A great civilization is not conquered from without until it has destroyed itself from within. – Ariel Durant

Traditional competitive analysis focuses on external threats.

The most famous framework, Porter’s Five Forces, for example, looks at:

  • Competitive rivalry
  • Supplier power
  • Buyer power
  • Threat of substitution
  • Threat of new entry

All of these factors analyze what’s going on outside the company and how the company fits in its competitive ecosystem.

Even the concept of an “economic moat” suggests that companies should be fortifying themselves against threats from without.

 

Expectations

Of course evaluating external threats is critical, but we believe that moat erosion typically begins behind castle walls.

Only after the company loses customer focus, gets lazy, or gets weighed down by bureaucracy, do competitors have a chance to destroy the incumbent’s moat.

In The Founder’s Mentality, Bain & Co.’s Chris Zook and James Allen write that corporate stagnation is “An internal problem caused by growth. Ninety-four percent of large-company executives cite internal dysfunction as their key barrier to continued profitable growth…As companies grow in size and complexity, they lose the dexterity and the flexibility they need to sustain growth.”

To illustrate, the common perception of Kodak’s downfall is that the company was slow to react as competitors launched the digital photography revolution. This is partially true. In fact, Kodak patented the first digital camera in 1978. Kodak just refused to market it, lest digital sales ate away at their high-margin film sales. Kodak’s moat erosion started from within.

To be sure, understanding internal dynamics is challenging for outside investors. (Perhaps that’s the reason researchers focus on more observable and measurable external dynamics.) Even boards can fail to recognize internal problems, which is why activist investors have a place in the market.

Yet we think it’s essential to get a big picture view of a company’s values, mission, and work environment. This matters for both “defensive” and “offensive” reasons.

On the defensive side, we want to own companies we believe will maintain (and ideally widen) their economic moat for the next decade and beyond. If we believe the company is culturally agile, run by exemplary stewards of capital, and cares for all its stakeholders, then we’ll be more confident it can keep competition at bay. However, if one of our companies is rotting from the inside, we want to get out as soon as possible.

As for offense, we like passionate companies that are sieging a castle that’s crumbling from the inside.

Reality

In 2016, for example, we concluded that Time Warner favored protecting its dividend over competing with Netflix on streaming. As such, we exited our position in Time Warner. We had been following Netflix closely, but had not built enough conviction in the strength of their moat to invest in the company. With Time Warner having trouble behind its castle walls, our conviction in Netflix’s ability to attack the profit stream of linear TV increased and we established our initial investment in the company.

Shortly afterwards, Time Warner threw in the towel and sold themselves to AT&T. Here’s what Sean wrote in an October 2016 post after Time Warner agreed to be acquired by AT&T.

While Time Warner has put resources behind HBO NOW and it has had some success in building a direct distribution business, the management team has seemed to believe that it is more important to protect their legacy business and their $1.3 billion annual dividend rather than invest aggressively in preparing their business for the transition to streaming.

By selling to AT&T, Time Warner is waving the white flag and admitting that Netflix has become HBO before the company could become Netflix. Therefore, their best option is to sell to a distributor like AT&T, which itself needs content to compete effectively against Netflix and other streaming platforms.

It’s behaviorally difficult for incumbents to innovate when it puts their cash cow at risk. While these companies are protecting their own interests, they are often doing so at the expense of their customers who want or need innovation.

As Professor Thales Teixeira writes in a recent Harvard Business Review article:

Disruption is a customer-driven phenomenon. New technologies come and go. The ones that stick around are those the consumers choose to adopt. Many of the fast-growing startups such as Uber, Airbnb, Slack, Pinterest, and Lyft don’t have access to more or better innovative technologies than the incumbents in their respective industries. What they do have is an ability to build and deliver faster and more accurately exactly what customers want. This is causing the change-of-hands of sizable amounts of market share is relatively short periods of time. 

And while Warren Buffett coined the phrase economic moat and painted the picture of companies fortifying themselves in the midst of unbridled competition, he made clear in his 2005 shareholder letter that what goes on behind the castle walls is what makes or breaks a moat.

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now.

It’s when companies take their focus off the customer, mission, and operational execution that challengers get an opportunity. And in today’s hyper-competitive world, it’s more important than ever that companies are internally strong and ready for a fight.

The better we can identify internal strengths and weaknesses in the companies we research – and their competitors – the better we believe we can play smarter defense and offense in the portfolio.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix. 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.

The last scene of the 1967 movie The Graduate is one of the most iconic in film history. Benjamin, played by Dustin Hoffman, rushes into the church where his beloved Elaine, played by Katharine Ross, has just been married. He bangs on the glass overlooking the altar, yelling “Elaine!” until she decides to rebel against her family and rush out of the church with Benjamin.


Laughing all the way, Benjamin and Elaine chase down a city bus and take a seat in the back. The movie ends as Benjamin and Elaine’s faces slowly turn from joyous to contemplative. The adrenaline rush has faded. The rebellion is over. Reality has set in.

Now what?

Starbucks faced a similarly sobering moment in early 2007.

In his 1997 book, Pour Your Heart Into It, Starbucks founder Howard Schultz wrote:

“What we proposed to do at Il Giornale (Schultz’s company that acquired Starbucks Coffee Company in 1987)…was to reinvent a commodity. We would take something old and tired and common – coffee – and weave a sense of romance and community around it. We would rediscover the mystique and charm that had swirled around coffee throughout the centuries. We would enchant customers with an atmosphere of sophistication and style and knowledge.”

In the 1980s, this mission would have sounded far-fetched and naïve, but Starbucks delivered. From 1997 to 2007, it grew from fewer than 1,000 stores to 13,000 – a pace of about 3.3 new stores per day, on average.

But by February 2007, trouble was brewing at Starbucks. So much so that now-chairman Howard Schultz wrote the following in a memo to CEO Jim Donald:

“We have had to make a series of decisions that, in retrospect, have lead (sic) to the watering down of the Starbucks experience, and, what some might call the commoditization of our brand…Some people even call our stores sterile, cookie cutter, no longer reflecting the passion our partners feel about our coffee…Let’s be smarter about how we are spending our time, money, and resources. Let’s get back to the core. Push for innovation and do the things necessary to once again differentiate Starbucks from all others.”

Starbucks was at a turning point. It was probably right about here in terms of its competitive life cycle.

If something didn’t change, Starbucks’ returns on invested capital (ROIC) would start to fade toward its cost of capital – and rather quickly.

Source: Bloomberg

As Motley Fool co-founders Tom and David Gardner wrote in their 1999 book, Rule Breakers, Rule Makers, “Business is as simple as changing the rules at the beginning and then making the rules at the end.”

By any measure, Starbucks in 2007 had changed the rules. It had reinvented a commodity and redefined coffee culture in the U.S.

But then what?

Starbucks was now making the rules. And being a rule maker is a totally different game – culturally, competitively, and operationally – from being a rule breaker. Now you’ve got upstarts aiming to disrupt your business. Now you’ve got a castle and moat to protect.

And it’s in the rule maker stage where companies can slip into complacency. Margins are fat, cash flow is copious, and everyone at the company is doing well financially. Even a little rest, a moment to smell the roses, can be enough to open the door to new competitors in today’s market.

This is what Jeff Bezos was talking about in his 2016 letter to Amazon shareholders when he emphasized the importance of it remaining “Day 1” at Amazon:

“’Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.’ To be sure, this kind of decline would happen in extreme slow motion. An established company might harvest Day 2 for decades, but the final result would still come.”

Despite this clear risk, it’s also in the rule maker stage that ROIC machines shine. The market justifiably bets that at most firms, bureaucracy and complexity will creep in and push ROIC toward cost of capital.

Exceptional companies – the kind we want to own – recognize the long-term threat of bloat and bureaucracy and continue to innovate and disrupt themselves. This helps them maintain (and ideally strengthen) their competitive advantages and fight against ROIC fade.

From an investment standpoint, this transition from rule breaker to rule maker should not be taken lightly. Most companies will struggle with it, so we need to be attentive.

In fact, we think two of our holdings – Google and Netflix – are working through this stage right now. Both are in a “Now what?” phase. Some of Google’s recent and well-publicized internal discord is evidence to us that the company is in a soul-seeking moment. And Netflix, long the rebel in the media industry, is now the standard by which all streaming services measure themselves.

We know with the benefit of hindsight that Starbucks turned out to be just fine. Howard Schultz returned as CEO in 2008 and reinvigorated the business. While the outcome was far from assured, Starbucks was culturally agile, innovative, and growth minded. ROICs not just stabilized from 2006 levels, but dramatically improved.

Source: Company filings and Ensemble Capital estimates

Like Starbucks, Google and Netflix have strong corporate cultures, have proven to be innovative, and haven’t settled for their current market position. We believe the combination of these factors increases the odds that both companies can fight through the rule breaker to rule maker transition and deliver attractive long-term performance.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Starbucks (SBUX), Alphabet (GOOG), and Netflix (NFLX). 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.

Weekend Reading

1 June 2019 | by Mike Navone

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

Future of Driverless Deliveries Depends on Large Auto Makers (Kelsey Gee, @kelseykgee, The Wall Street Journal)

We live in an on demand society with things like our dry cleaning and grocery delivery just a few clicks away from being delivered to our doorsteps.  All of these on demand services still have a human component that can be a big contributor to driving the price up.  Mountain View, CA based robotics company Nuro is advancing technology to try and reduce the human component by creating tiny self-driving delivery robots.  Nuro acknowledges the complexities and the sky high cost of developing this technology and they’re teaming up with large car makers to advance the project.

How Mastercard and Visa are Beating the Tech Giants at Their Own Game (Tae Kim, @firstadopter, Barrons)

Back in 2013 Apple was hinting about a revolution of the “mobile wallet” but 18 months later, little progress had been made.  Instead of starting from scratch, Apple decided to partner with major credit card companies: Visa, Mastercard, and American Express.  The integration of mobile payments into iPhones enabled users to easily pay for items with touching their phone to a compatible card reading device.  Many consumers also took Apple’s partnership as an endorsement of these companies and their stocks have continued on an upward trajectory for the past several years.

Amazon, in Need of Drivers, Turns to Its Employees (Jennifer Smith, @jensmithWSJ and Kimberly Chin, @MsKimberlyChin, The Wall Street Journal)

As Amazon continues its explosive growth and demand for online orders they’ve now run into the problem of finding enough delivery drivers to meet the number of rapidly increasing orders.  Amazon is still heavily reliant on FedEx and the US Postal Service for delivery and Amazon has now taken a step to expand their own delivery operations.  Amazon is offering an incentive to their employees and will pay $10,000 and three months of salary if they start their own delivery business.  “FedEx and UPS have played down the threat of Amazon delivering more packages itself, saying the online giant still needs to use the established delivery giants to ship many of its packages.”

Fed’s Patience Tested as Trade Spat Clouds Growth Outlook (Nick Timiraos, @NickTimiraos, The Wall Street Journal)

Continuing tensions of a trade war between the US and China paired with potential new tariffs on Mexican imports has the market wondering about the impact to the US economy.  Some investors are concerned that a trade war will hinder growth and many bond investors are questioning if this could lead the central bank to cut interest rates in an attempt to spur economic growth.  Fed officials have stated that they’re watching this closely and are staying patient until there is a case to be made to raise or to cut interest rates. As these conversations and increased uncertainty go on, the market has been reacting in fear of a material pullback.  Ensemble President and Chief Investment Officer, Sean Stannard-Stockton wrote about his thoughts on the subject in his article Trade Wars & Recessions: Investing Under Conditions of Uncertainty.

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.

“At heart, uncertainty and investing are synonyms.” –The Intelligent Investor, Benjamin Graham (1949)

Investors hate uncertainty. You hear it almost every day on CNBC. Some pundit saying a version of “we are cautious due to the high level of uncertainty.” But as Benjamin Graham said 70 years ago in his now classic book The Intelligent Investor, investing is itself an exercise in making decisions under conditions of uncertainty. Looking back on my own investment career, I recall no time period in which pundits on CNBC proclaimed their bullishness due to the high level of certainty. There is no certainty in investing, only making the best possible decisions based on the information you have at hand.

So while we reject the idea that uncertainty today is somehow unique relative to history, we do think the primary sources of uncertainty today have crystallized into two critical issues; the ongoing US-China trade war and various warning signs that a recession may be on the horizon. In our post today, we’ll describe how Ensemble Capital is thinking about each of these risks and how we are making decisions under these particular conditions of uncertainty.

Recession Risk

The current bout of recession worries began during the fourth quarter of 2018. In early November, we wrote this post explaining why even strong evidence supporting a relatively rare event does not actually make that event all that likely. We gave an example walking through why declining home sales, despite occurring before 75% of all recessions, only increased the odds of a recession occurring to about 25%. Our post highlighted an excerpt from professional forecaster Nate Silver’s book The Signal and The Noise explaining that “when the underlying incidence of something in a population is low (truth in the sea of data), false positives can dominate the results.” Since recessions only occur in 10%-15% of all years, we know that “false positives” will dominate.

Then after explaining on CNBC in the last week of December why we thought it was a good time to be buying stocks, we elaborated on our view of recession risk in our January client call saying:

“So, just as a general framing of the risk-reward that investors are facing today in US stocks, it seems there are three general possibilities.

  1. If no recession occurs: The stock market generates very strong returns over the course of the next couple of years.
  2. If a mild recession occurs: With the stock market already selling off by the magnitude that would typically be associated with this outcome, there may be limited downside even if things play out this way.
  3. If a severe recession occurs: In this event, there may be considerably more downside for US equity investors.”

But since that time, the market has rallied over 20%. Far from a recession starting in the first quarter, GDP grew over 5% vs the prior year with the sequential growth from the fourth to the first quarter being the fastest in four years.

With the fourth quarter panic subsiding, the market no longer appears to be discounting a near term recession. While we continue to think a recession is not the most likely economic outcome in the next year or so, we do continue to think that the risk of a recession is elevated. The most clear signal of this risk is the behavior of interest rates. While there are lots of ways to read interest rates, there is strong evidence that when the bond market is priced in such a way that implies the Federal Reserve is going to be cutting rates in the near term, the risk of a recession is quite high. As of today, 2-year treasury bonds yield less than the Federal Funds rate controlled by the Fed, which means the bond market expects the Fed to cut rates. This is a “yield curve inversion” and historically inversions of this sort that persist are followed by a recession, a fact the Fed themselves noted in a paper they publish last year.

Yet on the other hand, studies also show that unemployment rates tend to begin to rise materially over a period of months ahead of recessions. And today the unemployment rate is at the lowest level in 50 years (!) and unemployment claims, a weekly data set based on actual claims filed, not the surveys and estimates that underpin the unemployment rate calculation, are also at 50 year lows.

So why might the bond market be assuming the Fed lowers interest rates sharply even as US economic conditions are robust (GDP growing more quickly than it has for much of the last decade and unemployment at multi-generation lows)?

One reason may simply be that recessions almost always occur after periods of strong economic expansion. It might just be that today’s robust economy will roll over into recession before too long. While yield curve inversions do have a strong track record of forecasting recessions, they tend to precede recessions by one to two years (and interestingly for those worried about the inversion, stock markets tend to rally higher for much of the time period between inversion and a recession actually occurring).

The other reason…?

The US-China Trade War

We live in a global economy. While the Federal Reserve’s mandate is to nurture the US economy, this is not possible to do without accounting for the impact of foreign economies. That’s why the yield curve inverted and the Fed ended up cutting interest rates in 1998… but no recession occurred. Instead the market initially declined by almost 20%, just as it did in the fourth quarter last year, and then ripped higher by 60% over the next 18 months.

Economists across the political spectrum agree that a hot and extended US-China trade war would be negative for China, negative for the US and negative for the global economy. The negative economic impact of constraining trade was laid out in 2015 by the conservative economist Greg Mankiw who pointed out that this is one issue on which “economists actually agree… international trade is fundamentally good for the U.S. economy… among economists, the issue is a no-brainer.” The next year, when the the University of Chicago polled 39 economists from across the political spectrum, every one of them agreed that tariffs are a bad idea.

Of course, there is also bipartisan agreement that China engages in unfair trade practices. It is an entirely reasonable point of view that tariffs might be the bitter medicine we all have to swallow as part of a longer term agenda of pursuing a more level economic playing field between the US and China. But it would be naive to think that such a policy can be pursued with zero side effects.

But when following the back and forth on trade policy, it is critical to keep in mind that when two sides are engaged in intense, high stakes negotiation, you can’t take all of their statements at face value. For instance, if you are negotiating to buy a car and the dealer tells you this is his lowest possible offer that doesn’t mean it actually is. And when you storm out of the dealership that doesn’t mean you don’t plan to come back the next day to seal the deal at what you hope will be a better price.

Unlike the economic cycle, which plays out over multiyear time periods, the current US-China trade debate could just suddenly get resolved. It was only a couple weeks ago that the conventional wisdom was that the two sides were on the verge of a deal, until apparently miscalculations on both sides caused a breakdown in negotiations that neither side wanted or expected. If that’s accurate, then negotiations may well be revived and brought to a positive conclusion.

But here’s the thing; does anyone really expect that even the best possible trade war resolution will result in hunky dory US-China trade relations for the foreseeable future? We certainly don’t. Rather, we expect that uncertainty in US-China trade policy and a persistent “cold” trade war that occasional flares “hot” is the the sort of uncertainty investors should expect over the next decade. But that doesn’t mean we’re bearish. Remember, “at heart, uncertainty and investing are synonyms.”

Uncertainty feels like a negative word. But uncertainty about the future also captures the possibility of unexpected, positive events. Such as the strong Q1 economic results in the US or the fact that unemployment is at amazingly low levels and yet inflation is nowhere to be found. Or the possibility we outlined in February explaining why we might not get a recession for a long time.

So what are investors to do? What are we doing?

First and foremost, we think investors should accept uncertainty. Like the perennial advice that you can’t solve a problem until you admit you have one, admitting and accepting that the future is uncertain is a prerequisite to being a successful investor.

Second, in a long only equity strategy like the one we offer (Ensemble also offers comprehensive wealth management services that include asset allocation advice to our private clients), we believe that once you accept that the future is uncertain you are best served by preparing for the inevitable negative events that are sure to come.

We do this by owning a portfolio of companies with strong competitive advantages; a “moat” that helps protect them from the unexpected. One of the key attributes of a moat is the “pricing power” it confers on a company. The power to raise prices as needed without losing customers. This pricing power is particularly important during a tariff fueled trade war. If the price of a product is increased due to a tariff being levied directly on the product or on the inputs that are used to make that product, the ability for the company to raise the price to cover the cost of tariffs without losing customers is critical.

I explained this concept on CNBC earlier this month.


If you are reading this in an email,
click here to see the video.

While we employ our own approach to this concept, McKinsey & Company recently published an excellent look at why resilient companies thrive during and after recessions. That doesn’t mean competitively advantage companies don’t see their stocks decline during a recession. But it does mean that since recessions are unpredictable, rather than try to predict them, you should own businesses that will thrive over the long term despite the fact that recessions will occur, as McKinsey puts it, “sure as the sun rises.”

But while we do not think macroeconomics are highly forecastable, we do think it is critical for investor to be “macro aware”. To understand the general parameters of reasonable future economic futures and to seek as best an understanding as possible about where in a cycle each company in your portfolio is operating. This is distinct from trying to predict when exactly a recession will occur. Rather being macro aware means understanding if you are investing in a company that is operating with a depressed, normal or elevated point in the economic cycle. This is why we keep talking about whether we are truly in a New Normal economy or if the New Normal is a false narrative and, in fact, we are in the midst of returning to the Old Normal.

For instance, while investing in trucking logistics company Landstar Systems over the past seven years, we tried to understand the state of the US manufacturing economy that drives demand for Landstar’s services. Our belief in the 2015-2016 time period was that the weak demand was a result of recessionary conditions in manufacturing, despite the fact the overall US economy was not in recession. This led us to forecast in our valuation model, a steep increase in both the loads Landstar would haul over the medium to long term as well as a sustainable increase in the prices they could charge. But in the late summer of 2016, we simply had no idea that the cycle was about to turn and both loads and prices were about to explode higher. We never made a prediction that “called” the positive turn to the US manufacturing economy. But we were macro aware enough to have recognized that both load volumes and prices were depressed and thus our three to five year forecast should reflect stronger than average growth potential.

Today, we are working very hard to understand the macro context of the US and global economy and the impact the US-China trade war is likely to have. We are not foolish enough to think we can call the next recession. But we do think that while the most likely outcome is that a recession does not occur in the next year or two, the odds of a recession occurring are rising. Thus, we are systematically reviewing our portfolio holdings to ensure that our assumptions about future growth are neither too optimistic nor overly pessimistic.

As we began with a historical quote, so too shall we end:

“There is a Chinese curse which says “May he live in interesting times.” Like it or not, we live in interesting times. They are times of danger and uncertainty; but they are also the most creative of any time in the history of mankind.” Robert Kennedy (1966)

As it was 50 years ago, so it is today, and so it will be in 50 years.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Landstar Systems (LSTR), Ferrari (RACE). 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.

Do not go gentle into that good night. Rage, rage against the dying of the light. – Dylan Thomas

What do we say to the god of death? Not today. – Game of Thrones

Financial theory tells us that eventually a company’s returns on invested capital (ROIC) will decay toward its weighted average cost of capital (WACC), or discount rate:

Of course, “eventually” can be tomorrow or in 30-plus years.

The difference between days and decades in a company’s competitive advantage period is massive, yet is often overlooked, as Michael Mauboussin and Dan Callahan note:

Despite the unquestionable significance of the longevity dimension (of sustainable value creation), researchers and investors give it insufficient attention.

Why does longevity get ignored? According to New York University Professor Aswath Damodaran, almost 85% of equity research reports are based on some relative valuation metric. In other words, most investors are laser-focused on what might happen over the next few quarters or years. What happens to a company in year five and beyond is of little concern to renters of stocks.

But even if you take a long-term ownership perspective like we do, it’s easy to be dismissive of competitive advantage longevity.

Let’s say you’re building a five-year discounted cash flow model to estimate a company’s fair value, your terminal value (i.e. which assumes the company operates in a defined state in perpetuity) accounts for between 70-75% of your fair value estimate. A huge swing factor.

It’s rational to assume that the good times won’t last forever. As such, prudent analysts will assume some amount of ROIC decay in their terminal assumptions. But, again, the billion-dollar question is, “How long will it take for ROIC to decay to WACC?”

Assume the decay is too rapid and you’re undervaluing the business; assume it’s too slow and you’re overvaluing the business.

One thing we’ve noticed is that, while companies with top-quintile ROICs tend to fade toward WACC like any other cohort, they often stabilize at a rate still above WACC. Put another way, while it’s unlikely for a 50% ROIC company to sustain that level for decades, there’s a good chance it will still produce ROICs above WACC (say, in the 20% range) for an extended period. Assuming, of course, the company’s moat remains intact.

Source: McKinsey

As investors, our job is to compare our outlook with what is already baked into the market price. For example, if you think a company can generate 20% ROICs for two decades, but we conclude the market price already assumes these results, there’s no opportunity for alpha.

But because so many investors are ignoring ROIC longevity, we believe that, on average, market prices expect fade to happen relatively abruptly. To be fair, the market is right to be skeptical of extended competitive advantage periods. It’s the exception rather than the rule for companies to build moats in the first place, let alone successfully defend them for decades.

Those companies that can defend their moats, however, extend their competitive advantage period and require the market to continuously revise estimates higher. Somehow, these ROIC machines cheat natural decay and increase the company’s intrinsic value year after year.

Consider this chart for Fastenal, which stretches back to 1991 and compares its ROIC (shaded) with its stock price (white line). I’ve inserted a red line at 10% to approximate WACC over this period.

Source: Bloomberg as of May 5, 2019

An investor in 1991 might have prudently forecasted 10 years of cash flows and ROICs, with a terminal ROIC approximating WACC. Eventually, someone will compete away Fastenal’s advantages. Right?

Yet, as we see in the above chart, Fastenal’s ROIC held above 15% since 2001. In fact, it’s approaching all-time records set in the mid-1990s.

So, while the market kept expecting Fastenal’s ROIC to fade toward WACC, it never happened. Consequently, the market had to frequently revise expectations higher, which is reflected in the steadily rising share price (white line).

For some additional examples, here’s 3M:

Source: Bloomberg as of May 5, 2019

Paychex:

Source: Bloomberg as of May 5, 2019

And here’s Home Depot, which despite sharp ROIC decay during the housing crisis, is now producing ROICs well in excess of pre-crisis highs. About as many people expected that outcome as expected Lazarus to rise from the dead. Consequently, the stock price has concurrently and justifiably soared.

Source: Bloomberg as of May 5, 2019

Of course, it’s easy to identify ROIC machines with hindsight. Over the past 30 years, each of these companies has faced controversy, fierce competition, and macroeconomic headwinds. At many points along the way, investors could have talked themselves out of their position – and perhaps quite reasonably.

So, how might we identify a future ROIC machine and have the confidence to hold tight in periods of uncertainty?

First and foremost, we need to find companies with economic moats that can be defended and ideally widened over the next decade. This is no small task, of course. Once we’ve invested, we regularly evaluate the moat to see if it’s widening or narrowing.

Second, we want companies run by engaged management who understand the firm’s advantages and reinvest to strengthen those advantages. Incentives matter, for sure. But beyond that, we want to see thoughtful capital allocation and an intelligent use of debt. Owner-operators are particularly appealing.

Third, we seek companies we consider intrinsically understandable and forecastable. If we can’t fully appreciate the company’s opportunities and risks or we aren’t comfortable forecasting its financials, there’s no way we’ll hold on when times get tough.

Fourth, we seek companies with vibrant corporate cultures that are flexible and like a good challenge, for they will certainly come if the company’s successful. Costco’s ability to survive and thrive in a changing retail landscape is testament to its corporate culture.

Finally, we prefer companies who are value accretive to all stakeholders – not just shareholders. By this, we mean they also positively impact suppliers, customers, employees, and the communities in which they reside. As Professor Vicki TenHaken writes in her book Lessons From Century Club Companies: Managing for Long-Term Success: “Close-knit, mutually-supportive relationships heighten the company’s ability to weather challenges as well as to learn and adapt over time.” In other words, improve longevity.

Here’s Fastenal CEO Dan Florness on this topic: “There’s customers, there’s employees, there’s suppliers, and there’s shareholders. It has to work for all four for our business to be successful short-term and long-term.”

It’s a tall order, but if we can accurately check off these five criteria and pay a good price, we think we stand a good chance at finding and benefiting from the next ROIC machine.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Fastenal (FAST) and Paychex (PAYX). 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

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