done this:

The red line shows the date of Powell’s interview. The green line shows the 10-year treasury yield spiking to its highest level since 2011. The white line shows the S&P 500 selling off. Now, any good market analyst knows that markets are constantly reacting to many different inputs and it is impossible to completely attribute market movement to any one single data point. But while this is true, we think Powell’s statements were the key catalyst for the recent shifts in financial markets.

At Ensemble we don’t make investments based on the idea we can predict the next big move in the economy. Despite having a degree in economics, I don’t believe that economic predictions can be systematically applied to produce outperformance in an equity portfolio. But we do think it is critical for equity investors to be economically “context aware.” By “context aware” I mean to understand the range of potential economic outcomes and the probability that economic conditions (to the degree they drive company level performance) are running above or below what might be considered “normal” over the long term.

So what is the current economic context and why did Powell’s comments trigger such a sharp reaction? Back in August, we wrote about the potential end to the New Normal, a slow growth economic environment, and what may be the reemergence of the Old Normal, a higher growth environment. In that post we showed this chart illustrating how economic growth had recently reached the fastest rate since the great recession.

But while we may be returning to the Old Normal paradigm of higher growth, we may also just be experiencing the frothy growth typically seen at the end of an economic expansion. Maybe the New Normal is here to stay and the recent growth spurt will soon end in the midst of the next recession. The fact is, no one knows which one it will be. Even the Federal Reserve, with its myriad resources and access to both public and private economic data, has an extremely spotty track record of forecasting recessions.

It is in this context that Powell’s comment, “We’re a long way from neutral at this point” landed with a thud. The Fed Funds rate is currently at 2.25%. In theory, there is some interest rate that would be considered “neutral”. This is the rate that would be neither stimulating nor inhibiting to economic growth. Economists call this mythical number r*. But while r* exists, it is not a rate that is observable or objectively measured. In a very real sense we can only know what interest rate was actually neutral by looking in the rear view mirror at how the economy behaved in relation to various interest rates in the past. But what makes economics so difficult is that it is not a static science, but instead is a highly dynamic system. A rate that may have been neutral in the past may stimulate or inhibit economic activity today.

What Powell’s comment “we’re a long way from neutral” means is that the Fed chairman thinks that the current Fed Funds rate is still stimulative. Put simply, he thinks the economy can continue to expand even as the Fed continues to raise rates. How much further might rates need to rise? Well, Powell seems to think the answer is “a long way”. But the market isn’t so sure he’s right and if in fact interest rates are already near neutral, then raising rates a lot from here would start inhibiting economic growth and quite possibly tip us into the next recession.

Here’s a chart showing what members of the Federal Reserve believe the Fed Funds rate will be in the years ahead (each member’s estimate is a yellow dot with the green line representing the median), along with market estimates of of the same rate (the purple and white lines).

The Fed thinks they will raise rates by about 1.25% over the next two years to 3.5% before fading back towards 3% or what is essentially their best estimate of the neutral rate. Financial markets on the other hand are forecasting that after raising Fed Funds by about 0.5% next year, the Fed will have already gone too far and will begin cutting rates back towards about 2.5%, which is essentially the current market forecast of the neutral rate.

So while Powell’s statement “we’re a long way from neutral” doesn’t sound that dramatic, in many ways they are a double dog dare to the markets letting investors know that he does not agree with the market’s view on rates or its implied view that the economy is too fragile to survive higher rates. His statement is bullish on the economy (it means Powell thinks the economy is more robust than the market is giving it credit for), but it also exposes the fact that if the Fed is wrong and the economy is indeed still stuck in a New Normal environment of lower growth, and thus a lower neutral rate, that the Fed might be making a mistake and planning on driving rates too high and triggering the next recession.

We’re nine years into this economic expansion. Another recession is coming (they always are), but investors don’t know when. Like market pullbacks, they are an inevitable part of the cycle, but timing them correctly is near impossible. But while there are many possible futures for the economy, two distinct narratives are coming into focus with the market struggling to price them both in since they lead to quite different outcomes over the next couple of years.

The Old Normal Returns: Under this narrative, the economy has struggled through a ten year period of recovering from the financial crisis, but it has finally worked off the hangover and is now ready to support stronger growth and higher interest rates. In Fed speak, the neutral rate is likely near 3% or higher. While this view is not the consensus view, current economic growth is already running at Old Normal levels and the economist Mohamed El-Erian who literally coined the New Normal phrase said recently that he believes the US economy has exited the New Normal and is reentering the Old Normal paradigm.

The New Normal Persists: Under this narrative, the economy is coming to the end of a long expansion, it can’t handle much higher rates. In Fed speak, the current Fed Funds rate is already very close to neutral. While this has been the consensus view and overall the market is still primarily pricing in this outlook, over the past two years economic growth, inflation, interest rates and equity market valuations have all been trending higher suggesting the market is beginning to question if the New Normal is really here to stay or not.

I wish I could tell you we knew which narrative is right. But what I can tell you is that any investment professional who tells you they do know with certainty which way the economy is going to turn is fooling you and themselves. Which is why it is important to point out that Powell’s full quote was “We’re a long way from neutral at this point… probably.” In other words, Powell isn’t so committed to his view that he is going to ignore new economic data as it comes in. What this means is that with market views on the economy at a cross roads, the market will likely be hypersensitive to new economic data as it rolls in. Does it support a narrative of a return to the Old Normal or does it reinforce market perceptions that the New Normal is here to stay?

You might call this the Three Trillion Dollar Question. $3 trillion is the difference between the current size of the US economy and the size it would have been if economic growth after the great recession had returned to the Old Normal growth rate rather than growing at the slower New Normal rate for the past decade.

Credit: Scott Grannis’s Calafia Beach Pundit

The market is currently estimating neutral at around 2.5%, maybe even lower. The Fed is telling us they think it is about 3% or maybe a bit higher. But under the Old Normal, the best estimate of the neutral rate was something around 4% (all estimates assume 2% inflation). If you ask me, the Fed’s official projection of 3% for the neutral rate doesn’t quite square with Powell’s comment that “we’re a long way from neutral”, as 3% is only 0.75% above the current Fed Funds rate. So while suggesting neutral might actually be as high as 4%, that GDP growth could sustainably run at 5%, and that 10-year bond yields might hit 5% as well would put you far out of consensus, this is actually the pre-financial crisis “normal” that persisted for a very long time. Maybe Powell’s “long way from neutral” comment is a first step to suggesting the Old Normal can truly return.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Below is the Q3 2018 quarterly letter for the ENSEMBLE FUND (ENSBX)This quarter’s Company Focus is on Trupanion (TRUP) and Booking Holdings (BKNG). You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of the Ensemble Fund (“the Fund”) this quarter was strong, but modestly trailed the broader market after our relatively strong first half. The fund was up 6.00% vs the S&P 500 up 7.71%. Year to date, that brings our performance to up 13.49% vs the S&P 500 up 10.56%.

As of September 30, 2018

3Q18 YTD 1 Year Since Inception*
Ensemble Fund 6.00% 13.49% 21.81% 14.90%
S&P 500 7.71% 10.56% 17.91% 14.19%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at www.EnsembleFund.com.

The performance in the quarter was fueled by 10%+ gains in Starbucks (3.2% weight in portfolio), Apple (3.3% weight in portfolio), Oracle (6.5% weight in portfolio), Broadridge (4.6% weight in portfolio), Mastercard (7.0% weight in portfolio), Verisk (3.6% weight in portfolio), and Landstar (7.0% weight in portfolio). Weakness was seen in declines from Broadcom, which was down 14% before we exited this investment. Netflix (4.9% weight in portfolio) and Trupanion (1.8% weight in portfolio) which were down mid-single digits after being our best performing investments in the first half of the year with Netflix up 105% and Trupanion up 35% during the six weeks after we purchased our initial position during the second quarter. Booking Holdings (8.8% weight in portfolio) and Charles Schwab & Company (4.5% weight in portfolio) were down a couple percentage points in the quarter.

The gains in Starbucks and Oracle were relief rallies as these out of favor stocks seem to have seen selling exhaustion and investors are starting to get more comfortable with the medium-term outlook. While investors have sold both stocks down on growth concerns, we would note that consensus estimates call for high single digit EBITDA growth at both companies, highlighting that while each company has seen headlines calling their growth potential into question, they are still both expected to continue to produce solid growth with very strong returns on capital.

Apple rallied strongly in the quarter on good Q2 results and the market’s growing comfort in the sustainability of both iPhone unit sales and the associated cash flow streams which increasingly include services and accessories that improve cash flow per iPhone user. After owning Apple as one of our largest holdings for much of the last nine years, we’ve trimmed our position over the course of this year so that it now ranks near the bottom of our holdings. This reduction in our position size does not reflect any downgrade in our assessment of the business. Instead it is simply the fact that with a market cap of over $1 trillion we think the current market value no longer represents a material discount to the underlying company value. That being said, the company demonstrated strong pricing power last year in raising the flagship X model starting price to $1000 last year and this year they are pushing ahead with broad price increases across their model lineup. With an iPhone still costing about $1 a day while commanding an average of three hours a day of usage, it may be that Apple still has more untapped pricing power than we are giving them credit for. On the other hand, there is no guarantee that they will be able to maintain and slightly grow unit volumes over the very long term. We think the current market price comes close to balancing the risks and potential that the company faces and so we’ve reduced our holding to reflect this outlook.

Meanwhile, Broadridge, Mastercard, Verisk, and Landstar, a group of companies that provide a mix of software, services and data processing, were all up 10% to 15%. These businesses serve very different customers and end markets, so there is no reason to think that the strong and tightly correlated performance of these stocks was due to a common fundamental driver. But each of them do benefit from improving economic conditions, which have been playing out in recent months, while also operating asset light business models that cushion the downside impact from a recession should one occur. As investors grapple with both improving economic conditions and increased worries that the current economic expansion may be nearing its end, these types of economically sensitive, but asset light business models may be coming into favor with investors.

CLICK HERE TO READ THE FULL LETTER

 

Disclosures

Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

Fund Fees: No loads; 1% gross expense ratio.

Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

In the classic Nintendo game, Ice Hockey, you pick a team of four players with one of three body “types.”

Trait “Skinny” “Medium” “Heavy”
Speed Fast Average Slow
Slapshot Weak Average Strong
Checking Weak Average Strong
Face-Off Good Average Poor

*Source: GameFAQ

The optimal four-player mix is debatable, but no gamer would seriously recommend picking the same player type for every position. If you picked all “Skinny” players, for instance, you could fly around the rink, but you’d struggle to score. On the other hand, if you picked all “Heavy” players, you’d move like molasses. Once you got the puck, however, you were a scoring threat. Instead, some mix of the three player types provided a balanced offense and defense.

It’s much the same with corporate management teams. Too much of one personality type will typically lead to poor long-term results.

In June, we introduced our framework for evaluating Visionary and Optimizer CEOs, describing them as such:

Visionary Optimizer
Primary Motivation Intrinsic Extrinsic
Objective Growth and innovation; Fulfill mission Maximize cash flow and ROIC
Moat type Emerging/Reinvestment Legacy
Fiscal discipline Loose Frugal
Problem solving style Creative, experimental Disciplined, methodical
Capital allocation strategy Reinvest in the core business Opportunistic buybacks and M&A
Corporate culture Energetic, perhaps cult-like Decentralized, reserved
Major risks Loss of focus, no moat materializes Poor execution, lack of investment opportunities

 

We presented these differences, in part, to illustrate how investors – particularly value investors – can miss good investments by focusing solely on Optimizer-type CEOs and overlooking the opportunities presented by Visionary-led businesses.

Perfect harmony

An important point to add is that management teams are a mix of Visionaries and Optimizers. The wise leader – Visionary or Optimizer – will surround himself or herself with different and complementary personality types.

The most productive companies strike the right blend of Visionary/Optimizer skills at the right time in the company’s lifecycle. Think about Steve Jobs (Visionary) bringing on Tim Cook (Optimizer) to lead Apple’s worldwide operations in 1998, Mark Zuckerberg hiring Sheryl Sandberg as Facebook COO in 2008, or Google co-founders Sergey Brin and Larry Page naming Eric Schmidt CEO in 2001. If Visionaries don’t bring on Optimizers at the right time, it can stall the company’s progress. Conversely, if Optimizers don’t listen to Visionaries, it can accelerate the company’s terminal decline.

On this point, we believe one of the reasons blue chip consumer-packed goods (CPG) companies have struggled to fend off niche-brand upstarts like Dollar Shave Club, RxBar, and HaloTop is that they’ve been too reliant on Optimizer-type management. The CPG incumbents were so worried about hitting numbers, that the newcomers vaulted over the blue chips’ moats and walls before the alarm was even sounded.

To be fair, it’s hard to blame CPG companies for focusing on efficiency in the past decade. Private equity and activist investors were waiting in the wings. Still, we think companies like Procter & Gamble, Kellogg, and General Mills need to inject more Visionary types in their ranks to rekindle existing brands and build new ones faster than the upstarts can.

Bottom line

Ultimately, we want to invest with management teams who understand how to widen the company’s economic moat and allocate capital in a manner consistent with maximizing long-term, risk-adjusted shareholder returns. When there’s no blueprint for success, we look for evidence of Visionary leadership to discover creative solutions and build a moat. On the other hand, when the company is already the dominant player in an industry, we prefer management teams that have Optimizer traits like capital allocation skill and operational efficiency, which can further widen the moat.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Apple (AAPL) and Alphabet (GOOGL). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Each quarter, Ensemble Capital hosts a conference call with investors to discuss the current market, economic conditions, and a few of our portfolio holdings.

This quarter’s call will be held on Monday, October 8th at 1:00 pm (PST)

We’d love for you to join us on the call, which you can do by REGISTERING HERE or following the dial-in information below:

  • Dial: 1-800-895-1549
  • Conference ID: Ensemble

If you’d like to listen to our previously-held quarterly calls, an archive can be FOUND HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Legendary investor and observer of human nature Charlie Munger has said of Tesla and Elon Musk: “Tesla has already created more significance than anybody had predicted. Its founder is bold and brilliant, and he swings for the fences. People like that get some remarkable results. Sometimes they get some quick failures. I haven’t the faintest idea how Elon Musk will turn out, but he has a considerable chance of success and considerable chance of failure. He seems to like it that way.”

We could not have put it any better. Indeed, few entrepreneurs can boast having successfully built significant companies in three different very challenging, established, and staid industries – payments (PayPal), space travel (SpaceX), and automobiles (Tesla). On top of it all, Musk risked nearly everything for each venture.

Bold and Brilliant indeed!

But that does not preclude him from following the rule of law if not conventional norms — with the SEC filing suit last Thursday to bar Elon Musk from running any public company, Tesla had the real danger of failing just as the electric vehicle market it popularized reaches a tipping point towards real volumes.

Source: IEA, Bloomberg

Musk did end up settling with the SEC since then (not without his usual antics), but given his history of erratic behavior, flouting the conventional norms and rules governing public company executives, the significant risk still exists that he may not be able to lead the company to see its ultimate potential on his own.

While ignoring convention is very much in the DNA of every disruptive entrepreneur, Musk generally goes further than most in ignoring rules that don’t necessarily help his stated objectives, and in fact may be detrimental to some of them. Additionally, Tesla’s continuing dependence on raising capital as it scales production from the capital markets also presents risk if the market’s generally optimistic view of Tesla’s future were to reverse and close off funding.

Rather than get caught up in the day to day soap opera of Elon and his detractors, we think it is important to step back and think about the bigger picture. Tesla has already transformed the auto industry. Every major automaker is now launching electric vehicles with many pledging all electric fleets within the next decade. Despite the uncertainty around Musk and Tesla’s ability to deliver on their promises, there is tremendous potential value in the company. If Elon lost his ability to lead the company, it seems very likely to us that Tesla will be forced to sell, with rather dramatic implications.

One of the higher probability outcomes may well be that Google buys Tesla, combines it with their Waymo autonomous vehicle (AV) business and becomes the dominant player in the future of transportation with effectively unlimited cash and organizational resources to accelerate the transformation of the auto industry.

Match made in heaven

Combining today’s leading luxury EV producer (>200K annual production run rate) with the leading AV provider would serve to bring rapidly growing scale to both with a cost advantage of 10x relative to ICE based transportation, would enable Waymo to stretch its lead by a margin so wide that it would be the clear leader. Just as network effects help Google deliver better search results (reinforcing algorithms – more searches, more feedback, better searches, driving more searches), more trips make Waymo’s vehicles better “drivers” (more trips, more safe, higher quality rides, broader coverage area, more trips).

 

Source: @martinengwicht, insideevs.com 

Source: cleantechnica.com

Waymo is already the leader in the technology with the longest project tenure, lowest disengagement rate of any competitors, and most miles driven autonomously. It plans to rapidly scale its commercial AV taxi service beyond trials in the Bay Area and Phoenix, “targeting 1 million trips per day in the next few years” in conjunction with its partnership with Jaguar.

Source: Economist

While there is no doubt that Elon Musk and Tesla have demonstrated the feasibility and desirability of EVs complemented by the timing of government regulations around emissions (a tipping point enabled by Tesla’s success), the company has certainly had a haphazard record of scaling effectively with a lot of drama around every required capital raise in doing so. If Musk had a complementary partner with a more effective execution capability running production, many of Tesla’s woes and detractors would be extinguished.

As a buyer, partner, and incubator, Google could be the ideal partner for Musk/Tesla, leaving him to focus on what he does best – vision, design, and engineering – while installing an effective equally ranked executive to partner with Musk to manufacture and scale with a more robust process than that used to design the “machine to build the machine” hypotheticals that resulted in Tesla’s ongoing “production hell” saga.

Google also brings unlimited capital, a long-term investment horizon, and a fellow believer and friend in Larry Page, who has not only invested for a decade in Waymo’s AV technology but has also been willing to rescue Tesla in a previous distressed episode. We don’t believe Page’s buyout offer was just a charity offer for a friend but rather a belief in the potential that Tesla would have in transforming the overall transportation market, as it’s become clearer today.

Making it work

While some would argue that “firefly” like pods are what AV will eventually look like (despite being discontinued by Google), no one would argue that having a Tesla drive you around instead of your Ford Taurus at 1/2-1/5 the price wouldn’t be more appealing if you could get comfortable with an AV driver.

Source: Techcrunch

Of course, the most prolific early adopters will be the young and the carless, uber-loving inhabitants of large cities globally. In the meantime, those users choosing to own an EV could join the fleet of Tesla owners who actually drive billions of miles, while delivering real time imaging data to use in AV simulations, reinforcing behavioral learnings of the AV engines from real world human decisions.

We believe Google has realized that forgoing hardware in the smartphone market led to Apple dominating the profits in the market (~90% of the profits of the most lucrative consumer product ever created), the majority of the most valuable users (top 20% globally), and a trillion dollars of value. Most of Google’s hardware partners have produced sub-par hardware as a result of competing for small slivers of profits striving for market share with undifferentiated hardware powered by Google’s Android service.

Google used this strategy to get Android and its accompanying services to ubiquity. However, that ubiquity in services ended up being less lucrative than selling a premium integrated experience. Now Google has redoubled efforts to deliver a premium Android experience by building and selling its own smartphones with its Pixel phone line of products in order to win back some of these high-end customers but doing so is difficult from an entrenched competitor offering a great experience.

The secret of the iPhone’s success has been its integrated software/hardware/apps experience, great design (an identity feature), high utility, low cost (~$1/day), and high profit/ROIC. And now it is basically sold as a service with monthly financing plans allowing for the effective exercise of pricing power.

Riding in style

We think a similar analogy is likely with AV/EV — the most economically well-off people will still care about comfort, features, and identity that the AV/EV they ride and arrive in imparts on them. If Waymo can deliver a premium experience at a better price and higher utility than their current solution (i.e. driving themselves in their own cars or Ubers/taxis) with cost economics that yield a strong profit margin/ROIC at scale (1/2-1/3 the pricing of Uber at 1/10 the cost), it will have built an offering that will be set to be the leading AV service and create tremendous value for shareholders despite the early capital intensity. Estimates of the value of this Transportation as a Service (TaaS) or Mobility as a Service (MaaS) go from hundreds of billions on up based on Morgan Stanley’s estimate of 11 billion miles (3B in the US) driven globally and forecasted to double over the next decade.

Source: Electrek

Eventually, if Waymo is successful at taking the strong lead via network effects in AV and converting enough consumers to use its premium service (achieving a cultural and regulatory tipping point), it could decide to open up its service’s usage across other auto “hardware” partners as they demonstrate their ability to deliver a certain level of quality experience and scale globally, enabling a broader application of its service to lower tiers of the market with lower capital intensity (akin to Apple’s 2nd hand iPhone market, which broadens its user base for services offerings).

Having articulated the value, we think a reasonable price for Google to pay for Tesla in the event it were distressed would be $30-40B. This is 35%-50% below Tesla’s current enterprise value and could only occur in the event Musk is unable to execute on his vision, a possibility that we believe is very real. However, this is also well above the near zero value that many of Tesla’s detractors believe the company is worth as they expect bankruptcy to arrive before too long and fail to appreciate the very real value inherent in Tesla. A buyout at this price would be less than 5% of Google’s $800B+ market cap – coincidentally the change in the market cap just last week – a reasonably sized bet for Google to make in light of its own scale and ambition in the AV market, while also allowing it to clearly win any competition that could emerge from a traditional auto OEM or other likely suitor.

Bottom line

While the settlement with the SEC pushes out any sort of forced sale of Tesla in the near term and perpetuates the drama surrounding the company, we do believe that the value it has created is real and significant, but also still very much in doubt. Partnering the vision of its brilliant CEO Musk with a reliable long-term oriented execution partner and capital provider in Google would be a great outcome for both companies, their shareholders, and consumers globally.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.