“I do believe in simplicity. It is astonishing as well as sad, how many trivial affairs even the wisest thinks he must attend to in a day… So simplify the problem of life, distinguish the necessary and the real. Probe the earth to see where your main roots run.”

– Henry David Thoreau

According to a quick Bloomberg screen, there are about 2,000 companies in our investible universe. At any given time, we’ll own between 15 and 30 of them.

To narrow down the list of potential portfolio holdings, we employ a framework borne out of both our personal and team experiences.

Over the past four years, we’ve written dozens of blog posts that have elaborated on this framework. We wanted to boil all of that down into a one-page diagram that shows, as Thoreau put it above, where our “main roots run.”

Before we invest in any company, we must believe that three key factors – management, moat, and forecastability (which informs our valuation) – are present These factors are of equal importance.

Indeed, if even one of the factors is missing, we consider the idea a trap. We haven’t written specifically about traps yet, so here’s a summary.

• Commoditization Trap: If we have concerns about a company’s moat durability or its relevance over the next decade, we pass on it. This is true even if we like the management team and can understand the business model. Sure, great management teams can turn around struggling operations, but these examples are often best discovered with hindsight. An eroding moat or a low-growth business both hint at the company losing relevance, which we believe are underappreciated risks.
• Stewardship Trap: An award-winning garden left in the hands of an absentee caretaker will eventually grow weeds. To remain in top condition, the garden needs constant attention from a caring steward. We don’t want to invest in businesses that, as others have put it, “any idiot” or “a ham sandwich” could run. In an age of rapid innovation, global competition, and cheap and abundant capital, every company needs competent leadership to remain relevant.
• Complexity Trap: At times, we’ll identify companies with Visionary or Optimizer leadership and a wonderful track record of high returns on invested capital (suggesting the presence of a moat), but we don’t find the business intrinsically understandable. Sometimes key information is inaccessible or technically challenging to understand, making it difficult to fully appreciate downside risks. Other times, the business model operates in many competitive arenas and we can’t get a firm grasp of unit economics to make confident forecasts.

The majority of companies do not satisfy all three of these criteria, and are thus un-investable for us. This does not mean these are bad companies. On the contrary, most of the companies we look at fall in the top quartile of public businesses.

Indeed, it’s rare when moat, management, and forecastability are all present. But those are exactly the types of companies we want to own in our concentrated portfolio. We won’t always get it right, of course, but by setting a high standard for our portfolio, we believe we increase our odds of achieving better outcomes.

Please read important disclosures HERE

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.