“Invest in a promising company you don’t care about, and you might enjoy it when everything’s going well. But when the tide inevitably turns you’re suddenly losing money on something you’re not interested in. It’s a double burden, and the path of least resistance is to move onto something else. But if you’re passionate about the company to begin with – you love the mission, the product, the team, the science, whatever – the inevitable down times when you’re losing money or the company needs help are blunted by the fact that at least feel like you’re part of something meaningful, which is fuel to stop you from giving up and moving on.” – Morgan Housel

In early March, when global markets sold off amid COVID-19 concerns, the Ensemble Capital research team held a special portfolio review session.

The purpose of the exercise was two-fold:

• Stress test our valuation assumptions. No reasonable pre-COVID bear case for certain companies would have assumed months with no revenue, for example.
• Review our convictions. We only invest in companies we believe will survive recessions and come out stronger on the other side, but this was a unique scenario.

We concluded that our companies could both bear acute short-term revenue declines without impairing long-term value and were well positioned to emerge stronger on the other side of COVID-related lockdowns.

This was still true of the one company we sold, but we considered it our lowest-conviction holding and reallocated the capital to higher-conviction holdings. When you’re heading into a storm, you want the crew that gives you the best chance of navigating through it.

Now, this might be a clear example of endowment effect (people tend to overvalue a thing they already own than if they didn’t own it), but I think there’s more to it than that. Let me explain.

When I joined Ensemble Capital, I pitched the team on some businesses I determined had economic moats, or durable competitive advantages. While Sean and Arif agreed the companies had moats, they didn’t think they fit Ensemble Capital’s strategy.

I was confused. Don’t we want to own companies with moats? Sean clarified: these are good businesses, but we want great businesses.

This is an important distinction between what we believe we’re doing and what a generic “quality” strategy might pursue.

In other words, the “good” businesses I presented would likely be in the top 10-20% of all publicly traded companies in terms of quality. They’d fit just fine in a quality strategy. They might even turn out to be good long-term investments, but they don’t make our cut.

So, what makes for a great company?

In short, they do something interesting.

In the book Good Strategy, Bad Strategy, business professor Richard Rumelt gives an example of a silver machine dropped on Earth by aliens. The silver machine produces silver at zero cost. Does it have a low-cost moat? Yes. Is it interesting? No (other than the fact that aliens made it, of course).

Rumelt explains the difference:

“The silver machine’s advantage gives it value, but the advantage isn’t interesting because there is no way for an owner to engineer an increase in its value. The machine cannot be made more efficient. Pure silver cannot be differentiated. One small producer cannot pump up the global demand for silver. You can no more increase the value of the silver machine than you can, by yourself, engineer an increase in the value of a Treasury bond. Therefore, owning this advantage is no more interesting than owning a bond.”

What makes a competitive advantage interesting is when there are opportunities for management to use it to dramatically increase the firm’s value and widen the moat. If the best management can do is manage the status quo, that’s not interesting.

As an analyst, you’re always looking for an insight or a hook about a business that engages your interest. Not only does this make the research process more enjoyable, but it helps you to stay the course.

To illustrate, I’d known about Chipotle as a customer and investor, but I only got interested when I put together how hard it is for a restaurant to reach “escape velocity” from the gravity of its local/regional market and realize national scale advantages. Chipotle was in the early stages of realizing this benefit. More impressively, it was doing so with freshly prepared, responsibly sourced food. There are no microwaves, freezers, or can openers in the kitchens.

Once I established the longer-term implications of Chipotle’s strategy, the short-term fluctuations didn’t seem to matter as much.

To be sure, interesting doesn’t have to equal exciting.

Fastenal is a distributor of industrial supplies and, for most of its existence, its largest product category was fasteners (i.e. nuts, bolts, screws, etc.). Pretty boring at face value, right? But Fastenal has been one of the best performing stocks in recent decades.

What makes Fastenal interesting to us is that it steadily added more services to its traditional distribution business. This made Fastenal even more entrenched in its major customers’ day-to-day operations.

Idiosyncratic businesses in boring industries can also be interesting. Traditional banking itself is bland and commoditized, but we view First Republic Bank as a customer service franchise disguised as a bank. In an industry where customer satisfaction tends to be indifferent at best, First Republic’s Net Promoter Scores are akin to consumer favorites like Apple, Ritz Carlton, and Southwest Airlines.

Happy customers are great, but what makes First Republic interesting is that customer delight translates into superior financial performance. Over 50% of First Republic’s growth comes from existing clients and another 25% from satisfied clients’ word-of-mouth referrals.

Great businesses are interesting businesses. They are peculiar in their ability to widen their moats and enhance shareholder value over the long term, even during times of economic downturn.

Market sell-offs produce the very-human inclination to take action in the face of danger. Charlie Munger’s sage advice to never interrupt compounding unnecessarily can be cold comfort when the market drops 20% or 30%.

Owning truly great businesses, therefore, is somewhat of a brain hack. When you own great and interesting businesses and see the bigger picture, you’re more likely to hold them through the short-term turbulence, and increase your chances of maximizing returns.

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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