“A little learning is a dangerous thing. Drink deep or taste not the Pierian spring; There shallow draughts intoxicate the brain and drinking largely sobers us again.” Alexander Pope, 1709

Arif and I have just returned from a week long research trip to China with Rui Ma and Ying-Ying Lu, the hosts of the excellent TechBuzz China podcast, who gave us an immersive, deep dive into the Chinese business ecosystem.

We were fortunate to have a dozen of our investor friends join us from the US, Canada, Dubai, London, Singapore, Spain and Mumbai. We visited with 28 company representatives, industry experts, and government representatives in Beijing, Shanghai and Hangzhou. From executives at well-known global companies such as Didi, Xiaomi, and Ctrip, to companies less known to western investors such as Qutoutiao, Nio, Bilibili, LexinFintech, MOGU Inc, Club Factory, and Ruhnn.

While we do not currently have any direct investments in Chinese companies, nor do we plan to make any in the foreseeable future, we believe that US and global investors can no longer simply say that China is outside their circle of competence. As investors in global businesses, we know that China’s economy and their thriving corporate sector will play an ever-increasing role in global business. So, we decided we needed to spend some time there ourselves. In this series of posts, we’ll share some of our takeaways from the trip.

From 2009 to 2018, Ensemble Capital held a large investment in Apple in our equity strategy. As the company became big in China, we came to understand that Chinese users spent so much of their online life in WeChat, an app made by Chinese tech giant Tencent, and that they were not nearly as loyal to the iPhone as users in the rest of the world. This was because a Chinese iPhone user could buy the new, cool Android based phone, download WeChat and have all of their content ready to go. While in the past, the iPhone was far ahead of other phone makers, today there is a proliferation of other high-end phones, such as this $3,000 phone that is wrapped entirely in screen that was on display at Xiaomi during our visit.

Given that WeChat is barely used in the US, it can be hard for US based investors to appreciate the importance of WeChat to the Chinese online experience. Let’s just say that in many ways, WeChat *is* the internet in China. With Google not available, Baidu’s search results reveal a spammy mix of irrelevant ads, and with much of the internet outside of China blocked, the “world wide web” just isn’t a terribly important part of the Chinese internet experience.

Looking at our portfolio, about half of our holdings have some sort of intersection with China. In some cases, it is companies like Tiffany or Starbucks who have material sales into China. Other times it is businesses like Netflix or Google, who do not do business in China, but which possibly could over the long term. And then there are businesses like Mastercard, which after being blocked out of China and watching it become the only country with a non-Mastercard/Visa-based, robust payment infrastructure, now finds itself facing possible competition with these Chinese tech/payment giants in emerging markets or even in the US where “we accept Alipay” stickers have started to pop up in some locations.

Many investors don’t appreciate the level of latent knowledge they already have about a company or industry before they start researching a company. For instance, most American investors would know before they even started researching a company like Starbucks that coffee can be bought at lots of different retailers, but the nuanced difference between buying coffee at Starbucks, McDonald’s, Dunkin Donuts, Peets or a Third Wave coffee shop is something American investors already understand intuitively.

There is even knowledge you don’t know that you know. For instance, American office workers don’t order coffee for delivery all that often. Why is that? Many American investor may not even be conscious of the fact that this is true in large part because the vast majority of American companies offer free coffee on site to their employees. But this is not true in China.  And, so while it might seem strange to Americans that ordering coffee for delivery is big business in China, the reason has to do with subtle but important cultural differences that are entirely understandable if you take the time to learn about them.

Over the coming week or two, we’ll be publishing a series of posts on our key takeaways:

  • The rise of local Chinese brands
  • New Commerce
  • Two Chinas
  • The context that allowed for China’s rapid growth

As you read these posts, don’t get the impression that we’re experts on China. Our hosts for the trip are very much experts on China and if you’re an English-speaking investor who wants to expand your circle of competence related to China, we strongly recommend you listen to their excellent TechBuzz China podcast.

If you look back to the quote opening this post, you’ll note that we are acutely aware that a little knowledge can be a dangerous thing if you believe that knowledge makes you an expert. But the only way to become an expert is to wade through the early phase of having a little knowledge, recognize that you may have a tendency to get “drunk” on this knowledge and then keep learning more until you come out the other side and are “sober” again.

44% of the revenue of the S&P 500 comes from outside the US. Global markets have become far more correlated to each other as the world has globalized. The major global economic engines are now China, the US and the EU. But the thing about China is that it is changing so quickly. So knowledge that you have about China can get out of date quickly.

For instance, here is a photo we took of the Shanghai financial district. It simply dwarfs Manhattan and looks and feels far more developed than any of the mega cities in the US or EU.

And here is a photo of the exact same location in 1991.

We believe it is critically important for all active equity investors to decide that if China is not currently in their circle of competence, it is time to start building that competency now. And while a week long trip won’t do the trick, nor will sitting at your desk reading research reports.

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.

Ensemble Capital’s Senior Investment Analyst, Arif Karim, was recently interview by Bo Börtemark of the Investing By The Books investment blog whose insightful questions guided an in depth look at Ensemble Capital Management’s investment strategy, our research process, and Arif’s journey as an investor beginning with a serendipitous request by a desperate high school math teacher eager to fill spots in a local stock market competition to a career epiphany precipitated by legendary fund manager Peter Lynch!

CLICK HERE to read more in Arif’s inaugural interview.

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 investment in Tiffany & Co (TIF)

Excerpt (Todd Wenning speaking):

When we think about luxury goods, two things tend to come to mind. First, we tend to think of European brands like Louis Vuitton, Chanel, and Cartier. In fact, according to the consulting firm Deloitte, French, Italian, and Swiss companies together accounted for just under half of global luxury good sales in 2017. Second, we tend to recognize a luxury brand when we see one. A Ferrari, for example, is unmistakable, as are Louis Vuitton handbags with their ubiquitous LV insignias. That’s largely the point in purchasing a luxury item, of course – to communicate status to others.

Curiously, Tiffany does not fall into either of those buckets. It’s one of just a few global American luxury brands and the casual observer cannot tell a Tiffany diamond engagement ring from one purchased elsewhere. There’s no room on a diamond for logo placement, after all.

So how does Tiffany do it? Like its European luxury counterparts, Tiffany is draped in a wonderful narrative and history. You might be as surprised as I was to learn, for instance, that Tiffany has been around since 1837 and has been in the diamond business since 1848, when Charles Lewis Tiffany opportunistically purchased diamonds from fleeing French aristocrats in the French Revolution of 1848. His timing couldn’t have been better, as new American millionaires clamored for royal jewelry to show off their recently achieved status. That’s what got the ball rolling.

As a company, Tiffany is older than Cartier (founded in 1847), Louis Vuitton (founded in 1854), and Burberry (founded in 1856). This durability matters in luxury because it communicates a brand’s ability to endure all kinds of major socioeconomic changes and remain relevant over successive generations. It also communicates a certain timelessness of core products that remain in fashion despite intermittent fads and trends.

Tiffany is one of the few brands in the world that can be identified by a color alone. Its trademarked robin egg blue provides instant recognition, from near or far. And that color communicates elegance, exclusivity, and sophistication. To be sure, more than one would-be suitor has tried his hand at putting a non-Tiffany item in a Tiffany Blue Box to achieve the desired effect. It’s a risky move, of course, for if the ring doesn’t fit, you have some explaining to do when the recipient needs it to be resized. But that speaks to the power of the Tiffany brand – that the color of the box can multiply the value of what’s inside it. Assuming the item was properly acquired, a Tiffany ring in a Tiffany Blue Box communicates to the recipient that you’re worth the extra money.

Tiffany’s narrative has been carried forward into the modern era by popular media, such as the classic movie Breakfast at Tiffany’s starring Audrey Hepburn, and more recent movies like Sweet Home Alabama and The Great Gatsby. The most recent advertising campaigns feature millennial celebrities like Zoe Kravitz, Lady Gaga, and Elle Fanning.

To be sure, the Tiffany brand has been mismanaged at various points in its history. However, we think current CEO Alessandro Bogliolo, who joined the company at the end of 2017, has been a fantastic brand steward and is executing well in the areas the company can control. Notably, we are encouraged by his focus on “informal” luxury to better resonate with the Millennial generation. Last year, for instance, Tiffany opened a “style studio” in London’s Covent Garden, about a mile away from its ritzy high-end storefront on Old Bond Street. The “style studio” format is more informal than the main store, with barstool seating, fragrance dispensers, and opportunities to interact with and customize Tiffany-branded jewelry. We think this is a healthy way for Tiffany to reach out to new consumers without diluting the core brand value.

Like other luxury brands, Tiffany is seeing growth in emerging Asian economies, some of which are adopting Western-style engagement ring culture. In August, Tiffany announced a partnership with India-based luxury retailer Reliance Brands Limited to open new stores in Delhi and Mumbai. As the CEO of Reliance Brands put it in the press release announcing the deal, “Tiffany needs no introduction in India – it is iconic and timeless.”

That quote brings up an important point about Tiffany’s brand-driven moat. As I mentioned earlier, it’s extremely challenging to attach a brand (and command a related price markup) to a piece of jewelry that from a distance cannot be differentiated from a similar item. Given its rich heritage and place in popular culture, Tiffany, as the Reliance Brands CEO put it, “needs no introduction.” This is a huge advantage for Tiffany against any would-be upstart competitors.

In many other areas of the luxury goods market, we’ve seen direct-to-consumer brand startups leverage social media to take on incumbents. But it’s far more difficult to start and scale high-end jewelry, as the product doesn’t outwardly advertise the brand. It takes decades, if not generations, to be considered “iconic and timeless.” And this says nothing about the expensive input costs – gold, platinum, diamonds, skilled artisan wages – that would go into a high-end jewelry operation.

In summary, we’re confident in Tiffany’s moat and have growing confidence in Tiffany’s management. We think the company is set up well for continued relevance in future generations.

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 investment in Mastercard Inc Class-A (MA)

Excerpt (Sean Stannard-Stockton speaking):

We know that there are a lot of good companies that we don’t own. Our goal isn’t to have an informed opinion on every stock in the market, but only to find 15 to 30 stocks that possess all of the characteristics that we look for and also trade at a discount to what we believe they are worth. The truth is, stock picking is hard. While there are lots of stocks that we think might be a good investment, we are looking for a very select group of stocks where we think the odds are stacked heavily in our favor. Sticking to the discipline Todd just described is critical to our process.

So now let’s talk about a company we’ve owned in our portfolio for a long time and which we believe ranks near the top of our portfolio in terms of meeting and exceeding our requirements in each of the core areas of our assessment process.

Mastercard is a company that pretty much everyone has heard of. In fact, if you are listening to this call or reading the transcript, no matter where you live in the world as long as it’s not China, there is a very good chance you have a Mastercard in your wallet or purse. If you don’t, then you have a Visa card. You probably have both. These two companies hold an effective duopoly on the processing of credit and debit card payments.

Importantly, these companies do not lend any money. If you look at your credit or debit card, you’ll find that it is issued by a bank. If it has the name of a non-bank company on it, such as American Airlines or Apple, these companies have just partnered with a bank to issue the card. In American Airlines case, its Citibank and the new Apple credit card is issued by Goldman Sachs. The issuing bank is the one whose checking account a debit card is tied to and they are the ones lending the money to fund credit card payments.

On the other side of the transaction is the merchant and its bank. No matter whether you swipe your card, or wave your Apple Watch with Apple Pay, or use Paypal to process a payment via your credit or debit card, or use Google Pay or Amazon Pay to facilitate an online transaction, in each case your bank and the merchants bank need to exchange information across a communication network. And that network is almost always provided by Visa or Mastercard. While you might hear about how merchants pay 2% or more in credit card fees, Visa and Mastercard are only collecting about 1/20th of that fee, with the banks, the ones taking the credit risk, earning the bulk of the fee.

Americans are so used to using debit and credit cards that it is easy to lose sight of how amazing the Visa and Mastercard networks are. The fact is that when you walk into a store anywhere in the United States, you take it for granted that the merchant will allow you to swipe a little piece of plastic with either the Mastercard or Visa logo on it and they will then let you walk out with your purchase. The reason you carry a Visa or Mastercard is because you know they are accepted everywhere. And the reason they are accepted everywhere is because everyone carries one. This is a classic example of a “chicken and egg problem”. Before everyone accepted these cards, it was difficult to convince consumers to carry one. And before everyone carried one, it was difficult to get merchants to accept them.

Having solved this problem, Mastercard and Visa now have a competitive moat around their businesses, which makes it very difficult for any new company to compete with them. Recently I was at a Target in the middle of Silicon Valley. At the checkout stand I noticed a sticker advertising that they accepted Alipay, the payment network founded by the Chinese company Alibaba. When I asked the cashier how often people used Alipay, she actually didn’t know what I was talking about. Despite having noticed the sticker, no manager had ever thought to explain it to her, and no customer had ever asked to use it. Why wasn’t she trained on how to process Alipay transactions? Because her manager knows that few people carry this form of payment. Why don’t customers carry this form of payment? Because few stores accept it. Building a globally accepted payment network was hard in the past. But today it is even harder because not only must a new company in the payment industry solve the chicken and egg problem themselves, but now that it has already been solved, a new competitor must solve the problem in a way that is much better than the existing solution.

So let’s finish looking at Mastercard though the lens that Todd just introduced; moat, management and forecastability.

First of all, we think Mastercard has a very strong moat for the reasons just explained. We also think this moat will remain valuable because we think it is highly likely that a decade and more from now, the service Mastercard provides will remain critical to facilitating commerce and valuable to both merchants and consumers.

We also believe Mastercard’s management team is top notch. Not content to sit still and milk cash earnings from their network, Mastercard’s management team is forging ahead into business to business transactions. While a large portion of consumers transactions occur via cards, business to business transactions, the payment of invoice to vendors and other payments between business, is still a slow, manual process. So Mastercard has been investing earnings from their credit and debit card network into solving the B2B payments problem. They’ve also been aggressively forging ahead in emerging markets, where they have been a leader in using new technologies and adopting their systems to local markets.

While Americans are used to their cards being accepted everywhere, in India, the birthplace of Mastercard’s CEO and a country with a population four times larger than the US, only 5% of merchants accept credit cards. With the chicken and egg problem not yet solved in this country as well as some other emerging markets, the competition is fierce, but the opportunity for Mastercard is very large. Despite reinvesting in their business, Mastercard produces far more excess cash than they need to grow the business. So we are also glad that they have shown themselves to be smart allocators of capital, buying back significant levels of their own stock at very attractive prices, paying a dividend, and increasing the amount of debt in their capital structure in a prudent manner.

Finally, we believe that the company’s long-term economics and thus the value of the business, is reasonably forecastable. This is partial because of the domain expertise our team has built over the years and our confidence that we have a strong understanding of the payments industry in which Mastercard operates. But just as importantly, it is because we believe Mastercard’s business to demonstrate high levels of intrinsic forecastability.

While some companies are subject to highly unpredictable changes in macro factors, such as an oil company being dependent on the price of oil, Mastercard’s business is driven by far more stable trends. The key metric for them global consumer spending trends, which even during recessions do not decline by more than a couple percentage points and which we are confident will grow at a modest, but steady rate over the very long term. On top of that growth driver, the company benefits from the relentless shift of consumer spending from cash and checks to credit and debit. While it might seem that much of this shift has already played out in developed markets, we can look to near cashless country like Sweden to see that even US consumers are likely see continued declines in the use of cash and checks. I had a little example in my own life recently when my utility company emailed to say that rather than directly billing my checking account for my monthly bill, they were now offering the option to have by bill linked to my credit card. And in the bay area, we see more and more new stores opening which simply do not accept cash payment.

Of course, while we have very high levels of conviction in Mastercard, it doesn’t come close to being a risk free investment. All investments in equities involve accepting relatively high levels of uncertainty. It is the requirement of accepting uncertainty that explains why stocks offer higher rates of returns than bonds. But in seeking investments for our focused portfolio, we require every company to exhibit relatively low levels of uncertainty compared to the average public company on the core issues of the longevity and relevance of the their competitive positioning, the management teams capabilities in creating economic value and allocating excess cash flow, and both the intrinsic forecastability of the business as well as our own team’s capabilities and circle of competence.

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.

Sometimes, I am even asked why I can feel so optimistic about our future. The answer is simple; We are in a great business, with great people, great products and technology, and an unbeatable brand name. – CEO George M. C. Fisher, 1997 Kodak Annual Report

Like many kids over the last 50-plus years, my four-year-old son recently got into LEGO. You might even say his interest in LEGO was inevitable. The LEGO brand is so powerful it’s just assumed that kids will play with their interlocking plastic bricks.

Indeed, in 2018, global brand consultancy Interbrand ranked LEGO the world’s 74th most valuable brand, placing it ahead of Ferrari, Land Rover, and Johnson & Johnson. Impressive.

Back when I was playing with LEGOs in the 1980s, you could have reasonably argued that LEGO would remain a dominant children’s brand over the next three decades. And if we looked at two data points – say, 1987 and 2018 revenue – that seemed to be the case.

But what played out between those dates tells a different story. In the early 1990s, LEGO faced an existential crisis. Key patents on their interlocking bricks expired, leading to a flood of cheap knock-off competition. Fewer kids were being born in developed markets, limiting category growth. Children began playing video games at earlier ages, spending less time with physical toys.

In a panic, LEGO made some rash product decisions, seeking out “blue ocean” innovations that were outside of its core competencies, such as software, theme parks, and retail. Sales plodded ahead, but expenses grew faster – and worse, LEGO borrowed heavily to pursue its ambitious growth strategy.

In 2004, LEGO even came close to bankruptcy.

David C. Robertson’s excellent book on LEGO’s history, Brick by Brick, recounted the moment when the company realized the extent of the damage. Then-recent hire (and eventual Executive Chairman and CEO) Jørgen Vig Knudstorp, performed an Economic Value Added (EVA) analysis on LEGO’s financial results and made a shocking discovery.

“(Knudstorp’s) analysis revealed that with the exception of 1998, the LEGO Group had steadily produced accounting profits from 1993 to 2002, yet the company had lost some $1.6 billion of economic value of the same period…By backing LEGO, (the founding Christiansen family) had depleted their family fortune at the rate of almost a half a million dollars per day, every day, for ten years.”

In other words, LEGO’s return on invested capital (ROIC) was below its cost of capital, but the company continued to aggressively reinvest. That’s a recipe for value destruction.

Despite having well-intentioned founding-family leadership (typically a positive signal) in the Christiansens, a beloved brand with a cult-like following, and lucrative licensing deals with the Star Wars and Harry Potter franchises, LEGO was on the ropes. It took a sweeping restructuring to stabilize and improve the company’s prospects.

LEGO is a perfect example of why brand stewardship matters, even with a powerful underlying brand.

What’s brand stewardship? Broadly speaking, it’s maintaining and increasing the relevance of the brand over time.

Relevance is different from recognition. Xerox, Kodak, and Nokia remain recognizable brands, for example, but they are far less relevant today than they were 20 years ago.

Relevance commands attention, and a by-product of attention is pricing power. And sustained pricing power in the face of competition is a good sign of an economic moat.

We consider relevance a function of category growth and the company’s share of the category, over time. Ideally, a company will increase its share of a growing category. Mastercard is a good example. In contrast, we have little interest in companies taking share in a shrinking category, as it presents low growth risks.

Great brands can be sunk – slowly or abruptly – by management’s poor capital allocation decisions. Some famous investors said you want to look for companies that “any idiot” or a “ham sandwich” can run. And while that may have been true at one time, we don’t believe it’s true today.

As we illustrated in our investment philosophy diagram, in an age of rapid innovation, global competition, and cheap and abundant capital, every company needs competent leadership to remain relevant. For great brands to be great businesses, they need great capital allocators at the helm.

For more information about positions owned by ECM 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.