The Disconnect Between Corporate Fundamentals & Stock Prices
In early March we first started talking about a Stagflation Panic that we believe has gripped the market. Since then, we have observed an accelerating disconnect between the current economic reality of the vast majority of our portfolio companies’ reported corporate results, and the behavior of their stock prices.
Now that first quarter earnings season is mostly done, we would like to share a brief summary of what our portfolio companies are reporting about the state of their businesses and their current outlooks. This is not a complete list of our investments, but it covers every stock in our portfolio with over a 2% position size.
These brief highlights focus on just the metrics that illustrate the core aspects of each company’s current business conditions. Every quarterly report always includes details that are positive and negative. Our assessment of our investments is based on detailed analysis of their corporate results within the context of their operating environment. But given the huge disconnect between the share prices in our portfolio and the operating results of the businesses they represent, we felt that this brief review would be helpful.
Booking Holdings (online travel agent)
The company reported blowout revenue and earnings growth. The company said that after a very brief pause in hotel bookings in the week after the Russian invasion of Ukraine, business came roaring back. In April, demand went vertical with hotel bookings exceeding pre-pandemic levels. Gross bookings (the total value of travel reservations) jumped to 30% above 2019 levels.
Broadridge Financial Solutions (software and services for banks and brokers)
The company reported better than expected earnings and increased their full year guidance to the high end of the range they had offered previously. Broadridge’s business is so stable that it is the only company in our portfolio whose core results were barely impacted in 2020 and 2021 by the pandemic. This stability continues in 2022.
Charles Schwab & Co (brokerage and custody services)
The company reported revenue that was approximately equal to what they reported in the first quarter of 2021. A year ago, they had experienced a massive 80% surge in revenue as market values and trading boomed. The company is expected to return to double digit revenue growth this year as they move past the surging revenue of early 2021. One of the most powerful drivers of future earnings for the company would be higher interest rates which cause the company to generate much higher levels of earnings on the cash that clients hold in their brokerage accounts. Despite rising interest rates, the stock has fallen sharply this year causing the CEO to personally buy $10 million worth of stock in the days after the company updated investors on the state of their business, something we have not seen him do in years, indicating his enthusiasm for the outlook of the business.
Chipotle (fast food)
The company delivered first quarter revenue and earnings above expectations and guided for growth to accelerate as recent menu price increases have not slowed customer demand. Chipotle is accelerating the speed with which they open new locations as the shift to digital ordering has opened up opportunities for new store formats. They expect to increase store count by 8%-10% per year and believe they can more than double their total store base over the long term.
First American Financial. (title insurance)
While refinancing of home mortgages has fallen dramatically causing the volume of title policy orders to fall sharply, high levels of home price appreciation has driven up revenue from much more valuable home purchase title policies. Commercial real estate transactions and prices remain very strong driving continued growth in this segment as well. The stock now trades at its lowest earning multiple outside of the housing crash of a decade ago and the company bought back 3% of their shares in the first four months of the year saying if the stock stays at this level they see share buybacks as an excellent use of capital. The company reiterated their full year guidance.
Fastenal (manufacturing supplies)
This company serves a wide range of manufacturing businesses providing them parts and supplies. Revenue grew 20% and slightly exceeded expectations. The company said that demand strength was broad based across different customer types. They also said that they are seeing inflation slow in their industry and expect it to “drop fairly sharply” in the second half of this year.
First Republic Bank (banking for high net worth families)
San Francisco based First Republic reported their highest ever level of loan originations with revenue growing 23%. They maintained their 2022 guidance for mid-teens loan growth. When asked about the impact of higher mortgage rates on housing, the company said that housing supply is so far below demand that even if higher rates markedly reduces the number of buyers, there will still be multiple bidders on nearly every home for sale. This comment is supported by the fact that despite higher interest rates, a record high percentage of new home listings nationally are selling within just two weeks of going on the market. First Republic operates in some of the most supply constrained housing markets in the country such as San Francisco and New York, while also operating as one of the most conservative mortgage underwriters in the business.
Google (online advertising)
Despite having grown revenue at faster than typical 26% a year over 2020 and 2021, the company posted another quarter of elevated growth with first quarter revenue up 23% or 26% excluding the headwind from the strong US dollar. Looking only at their US revenue, the company grew revenue at a blistering 27%, even faster than their US growth rate across 2020-2021. While the company does not offer guidance, they were clear that they continue to invest heavily in the business in the face of significant growth opportunity. They are buying up real estate for new offices and told investors to expect their 20% annualized growth rate in hiring new employees to continue. The company has been buying back its stock at an accelerating rate and authorized a new buyback plan that implies this acceleration will continue in 2022.
Home Depot (home improvement)
Home Depot has not yet reported earnings, but the company and their competitor Lowe’s said at investor conferences a month ago that demand remained very strong, and they reiterated their full year outlook. Last week, home improvement company Floor & Décor reported better than expected revenue and earnings and reiterated their guidance for the year. The company noted repeatedly that they saw particularly strong growth with professional contractor customers, who make up half of Home Depot’s revenue base.
Illumina (genetic sequencing equipment)
The company reported better than expected first quarter earnings with as expected revenue growth of 12%. They reiterated their full year revenue growth guidance of 13% to 15% despite headwinds to international revenue from the strong US dollar and the COVID wave in China driving near term disruptions. In addition to strong growth in revenue, management also reported record backlog levels driven by strong adoption of gene sequencing in clinical applications like oncology and rare disease testing.
Landstar Systems (trucking)
The company reported 53% revenue growth and better than expected earnings in the quarter and guided to second quarter revenue growth of 29% with expected earnings much higher than the Wall Street consensus. When asked by analysts about media reports on rapidly deteriorating demand for trucking, the CEO said that while they are seeing “a little softness,” the slowdown of demand was “not even close” to what has been discussed in the media. Their CEO said on the call, “I don’t think in the history of my career, I’ve seen this sort of differential between what some of The Street is saying and some of the information out there [in the media], compared to what we’re seeing.”
Mastercard (payment services)
Revenue and earnings came in materially better than expected with revenue growing 24%, or 27% after accounting for the strength in the US dollar. Noting that for the first time since the pandemic began cross border spending (travel between countries) had exceeded 2019 levels, the company reiterated their full year growth outlook even after taking into account the shutting down of their services in Russia. In December, the company offered a three-year growth outlook that was higher than their pre-pandemic growth expectations and noted that even with contribution from Russia related growth now gone, they still planned to achieve their multi year growth goal. The company noted that “consumer spending remains strong globally,” “US retail spending remains healthy” and “our business fundamentals remain robust.”
Masimo (medical sensor technology)
The company had pre-announced weaker than expected results due to supply chain problems, but on the call said they were back on track and would fully recover the delayed sales in Q2 and in the full year. But while demand in the core medical sensor business has remained consistent, investors have been shocked by the company’s unexpected acquisition of an audio company as part of a strategy to extend their medical technology into home-based patient monitoring and consumer health products, such as hearing aids. In our own view, the company’s communication to investors about the strategy related to the large acquisition has fallen far short of what it should be. The company insists that explaining the strategy in more detail at this time would tip off competitors as they race to market and plan to provide an in-depth strategy update at an Investor Day in September.
Netflix (streaming video)
This is a business that has seen a sharp slowdown in their business. Despite adding over 8 million new subscribers in the fourth quarter, consistent with the strong growth from 2018 to 2021, the company’s growth rate slowed materially in 2022. Despite a mainstream media narrative that the company is rapidly losing customers, they actually added half a million new subscribers in the first quarter, growing their subscriber base by 8% over the last year. Offering guidance for the second quarter, the company said they expect to lose 2 million subscribers, or 0.9% of their subscriber base, before returning to growth in the second half of the year. But it is very clear that the jump in inflation has greatly impacted the company’s Latin American end market while inflation plus the war in Ukraine has created a big headwind in Europe. With this company, a big slowdown is indeed occurring with the debate being whether it signals the end of Netflix’s growth or a pause that they can recover from in the years ahead.
Nike (athletic shoes)
This company last reported earnings in March, but at that time they reported better than expected revenue and earnings growth saying that their main challenge was not limited demand but getting enough supply saying, “Marketplace demand continues to significantly exceed available inventory supply, with a healthy pull market across our geographies.” Supply challenges have been driven by COVID issues in Vietnam where the company produces many of their products, as well as logistical issues related to manufacturing and delivery in the midst of global supply chain problems. But the company sees this issue fading saying that at this point, “all factories in Vietnam are operational, with total footwear and apparel production in line with pre-closure volumes and our forward-looking demand plans. Nearly all of our supplier base is operational without restrictions.” Nike continues to accelerate its popular Direct to Customer strategy which drives increased profit margins.
Nintendo (video games)
The company reported the completion of a 2022 fiscal year in which sales of their popular Switch gaming console exceeded annual sales from pre-COVID levels despite significant supply chain issues limiting the number of consoles they could produce to levels below actual demand. They also said that the number of actively playing users exceeded 100 million for the first time, up 79% from the year prior to COVID and up 17% vs the period from April 2020 to March 2021 when global shelter-in-place orders drove up video game playing time. Switch owners remain highly engaged with the platform ahead of a slate of big games to be released this summer and fall. Nintendo did recently announce the delay of the highly important franchise game Zelda: Breath of the Wild 2, as well as the release of the coming Super Mario Bros movie, to early 2023. While a disappointing development, the shifting of both releases in the context of supply chain problems suggests the long-awaited next generation Nintendo Switch console – often referred to as Switch “Pro” or “2.0” – may finally be released alongside the movie and franchise Zelda game in an early 2023 series of events that we expect to catalyze a new upgrade cycle.
ServiceNow (enterprise software)
The company reported better than expected revenue growth of 27% and maintained their full year guidance of 26% growth despite facing incremental headwinds from US dollar strength. On the call, the CFO said, “While enterprises are navigating a complex macro environment, our ability to continue delivering strong results exemplifies the resiliency of our business and the mission-critical nature of the Now Platform… [we] outperformed across all of our Q1 guidance metrics. In fact, net new contract value growth accelerated year-over-year driving the fastest Q1 growth we’ve seen since 2018. We expect that momentum will carry into Q2 with net new ACV growth consistent with our very strong second quarter last year.”
NVR (home building)
Despite massive challenges getting labor and products to build new homes, NVR reported 17% revenue growth with much better than expected earnings as rapidly rising home prices allowed them to generate extremely high gross profits on the homes they were able to build. With the stock trading at its lowest valuation since the housing crash of over a decade ago, the company bought back 5% of their outstanding shares last quarter and quickly authorized significant additional share buybacks. NVR’s management team has an excellent reputation as a smart buyer of their own stock, having reduced shares outstanding in half since 2004.
Ferrari (luxury cars)
The company reported slightly better than expected first quarter results and affirmed their full year guidance. Despite the turmoil around the world, the CEO said, “Our order book continues to be very strong, much stronger than ever, and it covers very well into 2023. I’m proud to say that most of our models are already sold out and this is not just for the limited series.” The company is getting close to launching the hotly anticipated Purosangue, their first SUV. While the vehicle is expected to be distinct in many ways from other luxury SUVs, it is worth noting that high-end utility vehicles from other automakers currently have long wait lists and are being sold at huge premiums on the secondary market.
The health of the corporate fundamentals of our portfolio companies in aggregate remain very strong. The valuations of these same companies in the stock market have compressed dramatically as revenue and earnings continue to grow even while stock prices have declined. It is true that a recession may be coming. The fact is recessions occur from time to time in an unpredictable fashion. Yet the stock market declines on recessions fears far more often than recessions actually occur.
This is not the first set of recession fears to grip the market in recent years. In the fourth quarter of 2018, the US stock market declined 20% as fears of a recession swept the market. You can read how we were thinking about this risk as that decline began here, what we said near the bottom of that decline here, and how we were continuing to process recession risk even once the market had fully recovered here (note: the market fully recovered far before recession fears had dissipated).
It is possible that in order to ward off inflation, the Federal Reserve will need to raise interest rates so high that they drive even the currently extremely strong US economy into recession. If so, the bulk of our portfolio will enter a recession with stock valuations that already are at or below the very low end of their valuation ranges going back to the years after the financial crisis when investors had little confidence that the US economic expansion would continue. It is also possible that the US economy, with its extremely strong employment and wage growth, record levels of household cash savings, and record levels of home equity, will see slowed growth as the Fed intends without tipping into a recession.
It is not possible to know in advance when a recession will occur. One of the most dangerous ways to manage an equity portfolio is to delude yourself into thinking that you can predict the economy in advance and move faster than other investors to get out of the market before the associated decline in stock prices. Even worse is deciding after a large decline in stock prices that a recession must be inevitable and selling stocks at very low prices and valuations. Yet unfortunately this does not mean that every time the market worries about a recession it will be wrong. Or that every large decline in the market will bounce back quickly.
We believe that in aggregate our portfolio companies are wonderful business, managed by highly skilled management teams, that benefit from durable competitive advantages and expansive opportunities to grow the value they create for customers, employees, shareholders, and other stakeholders.
We are passing through a scary period in the US stock market and world affairs. We cannot say for sure when we will come out the other side of this period of fear. Along the way, we will adjust our portfolio to the extent that we lose confidence in the businesses we own or if we come to believe that stock prices overvalue the businesses they represent. We will keep our eyes firmly on business fundamentals and economic reality as we see it.
The core driver of superior investment performance is correctly identifying disconnects between the economic reality of a business and the value placed on the business in financial markets. Today we see as wide of a disconnect as we have ever seen.
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.
While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.
Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.