Executive Summary

• The Ensemble equity investment strategy is down approximately 22% on a year-to-date basis through March 7th 2022. Our portfolio performance is being negatively impacted by a panic over the risk of stagflation. Stagflation is a rare economic environment characterized by low or negative real growth along with high inflation.
• The war in Ukraine, like most military conflicts, primarily impacts stock prices through the economic impact of the war. Thus this post will focus on the concerns about stagflation that the war is influencing. Historically, events like 9/11, the Cuba Missile Crisis, and even Pearl Harbor, did not cause large and persistent declines in the US stock market. While we take the risk of direct military conflict between Russia and NATO very seriously, we believe the stock market impact of this risk can be best understood via the economic impact it would have. These war related economic impacts are the focus of this post.
• We believe our portfolio holdings are having their valuations marked down significantly due to indiscriminate selling of stocks that trade at relatively high valuations in reaction to stagflation fears. But our portfolio holdings have been selected specifically for their robust pricing power that allows them to better navigate inflationary environments than most other companies.
• The decline in our portfolio performance does not appear to be due to the reversal of any prior over valuation. In fact, our overall portfolio trades at a 12% price to sales valuation discount to where it traded prior to COVID. A quarter of our portfolio trades at a 20%+ valuation discount to end of 2019 levels. At this point, the rise in the value of the stocks in our portfolio has been notably less then the increase in revenue these companies have achieved during COVID.
• It is not inevitable that a stagflationary environment is coming. The current economic environment is characterized by strong, not weak, real growth. While a stagflationary environment could emerge, it is important to recognize that the stagflation of the 1970s was triggered by a far, far larger oil price shock than we are witnessing today. At the same time, the US economy is far less energy intensive than it was in the 1970s with each unit of GDP requiring less than half the amount of energy that was needed in the 1970s.
• We have a long track record of generating superior performance across different economic  environments. This track record includes multiple periods of underperformance, some quite notable. The degree of our recent underperformance has been highly unusual, but not without precedent. A decade ago, we experienced a similar degree of relative underperformance. So our long term track record of outperformance is inclusive of a prior period of under performance like today.
• We will not capitulate to other investors’ fears. Acting on other investors’ mispricing of stocks is the core driver of our long term outperformance. But we continue to monitor incoming news and stress test our assumptions. Should the evidence support trimming or selling any stock in our portfolio, we will take action immediately.

The first nine weeks of 2022 has brought with it a sudden and dramatic shift in stock market dynamics. Not only has the overall stock market fallen into a correction, the types of stocks that are performing relatively well or poorly has reversed dramatically.

At Ensemble, we believe deeply in the value of communicating regularly and transparently with our clients about what is going on in the market, our equity strategy, and with notable portfolio companies. While we do not typically comment on our investment performance in blog posts, given the significant decline in our equity strategy we feel it is important to lay out what is going on in the market and our portfolio, as well as our thinking around the path forward.

Because our performance track record is based on a composite of separately managed accounts that is reported on quarterly, this post will describe approximate investment returns to allow us to comment on an intra-quarter basis. You can download a full presentation of our performance track record from its 2004 inception to December 31, 2021 here. This presentation will be updated in April to include final returns for the first quarter of 2022. Important disclosure information related to our composite returns can be viewed here.

Across 2020 and 2021, we generated very strong absolute investment returns and ended 2021 just off our all-time highs. Our relative performance vs the S&P 500 peaked a bit earlier during the fourth quarter. But after returning a cumulative 61% over the last two calendar years, our investment strategy is down approximately 22% through March 7, 2022. We believe that the root cause of our weak recent performance is a panic sweeping through equity markets – and particularly through high quality business that trade at premium valuation multiples – about the risk of stagflation.

On our March 20, 2020 COVID conference call, we also used the word “panic” to describe what was happening during the market’s early reaction to COVID. But in doing so, we qualified what we meant by “panic”:

“Webster’s dictionary offers three definitions of the word panic. So I want to make clear about which of those I’m referring to. I do not mean what Webster’s defines as “a sudden unreasoning terror”… But Webster’s also defines a panic as “a sudden overpowering fright” and as “a sudden widespread fright concerning financial affairs that results in a depression of values caused by extreme measures for protection of financial assets.” It is to these latter definitions that I am referring.”

So when we refer to a panic over stagflationary concerns sweeping the stock market today, we do not mean to suggest these concerns have no basis. Instead, we mean that a sudden, overpowering fear of stagflation has gripped investors, who are reacting by taking extreme measures to protect their financial assets, which has the result of depressing the value of certain types of stocks more than others. In our post today, we’ll describe these stagflation fears, why they are particularly depressing the value of many of the stocks we own in our investment strategy, why we think this negative impact is significantly overdone, and why the worries of stagflation may not end up being realized.

Stagflation

Growth in the economy is made up of both “real growth” and inflation. Real growth refers to increased economic activity, while inflation represents increased prices. During the decade prior to COVID, real growth averaged about 2.25% while inflation averaged about 1.75%, for total growth of about 4%.

The economic cycle is generally described as having an expansionary period during which real growth and inflation are positive, and then recessions, or the relatively brief periods when real growth turns negative. In a typical economic cycle, as an expansion persists over a period of time, heightened demand builds to a level that exceeds an economy’s supply capacity. This excessive level of demand vs supply causes inflation to rise. Rising inflation causes the Federal Reserve to raise interest to reduce demand and head off inflation, and then at some point naturally weakening demand or increased interest rates from the Fed cause demand to fall below the economy’s supply capacity. Companies then cut back on workers and investing in new capital projects, and this leads to a recession.

In this typical, stylized economic cycle, inflation and real growth are correlated because it is real demand rising faster than an economy’s supply capacity that causes inflation to rise. But it is possible for high inflation and slow, or even contracting, real growth to occur at the same time. This economic condition is referred to as stagflation. Stagflation has been a very rare economic condition in the US, occurring only in the 1970s.

Since inflation is generally caused by rising demand, it typical occurs during periods of strong real growth. But there are some economic events that can simultaneously slow real growth while increasing inflation. Today, both the nature of the COVID economic recovery and the war in Ukraine are triggering worries that the US may be entering its second stagflationary period.

With COVID, both the fiscal stimulus programs passed by the Trump and Biden administrations and the supportive Federal Reserve policy were designed to support demand during a period when household income would otherwise have fallen dramatically due to the massive layoffs that hit in March 2020. But at the same time, businesses around the globe struggled to engage in economic activity, both due to attempts to keep their employees safe and government limits on business activity.

After the initial plummeting in real economic activity, the economic expansion that began in April of 2020 saw rapid growth in both supply and demand. This resulted in very strong real growth. As the recovery continued in 2021, consumer demand grew dramatically, aided by the stimulus but also the previous forced savings from the restrictions on services spending such as travel and restaurants. But the persistence of COVID restrictions impacted the ability of companies to increase supply by as much as demand was increasing. This imbalance caused inflation to climb towards 4% over the summer and then rise rapidly to about 7% as the Delta and then Omicron Waves once again limited businesses’ ability to grow supply, including being able to attract enough labor to come back to work.

So, the persistence of COVID has limited the ability of the American economy to produce economic supply. This is seen most notably in our snarled supply chains and in the fact that despite rapidly rising wages there are still about 3 million fewer people working today than there was pre COVID, and about 7 million fewer people than would have been employed if the pre-COVID job growth trend had continued.

(Source: Bloomberg)

With inflation racing up, the Federal Reserve has pivoted to say that they expect to raise interest rates faster than they had planned. Rather than supply naturally catching up with demand as COVID faded back in June of 2021 when many people thought the worst was behind us, the Delta and Omicron Waves kept supply growth in check and, thus, the Fed now believes that they need to dampen demand growth to give supply time to catch up.

But starting at the beginning of this year, equity investors started questioning whether the Fed would need to raise rates so quickly and so far, that rather than just giving supply a chance to catch up, the Fed might instead force demand to contract and send the economy into a recession.

At just about this same time, concerns about Russia possibly invading Ukraine started to heat up. In the middle of January, two things happened during the same week. The CPI measure of inflation was reported at over 7% and US-Russian diplomatic talks regarding Ukraine ended without any sort of resolution.

As we all now know, Russia ended up invading Ukraine, with massive US and EU sanctions being put in place, which have had the result of sending oil and other commodity prices skyrocketing. While the increase in oil prices is not as large as the increase seen in the 1970s, and the US economy is far less energy intensive then in was during the last bout of stagflation, equity investors have been reminded that it was a big oil price spike that was largely responsible for the stagflation of the 1970s. This is because high oil prices increase the cost of many goods (inflation) while also reducing households’ ability to spend money on non-energy related products and services (slowing growth).

Suddenly, even coming off 2021, which ended with year-over-year real growth of a remarkable 5.6% in the fourth quarter, investors have suddenly shifted to assume a major slowdown in real growth or even a recession will come quickly and be accompanied by high levels of inflation.

Thus, what was seen as a robust and likely long lasting economic expansion just a few months ago, is now seen by many investors as a low real growth or even recessionary environment that is accompanied by high inflation.

A stagflationary panic has gripped the market.

The Impact of Stagflation on Stocks

There are two ways that stagflation impacts the value of stocks.

• The low level of real growth reduces the opportunity for companies to grow real revenue and earnings. This is particularly true for economically sensitive or high growth businesses, while it is less true for slow growth businesses whose growth rates are less tied to the overall economic cycle.
• The high levels of inflation causes interest rates to rise, which means the rate of return offered by safe bonds increases. Thus, since stocks are riskier than bonds, the valuation placed on any given dollar of future corporate earnings is reduced, as investors seek to make sure that the stock they bought will outperform a safe bond that now offers a higher rate of return.

During the recent sell off, some investors have suggested that stocks that are dropping dramatically in value are doing so because they traded up to excessively high valuations or even entered a bubble during COVID. But if you look under the surface of the market, this does not seem to be the cause of the sharp selloff this year. Back in January of 2021 on our quarterly client call, we discussed what we said were excessively high valuation in some categories of “COVID winners”:

“There appears to be clear signs of speculative activity in some parts of the market. Stories of new investors gambling their stimulus checks on cryptocurrency, electric vehicle SPACs and Software as a Service stocks are everywhere, yet a collapse (if it comes) in these assets does not need to mean the broader market declines.”

One way to visualize what was happening in these speculative corners of the market is via the Goldman Sachs index of unprofitable technology stocks. This basket of technology and other “new economy” companies which do not yet earn a profit, saw its price rise by an astounding 255% from the end of 2019 to February of 2021. But far before there were stagflation worries, this bubble began to collapse.

(Source: Bloomberg)

Today, even after declining by 60%, the unprofitable tech index is still up 50% meaning it would need to fall again by a third to fully reverse its COVID era gains. Notably, some of these companies aren’t just overvalued, but are outright frauds that were taken public via SPACs to take advantage of the bubble in speculative stocks. During that same client call, we said:

“Nikola, a company that purports to be in the business of making electric vehicles, but has not actually generated any revenue, used a SPAC to go public and commanded an eye watering valuation of $30 billion before stories about the “ocean of lies” told by the company started to make the rounds, sending the stock down 80% over just the last six months.”

Today, Nikola is down another 50%. It isn’t just that the company isn’t profitable, they still haven’t even generated any revenue.

So, while the index of unprofitable tech stocks fell by 20% during 2021 and nearly 40% from its February 2021 high to year-end, the broader market and our investment strategy generated very strong 25%+ returns and finished the year just off all-time highs.

In contrast, our portfolio is largely made up of dominant businesses that exhibit solid, if not ultra-high, growth. We are not “growth investors” per se, and 3^rd party evaluators only categorize a bit less than half of our portfolio as so called “growth stocks.” But we purposely avoid low growth stocks, which we think have significantly under appreciated risks. In general, the dominant industry leaders we invest in have solid growth rates so our portfolio tends to tilt towards companies that grow faster than average.

Growth stocks as a group are down 18% this year through March 7^th. And when we look at the performance reported by other investors like ourselves who focus on competitively advantaged businesses, with long growth runways, and trading at a value that we believe is less than the future cash flow the company will generate, we see our peers mostly down by around 20%.

Our goal is to outperform our benchmark, the S&P 500, net of fees, by a meaningful amount over the long term. We have an 18 year track record of doing this. So, in mentioning the decline in growth stocks overall and the similar performance from investors we view as following a similar strategy to us and who have generated superior long term returns, we do not mean to downplay our own weak performance.

Rather, we are simply observing that our performance issues do not appear to be due to idiosyncratic issues with our investment strategy per se, but rather a very large swing in market valuations that have deeply discounted the valuation of the type of stocks we focus on.

This, of course will happen from time to time, as short to medium term conditions will favor certain specific baskets of stocks or industries, but over the long term, those companies that are able to grow faster than the average company while driving high rates of return on capital should predictably outperform, so long as investors do not excessively overpay for these best in class companies.

Stagflation Driven Sell Off is Overdone

As stagflation panic has gripped the market, many of our portfolio holdings have seen their valuations compress sharply. Today, top portfolio holdings such as Netflix, Illumina, Mastercard, Ferrari, and Masimo, which collectively made up about a quarter of our portfolio at the beginning of this year, have seen their valuation compress so much that on a price to sales basis, they are trading at an average of 20% below pre-COVID levels. Far from trading at inflated valuations, the sell off in these stocks has been so deep that they have much more than reversed any prior amount of COVID era valuation expansion. On a weighted average basis, our portfolio now trades at a 12% price to sales valuation discount to where our current holdings traded at the end of 2019.

The stagflation panic is so extreme that investors have lost a degree of confidence in the dominant industry leaders that we focus on owning. The fact that many of our holdings now trade at lower valuations than they did even prior to COVID implies that investors think these companies’ growth prospects and shareholder value creation opportunity ahead is greatly diminished. But we think these concerns are misplaced.

Academic theory tells us that when inflation is high, the valuation ascribed to cash flow that will be received in the future declines. But in practice, there has actually been little correlation between inflation and stock valuations.

(Source: Crestmont Research)

As you can see in the chart, price to earnings ratios have not been all that different during periods when inflation was anywhere between 0% and 5%. It is only when inflation has gone negative (deflation) or exceeded 5% persistently, that valuations tend to be negatively impacted. To illustrate this, it is worth noting that inflation averaged 3% during the 1990s. The 90s were characterized by robust economic growth, strong household wage gains and a big bull market in stocks.

Our portfolio companies have strong pricing power, giving them the ability to raise prices to help offset inflation. This is something they’ve been demonstrating over the last year, as many of our holdings have raised prices without seeing a negative impact on demand for their products and services. And while the cost of their expenses, notably wages, are inflating, we specifically select companies to invest in that pay above average salaries and maintain positive relationships with employees as well as all of their other stakeholders. On a relative basis, we think our companies have more room to manage inflating costs than do their competitors.

In January, we experienced the first large price decline in one of our top holdings when Netflix reported earnings. We wrote an extensive analysis of what happened that we won’t repeat here. But the over reaction in the market is illustrated well by noting that Netflix stock now trades at levels it first reached in 2018 despite revenue having doubled since then.

We believe that the broad based selloff in speculative stocks that began in February 2021 and is ongoing today, has now become conflated with the sell off in high quality, long duration growth companies that benefit from significant competitive advantages along with the pricing power that accompanies their competitive positioning.

Businesses that  generate strong returns on invested capital and offer long duration growth trade at relatively high valuations not because of a speculative bet on future growth rates, but because these sorts of businesses generate very large amounts of free cash flow per dollar of earnings and their competitive advantages help protect them from having other companies try to steal their growth opportunities.  But today, investors are selling off seemingly every stock that has a relatively high valuation as if they will all suffer equally in the event of stagflation. This is the root cause of the excessive sell off in the types of companies we invest in.

Is Stagflation a Fait Accompli?

Not only are investors indiscriminately selling off all relatively highly valued stocks, they are also acting as if stagflation is a foregone conclusion. But in the most recent quarter, real GDP grew by 5.6% vs the prior year. And the average 500,000 new jobs that were created in each month of 2021 has continued in 2022 with 480,000 new jobs created in January amid the Omicron Wave and 680,000 new jobs created in February. These are monster new hire numbers and point to continually increasing economic supply capacity and real growth potential.

Thinking about inflation is not new for us. In June of 2021, prior to the broad acceleration in inflation, we offered a detailed analysis of how investors should be thinking about investing in the “high pressure economy” that we saw ahead. As we explained at the time, while supply chains and labor markets are currently constrained, there is very significant room to grow supply capacity in the years ahead. Even though the recovery from COVID has been rapid, the economic output of the US remains well below its long-term trend. With demand surging, the limit on growth is a function of how fast supply can be increased.

(Source: SCOTT GRANNIS)

The 14 consecutive months of big new job creation numbers illustrates that while the persistence of COVID has caused supply to recover more slowly than demand, it is indeed increasing very rapidly and still has a long way to go to get back to the pre-COVID trend, let alone the much longer term growth trend that was interrupted by the financial crisis in 2009-10.

But what about oil prices? Having surged by 60% this year through March 7^th, investors are remembering the oil price surges of the 1970s and the way this created a stagflationary environment. But the price of oil quadrupled in the wake of the of the OPEC oil embargo and by the end of the inflationary spiral of the 1970s, oil prices had increased by a hard to comprehend 1,000%.

Oil prices started this year at $75/barrel. So, while oil prices have risen sharply in the wake of Russia’s invasion of Ukraine, they would have to rise to $300/barrel to represent a similar shock to the OPEC embargo. And, they would have to rise to $750/barrel to capture an increase of similar magnitude as seen during the stagflationary 1970s.

More recent history illustrates that oil prices were sustained near current levels from 2011 to 2014. Despite household earnings being well below current levels, these high oil prices did not create high inflation and did not notably slow economic growth.

(Source: Bloomberg)

How could this be? If rising oil prices were such a driver of inflation in the 1970s, why would they not have such a big impact a decade ago or today? The fact is the US economy has become far less energy intensive than it was 50 years ago. Today, it takes less than half as much energy to create a unit of economic output as it did in the 1970s. The average household spends much less of their income on energy than they did half a century ago.

So, while there is no doubt that higher oil prices will reduce households’ and businesses’ abilities to spend on other economic activity, the current magnitude of the oil price spike simply pales in comparison to the oil price shock that triggered the unique stagflationary period of the 1970s.

Conclusion

Ultimately, the effectiveness of our investment strategy will be determined by our long-term investment returns. The degree of our recent underperformance has been highly unusual, but not without precedent. A decade ago, we experienced a similar degree of relative underperformance. So our long term track record of outperformance is inclusive of a prior period of under performance like today.

Over our 18-year track record, our strategy has had lower volatility than the S&P 500 (ie a beta of less than 1.0). Our downside capture ratio has averaged 91%, meaning that during periods when the market has declined, our strategy has declined by less than the market on average. But we have indeed had many periods when we underperformed, yet our long-term track record of outperformance is inclusive of these periods of underperformance.

The fact is, we don’t know when investors will re-evaluate how they are valuing the stocks we own in our client portfolios. It could begin tomorrow, or it could take a year or more. We know that market prices are out of our control.

But we also know that we have an 18-year track record of effectively valuing our portfolio holdings more accurately than the market. A track record of outperformance using a long-term investment strategy is predicated on the investor being better at valuing the long-term prospects of companies than the average investor.

Our investment strategy is not designed specifically for any one specific economic environment. We generated superior returns during the economic expansion from 2004-2007 as well as through the deeply recessionary period of 2007-2010. After underperforming notably in 2012 and 2013, we returned to notable levels of outperformance in 2014-2019, with superior returns continuing during COVID up until just a few months ago.

Periods of weak performance like we are experiencing today are frustrating and emotionally painful for both our team and our clients. But we know that superior long-term returns don’t come easy. The market is currently valuing the stocks in our portfolio very differently than we are. It is always possible that the market is right, and we are wrong. To minimize this risk, we constantly stress test our forecasts and seek to understand where we might be wrong.

But at this point, our conclusion is that a stagflationary panic has gripped the market. The types of stocks we have long invested in have been swept up in this panic without regard for their robust long-term growth outlooks and dominant competitive advantages that protect them from competition and allow them to raise prices as needed more easily than most companies. Real economic growth in the US is currently robust with both supply chains healing and Americans returning to work at unprecedented rates.

Our conviction in our strategy remains high. We intend to continue monitoring incoming data, track out companies closely and change our assessment of the value of our portfolio holdings if the evidence supports us doing so. But we will not simply capitulate to market pricing. The market has a long history of overreacting to both good and bad news. And while it is difficult to be on the wrong side of these overreactions, it is these very same overreactions that give rise to the opportunity for long-term outperformance in the first place.

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