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Will Ashworth at InvestorPlace wrote an intriguing article highlighting 7 companies exhibiting pricing power as a core feature to their business models, including two that Ensemble Capital has owned for client portfolios, Netflix (NFLX) and Apple (AAPL). Pricing power lies at the core of most great businesses — a point often talked about by legendary investors Warren Buffett and Charlie Munger.

In his profile of Netflix, Ashworth quotes our Senior Investment Analyst Arif Karim’s recent Intrinsic Investing post discussing Netflix’s Pricing Power:

“What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since,” Arif Karim, senior investment analyst at Ensemble Capital, stated in a must-read October article in Intrinsic Investing. “Despite this increase in prices, it has continued to show very strong momentum  in signing up new customers for its service around the world.”

Ashworth goes on to note: “Since 2011, Netflix has grown subscribers by 30% compounded annually. In Q3 2018, it increased paid memberships by 5.4% from Q2 2018 and 25% year over year. While the U.S. growth has slowed, international streaming grew by 39% year-over-year with plenty of the world still to cover.”

Netflix’s pricing power has indeed been a topic that has not been discussed much in the public sphere, but one which we believe is an important driver of both the company’s future business strategy (helping fund the build out its moat and global subscriber base) and its future value.

In addition, Ashworth also discusses Apple’s pricing power and offers an apt recent quote from Warren Buffett, who is listed as the second largest owner of company shares [via control of Berkshire Hathaway (BRK/A) as of 6/30/2018]:

“I have a plane that costs me a lot, a million dollars a year or something of the sort. If I used the iPhone — I use an iPad a lot — if I used the iPhone like all my friends do, I would rather give up the plane,” Buffett said on CNBC in August. “Now it’s got competition so you can’t push the price, but in terms of its utility to people and what they get for a thousand dollars…you can have a dinner party that would cost that, and here this is, and what it does for you, it’s incredible.”

Arif discussed Apple’s iPhone franchise, the great utility it offered its users, and its positioning as a luxury brand with pricing power in our discussion about the sustainability of Apple’s iPhone franchise in 2016, when many public discussions were being had about the death of innovation at Apple with a market valuation that reflected those doubts:

“This brings the focus on the well-designed device, its capabilities couched in a simple intuitive interface, its elegance, and the daily needs it fulfills as well as aspirations it can help the user attain. It’s a brilliant strategy that emphasizes the brand and emotion that creates the connection with its users while de-emphasizing the technology that can be threatened by the latest, greatest, cheapest competing gadget… while expensive at a face value of $650-$850, the iPhone and smartphones in general, are the most important and personal discretionary device the consumer owns. They serve as the gateway to your entire digital life that has grown to be a very important part of yourself. It is your most used device and will only increase in importance over time.

And, with a life span of two to three years, the cost of the average iPhone translates to less than $1 a day. This is an incredible value per hour of usage for the average smartphone user in any developed country as well as a significant number of users in emerging market countries. Given how much time owners of smartphones spend using their devices and how important a part of their lives they play, paying up for a premium, more secure, easier to use smartphone is one of the most practical luxuries they can pay for.”

For other great examples of companies with pricing power, we invite you to learn more by reading Will Ashworth’s article posted below.

7 Stocks to Buy for Real Pricing Power

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of  Apple (AAPL) and Netflix (NFLX). The company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Netflix’s Pricing Power

18 October 2018 | by Arif Karim, CFA

Netflix (NFLX) has demonstrated a torrid pace of growth since launching its stand-alone streaming video service in 2011, with paying subscribers growing at a 30% CAGR through the end of 2018. What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since. Despite this increase in prices, it has continued to show very strong momentum  in signing up new customers for its service around the world.

Figure 1: Netflix’s Subscriber Growth

Source: Ensemble Capital Management and Netflix, Inc.

We’ve talked in the past about our thesis on Netflix and its powerful moat characteristics.  According to Warren Buffett, the definition of a good business is one that has pricing power. We believe Netflix has it in spades, and expect that they will announce regular price increases over time that will allow revenue to grow faster than subscribers. This is partly the result of its history of being a classic disruptor, offering a “good enough”, low price service to win customers.

However, over time, it has transformed into a great service by leveraging the capabilities of the new medium over which it serves its customers, the Internet for direct distribution and a variety of devices outside the television for consumption of media. In the process, it has increasingly won over large swaths of new customers by being the better experience and investing heavily to build the breadth and quality of its content that has earned it a place next to the longstanding leader in quality content, HBO.

Despite steadily increasing the quality of its service for customers, Netflix’s pricing has lagged the growth of that consumer value leading to the build up of a large consumer surplus. That surplus, or the excess consumer value over the price of the service, is an important factor that has driven such a rapid rate of growth for the service. The bigger the surplus, the better the deal for the consumer. But this also results in a sub-optimal return for the shareholder, at least in the short run, which can look like an inferior business model if you don’t look more carefully.

Figure 2: Consumer Surplus Creation

Source: Ensemble Capital Management

The power of the model is to realize that the consumer surplus represents latent pricing power that can be reallocated via price increases or reinvestment changes towards future profits for shareholders. In Netflix’s case, we believe this is an important lever in managing the rate of its growth and returns. By offering a compelling value proposition to incremental consumers, Netflix drives subscriber growth because it is a fantastic deal at $10/month. The consumer surplus is an investment in Netflix’s rapid growth, an implicit subscriber acquisition expense in the form of foregone revenue and profit, intentionally leveraged to quickly scale so that nearly all traditional media incumbents would be left too far behind when they awoke to the direct to consumer global scale streaming video opportunity. It’s clear at this point that this strategic goal has either been accomplished or nearly has.

Over time, we believe prices can be raised substantially to improve the economics of the business, potentially to the detriment of subscriber growth because it will be a less compelling offer. If the service has stickiness to it (we believe it does), then the vast majority of existing customers are unlikely to churn off as that surplus decreases. The result will be higher prices, higher profits, but slower growth. However, that assumes the value of the service remains constant. In Netflix’s case, by continually reinvesting a substantial portion of incremental revenue into improving the service experience and increasing its catalog of quality content, it is continually increasing the value of the service for all of its subscribers, which plays into a classic network effect moat. When coupled with a content scale moat, it becomes an increasingly tougher barrier for competitors to overcome.

Figure 3: The Netflix Flywheel

Source: Ensemble Capital Management

And that is really the secret sauce to Figure 1 that shows accelerating subscriber additions even as prices have risen over the past 5 years, while Figure 2 shows how consumer surplus can increase even with higher prices for the consumer, so long as value creation rises faster.

Netflix has continually increased the value of its service even as it has asked its customers to pay more, which has maintained its torrid growth rate at a massive global scale with 100MM+ subscribers and forecasted to grow by 28MM subscribers by the end of this year. That is an incremental $4B in revenue in 2018 alone enabling (via cash generation and capital market access) $7B in funding towards additional content, subscriber growth and scaling initiatives, and improved service investments. This also fits another of Buffett’s requirements for a great business, i.e. Netflix is a business that is focused on growing its moat every day. And management has proven itself highly competent in both understanding the levers they  need to command to do so, while also focusing on the right decisions for the business to maximize its value for the long term.

Figure 4: Netflix Cumulative Global Adds by Week

Source: Netflix, Inc.

As Netflix approaches mature levels of growth in specific markets (like the US), we believe it will make a rational shift in both pricing strategy and incremental reinvestment allocations towards a more balanced sharing of the value it delivers between its customers and shareholders, resulting in much greater profitability than is currently observed in reported numbers. To this point, the company has committed to growing its annual operating margin moderately going forward, a position that plays to our view on the strategic trade off between growth, profitability, and pricing while allowing the company to continue investing in maximizing the development and capture of the global long term growth opportunity in streaming video content.

As a simple illustrative exercise of how profitable the business could be if it were to price its service closer to the value it provides its current base of customers, we did a sensitivity analysis of the incremental profitability of average monthly pricing ranging from $15-25 per month:

Figure 5: Theoretical Netflix Price-EPS Normalization

It’s hard to argue that the service isn’t worth more than its current $10/month based on objective data like viewer engagement, content quality and breadth, price-user analysis, and anecdotal evidence. There is a growing proportion of people that are “cutting the cord” in favor of online entertainment choices, the leader among them being Netflix or, as is more often the case in international markets, discovering and signing up to view talked about differentiated original content on Netflix.

Therefore, an assumption that the service’s value to consumers as it currently stands could be worth $15-20/month and growing to $25+ over the next decade does not seem wildly optimistic to us. And if you were to believe that, then paying an average of 20x normalized current earnings for the disruptive runaway leader in the global scale media business, growing over 20%/yr with a long growth runway, scaling moat, and increasing profitability looks reasonable in our view.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of  Netflix (NFLX). The company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Netflix (NFLX) has been one POWERHOUSE of a stock with incredible performance, up approximately 3700% since 2012 vs the S&P 500 up 113% and five leading Media companies up nearly 200% on average (Jan 2012-Jun 2018).

Source: Bloomberg

Examining a few charts showing the fundamental momentum of the service makes it easy to see the reason for investors’ enthusiasm for Netflix stock relative to the incumbents:

Netflix has grown Subscribers and Revenue significantly and sustainably over the past decade, with an acceleration over the past 5 years…

Source: Kleiner Perkins Internet Trends 2017 Report

It’s done this by offering an over-the-top (of the Internet or OTT) streaming video subscription service, using the CLASSIC DISRUPTOR PLAYBOOK TO AN OVER-SERVED MARKET, that is significantly cheaper and more customer friendly than existing incumbent services in the US…

Source: Kleiner Perkins Internet Trends 2017 Report

Drawing significant consumer attention away from the traditional Media networks and demonstrating strengthening customer engagement (audience viewership in total and per subscriber)…

 

Source: Matthew Ball and REDEF

Source: Matthew Ball and REDEF

Boiling down these data leads to the conclusion that Netflix users spend about 10% of what their Pay TV spend would be on a Netflix subscription but spend 40-50% of their TV viewing time there, for a 75-80% cost advantage per hour of viewing.

Making matters worse, the trend among younger generations points to an accelerated decline in relevance of the traditional television media industry in the US…

Source: Matthew Ball and REDEF

Source: Matthew Ball and REDEF

 

(TV) VIDEO KILLED THE RADIO … Will OTT Kill Pay-TV?

Traditional Pay TV service is literally dying off unless it can change this trend. Not many could have predicted such change and performance prospectively 5 years ago, but we think it is generally indicative of the underlying value that Netflix has accrued in creating the first global scale media company by leveraging the inherent advantages stemming from internet distribution, global scale, and direct customer to content relationships.

Over the phenomenal period of returns and fundamental business performance, controversy has surrounded the company due to what had initially seemed like a limited and low-quality catalog, undifferentiable business model (reselling licensed content over the Internet), unsustainable/unscalable niche (media companies would stop licensing and kill it when it got too big), and its cumulative cash burn that continues at increasing levels even still. We were among them until we delved into the fundamental industry dynamics playing out a couple of years ago that led us to change our minds. We’ll address these issues in our discussion.

NETFLIX TAKES MEDIA AROUND THE WORLD… THE RISE OF GLOBAL SCALE MEDIA (more…)

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Ensemble Capital Client Call Transcript: Alphabet Update

18 April 2019 | by Ensemble Capital

We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Alphabet, Inc (GOOGL)

Excerpt (Sean Stannard-Stockton speaking):

For the balance of this call I’m going to talk about our investment in Alphabet, the holding company that controls Google. While the company has moved into a lot of areas outside of just search advertisements, 20 years after its founding the core of the Google profit machine is still its ad business. As Larry Ellison first put it all the way back in 2006, Google is “a one-trick pony, but it’s a hell of a trick.”. What’s amazing is how steady the growth of Google’s ad business has been even in the face of massive changes to the internet, most importantly the shift to mobile computing. We believe the key metric for investors to track Google’s ad business is to look at the rate of growth of currency neutral ad revenue net of traffic acquisition costs. This is basically the amount of money Google collects from all of their ad products after subtracting the amount they pay to acquire traffic on their sites. For instance, when you search for something on your iPhone the results you get are Google results. This is because Google pays Apple to make them the default search engine on Apple’s iPhones. Amazingly, since 2016, the company has reported average growth in this key metric of 20% with every quarterly report showing growth of between 17% and 23%. In fact, over half of all quarterly reports have seen this metric increase by within 1% above or below the 20% average.

High growth companies aren’t supposed to exhibit this sort of stability. But think about what drives growth for Google. The most important demand driver is the time people spend online. While many tech companies offer discretionary products that see variable demand and can see abrupt declines when the economy weakens, we would posit that time spent online is more of a consumer staple type behavior. In good times and bad, people around the world are turning to Google products to answer their questions. The persistent nature of this high level of growth is remarkable and has been instrumental in driving up the intrinsic value of Alphabet.

That growth is partly being driven by YouTube. With over 5 billion YouTube videos viewed every day and growing, the ad opportunity is huge. Depending on your own use of YouTube, you may not fully appreciate the power of this platform. While famous for viral cat videos and the like, YouTube is effectively the default global video platform for non-TV type content. With more and more time spent online consuming video, YouTube is in the pole position to benefit. While paid subscription products like Netflix may be a better business model for curated quality content such as TV and movies, the ad-supported YouTube format is far superior for short form, non-narrative content.

Interestingly Google does not break out the standalone financials of YouTube, leaving the investment community to guess at how profitable it currently is. Many investors believe that YouTube is currently less profitable than Google overall and yet as they grow, they will become more profitable, leading to longer, faster profit growth than might be apparent at first glance. While we are somewhat ambivalent about the validity of this thesis, primarily because we think YouTube fueled profit growth is needed to offset other parts of Google’s business slowing and so is not strictly additive to corporate growth, we do think that the breaking out of YouTube’s financials is going to occur before too long and it may have a dramatic positive impact to investors understanding of Google’s long-term prospects.

YouTube isn’t the only part of Alphabet that may have more value than generally appreciated. When they formed Alphabet, they created two subsegments, Google and what they refer to as Other Bets. The Other Bets group contains what Google historically called Moonshots, such as Waymo, their self-driving car business, Fiber and Loon, their internet access businesses and Verily, their health sciences business. Today, the Other Bets segment is losing approximately $4 billion a year. But when I say “losing” I mean they are burning this amount of cash as they seek to build profitable businesses. Today, the existence of Other Bets inside of Alphabet reduces the company’s reported earnings by about 10%.

So, Alphabet could boost current earnings by 10% by simply shutting down Other Bets. Of course, that would be a mistake. Any reasonable investor knows that Waymo in particular, but the other parts of Other Bets as well, have significant value. So, in thinking about the value of Alphabet, you need to remove the currently money losing Other Bets segment, value Google as a standalone business without the Other Bets losses and then add to that whatever you think the value of Other Bets is.

Of course, the value of Other Bets is highly uncertain. We’ve seen some investors talk about the value of Alphabet in relation to a PE multiple it should trade at. But given the negative earnings of Other Bets, this methodology implicitly values Other Bets as a liability. Believe me, there is a wide range of venture capitalists who would happily take ownership of Other Bets and so it is clearly not a liability. We’re also seen some analysts attribute as much as a $100 billion of value to Waymo alone. While Waymo is very valuable, in our view, on a probabilistic basis, $100 billion is way too high of an estimate. It could be worth that much, but it could be worth much less. In fact, Waymo could even end up failing without ever earning a dollar of profit.

We estimate that after removing Other Bets’ losses and removing the excess cash that Google has on its balance sheet (not all of its cash, just that amount we believe is not required to run the company), Alphabet is trading at around 20x what we expect them to earn in 2019. Given the company’s growth rate and its strong returns on invested capital, we think the stock will perform well from these levels.

That being said, we do have two concerns about the company’s management. In general, we evaluate corporate management primarily on their ability to create value and their abilities in allocating excess cash flow. On the first question, Google excels. It is amazing that they have become one of the most valuable companies the world has ever seen just 20 years after they were founded. As I mentioned earlier, their services have become a required part of modern life, almost a form of oxygen for internet connected populations.

But in allocating their excess capital we have been less enthusiastic. While Google has been criticized in the past for the M&A they engage in, YouTube and DoubleClick are two hugely successful acquisitions with YouTube ranking as one of the smartest acquisitions in the internet age. But Google has now built such a war chest of cash that they clearly have more than they will ever need, and we think shareholders would be better served if the company began to pay a dividend, bought back stock and used more debt in their capital structure to finance more return of capital. We had hoped that Ruth Porat, the CFO they brought in from Morgan Stanley, would be instrumental in improving capital allocation. But after some initial positive signs, it seems that for whatever reason, Porat is no longer focused on making this happen.

The other management issue we’re tracking is the company’s relations with their employee base. For pretty much all of their history Google has been considered one of the very best places to work. They have pioneered much of what we think of as modern Silicon Valley corporate culture with an employee base that has been raving fans of the company. But last year, employee concerns around the company’s work with the military and issues of gender equality and sexual harassment became flashpoints between management and employees. Of particular note to us was the various reports on the company paying large severance packages to key senior employees who were forced out after accusations of sexual harassment.

In our view, Google management’s handling of these cases has not been good. We believe for the short-term health of their corporate culture and their long-term ability to attract the best and brightest employees, they must do better. By “do better” we mean behave in a way that satisfies their employee base and preserves the belief that Google is one of the best places to work for the smartest, most technically savvy people in the world. To the extent that the company is not able to manage employee relations constructively, our confidence in the long term success of the business would deteriorate and should we decide to exit our position, something we are not currently contemplating, it would be due to our assessment of the long-term health of the business, which is very much a function of the company maintaining a positive corporate culture.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Alphabet, Inc (GOOGL).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to CONTACT US with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

Ensemble Fund Investor Letter – First Quarter 2019

16 April 2019 | by Ensemble Capital

Below is the Q1 2019 quarterly letter for the ENSEMBLE FUND (ENSBX)This quarter’s Company Focus is on Landstar Systems, Inc. (LSTR) and Alphabet, Inc (GOOGL). You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of the Ensemble Fund (“the Fund”) this quarter was strong, showing a sharp reversal in both absolute and relative performance compared to last quarter. The fund was up 17.39% vs the S&P 500 up 13.65%.

As of March 31, 2019

1Q19 1 Year 3 Year Since Inception*
Ensemble Fund 17.39% 10.07% 15.95% 12.21%
S&P 500 13.65% 9.50% 13.51% 11.43%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at WWW.ENSEMBLEFUND.COM.

Fund Fees: No loads; 1% gross expense ratio.

The strength in our equity strategy during the quarter was supported by positive returns from every stock in our portfolio with notable 30%+ moves from Netflix (6.4% weight in portfolio), Ferrari (8.4% weight in portfolio), TransDigm (4.9% weight in portfolio), and Tiffany (4.0% weight in portfolio) and 20%+ rallies in Mastercard (7.3% weight in portfolio), Paychex (5.0% weight in portfolio), Trupanion (2.3% weight in portfolio), Fastenal (2.8% weight in portfolio), and Verisk (3.2% weight in portfolio). On the weaker side we saw low single digit gains in Sensata Technologies (5.4% weight in portfolio), Charles Schwab (4.6% weight in portfolio), and Booking Holdings (7.3% weight in portfolio).

While over the medium to long term our investment returns are primarily driven by security selection and the individual corporate performance of the companies in our portfolio, the dominant driver of our strategy’s performance over the last two quarters has been shifts in market expectations around economic growth. We have been relatively overweight to more economically sensitive names for much of the past few years due to these types of stocks generally being relatively inexpensive in our view, while more economically defensive companies have seen their stocks trading at historically rich valuation. This led to our portfolio exhibiting more downside than the market as recession fears became pervasive in the fourth quarter and to strong outperformance this past quarter as market action was driven by the idea that recession fears had become overblown and decent economic data was reported.

The rally in Netflix was primarily driven by a general reversal of the downside that many higher volatility stocks saw during the fourth quarter. However, Netflix also reported another strong quarter of new subscriber additions and, very importantly, they announced a large price increase. Netflix strikes some people as an atypical investment for Ensemble. With its very high PE ratio on current earnings there is a general perception that it is more of a momentum play than a long-term cash generation machine of the type we seek. But we believe that Netflix is building a dominant global media company and, importantly, they are currently intentionally underpricing their service as part of a strategic plan to build a subscriber base well in excess of any competitor. While we have yet to see how it impacted first quarter subscriber growth, the almost 20% price increase on the heels of high single digit price increases in recent years demonstrates the strong pricing power both we and the company believes they have.

The rally in Ferrari was supported by the company’s earnings report in which management said that they had not seen any unexpected impacts to their order books as a result of the recent global market volatility. While it seems obvious that an entirely discretionary product like a Ferrari would see significant weakness in demand during recessions, historically Ferrari has been the most recession resistant automaker. Due to the long wait list to buy a Ferrari and the fact that the vast majority of Ferrari buyers can still afford a Ferrari even in the midst of a recession, the company does not see the sort of drop off in sales that most automakers experience during periods of economic weakness.

TransDigm’s rally was particularly satisfying for us. Back in early 2017, a well-known short seller accused the company of a wide range of bad behavior that focused on defrauding the Department of Defense via overcharging them for the company’s spare airplane parts. After extensive diligence on our part, we concluded that these accusations were wrong. After a near 25% decline in the wake of the short report, the stock has more than doubled in the past two years. During the last quarter, the Office of the Inspector General, that had begun auditing the company’s sales at the request of two politicians who were sent the short report, concluded their work. While the audit found that TransDigm earns very high profit margins on their sale of aftermarket parts to the Department of Defense, it did not find any wrongdoing and it supported our view that sales to the Department of Defense were done at similar pricing to what commercial airlines pay. As the sole source provider of low-cost parts that are required to be replaced on set schedules by the FAA, TransDigm earns very strong profit margins and returns on capital. But that does not mean they are overcharging their customers. While the Office of the Inspector General recommended that the military begin requesting much more stringent cost information even for low priced products, the Department of Defense has been moving in the opposite direction in recent years as they attempt to streamline purchasing of low-priced products so that they can efficiently ensure a fully operational air force.

The weak rebounds in Sensata, Schwab and Booking each had company specific drivers. With Sensata, the ongoing threat of tariffs on autos has been a persistent concern. These potential tariffs are not just related to the US-China trade war, but also to efforts by the Trump administration to deem imported autos as a national security concern and thus allow for tariffs to be imposed on foreign automakers, including those of key allies of the United States, in ways that would otherwise violate trade rules. But we would note that Sensata sells sensors to every global automaker of note meaning that so long as cars are being bought, it doesn’t really matter to Sensata which country they are being made in.

Schwab continues to gather client assets at an astounding rate. However, as we detailed on last quarter’s call, Schwab’s profit model has shifted towards their interest rate sensitive bank, so the recent declines in interest rates and flattening of the yield curve will limit the company’s near-term earnings power.

While investors have been negative on Booking for much of the past year, we would note that far from seeing their growth rate crumble, 2018 saw high teens revenue growth and EBITDA growth. Their guidance for Q1 was somewhat disappointing. However, when viewed on a currency neutral basis and accounting for Easter travel bookings falling into Q2 rather than Q1 this year, given the holiday falling in late April rather than late March, we think the company is continuing to see solid core demand trends. Although they are seeing some weakness in Europe, their largest market, it appears that much of that weakness is due to uncertainty related to Brexit, potential auto tariffs hurting the German economy, and protests in Paris. As those issues come to a resolution, we would expect demand in the EU to continue to be fine and would point out that Booking’s strong growth over the last decade has occurred within the context of a weak Europe economic environment.

Last quarter we wrote about the rising risk of a recession; where we discussed our outlook for equity markets and framed it by listing three primary outcomes:

  1. If no recession occurs: The stock market will likely generate very strong returns over the course of the next couple of years.
  2. If a mild recession occurs: With the stock market already selling off by the magnitude that would typically be associated with this outcome, there may be limited downside even if things play out this way. (To reiterate, this is what we said last quarter, prior to the recent large rally)
  3. If a severe recession occurs: In this event, there may be considerably more downside for US equity investors.

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Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

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