“Art is the imposing of a pattern on experience, and our aesthetic enjoyment is recognition of the pattern.” – Alfred North Whitehead

If you’ve learned the guitar, you know that most popular music follows similar chord progressions, the most popular being C – G – Am – F. Among the notable songs that follow this pattern are “Let it Be” by the Beatles, “With or Without You” by U2, and “No Woman No Cry” by Bob Marley.

Despite the many potential chord progressions, the C – G – Am – F pattern is particularly pleasing to our ears.

In investing, it’s also helpful to develop an ear for promising patterns. In a given year, the Ensemble research team looks at over 100 companies. Most of the companies are quickly discarded, while others move forward for more serious evaluation.

With time and experience, we have found certain attributes, or patterns, that pique our interest and push certain ideas forward in our research process.

Here are 15 of those patterns and a brief explanation of each.

• Idiosyncratic businesses. We define idiosyncratic businesses as having uncommon characteristics or straddling two or more industries. Because these companies are not like any others and aren’t easy compartmentalized, industry specialists can have a hard time fully appreciating the opportunity. Ferrari is a classic example. It’s not just an auto company and it’s not just a luxury brand – it’s both. In the case of Ferrari, we believe that being generalists rather than specific industry experts has helped us appreciate Ferrari’s auto and luxury characteristics.
• Predator and prey cultural advantage. It’s not enough for a company to have a great culture if its closest competitors also have great cultures. We prefer situations where there’s a vibrant culture in industries full of dull cultures. There’s no predator if there’s no prey. Take banking, which historically has had low levels of customer satisfaction. Money is a commodity and customers tend to bank where they can get the best rates. First Republic Bank turned that model upside down by positioning itself as a customer service business that happens to be a bank. Over time, it’s chipped away at established banks’ market shares with high-touch service. For established banks to compete, it would require massive cultural overhauls.

• A passionate fan base. If a company has a passionate – almost cult-like – group of core followers, it has evangelists producing free advertising. And not just free advertising, the best kind of advertising – social proof. Costco fanatics, for example, are quick to share with friends or their social media networks the tremendous bargains they found at Costco. In turn, you don’t want to miss great deals, so you’re inclined to either join Costco yourself or put your current membership to greater use.
• No-brainer products. We love coming across products and services where the utility is so obvious that the company’s success appears inevitable with enough time. This is what we saw, for instance, when we saw the clinical data around Masimo’s non-invasive, highly accurate pulse oximetry sensors. Among the benefits were a better patient experience, less stress on nurses and doctors, and reduced costs for the healthcare system.
• Playing a different game than competitors. Homebuilder NVR’s business strategy is to maximize local market share and to not own land. Most major homebuilders came into being as land developers and so they continue that approach today. They also want to be in the hot markets across the nation. In contrast, NVR options its land, only building when there’s demand, and stays within its core regions in the eastern part of the United States. It may not be the ideal strategy in every type of housing market, but it’s differentiated, and NVR’s operating results indicate that it’s a superior approach across long-term housing cycles.
• Products you can’t imagine living without. When we think about “staple” products, we typically think about household staples like detergent, tissues, and toothpaste – items we use and consume, regardless of the economy. Yet in our increasingly digital lives, some types of technology are similarly becoming staples. We think Google’s Search and YouTube products, for example, are not discretionary items anymore, but a core part of our digital world.
• Surviving a moat attack. Companies that have repelled previous threats to their moat provide us with additional confidence in the businesses’ resilience and ability to sustain high returns on invested capital. Most restaurants would have been permanently impaired by the type of bad press Chipotle received following the foodborne illness outbreaks of its own doing in 2016. Yet, even in those dark periods, Chipotle’s average unit volume only fell to the fast casual industry average. Being able to withstand the backlash provided Chipotle an opportunity to regroup and improve its operations.

• Founder’s pedigree. CEOs – and founders, in particular – set the tone for corporate culture. Leaders that have instilled productive values across the company, from the C-suite to the customer service representative, have set a culture that will last beyond their own tenure. We noticed this when we visited Masimo headquarters at their 2019 investor day. The employees seemed to share co-founder/CEO Joe Kiani’s love for solving tough problems, creating win-win products, and reducing the cost of healthcare.
• Mission-critical businesses doing what seem to be boring things. Once a business has adopted a piece of software (e.g. Broadridge, ServiceNow) that makes its back-office run smoothly or a supplier that is deeply entrenched in its process (e.g. Fastenal), it’s unlikely to change and potentially disrupt its operations just to save a few dollars. While these mission-critical companies may not make headlines in financial media, they provide a service that day-in and day-out provides value for their customers.
• Focus on consumer surplus. Customers who are convinced they are receiving tremendous value for their purchases will come back repeatedly. Value doesn’t always equal price but is instead a mix of price and quality. Costco passes on the savings it derives from its scale with members who have, in turn, come to understand – consciously or unconsciously – they are receiving value on each purchase. Similarly, Netflix’s membership prices have intentionally lagged the value being created on the platform through massive investments in content.
• Sacrificing the present for the future. In a world where investors love to see companies beating quarterly earnings, it’s refreshing to see companies that are less concerned about this or next quarter’s results and are instead thinking about increasing long-term intrinsic value. Rather than maximize short-term results, Old Dominion Freight Lines invests aggressively in its less-than-truckload (LTL) network capacity in all types of markets. Old Dominion’s investments in quality and capacity also allow it to maintain rational pricing with customers when competitors are chasing rates up and down.
• Positive feedback loops. Category killer businesses dominate their rapidly growing niche, operate in markets with high barriers to entry or scale, and have a long runway for continued growth. But the most critical component is that it has positive feedback loops to reinforce the company’s upward trajectory. To illustrate positive feedback loops, Intuitive Surgical was an early mover in the robotic surgery space and only recently have well-heeled competitors like Medtronic and Johnson & Johnson entered the mix in a serious fashion. But the latecomers have a ton of ground to make up. That’s because Intuitive’s larger installed base of technology and surgeon relationships allows it to learn faster and therefore improve its offerings faster, which in turn furthers its lead over competitors.
• Companies that appear to sell a product, but are selling a service. About a third of Fastenal’s revenue comes from private label fasteners (i.e., nuts, bolts, screws) that cost maybe a cent or two but are marked up 80%. While that may seem egregious, those prices are not related to the fastener itself as much as they are the service Fastenal offers the customer. You might buy a cheaper fastener from another supplier, but Fastenal’s services like inventory management and rapid fulfillment more than offset the big markup on fasteners.
• Branded commodities. We placed former holding, Tiffany & Co. in this group. A casual observer cannot tell a Tiffany diamond engagement ring from one purchased elsewhere, but the wearer knows it’s Tiffany. After all, the recipient saw it come in the trademark robin egg-blue box. And that romantic image alone allows Tiffany to mark up the price of their diamonds versus an unbranded one of comparable quality.
• Self-disrupters. We’ve written that moat erosion typically begins behind castle walls rather than from external threats. Successful companies with limited competition can get lazy and complacent, leaving opportunities for disruptors to take them by surprise. We like to see companies who are willing to disrupt themselves and are culturally able to do so. Netflix is a perfect example. It would have been successful for a time if it had stuck to DVD-by-mail, but would have been left behind as video moved to streaming. It also made the bold choice to develop its own content at a time when licensing desirable content was the blueprint for winning.

Each of these patterns are music to our ears. They come around a lot less frequently than we’d like, but then again, that’s what makes them special. And when you run a highly selective portfolio like we do, we must insist on only owning special businesses.

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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