In January, Ensemble Capital’s president and chief investment officer, Sean Stannard-Stockton, discussed our investment in First Republic Bank (FRC) at the Manual of Ideas Global Best Ideas Conference. 

You can also find more of Sean’s thoughts on First Republic by reading this earlier post on the Intrinsic Investing blog.

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 a recent conference, Jorge Paulo Lemann, co-founder of Brazilian investment firm 3G Capital, told the audience that he’s “a terrified dinosaur” in the midst of the disruption occurring in the consumer goods space. Since 2004, 3G has made notable investments in global consumer brands, including Heinz, Burger King, Kraft Foods, and Tim Hortons.

“We bought brands that we thought could last forever,” he added, “now we have to totally adjust to new demands from clients which are a lot more fickle.” As Sean has argued in these two posts, many consumer staple moats are being disrupted by upstart brands enabled by lower barriers to entry in advertising and distribution.

Whether it’s mobile commerce, robotics, genomics, energy, artificial intelligence, or autonomous electric vehicles (AEV), the amount of potentially disruptive technology can be intimidating.

As moat-focused investors, we’re looking for companies that can earn or retain a durable competitive advantage over the next decade and beyond. A dose of disruption makes this a more challenging – yet potentially more lucrative – task.

We believe there are four ways to approach disruptive technologies from an investment standpoint.

  • Invest in the disruptors themselves. This approach has the widest distribution of outcomes and payoffs are typically feast or famine. All else equal, we prefer companies with more predictable cash flows, which rules out many companies in this category. That said, we think we will participate in the growth potential of AEVs via our investment in Alphabet, which owns self-driving technology company, Waymo.
  • Invest in the beneficiaries of the new technology. We like companies that are culturally agile and embrace and integrate helpful innovations. Consider how Starbucks developed the leading U.S. mobile payments app, Schwab built robo-advisor capabilities, or Broadridge Financial invested in blockchain. Smart adoption of new technology can both defend and widen a firm’s economic moat.
  • Avoid the disrupted. While some companies are receptive to innovations, others are culturally resistant to change. These are not the companies you want to own during periods of disruption. In the past few years, for example, we’ve intentionally avoided blue-chip consumer staples stocks because we believe many of their moats are narrowing.
  • Look for opportunities from overreactions. Potentially disruptive technologies make for good stories and headlines. In the last five years, U.S. financial media has frequently written about the threat China’s Alipay mobile wallet poses to Visa and Mastercard. While we greatly admire the Alipay ecosystem, the network effects enjoyed by Visa and Mastercard are proving hard to overcome.

We live in an extraordinary era of innovation and it’s a great time to be a moat-focused investor. Over the next decade, some moats will be built, some destroyed, and others strengthened. If we’re to be successful, it’s important for us to consider both the potential impacts of new technology as well as its limitations.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Starbucks (SBUX), Schwab (SCHW), Broadridge Financial (BR), 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.

Below is the Q2 2018 quarterly letter for the Ensemble Fund (ENSBX). This quarter’s Company Focus is on L Brands (LB) and Prestige Brands (PBH). You can find historical Investor Communications here and information on how to invest here. Enjoy!

The performance of the Ensemble Fund (“the fund”) this quarter was solid and compared favorably to the broader market. The fund was up 5.04% vs the S&P 500 up 3.43%. Year to date, that brings our performance to up 7.07% vs the S&P 500 up 2.65%.

As of June 30, 2018

2Q18 YTD 1 Year Since Inception*
Ensemble Fund 5.04% 7.07% 18.43% 13.09%
S&P 500 3.43% 2.65% 14.37% 12.45%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at www.EnsembleFund.com.

Our outperformance this year has been driven primarily by stock selection with eight stocks in our portfolio up 20% or more. The stocks range from FAANG member Netflix (4.5% weight in portfolio), a new position in a small pet insurance business called Trupanion (1.3% weight in portfolio), to global luxury companies Tiffany (no longer held in portfolio) and Ferrari (6.6% weight in portfolio), to the athletic shoe manufacturer Nike (4.5% weight in portfolio), to stable financial data processing businesses Mastercard (6.8% weight in portfolio) and Broadridge (5.5% weight in portfolio), to the airplane spare parts maker TransDigm (2.6% weight in portfolio). We’ve also benefited from avoiding certain sectors. The fund has had no exposure this year to the telecom, consumer staples, materials, utilities or real estate sectors. They collectively make up 17.2% of the S&P 500 and each of these sectors are down year to date. Most notably, consumer staples, the largest of those sectors is down 8.9% this year.

For the most part these strong stocks produced solid returns in the second quarter as well as the first. All of the companies, with the exception of Broadridge, achieved 10%+ gains in the most recent quarter. Apple (4.1% weight in portfolio) and Paychex (7.4% weight in portfolio) joined the fun as well posting over 10% appreciation.

Rather than any particular unifying trend driving these stocks higher, for the most part they all benefited from company specific results. While many investors focus on capturing market wide trends across their broadly diversified portfolios, at Ensemble our entire approach is oriented around the evaluation of individual companies.

Click here to read the full letter

 

DISCLOSURES

Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

Upside Capture Ratio measures how much the security out or under performs during up-markets.

Downside Capture Ratio measures how much the security out or under performs during down-markets.

Return on Invested Capital (ROIC) is calculated by dividing NOPAT by Tangible Invested Capital. ROIC helps us understand if management is creating shareholder value. See below for definitions of NOPAT and Tangible Invested Capital.

Free Cash Flow Yield is calculated by dividing free cash flow the company is generating by the stock price. Free cash flow is the amount of cash generated by the business less cash needed to maintain the operations and capital expenditures of the business.

P/E (Price/Earnings) is calculated by taking the current price and dividing it by the earnings of the company. It’s a method of standardizing valuation to compare companies.

Fund Fees: No loads; 1% gross expense ratio.

Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.

 

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.

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.