Companies Trying to Do Unsustainable Things Sustainably

25 June 2021 | by Todd Wenning, CFA

In 2007, during the credit-fueled boom that swept across housing and financial markets, former Citigroup CEO Chuck Prince famously – or infamously – said about his company’s lending practices:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

We don’t need the benefit of hindsight to see the risks inherent in this logic. Prince himself admitted that the environment was unsustainable, yet Citigroup and other institutions pressed on regardless.

For long-term investors like us, you want to avoid companies trying to do unsustainable things sustainably. The longer the practice continues, the larger the off-balance sheet liability becomes. And when the bill comes due, watch out.

The challenge is that few unsustainable trends stop on a dime. Some last a year, others can drag out for a decade or more.

It’s our job as business analysts, then, to identify unsustainable practices and understand how the company is responding to them.

Here are a few examples of unsustainable practices.

We’ve written extensively about the importance of stakeholder analysis in our process. When a company takes advantage of a stakeholder to reward shareholders, we call this “mortgaging the moat.” In other words, the company is pressing its advantage too far, whether it be on excessive pricing for customers or damaging its community through poor environmental practices. Eventually, that stakeholder fights back or walks away.

We’re seeing this play out in the labor markets today, particularly in businesses that rely on lower-wage labor. We can debate the right level of minimum wage in the U.S., but it’s hard to argue that the federal minimum wage has kept up with both inflation and GDP per capita growth.

Many U.S. food service and retail operations have built their business models on a steady supply of minimum and near-minimum wage workers. So plentiful was the labor pool that their business models worked despite employee turnover rates being multiples of the national average.

This tweet from user “fed_speak” perfectly captures why this stakeholder deficiency should be a concern for long-term investors.

Restaurants and retail stores are typically low-margin operations to begin with, so now that the market clearing price for starting wages has jumped, many restaurants and stores are in crisis mode. Their ability to capitalize on plentiful and cheap labor likely masked rotting businesses underneath.

Some economic commentators argue credibly that temporary COVID-related matters like unemployment pay or remote schooling are the reason filling jobs in these industries is difficult. While this may be the case, these are both just explanations for why the current market price for minimum wage type labor is rising. It does not change the fact that restaurants are frustrated they can’t hire people at previously lower wages.

We own four companies in these industries – Starbucks, Costco, Chipotle, and Home Depot. Each of them has long been considered employers of choice due to generous pay and benefits packages. We also believe they have pricing power and can pass on the costs of higher wages to customers without losing demand.

Turning to healthcare, we’ve long argued that the U.S. healthcare system status quo is unsustainable. Relative to spending per capita, the U.S. has far worse outcomes than it should. Whether by government mandate, free market forces, or a combination of both, this will change.

As such, any healthcare company we would consider for the portfolio has to show improved patient outcomes and reduce system-wide costs.

Indeed, improving patient outcomes and reducing system-wide costs is explicitly stated in Masimo’s mission statement. Its non-invasive medical sensors provide better results than the alternatives and thanks to its superior accuracy, reduces false alarm costs. Intuitive Surgical’s minimally-invasive robotic surgery tools reduce recovery times and costs related to infections, blood loss, and readmission risks.

While it may take a lot longer for the U.S. healthcare system to change than we think, we also think that owning companies reliant on the status quo to persist adds risk to our portfolio.

Finally, we look to avoid unsustainable business plans. Companies that successfully developed a crown jewel product that’s throwing off gobs of free cash flow may naturally get too comfortable with their present situation. This opens the door for competitors and can lead to moat erosion.

As Clayton Christensen wrote in his book How Will You Measure Your Life:

 “If you study the root causes of business disasters, over and over you’ll find a predisposition toward endeavors that offer immediate gratification over endeavors that result in long-term success. Many companies’ decision-making systems are designed to steer investments to initiatives that offer the most tangible and immediate returns, so companies often favor these and shortchange investments in initiatives that are crucial to their long-term strategies.”

It’s easy to see how this can happen. Boards establish financial incentives for management to produce better results each year and salespeople know the crown jewel product sells and the next generation’s product is uncertain. A big bet on a next generation product that flops is not great for executive job security or the salesperson’s commission check.

We noticed this happening with Time Warner in 2016 and exited the position once we realized they were unwilling to make the necessary changes to better compete with Netflix on streaming.

Speaking of Netflix, the company has reinvented itself three times, starting out as DVD-by-mail, followed by streaming video, and now as a content creator. Not many companies have the culture needed to quickly pivot toward what they think will work over the next 5-10 years and beyond. To this end, we think Netflix is exceptional.

One industry that will need to adjust in the next decade is the internal combustion engine (ICE) automobile supply chain. Electric vehicles (EVs) have a lot of momentum at their back. Not only do EVs have the support of global governments looking to cut greenhouse gas emissions, but consumers increasingly find them to be attractive options on their own, especially as more charging stations are rolled out.

Tesla’s success with EVs forced the other major auto manufacturers to pay attention and participate. When Ford is willing to overhaul the most popular vehicle in the U.S., the F-150 pickup, to be fully electric, you know sentiment has shifted in Detroit.

Bernstein research suggests that ICE and EVs will reach upfront cost parity starting in 2023. If this proves true and you’re in the market for a new car in the next few years, you would not only have to be okay with paying a premium for an ICE vehicle – you’d also have to concede to higher maintenance costs.

We think there’s a greater chance of EVs taking more share than expected from ICE vehicles than the other way around. As such, we’re avoiding any company that’s taking the other side of that bet. If the ICE end market is not sustainable, then any company that serves that market but is unwilling to adjust its strategy is, to paraphrase Chuck Prince, trying to keep dancing until the music stops.

Companies trying to do unsustainable things sustainably present risks often underappreciated by investors. It’s true that unsustainable practices can go on a lot longer than we think and we might look foolish for not investing or stepping away too early from a trend, but over time we believe our portfolio is best positioned by avoiding these scenarios.

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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