As discussed on our Fall 2018 conference call, we owned shares of pet insurance company Trupanion in our core equity strategy. In July, we sold our shares prior to Trupanion’s earnings and wanted to provide an explanation of that decision.

Trupanion was an “emerging moat” position in our portfolio. With emerging moat businesses, we are looking to be early investors in companies that are in the process of establishing durable competitive advantages. Given the higher uncertainty around emerging moat companies, they are intentionally small positions in our portfolio.

The ideal situation is to own a Rule Breaker on its way to becoming a Rule Maker.

Netflix is a perfect example of this dynamic. For most of its history, Netflix was breaking the rules of traditional media on its way to becoming the first global scale media company. Having proven that model, legacy content creators like HBO and Disney are trying to replicate it.

With Trupanion, we expected something similar to happen over the next decade. In fact, we continue to believe that Trupanion offers a superior pet insurance product. Some of us are happy Trupanion customers.

In recent quarters, however, we grew concerned about Trupanion’s ability to communicate its value to pet owners and win market share. Over the past two years, for example, Trupanion’s subscription pet growth trailed the industry growth rate, as defined by the North American Pet Health Insurance Association (NAPHIA), after years of outperformance.

Source: Trupanion filings, NAPHIA State of the Industry Reports; Year-over-year growth

We anticipated an “S-Curve” in North America pet insurance as it becomes more accepted by vets and pet owners. And that seems to be happening. Yet, Trupanion’s subscriber growth has not accelerated in step. In fact, at Trupanion’s recent investor day, management slightly reduced its subscription pet guidance for 2019 and 2020. When there are industry tailwinds, emerging moat companies should further their lead from the pack.

Now, it could be argued that competitors are underpricing their policies to win share in an unsustainable fashion. (To be sure, Trupanion’s market share as a percentage of revenue held up.) Trupanion’s policies tend to be expensive – often much more so – when comparing quotes with other insurers.

The reason Trupanion is pricey, however, is it has more generous payouts – Trupanion’s loss ratio is 70% versus the industry average of 50%. Trupanion also uses its large database to determine monthly cost of care for a certain pet of a certain age in a certain zip code and then adds a 30% premium. It’s a straightforward and fair approach to pricing.

But this cost-benefit tradeoff is difficult to communicate to consumers, most of whom only realize the value of their insurance plan when they need to make a claim. It’s not like other consumer services where the value proposition is felt on a daily, weekly, or monthly basis.

For owners of “unlucky” pets, the Trupanion value proposition is fantastic, but it’s not as obvious for “lucky” pet owners who don’t file many claims and are paying high relative premiums. To this point, in Trupanion’s 2018 shareholder letter, CEO Darryl Rawlings noted that “general dissatisfaction” was the number one reason for policy cancellations and “90-day cancellation” was number three, behind pet death. And Trupanion, of course, needs lucky pet premiums to offset the unlucky pet claims.

A major part of our thesis was Trupanion’s advantage having “active” referral relationships with nearly 10,000 North American veterinary hospitals and its success at installing its automated claims software, Trupanion Express, at 4,000 hospitals. Other pet insurers have tried to replicate Trupanion’s vet-focused salesforce (Territory Partners) and failed, which was a sign to us that this could be a moat source for Trupanion.

While vet offices are not allowed to solicit insurance, Trupanion’s Territory Partners encourage vets and office staff to start asking new pet owners who their insurance is with and start a conversation about insurance. As discussed on our call, pet insurance can be a win-win for all parties, so it’s a healthy conversation to have.

Consequently, Trupanion is likely the first brand on many vets’ minds as they talk about pet insurance with new dog and cat owners. Indeed, Trupanion management said they believe they are generating most of the industry’s leads through vets starting conversations about pet insurance.

This made us even more concerned about the slowing unit growth rate. Why is Trupanion not outpacing the industry when it is the first name many pet owners hear? It could be that pet owners hear about pet insurance from their vet, go home, compare prices, and choose a more affordable option. It’s not an impossible problem for Trupanion to solve, but again, consumers don’t typically understand insurance value until they file a claim.

Additionally, while management is important at all companies, it is particularly important at emerging moat businesses where executives must proactively create a moat that does not yet exist. One reason for our previous confidence in Trupanion was founder Darryl Rawling’s mission-driven leadership. Darryl is a visionary leader who passionately advocates for responsible pet ownership, thinks long-term, and built a company with a wonderful corporate culture. His shareholder letters are always worth a read.

We had assumed that Rawlings would lead the company for at least another 10 years, as did Dan Levitan of Maveron (an early and ongoing Trupanion shareholder), who during a 2017 Motley Fool interview alongside Darryl said, “(Darryl will) do this for the next 15 or 20 years.”

But at an investor event we attended a few months ago, Darryl said that he was making plans to switch to an executive chairman role in 2025. While we understood Darryl’s choice on a personal level, it also sharply increased our uncertainty around whether company management will be able to successfully build a moat and transform pet insurance as we had hoped. In our opinion, Trupanion will continue to need a visionary leader in the CEO role and finding another visionary to replace Rawlings will be a massive challenge.

There were other concerns that led to our sale, but it’s worth noting that none of them were related to the popular short cases against Trupanion. (Trupanion is one of the most heavily-shorted companies in the U.S. market.)

As discussed in our call last autumn, many Trupanion short sellers think regulatory matters will bring down Trupanion’s business model. Pet insurance remains a tiny slice of the personal lines insurance industry – in fact, it’s so small it currently exists under the “Inland and Marine” classification.

Given the industry’s rapid growth, we think it’s perfectly normal for both regulators and pet insurance companies to have some growing pains. While Trupanion has been fined, faces more state investigations, and admits it should have paid more attention to regulators as a stakeholder, we considered these matters minor to our thesis. Regulators may require Trupanion’s Territory Partners to be licensed in all states, but this is more like a speed bump rather than a roadblock.

Ultimately, what brings down insurance companies is either they are insolvent or scamming their policyholders. Neither is the case for Trupanion or its profitable wholly-owned underwriter, American Pet Insurance Company. Our two visits to Trupanion headquarters made it clear that employees care about pets. Indeed, most of the customer service representatives had their own pets sitting next to them in their cubicles.

Trupanion is a good business and could very well make us look dumb for selling it. We lost faith, however, in the company’s ability to reach Rule Maker status in a highly-competitive and nascent market where value proposition communication is a challenge. As such, it no longer fit our definition of an “emerging moat” business and we decided to sell.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix (NFLX). This company represents 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.

Yesterday, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on CNBC to discuss the recent flaring up in the US-China trade war. The excerpt below is part of the extended interview.


Click here to see the video if you are reading this in your email.

You can read an in depth discussion of how Ensemble is managing risks related to the trade war here or watch one of Sean’s previous CNBC appearances in which he discussed the types of companies we think are best positioned to deal with tariffs.

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.

Weekend Reading

27 July 2019 | by Mike Navone

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Soon Your Phone Will Be Your Driver’s License, MetroCard and More (Joanna Stern, @JoannaStern, The Wall Street Journal)

These days it seems like we have a card for everything including our driver’s license, gym membership, credit cards, and many more.  Because of our expanding wallets, several companies have been seeing big success in selling slimmer and more compact versions of the wallet.  To take this concept a step further, the evolution of the digital wallet continues to progress and Delaware in particular is piloting a program for digital driver’s licenses.  Digital payments known as “contactless” are the normal method of payment in many metropolitan areas throughout Europe and this is expanding in the US.  This article discusses the progression of the digital wallet and what’s to come in the future.

Rare Nike Trainers Sell for More than £350,000 (BBC News)

A Canadian shoe collector is the proud new owner of a pair of Nike trainers for the bargain price of $437,500!  The shoes are an incredibly rare pair that were handed out to Olympic runners in 1972 and this particular pair is the only one that is thought to have never been worn.  The auction predicted that the shoes would sell for $160,000 and to give context, the second highest price achieved for a pair of shoes at a public auction was for a pair of 1984 Converse trainers signed by Michael Jordan for $190,373.

American Suburbs Swell Again as a New Generation Escapes the City (Valerie Bauerlein, @vbauerlein, The Wall Street Journal)

Many US metropolitan city centers have been seeing increases in job growth which has led to more people moving into already crowded cities.  With the influx of new people, also comes more traffic, impacted schools, and higher prices.  For many, this is enough to move their home search to the suburbs where you can get more space for your money.  As this trend continues, we can now see that some suburbs account for the fastest growing US cities.  This article examines the trends of millennials as well as where major employers are looking to base their main offices.

Mutually Assured Disruption in Silicon Valley (Justin Lahart, @jdlahart, The Wall Street Journal)

Silicon Valley is known for its innovation and for some of the world’s most iconic disruptors.  Because of this, the valley is rich with venture capitalists looking for the next big thing.  But what happens when venture capital frees so freely that the beneficiary company’s focus shifts away from innovation and more towards beating your competition.  This article explores some of the major disruptors as well as several companies that have had significant cash injections but fail to survive.

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.

“No one buys a quarter-inch drill bit because they need a quarter-inch drill bit. What they need is a quarter-inch hole.” -Ted Levitt, Marketing Myopia (1960)

When you buy a product you evaluate the reasonableness of the price based on two metrics 1) how valuable the product is to you personally and 2) your assumption of how much the product cost the seller. We generally only think much about the first metric. In general, we assume that the markup of what we pay vs what the seller paid must be reasonable since we live in a generally free market system. But when competition is limited, we sometimes perceive that we are being taken advantage of and that the markup in price is unreasonable.

Personally, I find myself extremely annoyed buying beer at a baseball game. Since I’m free to buy or not buy a beer, you would think that if I buy one then I must find the price reasonable. But due to the limited competition inside of a stadium, the price of a single beer at a San Francisco Giants game is more than the price of a six pack of the same beer outside of the park and for whatever reason, breaking that threshold causes me to simultaneously believe the price is outrageously inflated even as I make a purchase and thus validate that the price is less than what the beer is worth to me.

Interestingly, people tend to evaluate the price of services differently. Adding a new subscriber to Netflix for instance has near zero cost to the company. Yet few people think that means they should allow new subscribers to sign up for free. Services don’t have the same type of visible cost of goods sold and therefore super high gross margins don’t tend to bother their customers.

Sometimes a company that appears to be selling a product is actually selling a service and in these cases a superficial analysis of the profit margins can make them look unsustainably high or even exploitative.

Here’s an example from my own life:

My dishwasher kept breaking. The washing mechanism worked just fine but every six months or so, the little plastic piece that stops the top shelf when you pull it out kept breaking. This made the dishwasher essentially unusable as one side of the top shelf would hang down. It is an older model that came with the house and is no longer in production.

But guess what? While a new dishwasher would cost me around $400, after googling around for a bit I found a company that sells parts for out of production consumer appliances. I ordered a couple of these and now my dishwasher works great with a very simple one minute replacement of the plastic part when it breaks.

The part cost me $7.56. What would you guess it costs to make the product? It is a small piece of injection mold plastic. We’re talking pennies to make. But I was thrilled when I found the part. Why is this? The part saved me from needing to buy a $400 dishwasher (and finding a new one that fits the built in space under the kitchen counter).

The gross margin on the part is likely over 99%. Or in the language sometimes used by government accountability agencies, the “profit percentage” (or mark up over cost) is around 15,000%.

Is this an outrageous profit margin? As a consumer, I was excited when I found the product and realized I could fix my dishwasher so cheaply. I didn’t feel taken advantage of. I felt glad to have found this random online part seller of out of production appliance parts.

The $7.56 isn’t what I’m paying to obtain a part that costs pennies to make. $7.56 is the price I’m paying the company for the service it is providing me of keeping in stock out of production aftermarket parts that are very low cost but mission critical to the functioning of a much more valuable item.

Would it be good if there was more competition and I could have picked from a range of providers and gotten a cheaper price? Sure. But as a consumer I don’t really expect that there is going to be a vibrant market for aftermarket appliance parts. Seems like a super boring business. I can’t imagine many startups wanting to get into the business of producing these.

If I found out that an apartment complex manager was able to bulk order 100 of these units for $189.00 or a unit price of $1.89, I wouldn’t think that because I was paying $7.56 a unit that meant the company was jacking up prices by an outrageous amount. It also makes perfect sense that I would pay $7.56 for one aftermarket part even while the maker of the dishwasher was able to obtain these parts for pennies.

A couple years ago we wrote about how we seek out competitively advantaged companies that delight their customers rather than those who use their competitive advantage to exploit their customers through overcharging. I can’t say I was “delighted” by paying $7.56 for a piece of plastic that cost pennies to make. But I was delighted to have paid $7.56 to avoid needing to buy a new dishwasher.

When people not party to a transaction examine it, they sometimes misunderstand the nature of the transaction. The company that sold me the part for my dishwasher isn’t in the business of selling expensive parts, they are in the business of selling super cheap fixes for older appliances. As we described in a post earlier this year, understanding what a business really sells is critical to investment analysis. Nike doesn’t sell shoes, they sell self-identity. First Republic doesn’t sell banking services, they sell reduced time and frustration spent dealing with your money. TransDigm doesn’t sell airplane parts, they sell airlines on-time departures and thus happy passengers.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Nike (NKE), First Republic (FRC), Netflix (NFLX), TransDigm (TDG). This company represents 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.

Investors who’ve studied the works of Warren Buffett and Peter Lynch know that so-called “boring” stocks can present wonderful investment opportunities.

There’s something to it. In Lynch’s One Up on Wall Street, for example, he writes, “Blurting out that you own Pep Boys won’t get you much of an audience at a cocktail party, but whisper ‘GeneSplice International’ and everybody listens.”

Boring companies typically don’t make for media darlings. Often there’s not much variance in quarter-to-quarter or year-to-year growth – due to high recurring revenue, pricing power, etc. – so there isn’t a lot to debate.

In a 2013 paper, the British asset management firm, Fundsmith, set out to explain how and why boring companies are consistently undervalued.

As the below chart shows, people tend to be overconfident in low-certainty events (e.g. lottery tickets) and underconfident in higher-probability events (60-80% certainty). As certainty approaches 100% (e.g. a Treasury bond), people become more correctly confident.

Source: Fundsmith

Many high-quality, low-volatility stocks find themselves in the 60-80% certainty category. As Fundsmith wrote, these stocks “have regular bond like returns and low share price volatility but they are still stocks with uncertainty about share price and dividend payments whereas bonds have the relative certainty of redemption values and coupons.”

Put another way, this set of businesses is about as fundamentally certain as you can get in the market, but investors have systematically underinvested in them relative to their level of certainty.

To be sure, patient investors in boring stocks have been handsomely rewarded. From June 1990 through mid-July 2019, the S&P 500 Low Volatility Index outperformed the overall S&P 500 Index by about 100 basis points per year (11% vs. 10% CAGR).

Source: Bloomberg, as of July 16, 2019. Normalized, total returns.

Now, during most bull markets, you would expect economically-sensitive, high-volatility stocks to outperform low-volatility stocks, as they did from December 2002 to October 2007, as measured by the S&P 500 High Beta Index (purple line) vs the Low Volatility index (white line).

Bloomberg, as of July 17, 2019. Normalized, total returns.

Yet here we are today, riding a 10-year bull market and hitting all-time highs, and low-volatility companies continue to crush high beta names.

Bloomberg, as of July 19, 2019. Normalized, total returns.

Don’t get us wrong – at Ensemble, we also love boring, defensive companies flying under Wall Street’s radar. They often have economic moats and get stronger during recessions.

Yet some of these companies’ valuations have been challenging to justify. In August 2016, for instance, we wrote about former holding WD-40 being a case study of the “bubble” in safe stocks.

Remarkably, since we wrote that post three years ago, WD-40 has further expanded its already-lofty P/E multiple and outperformed the S&P 500. In 2016, we would have considered this a low probability outcome, but here we are.

Bloomberg, as of July 16, 2019

WD-40 isn’t alone. As of this writing, the broader S&P 500 Low Volatility Index P/E (blue line) is four full turns above the S&P 500 Index P/E (brown line).

Bloomberg, as of July 16, 2019

So what might be going on here? Why are boring stocks trading with such high multiples?

We offer three suggestions:

First, as we argued in our 2016 WD-40 article, investors might be placing a premium on “safer” equities due to bad memories from the financial crisis. Having experienced 30%-50%-plus drawdowns in 2008 and 2009, many investment managers don’t want to mis-time cyclical stocks and look foolish when their peers are hunkering down in safe stocks. Some amount of herding behavior is at play.

Second, index funds, ETFs, and quantitative screens have changed the game. While active fund managers in Lynch’s day (the 1980s) were worried about bad window dressing by holding boring companies, machines are narrative agnostic. Machines could care less if Stock A is boring or exciting – they see businesses as a set of data points. Because boring businesses often have attractive fundamentals, they might get more demand from passive investors seeking quality, low-volatility, and/or dividend yield factors than they otherwise would with active managers.

(As we were researching this article, we found it notable that the S&P 500 Low Volatility and High Beta Indexes were launched in April 2011, just two years after the market bottom.)

Third, the continuation of the low interest rate environment. We think the debate between a return of the Old Normal or getting stuck in the New Normal is a critical one for investors to consider. If we are moving back to an Old Normal (a “normalization” of inflation, higher rates, etc.) then boring stocks are massively overvalued; however, if we’re stuck in a New Normal (persistent low rates, low inflation, etc.), boring stocks, along with the rest of the market, may be fairly- to undervalued, albeit – and this is a key point/trade-off – with expected equity returns below long-term historical averages.

Indeed, if you’re buying low beta/boring stocks at currently-lofty valuations, you’re making an implicit bet that rates will remain low and that future equity returns will be lower than historical averages. We’ve found we’d have to drop our cost of equity assumptions well below 9% to make current valuations work on some low-beta/boring companies.

All three factors are at play, with interest rates playing the largest role in boring stock valuations. In a low rate environment, the opportunity cost for that extra 20-30% certainty (illustrated in the chart earlier in this post) drops. If you’re getting 2% on 10-year government bonds with 100% certainty, you’re more willing to increase your bet on 70-80% certainty in the hope of getting 5-7% annualized returns. The systematic undervaluation of 70-80% certainty names gets “corrected” in a low-rate environment.

Our opinion is that we’re more likely to return to Old Normal than New Normal, though we’ve heard compelling arguments for both cases.

We have a bullpen of boring, high-quality companies that we’d love to buy at a better price. Though our concerns in 2016 turned about to be early and wrong on a few of them (WD-40 being one), we also know that even great companies can be lousy investments if you pay too much for them.

Boring stocks are beautiful, but only at the right price.

 

 

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.