“Change is the only constant in life.” -Heraclitus of Ephesus, 500 BCE

In the years after the financial crisis, the phrase “the New Normal” took hold as a way to describe the seemingly permanent shift in the US economy to one characterized by lower growth, lower inflation and lower interest rates compared to an Old Normal of higher growth, higher inflation and higher interest rates.

The Coronavirus has made this framing irrelevant. Today, neither the Old Normal nor the New Normal is what matters. All that matters is what the Next Normal looks like.

One of the phrases you hear people using a lot right now is when we might “return to normal” or predictions that “we’ll never return to normal.” But life never returns to “normal” because the only constant in life is change.

Of course, the future will not look like the past because it never does. But the future also never pivots completely away from the past because so many economic behaviors are driven by deeply ingrained human needs and desires that do not change all that much even when our environment changes radically.

So, we think it is a huge mistake to expect a quick return to pre-COVID norms and trends. But we also think that the widespread belief that Coronavirus “changes everything” is similarly a misreading of how humans operate.

In analyzing the companies we own in client portfolios, and those we might like to invest in, we have been carefully trying to think through the major Coronavirus-driven changes in trends that may impact them. It is not particularly difficult to understand the short-term impacts, but most of the value of a company is made up of the cash flow it will produce over the coming decades.

In this post, we will lay out some of the shifts we think may play out and that we think investors need to be acutely cognizant of tracking as we move forward.

It is important to note that everything we describe below describes changes in trends that at this point we believe are likely, but that is very different from thinking we know what the future holds for sure. This is an important reason why so far we have only added two new companies to our strategy since the crisis began and exited only one due to us losing conviction in the business.

For instance, we recently read the quarterly letter of another investment manager that we admire. In the letter, they explained that they had sold a stock in the midst of the Coronavirus market sell off due to their expectation that the number of miles driven by Americans would decline materially. Now they may be right about that, but over the past six weeks there has been a growing recognition that in a post Coronavirus world, people will be less likely to fly or take public transportation and thus miles driven may actually increase a lot. And there’s evidence building in favor of this counter intuitive outlook.

Here’s Chinese auto sales which last month were actually higher than they were a year ago as people came out of shelter in place and bought a car so they could travel safely without exposing themselves to crowds.

(Source: Evercore ISI)

And here is a chart of map requests to Apple Maps.

(Source: Apple Mobility Trends)

As you can see while public transit direction requests have plummeted, driving direction request have more than fully recovered all of the decline seen during shelter in place. And shelter in place hasn’t even ended yet.

In fact this weekend, the New York Times ran a story about the role of cars as a shelter from Coronavirus and the elevated importance of cars in American life.

“Once just a way of getting from one place to another, the car has been turned into a mini-shelter on wheels, safe from contamination, a cocoon that allows its occupants to be inside and outside at the same time.

It took a pandemic to give the automobile its new role. When people pack up their families and friends, they can still adhere to social distancing rules. They remain under a roof, within closed doors, sealed off and separated from the rest of their fellow human beings.

Mobile safe distancing has generated a new way of life — a society on wheels.”

Even if we knew exactly what trends were going to unfold, we still likely wouldn’t invest in a whole new portfolio of stocks because we went into the crisis with a portfolio of companies that we already believed were exposed to powerful long-term trends. While the Coronavirus will reverse some trends, it will also accelerate trends that were already in place. The new holdings we’ve added to our portfolio,  and those we will add in the future, will be businesses that we think are highly aligned either to the trends we describe below or to other trends that we come to understand over time are likely to drive economic behavior. Most importantly, we’ll focus on the trends that will play out over the next five years or more, rather than trends that might just impact this year.

Remote Life

As a company that embraced remote work years ago, we at Ensemble Capital feel certain that Coronavirus will cause a significant step change in the number of Americans working remotely. But this is self-evident to anyone who is paying attention and in investing you do not get paid for obvious insights.  The stocks of companies that will benefit directly from an accelerated trend towards remote work shot higher early in the crisis but that does not mean they are good investments going forward.

But we think “remote work” is thinking too small. What about “remote life?”

Obvious: More people will work remotely.

Less Obvious: Video conferencing and other remote work tools will enable a large expansion of “remote” experiences across many aspects of our work and personal lives.

Since shelter in place began, the school events I’ve attended for my two kids in high school, such as teacher meetings and school wide informational sessions, have all been Zoom meetings. Guess what? It’s better than driving to the school and sitting in the gym to hear the same content.

With my eldest being a junior in high school, we should be flying around the country visiting colleges. But now they all have virtual tours which means that rather than spending a week and thousands of dollars many college applicants may not have, we have been able to virtually visit four or five schools on a Sunday afternoon from our living room couch. While this does not preclude our continued interest in visiting some schools in person, I can certainly see how a family of college bound students may use virtual tours to visit more  schools than they used to pre-Zoom, while reserving in person visits for the small number of schools that are the students top picks.

As another example, my wife and I belong to a gym where we do high intensity interval training classes. For the last two months, we’ve been doing these classes via Zoom. There are aspects of the remote classes that I like better than going in person to the gym. I hope that as shelter in place comes to an end, that my gym will offer both remote and in person classes. I believe that if they do so, I’ll end up working out more frequently, even as I go to the gym in person less frequently.

Humans are social creatures and we feel confident that people will want to continue spending most of their time with other people in person. But that does not preclude a really significant shift in the frequency with which we utilize virtual or remote experiences rather than doing them in person. The ramifications of this shift may cascade through all sorts of industries and is something we think investors should be thinking about very critically.

Supply Chains

Obvious: Supply chains will diversify away from China with more domestic sourcing of supplies.

Less Obvious: The definition of an optimized supply chain may shift to include more robust measures of resilience. Adding more “slack” to supply chains may be negative for some businesses but will be a big positive for medium term economic growth, job creation, and businesses which can help enable more resiliency.

Every MBA student is taught that they need to “optimize” their business. While this can mean different things in different industries, at its core it means to create the most outputs with the least inputs. This is clearly a good goal. But we have long believed that too many business leaders and investors have focused on optimizing for “normal” conditions and not given enough thought to how this “optimization” will work out during periods of unexpected turbulence.

For instance, the concept of “just in time inventory” is designed to minimize the amount of inventory a company has on its balance sheet. Inventory represents cash that has been deployed but is just sitting there on a company’s balance sheet. The more you can reduce inventory levels, the more cash you can draw out of the business. But the “optimal” level of inventory is no longer optimal if you have a sudden stop to your ability to buy more or if demand suddenly goes parabolic.

Think about the shortages of personal protective equipment (PPE) during this crisis. Much of this equipment are very basic items. The issue with the shortage isn’t that PPE is so hard to make, but that the levels of inventory of PPE and the location of those inventories may have been optimal for most conditions, but it was very sub-optimal during a pandemic.

In addition, supply chains for many companies now stretch around the globe and involve a huge number of suppliers. As such, one multiyear trend that may play out is companies carrying higher inventories than they did in the past and re-evaluating their supply chains through the lens of understanding if they are indeed optimal even during times of crisis. We may well see companies shifting more of their supply chain to domestic suppliers and seeking to simplify and secure their supply chain rather than focusing on optimizing and reducing the costs of their supply chain.

This trend would be a real drag on many companies as cash flow that might otherwise accrue to investors will need to be deployed to secure their supply chain and make inventory management more resilient with more duplication of suppliers. Yet it would also be a big positive for companies who are selling products into those supply chains or companies that are part of the solution to a more robust and resilient supply chain solution.

One exemplar of this is Fastenal, whose business in safety equipment sales surged 120% y/y in the month of April after growing 31% y/y in March, and more than offset declines in its other reported business segments due to shutdowns. In part, this was because Fastenal acted preemptively to source and stock safety supplies as the pandemic made its way around the world, but it also demonstrates the longer term higher levels of inventory that many companies may seek to maintain.

Source: Q1 2020 Company Earnings Presentation

Much of the debate in relation to the US trade war with China has centered around nationalistic advantages to manufacturing being done domestically or globally. Many of the difference of opinions on this topic were related to people’s political points of view. But with Coronavirus, we suddenly have examples of the US not having domestic production capabilities for essential items like vaccines, PPE, and other items that were outsourced long ago. Thus, there may well be a surge of global manufacturing capabilities that are brought back to the US as part of companies’ efforts to make their supply chain more resilient to global shocks.

Ecommerce

Obvious: Ecommerce sales will increase rapidly

Less Obvious: Incumbent ecommerce companies may face a significant competitive setback due to Coronavirus.

With the web now being over a quarter century old, it feels late to suggest ecommerce may be the wave of the future. But every indication we are seeing is that every retailer without an online presence is now deploying one asap and so called omnichannel retailers are moving with unprecedented speed to prioritize their ecommerce platforms. Amazingly, Visa said recently that 13 million people in Latin America completed their first ever eCommerce purchase last quarter. Shopify reported that the number of new stores joining its online platform grew 62% between March 13 and April 24, 2020 compared to the prior six weeks. Traffic was growing so fast by mid-April, that Shopify’s CTO, Jean-Michel Lemieux, said that Shopify was now handling 2019 Black Friday traffic levels every day:

The credit card industry tracks transactions based on whether the card is present or not. “Card not present” transactions are when the card is not physically presented to the merchant and while this includes transactions such as when you read your credit card number to a merchant over the phone, most of these types of transactions are ecommerce.

In this chart Visa lays out the growth in payment volumes of both “card present” and “card not present” as well as “card not present excluding travel spending”.

(Source: Visa)

As you can see, “card present” spending was still down nearly 40% at the end of April, while “card not present” transactions were up over 10% and if you exclude travel spending, “card not present” payment volumes were up nearly 30% vs 2019.

And then there is this amazing chart showing the increase in ecommerce as a percentage of retail sales. The last eight weeks has seen the same amount of increased ecommerce penetration as had been achieved over the prior decade (although note that with online sales up and offline sales down due to physical stores being closed, it is very likely that some meaningful portion of this ecommerce market share increase will quickly reverse as physical stores reopen).

Ecommerce does not just mean ordering stuff online that is delivered to your front door a couple days later. We believe ecommerce, paired with the Remote Life trend we described above, will catalyze large shifts in many industries.

For instance, with virtual tours having fully replaced open houses during shelter in place and states doing things like suddenly authorizing digital notarizations as legally binding for real estate sales, it may be that the real estate purchasing experience becomes much more of an online transaction. And even traditional retailers selling things that don’t really work in a delivery context, may start quickly following the lead of digital innovators such as Starbucks to integrate apps, cell phones and other ecommerce tools into the business of selling even those things (like a cup of coffee) that are nearly irrelevant to a more traditional definition of ecommerce.

For instance, as restaurants re-open we could see diners being asked to use their phones to pull up the menu and even place orders via their phone while sitting inside the restaurant. This would reduce the need for diners to touch menus handled by other guests and could allow restaurants to recognize “regulars” and even offer specials or discounts to them.

But again, you cannot just think about the “obvious” beneficiaries. For instance, it seems self-evident that a shift towards ecommerce would be a benefit to ecommerce king Amazon. But new competitive efforts flooding an industry is never good for incumbents. And the massive surge in demand seen by Amazon is by no means unequivocally good as you can see with the company saying on their recent earnings call that all of the earnings from Coronavirus related increased sales would need to be spent addressing the critical issues that Coronavirus has created for the company.

One of those issues has been shipment delays which we believe is likely causing some long time Amazon customers to go look at other options, thus breaking their knee jerk habit of ordering everything from Amazon. As an example of this dynamic at work, the chart below shows a massive increase in Amazon customers reporting a significant delay in shipping times with Amazon customers experiencing worse delays than at other major ecommerce sites.

(Source: Bespoke Intel)

Despite the surge of business during shelter in place, Amazon is now working to recapture the market share they lost.

“As millions more Americans turned to online shopping during the pandemic, Amazon struggled to keep up with the demand, and its rivals pounced. Target’s online sales shot up 141 percent last quarter, while Walmart’s rose 74 percent. Etsy’s were up almost 80 percent in April.

While Amazon’s sales did boom, its competitors’ grew even more. Before Covid-19, orders to Amazon accounted for about 42 percent of online spending in the United States. By mid-April, that had fallen to 34 percent, according to data from Rakuten Intelligence, an analytics firm.”

Digital payments

Obvious: Digital payments will increase.

Less Obvious: Acceptance of cash may collapse at a rate far more than what the consensus is expecting.

Every year consumers use a bit less cash and spend a bit more on their credit and debit cards. This trend is firmly in place, yet cash, a “technology” that has barely evolved over the centuries, remains a meaningful share of how payments are made. A step function shift away from cash may be driven from two separate, self-reinforcing events during Coronavirus.

First, due to the virus being transmitted through human contact, there has been a big increase in people using contactless forms of payment, such as Apple Pay or Google Pay via a watch or phone. Mastercard said on their recent earnings call that contactless payments of this type had increased by 40% in recent weeks.

One thing we know is that contactless payment trends have tended to accelerate greatly in a metro area once the local public transportation system implements this type of payment method. It turns out that when commuters get used to waving their phone or watch to pay twice a day during their commute, contactless payments become a habit and consumers start using them in other venues as well. We expect that the forced “training” to use contactless payments during the outbreak may stick with consumers for good.

In addition, retailers, in an effort to protect their employees, may simply refuse to accept cash when they reopen. We believe that accepting cash actually costs retailers more than the fees they are charged to accept credit cards due to all the indirect costs associated with accepting cash (slower check outs, employee theft, security costs, etc.), yet only a small number of establishments, mostly targeting younger consumers in urban areas, have stopped accepting cash in recent years. So we noted with interest that Nordstrom says they won’t accept cash when they reopen and Whole Foods will limit cash acceptance.

(Source: @pjs77777)

Health Care

Obvious: In a health care crisis, health care companies will do well.

Less Obvious: Coronavirus may accelerate long term shifts in the US health care system in ways that is terrible for the profitability of many health care companies, while being hugely beneficial to a select few.

In early 2017, we laid out our overall framework for investing in health care companies. The main thrust is that we think the current level of very high health care spending per capita in the US paired with health outcomes that put us on par with some developing economies is unsustainable.

Thus, we have only invested in health care companies that we believe both lower the cost of health care and improve patient outcomes.

What Coronavirus is making clear is that the health of our neighbors is indeed very relevant to each of us. Unlike many products and services that are distributed via market forces, health care offers social benefits when it is broadly available. Consequently, we think this crisis will accelerate the shifts in the health care sector we have been expecting.

These changes will need to focus on more preventative care and more care that keep patients out of the hospital, since it is time in the hospital that drives a lot of costs. Health monitoring may be about to go mainstream as people around the globe are tracked to assess any potential Coronavirus exposure. And, we think that companies that can help both individual consumers and the overall health care system monitor health conditions so resources can be deployed efficiently will become hugely important.

While it is difficult to predict the political conditions in the years ahead and how they might impact health care, it seems clear to us that the once “fringe” arguments that we should move to Medicare for All or at least “Medicare for All that Want It” is now very solidly in the mainstream of American opinion.

Realize too that health care companies are at war with the Coronavirus in an effort to support the public good. Will this be profitable? It is not clear. Typically, companies that profit due to supporting war efforts have been called profiteers and faced widespread condemnation.

For instance, it would seem that discovering a vaccine for Coronavirus would be hugely profitable for the company that does it. But will that turn out to be true? Will instead the world demand that the vaccine be distributed at cost or even cheaper to basically everyone on the planet? It is hard to say, but we note that the World Health Organization is already organizing most of the countries in the world and most of the leading health organizations to ensure that that the vaccine once discovered is made available to everyone without regard for their ability to pay.

On the other hand, a company like Masimo, that we have owned for some time, was able to repurpose existing technology to provide remote monitoring of Coronavirus patients to ensure they could stay home if their symptoms are not severe, while making sure that their doctor is alerted if the oxygen levels in their bloodstream should those levels decline, which is a key indicator that the illness has taken a turn for the worse. What’s fascinating about this technology is that even if the company does not make a lot of money using it during the Coronavirus outbreak, it will have proven out the money saving, health outcome enhancing benefits of the health care system shifting towards more outpatient monitoring.

Housing

Obvious: Coronavirus will cause people to flee cities and move to the country.

Less Obvious: No, it won’t. The pandemic won’t last forever, and the urbanization of the world is a mega trend that shows no sign of slowing down.

Even Less Obvious: But wait a second. Maybe people won’t flee cities for health reasons, but maybe the rise of Remote Life opportunities and the huge increase in recent years of the cost of urban living will bring about a major shift in housing preferences as newly full-time remote employees no longer need to live and work in the same area. And thus, can move to lower cost of living areas even while maintaining access to urban job opportunities.

The last hundred years has been a story of urbanization, not just in the US but around the world. We believe that many of the reasons that people need to, or desire to, live in cities will persist. But recent decades have also seen the cost of living in urban areas skyrocket, while the incomes of people living in urban areas have also greatly outgrown the income of people living outside of cities. So, while we don’t think urban environments will see people truly fleeing to the countryside, the combination of Coronavirus, high urban cost of living (especially real estate) and the rise of remote work being more mainstream, may all conspire to drive a surge of demand to live in suburban or exurban locations.

This shift would be very good for the US economy. Suburbs, exurbs and rural environments have more room to build housing and far more affordable housing. Yet these cost savings typically require people to move to places where job opportunities are scarcer and compensation levels are lower. Despite home prices in urban areas, especially along the coasts, rising dramatically, most of these areas have greatly limited the construction of new housing units making the problem even worse. Meanwhile, in much of the country a few hundred thousand dollars will buy you a large, amazing house in a wonderful neighborhood, but with limited job prospects to go with it.

Over the last decade, while home prices nationally have fully recovered their financial crisis losses, the number of home sale transactions has remained stubbornly low. Going into the Coronavirus crisis, transactions were starting to heat up and now, amazingly, according to Redfin’s CEO, housing demand has already recovered to above pre-COVID levels.

(Source: Redfin)

If this trend plays out, it will be fascinating to watch how labor market economics change. Last week, Facebook announced their plans to accommodate permanently remote employees saying they think that within a decade as many as half of their employees would be full time remote. But interestingly, the company said they plan to track where remote employees are living and adjust their compensation downwards if they move to low cost areas.

This policy of setting pay based on regional cost of living is very prevalent today, of course. But prior to the Coronavirus crisis only about 4% of the US workforce worked remotely. If 50% of computer engineering jobs are full-time remote, the practice of adjusting pay based on the IP address from which an employee connects to the company’s servers becomes nonsensical. This is easy to see if you invert the question. Is it reasonable to expect that employees will be able to trigger a raise simply by moving to a higher cost area? If a 24 year old who went to the University of Austin is working for Facebook out of their home in Texas, does it make any sense that if they decide to move back in with their parents in San Francisco that they’ll get a raise? What if they move to Thailand? If labor mobility greatly increases, then the labor market will get more efficient, not less so.

Baby Boom

Obvious: Coronavirus is going to increase the global death rate.

Less Obvious: Coronavirus is going to increase the global birth rate.

Historically, baby booms occur for a combination of cultural and biologically programmed reasons. In the aftermath of a tragic experience such as this pandemic, it’s natural for people to reconsider their goals, priorities, and changing circumstances. One of the important things that come out of an event like this, where people are stuck at home or dealing with potentially grave illness, is the realization of the importance of family, companionship, or simply boredom avoidance. Combined with the ability to move further away from urban areas and increasing affordability in the suburbs, it may well be that we see baby booms around the world. In the US, that may stabilize or reverse the trends of lower than replacement procreation (2019 saw only a 1.7 fertility rate, below the 2.1 needed to sustain a population ex immigration).

There are already early indicators of this sort of response that can be observed from pet adoptions spiking and reports like this charming video of a Florida dog kennel where all of the dogs were adopted for the first time in the kennels history.

In 2018 we wrote about how Millennials, after delaying household and family formation, were beginning to enter the stage of life of buying homes and having kids. In the chart below you can see that the crest of the Millennial generation turns 30 this year and while in the past people had kids and bought homes earlier in their lives, today we have a wall of people sweeping into household formation years with a huge number of 25-29 year olds lined up behind them.

The Decade Ahead

The fact is, we are all still grappling with how the reality of human society and global business will change. Many aspects of life will be unchanged while many others will shift. Most importantly, we think that the time period during which people will change their behavior, specifically to protect their health, will be relatively short on the order of one to three years. But as we have described above, Coronavirus may still be a catalyst that accelerates or even reverses important mega trends. As we gain conviction in what trends will persist and which will prove to be short lived, we will continuously adopt these views into our portfolio management decisions. And, even before we have a high level of conviction in where these trends are headed, to the extent they would present a significant risk to a portfolio holding, we will incorporate that risk, as well as the probability of it playing out, into our analysis

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

Earlier this week, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on CNBC’s Squawk Box Asia to discuss:

  • The “risk off” nature of the current rally
  • Why the Fed Chairman is “begging” Congress to spend more money
  • The unprecedented scope of fiscal stimulus and the new support for deficit spending by political conservatives
  • Why higher dividend yielding stocks are not as safe as some investors think

 
(Direct link to video)

 

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

This is a chart of the S&P 500 over the last five years.

(Source: Bloomberg)

Despite the market being down 12% this year and 16% from its high, many investors feel that this level of decline reflects a far too optimistic outlook given what is going on with the economy due to Coronavirus.

In this post we will offer some context that suggests the market is not nearly as optimistic as it might appear. But do not interpret this post as us saying that current market levels are justified or that the recovery will hold. Dramatic rallies such as the 27% move in the market over the past month have often occurred in the midst of multiyear bear markets.

The most important thing to keep in mind is that S&P 500 is often referred to as “the market,” but of course the S&P 500 is essentially the 500 largest companies in the US, which, especially during this crisis, are not indicative of the economy as a whole. And the largest 25 companies make up nearly 40% of the S&P 500. Here is a list of those companies:

Apple, Microsoft, Google, Facebook, Berkshire Hathaway, AT&T, Johnson & Johnson, Intel, Verizon, JP Morgan, Amazon, United Health, Pfizer, Bristol Myers, Merck, AbbVie, Bank of America, Proctor & Gamble, Cisco, Comcast, Visa, Home Depot, IBM, CVS, Amgen.

Now whatever you think about those companies, most all investors would agree that they are far, far more likely to survive this crisis than the average company. And, in fact, with so many smaller companies struggling it seems very likely that many of these large companies will thrive in a post-Coronavirus world in which their competition has been dealt a huge setback.

So looked at this way, the fact that the S&P 500 is only down 16% from its highs does not suggest that the market thinks the economy will be OK, but rather that the largest companies in the world will see their way though, and as demand returns they will face much less competition.

If instead, the market was reflecting investors being naively optimistic about the economic impact of Coronavirus, then you would expect to see economically sensitive stocks leading the recovery. But the reverse is true.

In this chart from Evercore ISI, you can see that over the past month the best performing segments of the market have primarily been more defensive stocks and those that benefit from low interest rates. While energy stocks have rebounded the most over the last month, it is still the worst performing sector so far this year.

(Source: Evercore ISI)

If investors were really expecting a quick economic recovery, then we would be seeing firms with weaker balance sheets performing well during this rally. But again, the opposite is true as this chart from Goldman Sachs illustrates how the companies with the best balance sheets, protection against economic weakness, are outperforming.

When investors collectively have an optimistic economic outlook, they tend to bid up the price of smaller companies. While smaller companies have more growth potential, they often lack the balance sheets or market dominating competitive positioning to thrive during recessions. And, we can see this concern from investors in this five-year chart of the S&P 600 Small Cap Index.

(Source: Bloomberg)

Not only is the S&P 600 Small Cap Index still down 31% from its high, it is trading at levels first reached in 2015. While the S&P 500 Large Cap Index has seen 0% returns over the past two years, the S&P 600 Small Cap index has seen 0% returns over five years.

We don’t know if the market is fairly valued today. We’re surprised that the market has rallied back so sharply, even before Coronavirus shutdowns have ended in the US. In our March 18th blog post about Coronavirus we noted that the Chinese equity market had begun rallying the day after the shutdowns were implemented in Wuhan and fully recovered all its losses, until it later became clear that the outbreak would spread globally. But while we had seen what happened in China, we wrote at the time, “now to be clear, we are not suggesting we think the decline in the US stock market will reverse over the next month.”

The recovery in the S&P 500 is unexpected. Big rallies, just like big selloffs, are always unexpected. This doesn’t mean it will last. But nor does this rally appear to signal that investors have become irrationally optimistic about the economy.

Instead, it appears this has been more of a “risk off rally” with investors rapidly selling the stocks of smaller companies, those with weaker balance sheets and those with economically sensitive business models, and piling into stocks of larger companies, with strong balance sheets and economically defensive business models.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investments in Blackline and Home Depot and why we expect them to survive and thrive on the other side of COVID-related economic and business impacts.

Excerpt

Arif Karim:

Let’s talk about Blackline next.

Blackline supplies cloud-based software that enables the automation, management, and tracking of manual and repetitive accounting procedures, especially related to a process called accounting closing. This relies on collecting sales and expense transaction data from multiple IT systems within mid-size and large enterprises, matching and reconciling those transactions and posting them into a final ledger that is then used to construct the financial statements of a company.

This process has traditionally been manual with excel spreadsheets sent back and forth between multiple individuals and parties, leading to a process that can be error prone or worse. By automating the process, not only do enterprises increase the speed, efficiency, and transparency of their accounting close process, but they also have an auditable system of record and tracking for compliance and management purposes.

Source: Blackline

All this is to describe just how critical Blackline’s software is to customers. Just as an old adage goes that accountants are needed in good times and bad times to tell you which one you’re in, so it goes for Blackline’s software. In fact, its ability to automate processes means that it also reduces costs in those bad times while allowing companies to act faster in a changing economic environment.

With a 97% customer retention rate and about 110% revenue retention rate, the company’s software is clearly very sticky. But this is a young market and Blackline is the leader, so growth is an important value creation goal. As a result, it rationally invests heavily in sales marketing and R&D to both acquire new customers and grow its footprint of products within its customer base.

We expect that with a recently deepened partnership with SAP in its go-to market strategy, when customers are ready again to focus on faster speed, lower cost, and improved efficiency in the virus’ aftermath, Blackline will be ready to help them do just that with its software solution.

Sean Stannard-Stockton:

Home Depot is a newer addition to our portfolio. However, we’ve followed the home improvement space for many years and we’re particularly excited about the opportunity ahead for Home Depot. In the years since the housing bust, the company has managed to increase revenue by 60% and earnings by 240% even while only increasing their store count by just 2%. This sort of disciplined execution has led to the company exhibiting returns on invested capital far above most other established retailers, although Starbucks, another holding of ours also generates very high returns on capital.

As discussed during my comments on First American, we do expect housing activity to come to a standstill in the near term. However, Home Depot is deemed an essential business and their stores remain open. With ultra-low interest rates enabling cash out refinancing and with a home owner’s deck that needed repairs prior to Coronavirus still needing to be repaired after this is over, we expect an explosion of pent up demand to come back to the home improvement sector when the crisis has passed. Just as housing transactions were growing rapidly in January and February, most leading indicators of home improvement activity were also accelerating going into this period.

Source: Home Depot

As anyone who owns a house knows, it is often easy to overlook cosmetic issues in a house you’ve lived in a long time or defer maintenance on small items. But after being stuck in their homes for a month or two, it would not surprise us at all if many homeowners emerge with a long list of items they want to fix. And while Home Depot is the leader in their category and we feel confident they can get through this crisis, the same cannot be said of the large number of local hardware stores which collectively still have a meaningful portion of home improvement market share.

2020 is going to be a highly unusual year. Exactly how it plays out is not knowable. But for those companies that can get through this year, and we think every one of our holdings is among that group, the years ahead will be unique in the degree to which weaker competitors have been swept aside and the opportunity for market share gains for the remaining, undamaged market leaders will be unprecedented.

You can read the full transcript here.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investments in Fastenal, Chipotle, and Intuitive Surgical and why we expect them to survive and thrive on the other side of COVID-related economic and business impacts.

Excerpt

Arif Karim:

Lets talk about Fastenal next.

Fastenal is a distribution service business for industrial manufacturing companies in the US. They make it possible to economically and efficiently move lots of small, heavy, high volume, low value parts across vast distances from Asia to the US and then coast to coast. These include things like screws and rivets to gloves, tools, and janitorial supplies. Its network of 2,100 free-standing company stores, 1,100 stores onsite at customer factories, and 100,000 vending machines at customer facilities creates a vast embedded distribution network that physically maintain the company’s relationship with its customers on a daily basis as a critical part of their manufacturing operations.

Source: Fastenal

However, in this time, we know that manufacturers of all sorts of physical goods that are non-essential in the present moment are taking a big hit to demand. But many of these products wear out over time, need refreshing, repair, or fulfill new needs in consumers’ and business’ lives. As life returns to normal over time, whatever that new or old normal may look like, we know that consumers and businesses will have a pent up demand to fill or replace those product needs. Exactly what products they will need to fill is unknown at this time, but because Fastenal serves thousands of manufacturing customer across industries, Fastenal’s services will be needed and will shift to fulfill where the demand is.

The key to benefiting from this resurgence in the future will be the ability to serve customers well as they ramp up their production. We estimate it would take a sustained revenue decline more than twice as deep as was seen during the Great Recession for the company’s profits to fall to zero while a strong balance sheet can tide the company through an extended recessionary period.  On the other hand, the company’s strong culture and renowned service performance mean that it can leverage its balance sheet strength to continue investing in new customer relationships and distribution categories while weaker competitors in this very fragmented market are caught on their back foot over the next few quarters.

Todd Wenning:

Competitive moats are not common in restaurants. Margins are typically low, and customers are fickle. But if you drive down Main Street America, you’ll find that most of the national chains you grew up with are still around. One thing we’ve come to appreciate is how difficult it is for a restaurant concept to emerge from local or regional prominence and onto the national stage. But with that national scale comes myriad benefits including spreading advertising dollars over a wider base of stores and bargaining power with suppliers and delivery aggregators.

It’s particularly difficult to scale freshly prepared food with no freezers, preservatives, or microwaves. This is one reason why we believe Chipotle is an exceptional business and started building a position in the first quarter. Indeed, it was in trying to scale freshly-prepared, quickly-served foods that Chipotle experienced the major risk of the process, namely foodborne illness. It’s hard to overstate the impact of the negative headlines that followed in 2015 and 2016. That event would have destroyed most restaurants, but not Chipotle. The company improved food handling processes and aggressively sought to win back customer trust and was successful.

Source: Chipotle

Operating company-owned restaurants (as opposed to franchises) allows Chipotle to adjust quickly to changes in the market. We were impressed, for example, by how quickly the company mothballed its planned Queso Blanco marketing plan to offer free delivery during March and April to reach customers staying home. To that point, Chipotle’s delivery and mobile order capabilities are exceptional because most of its locations have second lines to prepare mobile orders without complicating the in-store order process. In addition, about two of every three Chipotle orders are bowls, which travel better than most other quick-serve foods. Suffice it to say that Chipotle is well positioned to capitalize on delivery and mobile order trends. Before COVID, we believed Chipotle customers would slowly shift toward more digital orders and pickups – Chipotle’s highest margin order type – and delivery. Post-COVID, we believe this trend will accelerate now that more customers became used to mobile ordering during their time in quarantine.

The coming months will undoubtedly be challenging for Chipotle. Fortunately, Chipotle has a solid balance sheet with no debt. Indeed, while Chipotle qualified for government assistance through the Paycheck Protection Program, it turned down the offer. Because of Chipotle’s financial strength, we think COVID-related commercial real estate turmoil will allow Chipotle to accelerate its store buildout into excellent locations at attractive lease terms.

Before I hand it over to Arif, it’s worth noting that both NVR and Chipotle are partially exempt from business shutdown rules because both are considered essential services.

Arif Karim:

Intuitive Surgical makes robotic minimally invasive surgical systems and tools. For any of you who have watched a popular medical series in the past 5 years, you’ve probably seen an image of this 4-armed robot hovering over a patient with long pointed tools at their ends.

Source: Intuitive Surgical

In a very real sense, Intuitive’s DaVinci surgical robot allows the surgeon to gain bionic powers while improving patient outcomes. From a patient perspective, the use of previously unavailable minimally invasive surgery for traditionally open surgeries means lower infection rates, lower blood loss, quicker recovery, and lower complication rates. For the surgeon, instead of leaning over the patient and using physical strength and stamina to manipulate a patient’s tissue for hours, she sits off to the side looking into a console and controls the robot remotely with her hands and feet, which does all of the manipulation work on patients with precision, better articulation, and haptic feedback. In addition, the 3D HD endoscope attached to one of the robotic arms gives the surgeon “bionic” vision allowing for better magnification and more precise visualization with the help of fluorescent dyes to identify targeted surgical areas. A new set of augmented reality technologies will take visualization further by layering radiologic images over the endoscopic view to further improve surgical performance. AI will take performance even further, assisting surgeons’ real time operative decisions by incorporating historical kinematic data culled from millions of previous cases.

With a two decade lead in robotic surgical development, over 7 million cumulative procedures conducted, and tens of thousands of surgeons trained and experienced using the DaVinci, Intuitive Surgical is in a unique position in the future of robotically assisted surgery. It is highly profitable, and it has nearly $6B in cash on the balance sheet with no debt. While the pressure of COVID-19 patient care in the near term will impact the performance of all other elective surgeries, we believe the critical nature of most of these (about half are cancer removals) means they can only be delayed for a few months. When hospitals are able to once again normalize their patient care, Intuitive is likely to see a strong resurgence in growth of its procedures and shipments of new systems to accommodate them.

You can read the full transcript here.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.