Why We Like Idiosyncratic Companies
One of the best things about raising kids is watching them learn.
Our three-year-old, for instance, recently entered the “Why?” phase, leaving Mom and Dad scrambling to answer heavy questions like, “Why is there a universe?” and “Why are there earthquakes?”
Thankfully, our five-month-old still has a few years before she peppers Mom and Dad with existential questions. Among the first skills that she’ll learn is sorting objects by colors and shapes. Learning to group objects is an essential skill to develop. In a primal sense, classifying allowed our distant ancestors on the plains to promptly assess threats (a big animal) from non-threats (a tree).
A recent paper by Blue Mountain Capital Management’s Michael Mauboussin explored how the investment world makes comparisons. More specifically, Mauboussin shows how our field frequently does a poor job comparing companies. He concludes that:
“Comparing, essential to effective decision making, comes naturally to humans. But our basic approach of relying on analogy can limit our ability to compare effectively. In particular, we fail to incorporate sufficient breadth and depth into our comparisons, and we can be easily swayed by the presentation of information or the allocation of our attention.”
We believe there are opportunities to capitalize on these bad habits by seeking idiosyncratic companies. These are companies that we think are difficult to classify because they have a differentiated business model.
Tangerines among oranges
Most sell-side research shops use the Global Industry Classification System (GICS) to organize their analyst staff. For example, analysts are typically placed into sector-based teams (e.g., energy, consumer staples, healthcare, etc.). Each team is divided further into industries (e.g., energy equipment, beverages, healthcare technology, etc.) for which an analyst or a group of analysts is responsible.
Let’s say you’re the beverages analyst. Your job is to provide clients with deep research and actionable ideas among a specific group of brewers, soft drinks, and distillery companies.
Not only are you incentivized to be laser-focused in this niche, but a sell-side analyst with only “hold” recommendations is of little value to clients. As a consequence relative valuation techniques – i.e., comparing multiples – reign supreme in determining price targets. It makes sense. You’re intimately familiar with the companies you’re comparing and, regardless of market trends, you’ll always have names that are relatively under- or over-valued.
Relative valuation works fine for the analyst and his or her clients when the compared stocks have similar fundamental characteristics. There are circumstances, however, where a stock on an analyst’s coverage list has unique fundamental characteristics and may thus be misunderstood.
Square peg, round hole
We’ve found that First Republic Bank to be a case in point. The regional banking industry is broadly commoditized, making relative valuation a fair way to assess value among regional banks.
However, we believe that First Republic’s fundamental characteristics are different from its GICS-assigned peer group. To illustrate, First Republic’s Net Promoter Score is miles ahead of the U.S. banking industry and more in line with retail businesses with highly-regarded customer service.
Source: First Republic investor presentation
Put simply, we think First Republic is playing a different game than its banking peers. As a result, judging it against banks alone is a mistake.
Going back to late January 2011, for instance, the average percentage of “buy” ratings on First Republic is just 44.9%, according to Bloomberg, despite the fact the stock price has more than tripled over that period. Instead, “hold” ratings dominated analyst opinion for most of the last seven years. This suggests that the covering analysts likely struggled to assess First Republic’s value on a regular basis.
Consider these November 2011 statements from a well-regarded sell-side research shop: “We are impressed by the uniqueness and simplicity of the First Republic business model. Its focus on customer service goes above and beyond that offered by any other bank…What holds us back from taking a more constructive view is relative valuation.”
In other words, the analyst recognized First Republic’s unique franchise, but still valued First Republic solely against other banks. When the report was released, First Republic traded at $26.52 (dividend adjusted). It recently traded near $91.
Granted, the banking regulations by which First Republic must abide will never make it entirely comparable with customer-friendly retail or hotel franchises, either. As such, it’s reasonable to compare First Republic against other high-quality banks, but it shouldn’t be the only approach used.
At Ensemble, we are drawn to businesses that aren’t easily categorized. Differentiated business models can not only be a source of competitive advantage, but can also present value opportunities. Because analysts and investors have a natural tendency to classify – and subsequently cling to that classification – there’s a good chance that firms with idiosyncratic business models will be misunderstood and therefore mispriced.
Clients, employees, and/or principals of Ensemble Capital own shares of First Republic Bank (FRC).
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