Note: During times of stress, investors often lose conviction in their previously strongly held beliefs. This cracking of their conviction is the main culprit behind why investors often make bad decisions during stressful market environments. While this post is not specifically related to the Coronavirus issue currently roiling the market, we are publishing it now as the issues it addresses are critical for navigating turbulent markets.

“Invest in what you know.” -Peter Lynch

The Peter Lynch quote above is good advice. You should only ever invest in an individual company on which you have done the research needed to understand it deeply. But Lynch’s quote is often interpreted to mean that investors should invest in companies that sell products or services that they are familiar with as a consumer. This isn’t what Lynch meant and he even clarified his comments so there would be no confusion.

“Peter Lynch doesn’t advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock!” -Peter Lynch

Why does it matter how well you “know” a company? Because investing is fundamentally based on making forecasts about the future and these forecasts need to be informed by how the world actually works. For instance, as a coffee drinker, I know that there are important differences between why people buy a cup of coffee at Starbucks vs McDonald’s vs making it at home. These are nuanced, but important elements of understanding the company. But Todd’s recent post on why recognizability is different than relevance is highly applicable here.

In fact, familiarity with a topic can actually reduce your ability to make accurate forecasts about the future. “Familiarity bias” is the observed phenomenon that people assess the likelihood of events they are familiar with to be much higher than events they are less familiar with. This is caused by the “availability heuristic, a mental shortcut that relies on immediate examples that come to a given person’s mind when evaluating a specific topic, concept, method or decision. The availability heuristic operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as readily recalled.”

The worst part of familiarity bias is that it hits hardest during times of stress. During recessions or financial market crises, the very moment when your conviction in your investments is tested, familiar companies will seem safer than unfamiliar companies. Yet what makes a company safe is how forecastable its future financial results are. If you knew exactly how much cash flow a company would produce over time, then you’ll know exactly what a stock is worth. It doesn’t matter how familiar you are with a product or service; it matters how well you can forecast a company’s financial results.

However, there is a class of companies that we think tend to be ignored by many investors due to a lack of personal experience with their products and services, but which often offer far more forecastable business models than consumer facing companies.

Business service companies are companies that offer some sort of service to other businesses. Typically, these services are critical to their customers, but are not a core part of what their customers offer. It is the fact that they are important, but not the focus of their customer’s value proposition, that leads to these functions being outsourced.

Service stocks tend to have great business models. They don’t carry inventory, don’t have a lot of capex requirements, tend to have solid pricing power, and often charge using a subscription or subscription-like model. Those service companies that serve other businesses rather than consumers also tend to be far more protected from shifts in customer preferences or shifts in what is popular.

In Ensemble’s portfolio, examples of business service stocks include:

• Mastercard: Provides payment facilitation services to banks and merchants.
• Broadridge Financial Solutions: Provides customer communication and trade processing services to banks, brokers, asset managers and corporate issuers.
• Landstar Systems: Provides trucking logistics services to shippers.
• Paychex: Provides payroll processing services to small and medium sized businesses.
• Verisk Analytics: Provides data and analysis to insurance companies, as well as other specific industry groups.

There are also a number of companies in our portfolio that share similar characteristics, but which are not technically business service companies. For example, Masimo nominally sells patient monitoring devices to hospitals, but really their business model can be thought of more as a razor and razor blade version of a home alarm system company where the sale of the monitoring system (which lasts about eight years) is how they establish a relationship with a customer, but providing replacement sensors for that system is a service that creates a subscription-like annuity stream.

These types of companies represent almost half of our portfolio. Yet no one on our team has ever directly been a customer of one of these companies. So are we ignoring Peter Lynch’s advice to “buy what you know”? We think not.

One key driver of how forecastable corporate results are over the medium to longer term is the behavior of the company’s customers. Consumer facing companies have to deal with consumers. Will consumers ever really want to buy electric cars? Will consumers still demand plant based “meats” in the future? Will superhero movies still dominant the box office a decade from now? These are really hard questions. No matter how familiar you are with cars, food and movies, these are still questions with highly uncertain answers.

But business service companies don’t have to deal with preferences as much as consumer facing companies do. Sure their customers still have preferences, but when a business service company provides a valuable service at a low cost (compared to their customers’ total expense structure), their customers tend not to make any changes to their behavior unless they have to.

Here’s how we described this dynamic operating at Broadridge Financial on a recent conference call:

“Imagine you are an executive at a large broker and one of your managers suggests switching from Broadridge to a competitor for the service of delivering monthly statements and trade confirms. The first question you might ask is whether the change will make clients happier. The answer is likely to be no. It is important to deliver statements and trade confirms and indeed it is a mission critical regulatory obligation. But investors are never going to pick a brokerage firm because they get monthly statements out more effectively. In fact, it isn’t even that clear what that would look like. It is just something that needs to get done without errors. There is no such thing as a premium statement delivery system.

So as the executive at a large brokerage firm, you might wonder why the manager is even wasting your time bringing up the idea of switching. So you ask a simple questions: “If the new service provider was free, would it save us enough to make a difference?” The answer would be no. These costs are so small relative to the huge cost structure of a broker, that the savings would be rounding error for the overall business.

So faced with a situation where changing to a competitor would provide no better of a service to investors and not save any material amount of money, but doing so would run the risk of errors occurring during the transition process and in fact could even cause regulatory issues, there is simply no reason to even consider moving to a competitor. And this is why Broadridge reports around 98% revenue retention meaning that every year, 98% of their customer base by revenue renews their contract for another year.”

What percent of McDonald’s customers will switch to another fast food company next year (maybe a healthier one)? No matter how familiar you might be with McDonald’s, that doesn’t help you answer the question. In fact, it is extremely hard to imagine the world changing dramatically away from things you are familiar with. What percent of customers will switch to a new provider for investor communications? With no familiarity you would likely have no idea what the answer might be. But research will show you that the answer is only about 2% and that this low rate of client attrition (which is more than offset from winning new customers) has been stable for many years.

So we agree with Lynch’s famous question. “Buy what you know” is excellent advice. But that doesn’t mean buy companies you are familiar with from your day to day consumer experiences. It means get to know companies in depth prior to investing in them and only invest in those companies you are able to build a strong enough understanding of that you “know” how things will turn out even as the uncertainty of the future continues unabated.

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.

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.

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