Search Results for: schwab

Ensemble Capital’s Senior Investment Analyst, Arif Karim, recently had the pleasure of speaking with Stig Brodersen and Preston Pysh on their Investors Podcast show We Study Billionaires about our investment thesis on Charles Schwab (SCHW).

During the interview, Arif discussed:

  • Schwab’s history and  business evolution from its roots as a modest discount broker into one of the largest custodian of assets with over $4T of client assets.
  • The intermingled role of scale and culture in driving efficiency, customer value proposition, and competitive advantage for Schwab.
  • Importance of Schwab Bank in supporting low fees for all client services while generating a strong return for shareholders.
  • The impact of interest rates and inflation to Schwab’s business through the business cycle.

To listen to the interview, please click on the link 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.

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.

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

Below is an excerpt from the call discussing our investments in Ferrari, First American, and Schwab and why we expect them to survive and thrive on the other side of COVID-related economic and business impacts.

Excerpt

Arif Karim:

We’ll talk about Ferrari next. Obviously being located in one of the hardest hit countries, Italy, has had a major impact on Ferrari’s ability to operate its production operations normally. This hits right at the heart of its ability to supply customers with its highly coveted products.

Given Ferrari’s high average selling price and margins, we believe the company is resilient enough to see through a multi-month period without severe cashflow issues while we expect demand to be fairly inelastic given its long 12-24 month waiting lists across 6 recently launched and limited supply models, all supported by the wealth of its clientele.

So, while supply will be even more constrained at both Ferrari’s and its suppliers’ productions facilities this year, we believe demand will be generally resilient. As a datapoint, even during the depths of the Great Recession in 2009, unit sales only declined 4%. Coming out of the current disruption, we expect a reasonably quick ramp in production to fulfill that pent up demand.

Source: Ferrari

To understand why that might be, lets revisit the core value proposition of Ferrari. Though Ferrari builds and sells cars, the cars are conduits to deliver a great experience to the world’s wealthiest and most elite clientele. Buying and driving a Ferrari is an experience that combines many characteristics including automotive driving and racing passion, status, and an appreciation of design and engineering craftsmanship. Buying a Ferrari also buys membership into an elite global network of peers who share the passionate and thrilling desire for driving and racing. Being a part of this club and being invited to Ferrari’s events provides a lot of value to clients, while working their way up the loyalty ranks earns them the privilege to buy exclusive, limited series models. These limited series models are the most coveted and most restricted in supply. Some of these become collectibles over time and can see strong appreciation in value upon delivery.

Because of the general supply/demand imbalance Ferrari usually favors to maintain product exclusivity, a practice inherited from its founder Enzo Ferrari, those who cancel their order while on the waiting list, do so only reluctantly since there is likely to be someone else nipping at the chance to take their place. And this could also impact their opportunity to buy the next exclusive model creating a strong motivator to follow through on delivery of their orders.

Sean Stannard-Stockton:

First American Financial, along with their competitor Fidelity National Title, control most of the title insurance market in the United States. When you buy a home with a mortgage, the lender requires title insurance to make sure that the seller actually has full and clear title to the property. While it is just one small piece of the overall home buying transaction, when you sit down to sign the final closing paperwork to buy a house you will generally find yourself sitting in the office of First American or Fidelity National as title companies provide the escrow services to allow the buyer and seller to transfer cash and title to escrow before each is released to the other side.

Of course, the number of home sales is going to drop dramatically during this spring selling season. It is not legal in many parts of the country to host or attend an open house. But the fact is Americans are still going to want to buy and sell homes in the future. Indeed, while home prices have increased a lot in recent years, the number of home transactions, the primary driver of First American’s business, have run at historically low levels. The rate of growth in January and February was actually heating up and growing at the fastest rate since prior to the housing bust over a decade ago. So while home buyers may spend shelter in place browsing Zillow and Redfin in search of their next home, when economic activity returns, we expect First American to benefit greatly from the pent up demand that will be even stronger given even lower rates on mortgages.

Source: First American

While there has been little in the way of new competition to title companies, we expect that many of the small digital first startups that are interested in competing will not be able to survive. Instead, industry participants will be far more focused on staying loyal to First American knowing that in a crisis as well as when trying to emerge from a crisis, if you are engaging in multimillion dollar complicated transactions such as buying and selling homes, you want to work with a trusted leader. As an aside, it is worth noting that title services along with many of the functions involved in home transactions have been deemed essential services and thus are allowed to continue during shelter in place.

Arif Karim:

With $4 trillion in custodied assets, Schwab is one of the largest financial institutions in the US and among the fastest growing. It has two main lines of businesses that generate substantially all of its revenue, its asset management and advisory business, which collects revenue from a fee charged as a percent of assets under management, and its bank business, which collects a spread between the interest it pays clients for their cash balances and the rate it collects from investing that pool of cash in predominantly low risk bonds issued or backed by the US government.

Schwab has a long history dating back to the 1970’s and has lived through many recessions and shocks. Consistent along its history has been the ability to adapt and grow by winning for its clients and itself by delivering valuable services more cost effectively as it has leveraged its growing asset and operational scale.

We believe its business model is built for both growth and resilience. The combination of the AUM based asset management business and the spread based bank can create a balancing dynamic, though with the fed funds rate cut this year at 150 basis points, both businesses will be pressured but with some offset as clients raise cash due to uncertainty and market volatility.

Source: Schwab

Net-net, we expect to see Schwab’s revenue decline relative to 2019 in one of the most severe economic periods in history, while operating margins are expected to remain robust even after declining materially.

On the other hand, we believe many of the FinTech startups competing in this space will see a much harsher impact in their ability to continue serving customers and investing in their businesses during this period of tighter capital availability and their subscale, developing business models. This will earn Schwab even greater competitive advantage exiting this period.

You can read the full transcript 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.

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.

Schwab Kills Commissions to Feed its Flywheel of Scale

28 October 2019 | by Arif Karim, CFA

On September 26, Interactive Brokers announced its Interactive Brokers Lite service, offering commission-free trading on all US listed stocks and ETFs. Interactive Brokers (aka IB) is a relatively small online broker with AUM of about $160B vs Schwab’s $3.7T. In the last year alone, Schwab added $200B in net new AUM from customers.

So it surprised the market when, on October 1, the behemoth Schwab (SCHW) announced that it too would eliminate trading commissions for US and Canadian Stocks, ETFs, and Options commissions.

Source: Bloomberg:Online Brokers performance 9/23/19-10/24/19

With that move, Schwab effectively killed the business that birthed it 44 years ago.

IB’s management was taken aback by its impact on the industry a few weeks later during its earnings conference call:

“ we did not expect such a swift reaction in the sense that we thought that we come out with IBKR Lite as an additional offering and that we go on for a while, and will attract some customers and then eventually, other people will start reducing and maybe all go to zero. So this — this very swift reaction was a surprise to us.” – Thomas Peterffy, Founder and Chairman, Interactive Brokers Group (IBKR), 3Q 2019 Earnings Call

Schwab’s price cut was put into effect a week later on October 7, coinciding with the release of its founder and Chairman, Mr. Charles Schwab’s new book Invested. Charles Schwab was one of the key figures fathering and successfully growing the discount brokerage industry after the SEC deregulated trading commissions on May 1, 1975 (aka May Day). He adopted the use of computing technology and operational efficiency to continually drive down the cost, and with it the price, of trading shares.

By offering better value to customers, Schwab (the eponymous company) was able to grow its scale and with scale it improved its efficiency, which allowed it to further invest in technology, service capabilities, and lower prices resulting in further improving value and winning over more customers.

In examining its history, it’s clear that Schwab’s culture has played an important part in the use of technology and efficiency as a force for disruption and commoditization, either as a leader or fast follower (as in the latest incident swiftly following on the heels of IB).

As a result of this, Schwab has earned its customers trust and business, which has enabled it to leverage growing scale to disrupt lower value services (commissions, index funds, vanilla mass financial advisory) while climbing up the value chain of higher value services, thereby broadening its platform and scale. Most recently, that strategy has been embodied in Schwab’s dual mantras of viewing its service delivery “Through Clients’ Eyes” and with “No Trade-offs”, delivering everything the client wants at the lowest effective price in its market.

On the surface this looks like bad business, but delve a little more deeply and it becomes clear that it’s all in the service of scale and efficiency which trumps “price” as a driver for long term competitive advantage in this business.

Source: Charles Schwab, Fall 2019 Business Update

As the most scaled and efficient player in its industry, Schwab has the best expense efficiency on AUM (referred to by Schwab as EOCA = Expenses on Client Assets).

Source: Charles Schwab, Winter 2019 Business Update

The scale and efficiency have allowed Schwab to deliver lower prices to customer over time while increasing profits for shareholders – a win-win scenario we love to see in companies because it represents a non-zero sum relationship between a company and its customers.

Source: Charles Schwab, Fall 2019 Business Update

Despite its relatively small size, IB is a credible player, especially among active traders, to have elicited a response from Schwab (we were not surprised) — the type of aggressive response that had been brewing as the new style of “fintech” players like Robinhood have arisen, leading their value proposition with commission free trading while monetizing client trades via order flow.

IB’s move essentially brought that commission-free/order-flow monetization model into the boundaries of the mainstream discount brokerage business, and Schwab’s aggressive move brought the model from the boundaries into the center, and forced the rest of the industry to follow suit  and leaving them to nurse their now wounded financial models.

The timing may have been surprising, but the end state of commissions was not to anyone who has been paying attention. When computers do all the trading, the marginal cost (and revenue) trend to zero. The trading infrastructure has transformed from expensive people to predominantly cheap computers, and so did the business model.

Source: Vice.com, Ensemble Capital Management

Luckily for Schwab’s investors, its strategy of moving up the value chain (vertical expansion) and creating increasing platform leverage across market participants (horizontal expansion) have rendered its original trading commissions business, the most commoditized segment, of low importance to the whole at just 3.5% of revenue and ~8% of profits. Some modest expense control is all it would take to offset most of loss or ~6% incremental growth in AUM (all other factors being equal).

Source: Ensemble Capital Management

Building the business this way needed healthy doses of both long-term foresight (where does competitive advantage come from today and in the future – i.e. customer value and scale) and near-term opportunism (what should be within the business’ focus area to invest in and what’s not).

TD Ameritrade’s (AMTD) CEO Tim Hockey candidly admitted during its 4Q2019 Earnings Call:  “The best time to have, I think, build out a proprietary product offering was probably 25 years ago. There is a significant price point pressure obviously on active and passive… But as we know, you need absolutely massive scale for an offering and asset management fees base and so we don’t think that makes sense for us.”

In fact, as we’ve discussed in our previous post here, Schwab has increasingly shifted its customer monetization strategy from explicit fees via commissions and AUM based investment fees towards implicit fees based on opportunity cost of cash balances via net interest margins (NIM) at its Bank.

Therefore, Schwab wins over and retains customers with the lowest fees on the ~90% of their investment portfolio, thus accelerating market trends of declining AUM fees which is good for clients and a key decision point for them, while making money on the residual ~10% of their portfolio cash balance that is automatically swept into its Bank.

In its most recent 3Q 2019, proforma operating margins hit nearly 48% and 21% ROE (45.6% and 20% including a $62MM charge in 3Q19). For all of 2019 we expect a nearly 47% proforma operating margin and 20% ROE, while we expect to see only a modest impact to 2020 profitability of less than 5% from the commissions cut due to offsetting expense controls and some incremental AUM growth.

The impact of eliminating trading commissions is asymmetric across the major online brokers, with Schwab most insulated with only about a 3-4% net revenue impact and 8% hit to earnings (before expense adjustments), while TD Ameritrade (AMTD) noted a 15%-16% impact to revenue and E-Trade (ETFC) could see about a 10% impact. Goldman Sachs estimated a much deeper initial impact to earnings for AMTD and ETFC at -32% and -24%, with expense controls likely to mitigate some of the impact.

But there is no doubt the impact of the commission cuts has significantly weakened competitors AMTD and ETFC ability to invest in client service and technology investment going for several quarters to come.

On that note, TD Ameritrade’s management commentary is an interesting contrast to Schwab’s CFO commentary:

“we know that this boost to business alone will not replace all of the lost revenue. Accelerating and diversifying revenue remains a strategic priority – one that will guide continued exploration and efforts to recoup the lost economics over time. Over a year ago, we also started a formal strategic resiliency program to inject more discipline into how we allocate resources. Our work involved identifying our strategic differentiators – the things we can be really good at and win (things we could potentially accelerate) – as well as what we need to do to keep the lights on… Now, we’re tackling what’s left – the non-differentiators and things that don’t drive growth – to slow or stop investments and redeploy them to the things that matter.”

“Charging for help/advice. With the commission reset, we have shifted from the premium price in the market, ensuring that our value to customers justified that price, to an environment where we are providing extraordinary value to our customers. We have received numerous phone calls concerned that zero commissions could result in less insight to customers, fewer interactions with our highly qualified people, etc. We have been exploring a number of potential ways to monetize this value, but fear of cannibalization or being perceived as charging beyond a premium price had held us back. Now, armed with segmented customer data, both on profitability and usage of services and information, we are well positioned to begin to monetize this value. This could take the form of recurring fees for premium services or charging for episodic advice. Where the customer does not attribute value to these services, we can adjust our costs accordingly.”Management Commentary, 3Q 2019 TD Ameritrade

In contrast, Schwab’s commentary took on a different tone that is reflective of its business’ strategic and financial positioning going into the price cuts:

Why did we take this step, and why now? [We are] continuing our tradition of challenging the status quo on behalf of individual investors… it’s the right move from a competitive standpoint. There has been a clear pause in the so-called commission wars among the “traditional” e-brokers since the price reductions we made [offensively] in 2017. At the same time, we are seeing new firms trying to enter our market – using zero or low equity commissions as a lever. We’re not feeling competitive pressure from these firms…yet. But we don’t want to fall into the trap that a myriad of other firms in a variety of industries have fallen into and wait too long to respond to new entrants. It has seemed inevitable that commissions would head towards zero, so why wait? We have a business model that doesn’t depend on commission revenue, a long-term orientation and a history of being willing to disrupt ourselves based on client needs and competitive dynamics. That’s exactly what we are doing here – we’re making these pricing changes because we believe they enhance both our value proposition and our competitive positioning, encouraging the consolidation of client assets and trades at Schwab.”CFO Commentary, Charles Schwab 

“This elimination of commissions is something that we have been anticipating, was inevitable for over a decade. And we’ve been aggressively at work over the last couple of decades executing on strategies that reduced our reliance on commissions from a level of almost half of our revenue down mid-single digits. And while some might have been surprised by the timing of our move, our view is that anyone carefully following our commitment to the virtuous cycle would likely have anticipated it…

Now importantly, price is only one aspect of our commitment to delivering the best combination of value service and capabilities to all investors. Whether it’s our industry-leading client service, our broad range of solutions, our robust research tools and our industry first and still only satisfaction guarantee. We’re committed to serving investors in a manner unmatched by any competitor… in reality the virtuous cycle is not intended for short-term timeframes. It’s designed to be effective over the years, many years, and even over decades…

It begins at 12 o’clock by challenging the status quo on behalf of investors… how that has benefited our clients. Pretty remarkably what clients pay us in total for our services has declined by about 80% over the last 30 years. And as we share the benefits of our scale and efficiency with our clients, they bring us more assets. With assets growing exponentially over the same 30-year time horizon. Our commitment to operating efficiency and technology investments has enabled us to consistently grow our pre-tax margin over the last 30 years, even as our revenue per dollar client assets again has declined by about 80%. And our stockholders have benefited, as our net income and earnings per share have grown dramatically… of course, the virtuous cycle works, because we continue to make a variety of investments that benefit our clients. Sometimes we do so in services, products, capabilities, sometimes in price, as we did a couple of weeks ago.”Walt Bettinger, President and CEO, Charles Schwab during 3Q19 Business Update Call

We believe Schwab’s business stands to benefit the most because of the relatively small impact to its revenue and income and the broad, efficient set of high quality service it offers to clients. While the commission cuts mean Schwab offers an even more compelling value to its customers for its existing suite of high quality services, a disadvantaged competitor like TD Ameritrade is trying to figure out how to charge for its “premium” services for customers, effectively raising prices for service in other ways and depressing its value proposition.

Decades of experience  indicates the companies offering higher value propositions win more customers. By  continuing to pursue aggressive reinvestment in both client service and technological efficiency, Schwab can continue to leverage its growing scale to further improve upon the value proposition it provides clients while continuing to drive down its expense (efficiency) ratio. We believe the gap in differentiation will only get wider now that the smaller competitors are much weakened financially, which is why it made sense for Schwab to be so aggressive in cutting commissions both in 2017 and again October 2019.

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.

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.

The Disconnect Between Corporate Fundamentals & Stock Prices

10 May 2022 | by Sean Stannard-Stockton, CFA

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.

Conclusion

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.

The Critical Role of Empathy in Investing

3 January 2022 | by Sean Stannard-Stockton, CFA

“Could a greater miracle take place than for us to look through each other’s eyes for an instant?” -Henry David Thoreau

The design firm IDEO is one of the most influential companies that most people have never heard of. The mouse that you may be using to control your computer as you read this article? Invented by IDEO. But their influence goes far beyond the physical items they have designed. Instead, the company pioneered the idea of design thinking, or the practice of using concepts drawn from the field of design during the earliest stages of idea generation.

Here’s how IDEO CEO Tim Brown explained this concept in his seminal 2008 Harvard Business Review article titled Design Thinking:

“Historically, design has been treated as a downstream step in the development process—the point where designers, who have played no earlier role in the substantive work of innovation, come along and put a beautiful wrapper around the idea… Now, however, companies are asking them to create ideas that better meet consumers’ needs and desires. The former role is tactical, and results in limited value creation; the latter is strategic and leads to dramatic new forms of value.”

One simple example of the application of design thinking is found in the Keep the Change program that IDEO designed for Bank of America. The program automatically rounds-up purchases made on debit cards to the nearest dollar and transfers the extra cents to the customer’s savings account. In the first decade after launch, 12 million customers signed up for the program and set aside $2 billion in extra savings, with 99% of people who signed up for the program remaining enrolled. IDEO didn’t just design a physical debit card inspired by Bank of America, rather they designed the program concept from inception using the principals of design thinking.

In his HBR article introducing design thinking, Brown argued that design thinkers exhibit five core attributes:

  • Empathy: They imagine the world from multiple perspectives – those of colleagues, clients, end users, and both current and prospective customers.
  • Integrative Thinking: They do not rely solely on analytical processes, but seek out all salient, and sometimes contradictory, aspects of a problem.
  • Optimism: They assume that no matter how intractable a given problem is, there is at least one potential solution that is better than the existing alternative.
  • Experimentalism: They recognize that innovation doesn’t come from small tweaks, so they pose questions and explore constraints in ways that proceed in entirely new directions.
  • Collaboration: The idea of the lone genius is mostly a myth. In reality, it is enthusiastic interdisciplinary collaboration that drives the creative process. IDEO believes in this so deeply, that they actively seek to hire what they call T-Shaped People, who exhibit the ability to combine deep domain expertise, with passionate interest in learnings from a wide range of other disciplines.

At Ensemble Capital, we believe that these design thinker attributes are also often exhibited by outstanding long-term investors and business operators. The stereotypical hedge fund manager imagined by the general public might be a ruthless barbarian seeking to squeeze money out of other investors. But in reality, successful, long-term investors like Warren Buffett are often characterized by their flexible and integrative thinking, willingness to experiment and adapt, and openness to collaboration. And while maintaining a degree of healthy skepticism is important, in the final analysis great long-term investors are almost always optimists.

But what about empathy? Empathy isn’t a concept discussed much in investment management. But we believe that empathy is one of the most important traits for generalist investors like ourselves to cultivate. The fact is, when you manage a portfolio of companies across a range of industries, there is no way that you can rely on your own firsthand experiences to make judgements. Instead, you must cultivate the ability to seek to truly understand each of the stakeholders connected to a company and see the world through their eyes, not just your own.

Peter Lynch famously advised an investor to “buy what you know.” His point was that investors have an advantage when they invest in companies of which they themselves are customers. When you are a customer of a company yourself, you have a natural ability to understand the company from the customer’s perspective. Yet while this is helpful, the best investors need to cultivate an empathetic understanding of a company’s core target customers, not just the investor’s own personal feelings as a customer.

One example of a time I mistakenly substituted my personal feelings as a customer for an empathetic understanding of a company’s core target customers, was when I decided to sell most of Ensemble’s holdings in Costco in 2012. It wasn’t until 2020 that I came to fully understand why my decision had been so wrongheaded and we bought the stock back.

In 2012, I myself was a Costco member. I was married with two kids and lived in a suburban house with ample storage space to hold large size products purchased at Costco. But I had also been an Amazon Prime member since the inception of the program. Instacart launched in 2012 with Google Express (an early delivery service similar to Instacart) launching in 2013. I lived in the heart of the San Francisco Bay Area, and I was watching all of my retail shopping rapidly shift online. None of this was particularly new for me. I had started shopping on Amazon in 1999 during the Dot Com boom and used Peapod for online grocery delivery, and Kosmo.com for same-day delivery of small, local items.

Costco’s online offering was (and is) notably inferior to the new online shopping options that were springing up all around me. Why would I want to go spend a Saturday afternoon in a huge Costco warehouse hunting for bargains when I could spend a fraction of the time sitting at home on my laptop ordering from a range of stores, and having it all delivered to my home?

The situation seemed obvious to me. Costco was failing to make the transition to online shopping and customers were going to start canceling their memberships (as I did) at an accelerating rate. Who would want to go to Costco to shop in a world of ubiquitous, cheap delivery services?

A whole lot of people it turns out! Here’s a chart of Costco’s membership levels over time.

Not only did Costco’s membership growth not slow down as I expected, but notice how in 2020 and 2021, the period of fastest ever eCommerce growth, Costco’s membership growth accelerated!

While I recognized I had made a mistake as I watched membership continue to grow, I didn’t understand why my analysis had been wrong. The shift to online shopping did play out as I expected, but somehow the shift did not seem to impact Costco’s customer behavior despite the company refusing to build a high-quality eCommerce offering.

The nature of my mistake – the specific way in which my analysis had lacked empathy for Costco’s core target customers – did not become clear to me until 2020, when we added Costco back to our portfolio. I had been correct about the coming rapid shift towards eCommerce. And I had been correct in my assessment that Costco’s eCommerce offering was inferior and not something they planned to greatly improve. But I had lacked an empathetic understanding of why Costco’s core target customers didn’t care about the same things I did.

There are really two types of people in the world. People like me that look at this picture and think that it is one of the very last places I want to spend my Saturday and people like Costco’s core target customers who view a trip to Costco as a fun and enjoyable way to spend a weekend morning.

Source: Reuters/Duane Tanouye

Costco offers frugal people permission to splurge. Going into a Costco and engaging in the “treasure hunt” to find great deals, while feeling confident that anything and everything you buy will be of high quality and a good deal, is of huge value to Costco’s core customers. Me? I just want Amazon to dump stuff on my front doorstep and avoid the need to “go shopping” completely.

This isn’t just some weird American cultural quirk either. Here’s opening day of Costco’s second store in China.

(Source: Beijing News)

The fact is many people enjoy the experience of shopping at Costco. Shopping in person at Costco is not a “cost” that their customers want to minimize (in the way it was for me), it is a “benefit” that they enjoy taking advantage of. The reward of the $1.50 hot dog at end of the trip isn’t meant to make up for the exhaustion of shopping, rather it is more like a trophy awarded for frugal splurging.

I could have known this back in 2012. I could have engaged in a more empathetic research process that sought to identify why Costco’s customers were such raving fans. But instead, I substituted the reasons I shopped at Costco and noted that many, many people were shifting to online shopping. I mistakenly thought that other Costco customers would experience the same decline in the Costco value proposition as I was experiencing. So, I traded based on “what I knew” as Peter Lynch might have said, and missed the fact that most Costco shoppers viewed Costco through an entirely different lens than I did.

Empathy is hard. As Henry David Thoreau said in the opening quote to this post, “Could a greater miracle take place than for us to look through each other’s eyes for an instant?” But it is a skill that investors must cultivate to be successful.

In our portfolio today:

  • Ferrari: I’ve never driven a sports car and I can’t even tell you the horsepower of my own 7-year-old sedan. But I have come to understand the motivations that drive a successful CEO to shell out nearly $3 million for a new Ferrari sight unseen.
  • Chipotle: As a kid who grew up eating tacos in San Francisco’s Mission District, my food preferences run along the lines of the crazy people who got a Casa Sanchez tattoo to score authentic taqueria tacos for life. I don’t eat much fast food and while I do enjoy Chipotle, it’s not at all my favorite place to get a taco or burrito. Yet, if I put myself in the shoes of someone ordering fast food and take into account how much healthier and better tasting Chipotle is than the frozen, processed, and fried food that characterizes the vast majority of quick service restaurants, I can completely understand why the company is growing so quickly.
  • Fastenal: It’s self-evident that I’ve never run a manufacturing facility or can fully understand what it’s like to work on the floor of a production facility and need easy and fast access to fasteners and other supplies. But I have run a small business for most of my adult life and I can empathize with the way a company would value effectively outsourcing their basic supply inventory management to a third party so the company can focus on the highest and best use of their own time.

The best run businesses seek to deeply understand, to empathize with, their core customer. That’s why Charles Schwab & Co, a portfolio holding of ours, uses the tag line ‘Through Clients’ Eyes,’ almost as if they were attempting to channel their inner Henry David Thoreau! That’s what “putting the customer first” really means.

For long-term investors, seeing “through customers eyes” rather than through their own eyes is key. This is what empathy means. To walk a mile in another person’s shoes, to seek to truly understand how other people feel. Not how you would feel if you were in their place, but to understand how they actually feel.

So much of what we talk about in investing are lessons we learn as adults as we seek to master our craft. But all those spreadsheets we build are really just trying to quantify how the people who run a company and the people who make up their customers and competitors, will behave in the future. Forecasting behavior is about understanding how other people feel. It’s about empathy.

Cultivating empathy isn’t easy. Our own feelings about the world often seem to be “right” while other people’s feelings can seem “wrong.” But while empathy isn’t always easy, it is indeed very simple. So simple that Sesame Street can explain it to little kids. So, there really is no excuse for investors not to recognize the importance of empathy and seek to better understand how other people feel as a key driver of long-term investment performance.

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.