(This is Part II of a five-part series. Part I. Part III. Part IV. Part V.)

“[Assuming] ‘what you see is all there is’ facilitates the achievement of coherence and of the cognitive ease that causes us to accept a statement as true… and explains a long and diverse list of biases of judgment… including overconfidence, framing effects, and base rate neglect.” -Daniel Kahneman, Thinking Fast and Slow.

In Part I of this series, we looked at how investors as a group have done a terrible job at forecasting growth, while we also recognized that, like it or not, all investors must implicitly or explicitly make forecasts about the future. In this post, we’ll look at the concept of base rates in making forecasts and how they provide guardrails that help avoid forecasting mistakes.

For us, this comic does a great job of illustrating the challenge at hand.

(Source: Natalie Fratto)

Let’s assume that the illustration shows an investor trying to understand the future of a particular company. A traditional value investor stands on the shore and declares they won’t be tempted into the abyss. They are going to stay on the shore, thank you very much, and leave the reckless exploration for growth investors.

As illustrated by Ed Yardeni’s data shown in Part I, growth investors look at the deep abyss in front of them and cry out in excitement. “The water is crystal clear!” They shout as they peer down to what they think is the bottom. But what they don’t appreciate is they can only see a very small portion of the future, while the vast majority of what lies beneath is hidden from view.

So how then should investors behave? Faced with the comforting, but naïve choice to simply stay on the shore, vs the reckless option to dive into the abyss headfirst, the answer is not immediately clear.

What would you do if faced with a need to explore an uncharted and mostly not visible body of water? If you’re a professional explorer, you plunge in, but only with a significant set of safety measures in place. Tools that you can use to keep yourself from falling off the deep end.

At Ensemble, we look out over the abyss with excitement and the healthy dose of humility that comes from having invested in growing companies for two decades and built firsthand knowledge of the dangers that lie out of sight.

Just as Odysseus had his crew tie him to the mast as they sailed past the Sirens so that he could hear their song but not throw himself to his death, we forecast growth while metaphorically tying ourselves to the shore. The length and types of ropes we use vary over time and between companies, but at its core, our process is built on trying our best to understand the future that is visible, while at the same time accounting for the fact that most of the future is not visible.

One of the most fundamental tools we use are “base rates.”  Let’s say you are asked to guess whether it is more likely to rain in Seattle or in Las Vegas on a random day in the future, but you are given no other information to assist you in making your forecast. Most every person who has even the most general sense of American weather patterns would say that it is more likely to rain in Seattle.

This is because while you may not know the exact historical probabilities, you know that Seattle is a city where it rains frequently while Las Vegas is a city that gets little rain. So, the “base rate” of the frequency of rain is higher in Seattle than in Las Vegas. If you take the time to look up this base rate, you’ll find that it rains in Seattle on about 42% of all days, while it rains in Las Vegas about 7% of the time.

The base rate describes the probability of something happening based on the historical record. The “reference class” describes the set of data you are using. Are you using the frequency of rain from last year or the last hundred years? Are you including only the city proper or the entire metro area when measuring rain frequency?

Now let’s say that you are asked what the probability is that it will rain tomorrow in each city, and you are shown a current photo of the sky in each city. If the sky was full of dark clouds in Las Vegas, but clear and blue in Seattle, which city would you say is more likely to get rain tomorrow?

This isn’t an easy question to answer. We know that dark clouds fill the sky before it rains, and that rain doesn’t fall from clear blue skies. But we also know that Seattle gets much more rain in general while Las Vegas gets little. So, it is common sense to try to combine these two sources of data.

In forecasting, the “inside view” refers to the information you have about the specific forecast being made. In this case, the inside view is the information about the conditions of the sky in each city. The “outside view” refers to the base rate data about the historical experience of a relevant reference class, or in this case, the frequency with which it rains in each city.

Most people neglect or underweight outside view information. The dark cloudy skies are such a compelling and tangible indicator of rain, that we discount the base rate probability of rain in Las Vegas being rare. And so most people, when faced with a conflict between inside view and outside view information, go with what the inside view information suggests. After all, they are trying to forecast the likelihood of rain tomorrow, not just the general probability. And look at those dark clouds!

But as Nobel prize winning psychologist Daniel Kahneman explains in the quote opening this post, while inside view information is extremely compelling in helping us get comfortable with a forecast, overweighting this information and neglecting the outside view information of base rates is a primary reason most people are so bad at forecasting.

It is base rate neglect that is the root of Paul Samuelson’s quip made in 1966 that, “Declines in the US stock market have correctly predicted nine of the last five recessions.” Investors take note of inside view information about a potential coming recession but forget that the base rate of recession frequency is relatively low. We explored this concept during the recession scare in the fourth quarter of 2018 in our post Strong Evidence of Rare Events: False Positives in a Sea of Noise.

In the post, we explored the lessons of Bayes Theorem as explained in Nate Silver’s book, The Signal & The Noise: Why So Many[…]

(This is Part I of a five-part series. Part II. Part III. Part IV. Part V.)

“Therefore, take me and bind me to the crosspiece halfway up the mast; bind me as I stand upright, with a bond so fast that I cannot possibly break away, and lash the rope’s ends to the mast itself. If I beg and pray you to set me free, then bind me more tightly still.” -Homer, The Odyssey

In the Odyssey, Odysseus is warned by Circe, the daughter of the sun god Helios, to steer clear of the Sirens, whose beautiful songs lure adventurers to their deaths. She warns him that he must stuff the ears of his crew with wax so that they are unable to even hear the Sirens. But for Odysseus, she advises him to be bound to the ship’s mast so that he may hear the glory of their songs, while remaining safe.

When attempting to forecast growth, investors face a similar dilemma. In this series of posts, we’ll explain how we use a similar set of techniques to Odysseus so that we can venture amongst the glorious potential of high growth businesses, while avoiding being lured into traps that create devastating losses.

Investing is always and only about the future. When you make an investment in a company, you obtain a claim on the future cash flows of that company. The key problem in investing is that there are no real-life oracles to consult and so the future is intrinsically unpredictable.

In this analysis by Ed Yardeni, the historical earnings growth estimates for the S&P 500 are displayed. For each year, the estimates that were first issued a year prior up until the final estimate at year-end are charted. For instance, looking at the light blue line representing the year 2011, you can see that as of January 1, 2010, analysts expected the 2011 earnings growth rate to be about 22%. But by the time 2011 ended, actual growth came in at just 15%.

(Source: Yardeni Research)

As you can see on the chart, in most years the initial growth estimates were way off base. Generally, the initial estimates were too high, with analysts systematically reducing their growth forecasts as the future drew closer. The two major exceptions to this tendency of analysts to be overly optimistic about growth were 2010 and 2021. Both years occurred just after a recession and in both cases, analysts were far too pessimistic as they missed the coming inflection in the economy. The rise in 2018 earnings estimates was an anomaly caused by the change in the corporate tax rate, which caused analysts to increase their estimates, but only after the new tax law was actually passed. In every other year, initial growth expectations proved to be overly optimistic.

The chart shows that investors as a group tend to be far too optimistic about growth, except for just as the economy is coming out of a recession, at which point investors end up being unhelpfully pessimistic.

Traditional value investing selects stocks that trade at inexpensive valuations based on historical or current financial results. This general approach was much more successful than growth investing for a very long time. This was primarily because it turned out that assuming the future would be a lot like the past was a more accurate approach to forecasting than the overly optimistic (punctuated by excessive pessimism) approach used by growth investors.

But traditional value investing has underperformed growth investing for the last two decades. It turns out that an era characterized by the rise of the global internet, a worldwide financial crisis, and a global pandemic was… different. The future turned out to be not so much like the past and forward-looking investors were well rewarded for recognizing this as it was happening.

At Ensemble Capital, we think that all investors, even those who purport to not make forecasts, make either implicit or explicit forecasts every time they decide to buy or sell or even just hold a stock. Because ownership of a stock is only as valuable as the future earnings power of the company in question, all investors, even those who simplistically assume the future will be like the past, must make judgements about the future.

Value investing absolutely requires forecasting the future just as much as growth investing does. The difference is that traditional value investing implicitly assumes that the future will be similar to the past, which is still very much a forecast. In this way, the traditional value investor acts much like Odysseus’s men. By “stuffing their ears with wax” they seek to protect themselves from the siren song of growth.

But notwithstanding the strong relative performance of growth investors in recent decades, listening to the siren song of growth can be extremely dangerous. Investors who make explicit forecasts of rapid growth for the companies they invest in run the risk that they will be lured into taking devastating losses if those beautiful forecasts turn out to be a mirage.

So, the question at hand for investors is not whether they should forecast the future growth (or lack thereof) of corporate earnings power. Rather it is how should investors go about making those forecasts without being too optimistic, nor by naively ignoring growth potential.

As Warren Buffett has said, “growth is always a component in the calculation of value, consisting of a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” Thus, no matter what investment approach you use, the future growth of a company is a key variable in driving investment results. This is true whether you are buying high growth stocks or low growth stocks. It is true whether you make explicit long-term growth forecasts or whether you make no explicit growth forecast at all.

But while future growth is very difficult to predict, investors can embrace a probabilistic approach to growth forecasting. This approach recognizes the lack of certainty about the future, while also not naively pretending that nothing about the future can be known.

In the rest of this series, we’ll explore the tools and approaches we use for making probabilistic forecasts about future growth.

Read Part II.

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.

Each quarter, Ensemble Capital hosts a conference call with investors to discuss the current market, economic conditions, and a few of our portfolio holdings. This quarter, the team will discuss Booking Holdings and Landstar in more depth.

The event will use a webinar format. Participants will have a chance to ask live questions of the research team during the Q&A portion of the event.

This quarter’s webinar will be held on Friday, October 8 at 1:30 pm (PST)

We’d love for you to join us, which you can do by REGISTERING HERE.

If you’d like to listen to our previously-held quarterly updates, an archive can be FOUND HERE.

We hope to see you there!

Ensemble senior investment analyst Todd Wenning was recently interviewed by investing newsletter, Investment Talk. Among other topics, Todd discussed:

  • His professional background, including what led him to join Ensemble Capital
  • Why Ensemble Capital’s equity strategy is only interested in owning the top 1-2% of companies in the quality universe
  • Ensemble’s investment philosophy diagram

To read the full interview with Investment Talk, 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.

We recently repaired my grandmother’s mantle clock. It’s a nice piece and looks good in our living room, but it only has sentimental value. The repair cost outweighs its market value.

When we brought it to the repair shop, we learned that almost all the internal mechanisms were rusted and had to be replaced. Fortunately, the external features were in great shape. It still looks like the clock I walked past in her foyer as a child.

At some point in the repair process, especially if we’d needed external replacements, it would no longer have been my grandmother’s clock. It would instead be a whole new clock that happened to resemble my grandmother’s clock.

Over a long enough timeline, the same thing happens to companies. Everything internal – from the copiers to the offices to the management teams – gets replaced. This point often gets overlooked because, like my grandmother’s clock, the exterior looks the same.

As companies get larger, the decisions made by present-day management have an outsized impact on the company’s subsequent fundamentals. What came before matters less with each passing year. As Warren Buffett quipped, “After ten years in a job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

To illustrate, Wal-Mart today is not the same Wal-Mart led by founder Sam Walton. When Walton stepped down from the CEO role in 1988, Wal-Mart’s shareholder equity amounted to $2.26 billion; in fiscal 2021, it was $87.5 billion. In other words, 97% of Wal-Mart’s current shareholder equity was generated after Walton stepped down.

Business strategies also get replaced. Starbucks founder Howard Schultz’s early vision for the coffee house was rooted in its “third place” allure – a place other than work and home where customers could sit on comfy couches and enjoy a book or have a conversation with a friend. That strategy, by any account, was a massive success.

Just before the pandemic struck, however, over 80% of Starbucks’ U.S. orders were “to go,” and in the most recent quarter, nearly half of U.S. orders were made through drive-throughs. Starbucks is currently restructuring its U.S. store footprint and focusing on rapid fulfillment. Though the “third place” is still a key strategy in China, the U.S. strategy has been dramatically reimagined.

Starbucks 2003 Annual Report (left), New Starbucks Pickup store format (right)

If you happened to own Wal-Mart or Starbucks for the last 20-plus years, you implicitly approved of all the major changes at the company along the way. But if you didn’t give those changes any thought, your outcome was mostly luck. It wasn’t predestined that either company would have a positive outcome.

So how might we as investors, with some level of confidence and reason, explicitly approve of such changes with a forward-looking approach?

We suggest focusing on culture. Founders like Walton and Schultz set the algorithms for how their companies proactively and reactively respond to change. As investing legend Philip Fisher put it: “More successful firms usually have some unique personality traits – some special ways of doing things that are particularly effective for their management team. This is a positive not a negative sign.”

While subsequent leadership teams might tweak the founders’ mission statements, the core cultural algorithm is hard to break. So much so that when an outsider CEO goes against the grain and redefines an algorithm that works, trouble emerges.

This was the case at Home Depot in 2000 after co-founder Bernie Marcus stepped down and handed the reins to former General Electric executive, Bob Nardelli. Nardelli had no retail experience and pushed the centralized Six Sigma lean management style he learned at GE onto the Home Depot system, which had previously been decentralized and entrepreneurial in nature. Momentum at Home Depot stalled. It took nearly seven years for Nardelli and Home Depot to part ways, but once Home Depot was put back on track, it emerged stronger than ever.

Being outside shareholders, we’re not privy to the daily decisions companies make that over time determine their success or failure. But we aim to learn and understand the cultures – the algorithms – behind the businesses we own so we can better filter through daily and quarterly news flows.

A recent example is Netflix. Netflix announced it was moving into the video game space to provide subscribers with additional ways to engage with Netflix content. At first glance, you would be wise to be skeptical, as the video game industry is quite different from the TV series and movie business that’s been Netflix’s core focus for over 20 years. You might conclude that Netflix’s management is taking its eye off the ball.

Having studied Netflix for years, however, we’ve come to understand that the culture founder Reed Hastings set in motion is one that emphasizes experimentation and fast learning to create consumer surplus. Games will be available to Netflix subscribers at no additional cost. The point is to make your Netflix subscription even more of a no-brainer expense than it already is.

Without this understanding of Netflix’s culture, we may have reached a different conclusion.

A company that you’ve owned for a decade or longer is, in many ways, a different company from the one you originally bought. There’s no such thing as buy and hold with equities because corporations are organisms operating in ecosystems and, as such, are changing internally and responding to external stimuli. You can buy and hold something static like a painting or gold, but not equities.

As equity owners, then, we need to regularly evaluate our investments and reaffirm or change our conviction ratings. By getting closer to the company’s culture and the algorithms that drive its decisions, we can better sort through noise and identify important signals.

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.