In recent months, there’s been heightened debate over the term “economic moat.” The peak came during the first week in May, when during the Tesla earnings call on May 2nd, Elon Musk commented:

“First of all, I think moats are lame…They are like nice in a sort of quaint, vestigial way. But if your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation. That is the fundamental determinant of competitiveness.”

A few days later at the Berkshire Hathaway annual meeting, Warren Buffett – who coined the term “economic moat” – responded to a question on Elon’s comments:

“The pace of innovation accelerated in recent years. There are more moats susceptible to innovation than earlier, but folks always attempt to do it. You have to always work to improve and defend your moat. Elon may turn things upside down in some areas, I don’t think he’d want to take us on in candy. There are some pretty good moats around.”

Pass the popcorn. This is about as exciting as news gets for moat-focused investors like us.

A moat by any other name

It’s true that some companies have relied too heavily on legacy moats and have not innovated enough. This is especially true in the consumer-packaged goods industry, where blue chips like Procter & Gamble and Campbell’s Soup became complacent and their moats shrunk. Consequently, it’s easy to point to failed “defensive” moats right now.

Yet we caution against taking the moat analogy too literally. Yes, medieval castle moats were rendered obsolete as a defensive measure by technology (cannon), but the business analogy remains relevant.

Indeed, you can call a “durable competitive advantage” whatever you’d like, but ultimately companies are all after the same thing: winning. (Or at least, they should be.)

And what does winning look like? To us, that means sustainable high returns on invested capital (ROIC). It’s the ability to consistently invest $1 and get $1.40, $1.50, or even $2 back while your competitors either can’t figure out how you do it or simply can’t match you. What prevents companies from chipping away at your ROIC is what keeps you winning – and that’s what moat analysis measures.

Even more importantly, we like companies that are winning by a wider margin. They’re getting better each day. They’re delighting more customers each day. They’re hiring more talented individuals every day. Or as Buffett might put it, they’re “widening the moat.”

Innovation is a critical part of this process. If companies don’t improve, their competitors will. If companies are unwilling to change, their competitors will eventually force them to change.

Bottom line

As investors, our job is to adapt and evolve our process while holding onto core principles. We continue to believe a moat-based framework is the best method for evaluating business quality, yet we agree that moat analysis is changing. As the economy shifts toward intangible assets (i.e., ideas, culture, know-how, etc.) and becomes less capital intensive, the type of analysis that worked in the past will not apply in the future.

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 Wall Street Journal published an article this week quoting me saying “The high end of the smartphone market where Apple is dominant is very mature,” and that the large increases in unit growth are “dead”. While large unit growth is indeed likely in the past, we think the company can continue to generate significant and growing value for both its customers and shareholders.

As we’ve discussed in past posts herehere, and here, we believe that Apple’s iPhones provide a very compelling value proposition for its customers, with the cost of owning an iPhone being in the range of $0.50-$1.00 per day for a device consumers look at hundreds of times a day and spend 2-5 hours on every day.

Source: Statista and Business Insider

According to IDC, Smartphone market growth was roughly flat for all of 2017 compared to 2016 while 1Q 2018 saw shipments decline nearly 3%. Our view of unit growth for Apple’s iPhone business is consistent with a maturing global smartphone market (though iPhone continues to gain modest share), but what still makes Apple an attractive business to own is the high loyalty rate among its customers, reliably bringing back customer to buy new iPhones every 2-4 years, and the profitability of those customers due to Apple’s ability to create products that customers desire emotionally, as they would luxury goods, not just need as a utility. This results in the iPhone’s ability to command 4x pricing over the average utilitarian smartphone enabling Apple to capture around 85-90% of profits in the smartphone market with its 14-15% share of units.

The success of its flagship iPhone X model at a $999 starting price (the top selling smartphone in the world)  has driven the average selling price of iPhone up 14% since its introduction and iPhone revenues up 14%, demonstrating that Apple can still grow its revenue and earnings despite a flat unit market in its largest business, because its products deliver such high value to customers for a reasonably low price. The ability to continue capturing a greater share of that “surplus” value is what will enable Apple to continue growing its revenue and profit over time, albeit at a lower growth rate than in the past. Not to be overlooked is the additional value that Apple is able to provide to its customers with add on services, such as the App Store, AppleCare warranty services, Apple Music, iCloud storage, ApplePay, and iTunes content, and complementary wearables products, such as the Watch, AirPods, and Beats products. Services are a $33B business growing rapidly at over 20% for the past two years and accelerating while the Wearables business is the size of a Fortune 300 company (estimated at $9B revenue) and growing nearly 50%.

In concluding, we believe that despite the maturation of the Smartphone market, Apple still has multiple ways to continue adding value for its customers while generating revenue and profit growth for shareholders. With all of its core capabilities in bringing technology into the lives of consumers in an easy to use way combined with the emotional desire it creates with the design of its products for consumers, we believe it continues to be one of the world’s most competitively well positioned companies.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Apple (AAPL). 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 phrase “corporate culture” can be eye-roll inducing. It sounds like something right out of an M.B.A. textbook or the movie Office Space.

Culture nevertheless matters. In fact, Costco founder Jim Sinegal even went so far to say, “Culture is not the most important thing in the world. It’s the only thing…It is the thing that drives the business.”

Put another way, culture is the operating system from which all decisions – large and small – are made on a daily basis.

Or as Warren Buffett put it in his 2005 letter to Berkshire Hathaway shareholders:

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.”

It’s precisely the imperceptible daily actions on which culture plays such an important role. Public companies are loaded with smart and talented managers capable of forming business strategy. But it’s those daily actions – good or bad – that add up and have a massive impact on the company’s economic moat.

Defining culture

What specifically makes for a virtuous culture varies by industry. For example, a virtuous culture in an industrial company may be one that’s obsessed with process. At a luxury apparel maker, perhaps creativity and design.

There are some common attributes, however, and Daniel Coyle provides a nice summary in his new book, The Culture Code: The Secrets of Highly Successful Groups:

  • Build Safety: A sense of belonging and identity.
  • Share Vulnerability: Ability to ask for help and admit mistakes.
  • Establish Purpose: Narratives create shared goals and values.

As an outside investor, it can be difficult to evaluate these attributes, but there are a few things that get our attention.

Coyle’s first point, about building a sense of belonging and identity, can often be found in the way management refers to its employees. Wal-Mart’s 1982 annual report, for example, referenced the “approximately 41,000 associates who are partners in the business.” (My emphasis.) Starbucks has also long referred to its employees as “partners.” Google employees are internally called “Googlers.”

From the outside, these phrases may seem silly or even empty, but having been part of the Vanguard “Crew” and The Motley Fool “Fools” earlier in my career, I can attest that they helped foster a unique sense of identity and teamwork. If they didn’t, they wouldn’t have stuck around.

It can also be encouraging to see management teams that openly admit mistakes. If management is admitting mistakes, that humility and ownership mentality likely exist in other parts of the business. A classic example is the Domino’s Pizza television advertisements from about ten years ago, where company president Patrick Doyle shared customer feedback saying Domino’s Pizza was terrible. These admitted weaknesses allowed Domino’s to revamp its menu rather than try to market its way around an inferior product.

Another way companies can hit on Coyle’s second attribute is by making all employees part owners of the business. This way, everyone has some skin in the game when making decisions. U.K.-based insurer Admiral Group, for example, immediately makes new employees shareholders. They are then eligible to receive up to £3,600 ($5,000) of shares every year with three-year vesting.

Finally, as Coyle points out, corporate narratives can help establish shared goals and values. In the mid-1980s, Danaher developed a lean manufacturing process called the “Danaher Business System,” which, as the company states, “drives every aspect of our culture and performance.” Over the last 30 years, Danaher used the DBS process to both evaluate and integrate a portfolio of acquired companies. A binding corporate narrative like DBS is the only way a conglomerate can keep so many business units working in harmony.

Bottom line

Culture can be a moat itself if it is virtuous, impacts return on invested capital, and is not easily replicable within its industry. This is one reason why First Republic Bank’s customer service-driven culture is a vital part of our investment thesis. To replicate its culture, First Republic’s traditional banking peers would need to uproot legacy systems and bureaucracies which may not be in the best interests of bank management and employees. Consequently, we think First Republic’s culture provides it with at least a decade’s head start on its main competitors.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Google (GOOGL) and First Republic Bank (FRC). 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

28 April 2018 | by Paul Perrino, CFA

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

Electric Buses Are Hurting the Oil Industry (Jeremy Hodges, @jeremylawhodges, Bloomberg)

China is in full speed in deploying electric buses to combat pollution. Shenzhen replaced all 16,359 buses with electric buses. China is rolling this out in other cities throughout the country. “Every five weeks, Chinese cities add 9,500 of the zero-emissions transporters—the equivalent of London’s entire working fleet, according Bloomberg New Energy Finance.” Buses fuel consumption is approximately 30 times cars. This is starting to impact the oil industry. “BYD estimates its buses have logged 17 billion kilometers (10 billion miles) and saved 6.8 billion liters (1.8 billion gallons) of fuel since they started ferrying passengers around the world’s busiest cities.”

Insight: Waymo – Google’s self-driving division (Jim Holder, @Jim_Holder, AutoCar)

Waymo’s CEO says “We are not the enemy. Yes, you can have self-driving cars and enthusiasts’ cars.” The goal appears to be to “disrupt the utilitarian market, because we can likely cover those needs in a cost-effective way.” Unlike other car start-ups, they quickly realized that building their own car was difficult and “is best left to the experts.”

Expensive stocks may not be so dear after all (John Stepek, @John_Stepek, MoneyWeek)

Financial metrics offer a quick and easy way to talk about a company. Be careful about creating an investment strategy focused on them. In a study of companies from 1993 to 2017, Travis Fairchild at O’Shaughnessy Asset Management, shows that “firms with negative book value (ie, liabilities apparently worth more than their assets), and companies that looked expensive on a p/b basis, but cheap on other measures, tended to beat the wider market. In other words, if you avoided these stocks on the basis of the p/b, you’d miss out.”

Visa, Mastercard Talk About Cooperating in Online Shopping (AnnaMaria Andriotis, @AAndriotis, WSJ)

To compete against PayPal’s payment tab and the growing competition in the payment industry, MasterCard and Visa created their own in 2012 and 2014, respectively. After years of testing they got together and decided to adopt a single pay tab for both MasterCard and Visa.

 

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Google (GOOGL) and MasterCard (MA). 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.

Before joining Ensemble, I wrote a book called Keeping Your Dividend Edge, which discussed ways investors can identify promising dividend-paying stocks and avoid at-risk dividends.

Over the past decade, three factors changed the game for dividend-paying companies.

  • The financial crisis years saw the most dividend cuts since the Great Depression, including some dividends once considered sacred.
  • Rapid innovation created disruptive products and technologies that challenged blue-chip dividend payers with legacy moats.
  • Boards and management teams have increasingly adopted share buybacks as an alternative to cash dividends.

As a result, it’s essential that investors keep a close watch on their companies’ financial strength, competitive position, and capital allocation practices. While dividends can represent a commitment from the board of directors, they are never guaranteed.

Blue chip blues

Blue-chip consumer packaged goods (CPG) stocks have long been steady dividend payers. Indeed, Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive are members of the “Dividend Aristocrats” list for having raised their annual payouts for over 25 consecutive years. The group also broadly avoided dividend cuts during the financial crisis due to regular demand for their everyday consumable products like tissues, toothpaste, and laundry detergent.

More to the point, these impressive dividend track records were made possible by the CPG companies’ brand- and scale-based economic moats.

But moats are not static – they are either widening or narrowing each day – and management’s capital allocation decisions play a massive role in determining moat trends. Unfortunately, it seems many CPG firms focused too much on returning capital and not enough on reinvesting it.

In the last ten years, CPGs have been particularly impacted by technology, which lowered both barriers to entry and barriers to scale. The Honest Company and Dollar Shave Club are just two examples of companies born after the financial crisis – both in 2011 – that quickly challenged the old guard.

Upstart competitors are also leveraging low-cost social media marketing to target customers (thus sidestepping traditional advertising) and engaging with customers in a highly personalized way, leaving CPG firms scrambling for a response.

Finally, the rise of online shopping – primarily via Amazon – moved consumer dollars away from grocery stores where CPG firms had the best shelf space to a platform where the customer has many choices.

These factors are starting to show in CPG financial results and are reducing dividend safety.

Tighter squeeze

As the following chart shows, earnings cover (earnings/dividend) has declined significantly at Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive over the past twenty years.

Source: Bloomberg, as of April 25, 2018. Red line = breakeven.

Meanwhile, the companies have slowed dividend growth rates.

Source: Bloomberg, as of April 25, 2018

Each company has also made regular share repurchases on top of their dividend payments, leaving little – if any – free cash flow left over to fund acquisitions or fuel innovation.

Total FCF Payout Ratio
Kimberly-Clark 93%
Procter & Gamble 119%
Colgate-Palmolive 97%

Source: Bloomberg, as of April 25, 2018. Based on latest trailing twelve-month figures.

Yes, all else equal, you should expect maturing companies to pay out a higher percentage of earnings and cash flow, but things are not equal in the CPG world. The CPG companies will either need to find a way to make their traditional business models work in the new landscape or revamp their strategies to address competitive threats.

As P&G alumnus and venture investor Dave Knox notes in his book, Predicting the Turn: The High Stakes Game of Business Between Startups and Blue Chips: “The companies which remain on the Fortune 500 ten years from now will be the companies that leverage a mixture of tech acquisitions, investments in startups, innovative partnerships and even their own disruptive launches to transform their companies. While it will not be a single strategy that enables their survival, it also will not be a single effort.”

If true, this will require both a cultural change and a change in the way the firms allocate capital.

Gimme shelter

Ultimately, companies cut their dividends for one or some combination of three reasons:

  • Creditors demand it (e.g., breached covenant).
  • They can’t afford the payouts (e.g., energy company reacting to plunge in oil prices).
  • They need the capital for a new strategy.

Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive all have excellent credit ratings and shouldn’t run into any trouble with creditors. But a strong credit rating alone doesn’t mean a safe dividend. Pfizer and General Electric, for instance, both carried top-notch credit ratings when they cut their payouts during the financial crisis.

The CPG firms could technically afford their payouts for some time by issuing debt or selling assets, but this is not a sustainable strategy and may deprive the companies of future earnings power.

If blue-chip CPG firms cut their payouts, it will likely be because they feel “handcuffed” by the commitment of capital to dividends, which restrict their ability to compete and defend their moats.

Dividend cuts by blue-chip CPG companies would be wildly unpopular among investors who rely on the companies’ dividends to supplement their income. The companies will also be reluctant to break their multi-decade dividend increase streaks, as they would drop off popular dividend-based indexes. As such, I do not expect such a decision to be taken lightly.

Final thoughts

Management’s goal should be to optimize capital allocation to improve return on invested capital and create long-term shareholder value. The ability to sustain a dividend springs forth from smart capital allocation decisions that defend or widen the company’s moat.

Dividends can indeed play an important role in capital allocation by limiting management “empire building” risk, but generous dividend policies can also be a problem when they become burdensome. Efforts to sustain an unsustainable dividend come at the expense of long-term shareholders. In the coming years, CPG firms may have some tough decisions to make.

 

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.