(This is Part V of a five-part series. Part I. Part II. Part III. Part IV.)

“We should not try to design a perfect world. We should make better feedback loops.” -Tim Hartford

At Ensemble Capital we are not in the business of trying to forecast the growth of the average company. We are in the business of trying to identify special, unique companies that we believe are unusually well positioned to outperform the average company. While we may be wrong in our analysis from time to time, it would be an abdication of our duty to make reasonable forecasts when making investments if we were to identify highly unique companies and then simply assume they would grow like an average company plucked from any particular industry during time periods stretching back decades.

For many of our portfolio holdings, our integrated analysis of inside and outside view perspectives leads us to make growth forecasts that are not particularly high. Some of the businesses we invest in only grow at about the rate of GDP. Although we try to avoid investing in truly slow-growth businesses, or those that may see their growth rate decline below the rate of GDP, as we discussed in our extended series on The Risk of Low Growth Stocks.

In fact, we do not view ourselves as “growth investors.” Our investment process centers around identifying highly competitively advantaged businesses, not those that have high growth rates. While we certainly own stocks that third party evaluators deem “growth stocks,” these same evaluators only categorize about half of our current portfolio in this way.

But there is a group of companies in our portfolio where our outlook is for an extended period of super normal growth. We don’t make such forecasts lightly. But these companies share a set of circumstances which are relatively rare. Building a reference class of these companies, which we believe must be selected based on subjective, qualitative assessments, would be extremely challenging. This is particularly true on a retroactive basis where it would be impossible to make subjective, qualitative assessments of companies where you already know the outcome. But we are not arguing that these companies are immune from base rates, rather we are saying that we believe the base rate of growth of these companies is materially higher than the base rate of growth for the average company.

We think of these companies as category killers that benefit from positive feedback loops in rapidly growing markets.

Three of the main reasons that growth tends to slow over time is because:

• Most markets have robust competitors who compete for current growth opportunities.
• High growth markets draw in new competition, reducing future growth opportunities.
• The available market becomes saturated, limiting growth opportunities for all competitors.

But category killers that benefit from positive feedback loops in rapidly growing markets are insulated (although not immune) from these pressures. Instead, these companies:

• Dominant their current market and face only limited competitive pressures.
• Operate in markets with high barriers to entry and/or scale (i.e. Industries that are hard for competitors to enter at all or feature significant barriers to generating material initial growth).
• Participate in industries in which the longer-term addressable market is almost certainly much larger than the current market.
• Feature a set of positive feedback loops that cause the company’s products or services to improve more rapidly than their current or future competitors are likely to be able to achieve.

This last feature, the positive feedback loop, is critical. Most activities in business (and life for that matter) exhibit negative feedback loops, at least over the long-term. These negative feedback loops are a chain of reactions that leads a particular activity to stabilize at some sort of equilibrium. The fact they are called “negative” feedback loops does not mean they are always bad. Indeed, negative feedback loops are important to creating stability.

One example of a negative feedback loop is the way in which the increased profits that a company earns when they raise prices leads to more interest in entering the market from potential competitors. Thus, the negative feedback loop kicked off by raising prices is the reason why free markets in which companies are able to charge any price they want tend to result in relatively low and stable prices for consumers.

Positive feedback loops, on the other hand, lead to exponential outcomes, rather than equilibrium. The fact they are called “positive” does not mean they are always good. For instance, climate change is triggered by positive feedback loops. As more greenhouse gases are released, the atmosphere warms. Warmer air holds more water vapor and water vapor traps heats. This causes the atmosphere to warm further, which causes air to hold more water vapor.

Here is a useful illustration of the difference between a positive and negative feedback loop.

(Source: J. de Rosnay, Principia Cybernetica Web)

One example in our portfolio of a category killer that benefits from positive feedback loops is Intuitive.

Intuitive is the leading provider of robotic surgery systems. You can see our full presentation on the company here. From our report:

“One of the most intriguing things we discovered in our research on Intuitive was the relationship it has built with surgeons in the field and their influence on how Intuitive invests in development of new da Vinci systems, capabilities and tools.

The adoption of da Vinci has been on a procedure-by-procedure basis. Intuitive works on incorporating new technologies and learnings from the field that it believes will enhance the safety, utility, and value of the system. As new capabilities are introduced, intrepid, early adopter surgeons will try them in their practices in new procedure categories. When they find a fit, they share feedback with Intuitive and push it to develop the category appropriate tools to widen the system’s use for it.”

(Source: Intuitive)

The company’s robotic systems now incorporate learnings from over 9 million cumulative procedures with nearly 2 million more and growing rapidly per year expected as we arrive on the other side of COVID. Now the company is doubling down on cultivating the positive feedback loops that characterize their business model. For example, they are rolling out My Intuitive, an app that will allow surgeons to review their own procedure data, compare their performance to the large group of fellow surgeons using the same system for the same procedures, and identify ways to improve.

Intuitive’s robotic surgery systems and the surgeons that use them are part of a positive feedback loop. More surgeons, running more procedures, leads to better outcomes, which attracts more hospitals to buy more systems, which drives more surgeons to run more procedures.

Or in the words of Intuitive CEO Gary Guthart:

“We know that surgeons are absolutely high-performance human beings. They are like elite athletes. I think the My Intuitive App is going to be revolutionary. The power of millions of procedures, projected to the palm of your hand, in close proximity to a computer in your operating room. What we’re doing here is going to change the future in a way that will not revert to the past, and I think it’s important, and it’s crazy exciting.”

Now lots of CEOs get excited about their business. But it is the rare CEO who guides a rapidly growing category creating company as they leverage their massive lead to improve their product in a way that will attract more users whose use makes the product and their fellow users even better. These sorts of opportunities are rare. When they occur it is important that investors do not simply assume that the company’s growth will revert to some base rate average that reflects a reference class of companies that operate in industries with entirely different characteristics.

But positive feedback loops alone are not enough. If an industry is made up of many competitors, all of whom benefit from positive feedback loops, cultivating these loops may only be enough to keep a company competitive, not vault them far ahead of their competition. But Intuitive currently hold more than 90% market share of the soft tissue, robotic surgery market. Their distant competitors are primarily focused on launching their first products not on how to leverage data from millions of procedures to improve outcomes.

Intuitive already handles the vast majority of all robotic surgery procedures, and, thus, captures the vast majority of the available raw inputs to drive their positive feedback loop. Yet today, the company’s systems are only used for about 15% of procedures (human surgeons operating without the assistance of a robotic system do the rest). They are only at 2% of procedures in Europe and a rounding error in Asia.

The growth opportunity is obvious and will continue to attract attempts to enter the market. But it isn’t easy to get regulatory approval to allow a new robotic system to start poking sharp tools around inside of living humans who face life threatening situations. And even if a company successfully enters the market, in order to scale they need to convince hospitals to buy their new, unproven system instead of using Intuitive’s. And then they need to convince surgeons who have spent a decade or more learning to optimize their use of Intuitive’s systems to give the new system a try.

So Intuitive checks off each of the four conditions of a category killer that benefits from positive feedback loops in a rapidly growing market. Their growth will indeed slow down over the very long term. But the forces that conspire to slow down rapid growth are materially less applicable to Intuitive than to the average company included in a broad reference class of corporate growth base rates.

If an investor is any good at all at identifying superior companies with superior growth potential, then the base rate of growth they should expect from their portfolio should naturally be higher than average. Yet at the same time, humble investors (and all investors with strong long-term records are humbled many times along the way) recognize that just because they may attempt to identify superior companies does not mean that they will always be successful. So, neglecting base rates entirely is not something even the most talented investors in the world should allow themselves to do.

At the end of the day, forecasting the future is very, very hard. As the multidecade underperformance of traditional value investing has shown, assuming the future will always look like the past, or “stuffing your ears with wax to avoid being tempted by the siren song of growth,” is not effective. Yet going exploring in the abyss without being tied to the shore in some way or another may well lead to the crushing losses that are common among undisciplined growth investors.

The key is to remain flexible in your thinking. To understand how tempting, yet dangerous, the Siren song of growth is while also recognizing that as Warren Buffett said, “Growth is always a component in the calculation of value.”

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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