Ensemble Capital chief investment officer Sean Stannard-Stockton recently sat down with John Rotonti of The Motley Fool to discuss our investment philosophy. A couple excerpts are below. You can read the full interview here.

John Rotonti: How do you define a high-quality business?

Sean Stannard-Stockton: The most important indicator of quality is the strength and sustainability of a company’s moat. A moat is a set of competitive advantages that protect a company from competitors. The fact is that most businesses do not possess much of a moat, and so while they may experience good results – or even great results for periods of time – if their business prospects are compelling, they will attract aggressive competition.

High-quality companies, with significant and sustainable moats, are much more in control of their own destiny. While they will face unpredictable challenges, their moat protects them and provides them with the room to adjust to changing conditions and maintain long-term profitability

JR: Please explain how you narrow down your investable universe and how large that universe is.

SSS: Our investable universe is all U.S.-listed companies with a market cap in excess of our equity assets under management (currently about $450 million). Because we run a concentrated portfolio of 15 to 25 companies, we generally would not invest in a company with a market cap less than our AUM, because doing so would require us to own a large enough portion of the business that liquidity would become an issue and we would feel a need to actively engage with the board, which is something we have not done historically.

However, while this investable universe is very large, we only invest in companies that pass our rigorous requirements that they have a strong and sustainable moat, have a management team focused on generating strong returns on invested capital and maximizing shareholder value, and operate an understandable and forecastable business.

While these requirements are not complicated, they eliminate the large majority of companies. One way to estimate the percentage of companies that we might deem investable after completing our full due diligence process is to note that Morningstar, the only sell-side research organization that rates companies based on their moat, assigns their “wide moat” rating to just 10% of the over 1,500 companies they cover.

JR: How do you approach valuation?

SSS: We think that for the sort of companies we target, the only reasonable way to think about valuation is as the present value of future distributable cash flow. As shareholders, this is really the only claim you have that makes your shares valuable.

Of course, discounted cash-flow analysis is sensitive to a range of factors that allow people to abuse this tool to generate whatever fair value they have in mind. At Ensemble, we have a disciplined framework for generating these inputs that protects us from backing into the valuation we want and instead keeps us focused on the true intrinsic value of a business.

But at the end of the day, our valuation process results in an implied P/E ratio, which provides us with a sanity check. If the implied P/E ratio doesn’t make sense to us, we’ll stress-test our valuation model to understand what assumptions are driving the unexpected output.

In general, because our portfolio is full of “capital-light compounders” that can distribute cash to shareholders even while they grow, the fair-value P/E ratio of our holdings is higher than the P/E ratio of the market as a whole, since the market is made up primarily of companies with mediocre returns on invested capital and average growth potential.

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