Michael Lewis’s classic book, Moneyball, describes how the Oakland Athletics baseball team used quantitative analysis in the early 2000s to scout promising talent.

In one example, A’s researchers found that on-base percentage was a stronger indicator of success than batting average, yet the latter was the preferred metric used by scouts. Identifying useful factors like on-base percentage helped the A’s win more games on a smaller budget.

Using backtests of historical data, the investing world has similarly sought out and identified promising factors of outperformance. Included in this group are:

  • Size – small beats large
  • Value – cheap beats expensive
  • Momentum – winners tend to keep winning
  • Quality – well-run companies outperform poorly-run companies

To illustrate, a 2016 study by Fidelity found that, from 1985 to 2015, the Quality factor posted 1.59% annual excess return relative to the Russell 1000 Index.

Since we at Ensemble focus our research on firms we consider to be high quality, I wanted to take this post to explain how our approach differs from a traditional Quality factor portfolio.

Blind spots

Depending on the study, the definition of Quality will vary at the margins, but generally tries to capture the following traits:

  • High returns on investment (ROE, ROA, ROIC, etc.)
  • Low amounts of leverage (debt/equity, interest coverage, etc.)
  • Reliable growth (cash flows, low accruals, earnings stability, etc.)

We have no problem with these metrics and agree they can be strong indicators of quality. However, simply screening for companies with these attributes has two shortcomings.

First, because the screens are backward-looking, they tend to show a lot of “legacy moats.”

Companies with legacy moats rely on advantaged existing assets and have impressive historical profitability and growth. As such, they’re natural fits for quality screens. This may have been a positive signal in previous eras, when return on invested capital (ROIC) persistence was much stronger (i.e. winners were more likely to keep winning), but that dynamic is changing.

Due to rapid technological innovation, capital availability, and globalization, barriers to entry in many industries have fallen. Whether it’s through a platform-based business model (e.g. Uber, Airbnb), software-as-a-service (Slack, Salesforce), viral marketing (Dollar Shave Club), or influencer marketing (Spanx), there are myriad ways to challenge today’s blue chips. Jeff Bezos’ statement that “Your margin is my opportunity,” nicely summarizes the threat upstart competitors pose to incumbents now.

And as Michael Mauboussin’s research has shown, “The market rewards improvement and punishes decline in economic returns.” In other words, it’s very hard to outperform the market by owning firms with declining ROICs, and legacy moats are particularly susceptible to ROIC erosion.

Emerging moats

Second, traditional quality screens can overlook what we call “emerging moats.”

Emerging moat companies have a huge market opportunity and have plenty of high-return projects in which to invest. Because of the high returns on incremental invested capital, they’ll have bigger capital expenditures (leading to lower near-term free cash flow) or increased expenses (leading to lower near-term profitability) as they establish their competitive advantages.

This is particularly true with platform-based businesses, such as Alibaba, Facebook, and Booking Holdings. Because platform moats are driven by network effects, these companies are rightly motivated to scale quickly and prudently. As a result, their financial profiles during the ramp phase typically don’t fit quality screens. Looking under the hood, however, can reveal early stage moat development.

Correctly identifying emerging moats is admittedly difficult, but can be a lucrative endeavor. As a successful emerging moat scales, it should produce stronger ROIC and more profitable growth. In turn, other investors should re-rate the company’s prospects and drive the stock price higher.

How we address it

While the Quality factor screens can be informative in identifying strong past performers, we find more value in doing qualitative research centered on moat analysis. Rather than depend on historical data, we examine each company’s moat durability over the next decade. Our moat analysis will turn out to be wrong now and then, but we believe we’ll do better looking ahead than relying solely on quality screens.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Booking Holdings (BKNG). 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.

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

Atul Gawande, a surgeon injecting humanity into US healthcare (Anjana Ahuja, @anjahuja, FT)

A profile of Atul Gawande, who is tasked to head the “non-profit venture funded jointly by Amazon, Berkshire Hathaway and JPMorgan Chase.”  Dr. Gawande is “an endocrinologist and surgeon at Brigham and Women’s Hospital in Boston and a professor of public health at Harvard.” He has also written several books. I’ve read his book The Checklist Manifesto, which is fantastic. I look forward to seeing his continued positive impact on the health care industry.

How Amazon Steers Shoppers to Its Own Products (Julie Creswell, @julie_creswell, NYT)

Amazon’s move into the private label retail space started small and quiet. As the article says, “It started with a simple battery.” Now, AmazonBasics batteries account for a third of online battery sales. To stay competitive, brands like Energizer are paying to advertise at the top of relevant search results. While AmazonBasics only has about 100 products, the room for growth is large, and they have the data to see what products to take private next. “About 70 percent of the word searches done on Amazon’s search browser are for generic goods. That means consumers are typing in “men’s underwear” or “running shoes” rather than asking, specifically, for Hanes or Nike.”

Amazon Has a Business Proposition for You: Deliver Its Packages (Julie Creswell, @julie_creswell, NYT)

So far, Amazon has done an amazing job managing the speedy delivery of its products to customers. In typical Amazon fashion, they’re looking into optimizing it even more and becoming more vertically integrated. One new option is the use of contract drivers. This will help reduce their dependence on current shippers like USPS, UPS, and FedEx.

Industries, Looking for Efficiency, Turn to Blockchains (Laura Shin, @laurashin, NYT)

The uses of Blockchain are great and they’re now moving from being theoretical to practical. Firms from insurance companies to logistic companies are developing processes to utilize Blockchain technology. It has the potential to reduce fraud and improve efficiency. One of the biggest hurdles is the lack of a clear network. In order for this technology to be effective, there needs to be enough people on the network to make it worth it.

 

 

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

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

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

This quarter’s call will be held on Tuesday, July 17 at 1:00 pm (PST)

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

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

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

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

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

Ensemble Capital Management Named to 2018 Financial Times 300 Top Registered Investment Advisers

 June 28, 2018 – Ensemble Capital Management is pleased to announce it has been named to the 2018 edition of the Financial Times 300 Top Registered Investment Advisers. The list recognizes top independent RIA firms from across the U.S.

This is the fifth annual FT 300 list, produced independently by the Financial Times in collaboration with Ignites Research, a subsidiary of the FT that provides business intelligence on the asset management industry.

RIA firms applied for consideration, having met a minimum set of criteria. Applicants were then graded on six factors: assets under management (AUM); AUM growth rate; years in existence; advanced industry credentials of the firm’s advisers; online accessibility; and compliance records. There are no fees or other considerations required of RIAs that apply for the FT 300.

The final FT 300 represents an impressive cohort of elite RIA firms, as the “average” practice in this year’s list has been in existence for over 22 years and manages $4 billion in assets. The FT 300 Top RIAs hail from 38 states and Washington, D.C.

The FT 300 is one in series of rankings of top advisers by the Financial Times, including the FT 401 (DC retirement plan advisers) and the FT 400 (broker-dealer advisers).

You can download a copy of the Press Release Here.

 

The Financial Times 300 Top Registered Investment Advisers is an independent listing produced annually by the Financial Times (June 2018). The FT 300 is based on data gathered from RIA firms, regulatory disclosures, and the FT’s research. The listing reflected each practice’s performance in six primary areas: assets under management, asset growth, compliance record, years in existence, credentials and online accessibility. This award does not evaluate the quality of services provided to clients and is not indicative of the practice’s future performance. Neither the RIA firms nor their employees pay a fee to The Financial Times in exchange for inclusion in the FT 300.

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.