Shortly after Coronavirus began spreading in Italy, we published our post How We’re Thinking About Coronavirus. In that post, we outlined our belief that the economic impact of Coronavirus was extremely difficult to forecast, and that information must be meaningful and actionable in order for investors to use the information in ways that increase their expected return.

In this post, we’ll lay out what actions we are taking based on our current forecasts and offer a preview of how we expect to act as more information becomes available.

First of all, let’s be clear; the Coronavirus has already had a meaningful negative impact on economic activity and this negative impact will continue. The question at hand is how negative the impact will become, how long it will persist, and finally how the economy will behave after Coronavirus recedes.

Here’s an economic scenario analysis put together by Bloomberg.

Here’s another way to think about a Widespread Contagion impact on the US economy from Goldman Sachs. Note that this chart is showing the impact on GDP. So the -3% in Q2 would be about -1% GDP if you assume 2% growth ex-Coronavirus.

And finally here is ISI Group, one of the very best economic teams on the Street whose work we’ve followed closely for two decades, who this morning said they now expect a quick and sharp recession followed by a rebound.

At Ensemble Capital, we’re in the business of evaluating individual companies, not making economic forecasts. However, while we think that typical economic cycles are nearly impossible for anyone to forecast correctly, what is happening right now is not so much a typical longer cycle economic slowdown but an abrupt “halt” to economic activity that is taking place right now. While it is beyond the abilities of economists to know if this event will tip the US and the rest of the globe into a recession, it is very clear today that many segments of the economy are experiencing, or are about to experience, sharp drops in demand.

So, in practical terms what that means is that we have adopted a set of assumptions across our portfolio that assumes a very meaningful negative impact to demand that lasts for about six months. Of course, beyond the overall economy wide impact, we’ve also considered company specific impacts since Coronavirus will very clearly hurt some companies much more than the average company, while indeed it will have little impact or even improve the economic outcomes of other companies.

As a broad narrative, this outlook assumes a very sharp, short term economic contraction followed by a rebound. This economic shock risks pushing weaker economies into recession but may not do the same for stronger economies. However, we’re well aware that even though the US economy is relatively healthy with strong new jobs numbers reported for February, if the Coronavirus shock is severe enough it could ripple through the economy and cause a recession that persists beyond the end of this outbreak.

Why do we expect the direct impact to only last six months? Because every viral outbreak has behaved that way. The big question is how bad it gets, more than how long it lasts. Even in the worst-case example of the Spanish Flu, the outbreak ran its course over just a few months (although it did come back the following year, much like Swine Flu continues to circulate in the US every year despite fading in economic relevance).

(Source: InvestorAmnesia)

The Spanish Flu was 100 years ago, and the world is a different place. But the underlying biology of viruses have not changed. In this report written by the Federal Reserve in 2007 about the economic impact of the Spanish Flu, you can read the relatively optimistic sounding assessment. It is also useful to note that the US stock market was up 11% in 1918 and up 30% in 1919. The Flu itself didn’t help the economy or the market obviously, but it is important to recognize that there are a nearly infinite number of inputs into what drives the market and the economy (which is why they are impossible to predict in the short term). And of course, we know the Roaring 20s followed the Spanish Flu with robust economic and financial market gains for a decade.

The fact is that a recession will indeed come, the only questions is when and why. A year ago, many people thought that a recession would come due to the Chinese economy slowing down and the trade war. But the US economy only slowed modestly and has been reaccelerating. The Coronavirus outbreak could be the event that triggers the next recession. But if it doesn’t there will still be a recession at some point later. This is an underlying operating assumption for every investment we make. While we can’t time recessions, we know they will occur from time to time and we only make investments in companies we believe can successfully navigate them and come out healthy on the other side.

Since we seek to be invested in companies that we believe are undervalued, a negative reassessment of the value of a company does not necessarily mean that we will sell or trim that position. It means instead that at any given market value for the stock, we would want to own less today that we would have wanted to own under our prior forecasts.

As a general statement on our total portfolio, we believe that the negative economic impact of Coronavirus on the value of our holdings is most likely going to end up being less than the amount that their stock prices have already declined. This means that today, we believe our portfolio offers a higher expected return over the next five years or more than it did prior to Coronavirus breaking out in Italy, and the related selloff in the US stock market. Not because Coronavirus doesn’t matter, but because the impact of this event on the intrinsic value of the companies we own is likely less than the nearly 20% decline that has occurred over the past few weeks in the broader stock market.

We’ve also stress tested our portfolio holdings to confirm our belief that even under a far more negative outcome, each company can continue to operate and will not face a cash flow crunch that could prevent them from making it through the crisis.

While we cannot know today whether the crisis will recede more quickly than we expect or whether it will spiral into a Severe Global Outbreak that causes a global recession, we can continue to monitor the situation and be prepared for the moment when the probabilities begin to shift more clearly towards a different scenario than the one we currently expect.

The problem is that today, the information that is known about the Coronavirus economic impact is still consistent with a range of future outcomes. In the simple drawing below, we show three paths that could play out over the next year or more. The blue arrow points to today.

As we move forward in time, we will approach a point where the crisis begins to follow a path that is no longer consistent with a better or worse outcome than our base case. However, it is still extremely difficult to know what that information might look like. It may well even be hard to recognize the information once it arrives.

For instance, Italy has announced they are locking down their entire country, much as China did in Wuhan, in an effort to contain the outbreak. How does this new information impact our scenario analysis? On the one hand, we know that China’s response appears to have worked relatively well. While they didn’t stop the outbreak, it has not run rampant across all of China, active cases have gone into decline, stores and factories are reopening, etc. On the other hand, we know that the lock down in China has had huge negative ramifications on their economy. And we know that, in general, it is not the health impacts of viral outbreaks that cause most of the economic impact, but the actions taken to stop the outbreaks that causes most of the damage.

What this means is that it may be a mistake for investors to focus on the spread of the virus and they should instead focus on the actions taken to stop it. Not just the official government actions, but just as importantly the behavioral changes being made by businesses and consumers. While it would certainly have meaningful social impacts, the economic impact of people being sick and even dying is minimal at the macro level. Conversely, people not going to work and not spending as usual would have profound economic implications, if only for a time.

This is an important point, but it can sound callous. The stock market is not a measure of how much good or bad there is in the world, it is a measure of the long-term value of corporate cash flows. The steps that Italy and China took to try to limit the health impact of the virus may cause a worse economic impact than if they had not shut the country down. That does not mean they made a mistake. It may be well worth accepting economic losses to limit the health impact of Coronavirus. But it is important for investors to not confuse the two issues when making investment decisions.

That’s why we’re closely monitoring charts like this one that shows how the progression of the outbreak in Italy is following a very similar path to how things played out in China, but also keeping in mind that active cases and death counts are not the same as the impact on corporate earnings or the degree of economic drag.

(Source: Avatorlv)

At some point over the next month or two, the scale of the negative economic impact of Coronavirus will become clearer. While on the one hand it would give us and our clients some mental comfort to simply assume the worst case outcome and act accordingly, the fact is that the best investment opportunities come not from always assuming the worst, but by having better calibrated expectations than other investors. The very best investment opportunities come about precisely because the crowd assumes the worst, leaving stocks priced so that they perform well even if the actual outcome is bad (but not as bad as the worst-case outcome other investors assumed).

But while investors get paid to not assume the worst if they indeed are right, this does not apply to much of everyday life. Making sure your family is prepared for an emergency is just good common sense. Of course, you should have an emergency kit, of course you should be prepared for possible disruptions to supply chains, of course your company should have a plan in place to ensure business continuity and the safety of all employees. The costs of “over reacting” to risks is often low in everyday life. But anyone who knows someone who assumed that financial markets would never recover from the financial crisis and decided to liquidate their portfolio can tell you how overreacting to risks is one of the surest ways to destroy your financial situation.

At Ensemble Capital we’re committed to being transparent in how we are managing our clients’ assets. While we can’t tell you what will happen in the future, we can tell you how we are thinking, what we are doing, and how you can expect us to behave under various future scenarios.

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.

Note: During times of stress, investors often lose conviction in their previously strongly held beliefs. This cracking of their conviction is the main culprit behind why investors often make bad decisions during stressful market environments. While this post is not specifically related to the Coronavirus issue currently roiling the market, we are publishing it now as the issues it addresses are critical for navigating turbulent markets.

“Invest in what you know.” -Peter Lynch

The Peter Lynch quote above is good advice. You should only ever invest in an individual company on which you have done the research needed to understand it deeply. But Lynch’s quote is often interpreted to mean that investors should invest in companies that sell products or services that they are familiar with as a consumer. This isn’t what Lynch meant and he even clarified his comments so there would be no confusion.

“Peter Lynch doesn’t advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock!” -Peter Lynch

Why does it matter how well you “know” a company? Because investing is fundamentally based on making forecasts about the future and these forecasts need to be informed by how the world actually works. For instance, as a coffee drinker, I know that there are important differences between why people buy a cup of coffee at Starbucks vs McDonald’s vs making it at home. These are nuanced, but important elements of understanding the company. But Todd’s recent post on why recognizability is different than relevance is highly applicable here.

In fact, familiarity with a topic can actually reduce your ability to make accurate forecasts about the future. “Familiarity bias” is the observed phenomenon that people assess the likelihood of events they are familiar with to be much higher than events they are less familiar with. This is caused by the “availability heuristic, a mental shortcut that relies on immediate examples that come to a given person’s mind when evaluating a specific topic, concept, method or decision. The availability heuristic operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as readily recalled.”

The worst part of familiarity bias is that it hits hardest during times of stress. During recessions or financial market crises, the very moment when your conviction in your investments is tested, familiar companies will seem safer than unfamiliar companies. Yet what makes a company safe is how forecastable its future financial results are. If you knew exactly how much cash flow a company would produce over time, then you’ll know exactly what a stock is worth. It doesn’t matter how familiar you are with a product or service; it matters how well you can forecast a company’s financial results.

However, there is a class of companies that we think tend to be ignored by many investors due to a lack of personal experience with their products and services, but which often offer far more forecastable business models than consumer facing companies.

Business service companies are companies that offer some sort of service to other businesses. Typically, these services are critical to their customers, but are not a core part of what their customers offer. It is the fact that they are important, but not the focus of their customer’s value proposition, that leads to these functions being outsourced.

Service stocks tend to have great business models. They don’t carry inventory, don’t have a lot of capex requirements, tend to have solid pricing power, and often charge using a subscription or subscription-like model. Those service companies that serve other businesses rather than consumers also tend to be far more protected from shifts in customer preferences or shifts in what is popular.

In Ensemble’s portfolio, examples of business service stocks include:

  • Mastercard: Provides payment facilitation services to banks and merchants.
  • Broadridge Financial Solutions: Provides customer communication and trade processing services to banks, brokers, asset managers and corporate issuers.
  • Landstar Systems: Provides trucking logistics services to shippers.
  • Paychex: Provides payroll processing services to small and medium sized businesses.
  • Verisk Analytics: Provides data and analysis to insurance companies, as well as other specific industry groups.

There are also a number of companies in our portfolio that share similar characteristics, but which are not technically business service companies. For example, Masimo nominally sells patient monitoring devices to hospitals, but really their business model can be thought of more as a razor and razor blade version of a home alarm system company where the sale of the monitoring system (which lasts about eight years) is how they establish a relationship with a customer, but providing replacement sensors for that system is a service that creates a subscription-like annuity stream.

These types of companies represent almost half of our portfolio. Yet no one on our team has ever directly been a customer of one of these companies. So are we ignoring Peter Lynch’s advice to “buy what you know”? We think not.

One key driver of how forecastable corporate results are over the medium to longer term is the behavior of the company’s customers. Consumer facing companies have to deal with consumers. Will consumers ever really want to buy electric cars? Will consumers still demand plant based “meats” in the future? Will superhero movies still dominant the box office a decade from now? These are really hard questions. No matter how familiar you are with cars, food and movies, these are still questions with highly uncertain answers.

But business service companies don’t have to deal with preferences as much as consumer facing companies do. Sure their customers still have preferences, but when a business service company provides a valuable service at a low cost (compared to their customers’ total expense structure), their customers tend not to make any changes to their behavior unless they have to.

Here’s how we described this dynamic operating at Broadridge Financial on a recent conference call:

“Imagine you are an executive at a large broker and one of your managers suggests switching from Broadridge to a competitor for the service of delivering monthly statements and trade confirms. The first question you might ask is whether the change will make clients happier. The answer is likely to be no. It is important to deliver statements and trade confirms and indeed it is a mission critical regulatory obligation. But investors are never going to pick a brokerage firm because they get monthly statements out more effectively. In fact, it isn’t even that clear what that would look like. It is just something that needs to get done without errors. There is no such thing as a premium statement delivery system.

So as the executive at a large brokerage firm, you might wonder why the manager is even wasting your time bringing up the idea of switching. So you ask a simple questions: “If the new service provider was free, would it save us enough to make a difference?” The answer would be no. These costs are so small relative to the huge cost structure of a broker, that the savings would be rounding error for the overall business.

So faced with a situation where changing to a competitor would provide no better of a service to investors and not save any material amount of money, but doing so would run the risk of errors occurring during the transition process and in fact could even cause regulatory issues, there is simply no reason to even consider moving to a competitor. And this is why Broadridge reports around 98% revenue retention meaning that every year, 98% of their customer base by revenue renews their contract for another year.”

What percent of McDonald’s customers will switch to another fast food company next year (maybe a healthier one)? No matter how familiar you might be with McDonald’s, that doesn’t help you answer the question. In fact, it is extremely hard to imagine the world changing dramatically away from things you are familiar with. What percent of customers will switch to a new provider for investor communications? With no familiarity you would likely have no idea what the answer might be. But research will show you that the answer is only about 2% and that this low rate of client attrition (which is more than offset from winning new customers) has been stable for many years.

So we agree with Lynch’s famous question. “Buy what you know” is excellent advice. But that doesn’t mean buy companies you are familiar with from your day to day consumer experiences. It means get to know companies in depth prior to investing in them and only invest in those companies you are able to build a strong enough understanding of that you “know” how things will turn out even as the uncertainty of the future continues unabated.

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.

When various world news breaks that seems scary for the market, the main way we process this information is the degree to which we think it allows us to accurately change our forecasts about the future. Something that is only a modest driver of market returns, but very certain how it will impact things will be quickly incorporated into our forecasts and thus our portfolio will change to reflect the news. But many big events have extremely uncertain impacts on the market and thus while they may matter a lot, they may not be actionable from the standpoint of making investment decisions.

In order to generate investment performance that is better than the market, we must be able to make better forecasts than other investors. When we buy or hold a stock, it is because we believe that the set of forecasts about the company’s future cash flows that other investors are using in valuing the company are too pessimistic. That’s what it means for a stock to be “cheap”. If we’re right and the cash generated by the company is closer to our forecasts than the market’s forecasts, the stock will rise faster than the market over time.

So in making decisions about how to incorporate any new bit of information we come across into our portfolio management decisions, it always boils down to the question “how does this information change our long term forecasts of company cash earnings?”

For the last month or so, the market has seemingly been “ignoring” the risk of Coronavirus. And then over the last two days, global markets have fallen sharply. We believe the explanation for this is that the market was never ignoring Coronavirus in the first place. But investors had limited confidence that the virus would materially reduce economic growth or corporate profits outside of China. With the outbreak of the virus over the weekend in Italy and the Center for Disease Control warning Americans today to prepare for the virus to spread in the US, investors have suddenly re-calibrated their expectations and now appear to be assuming that the economic impact of the virus will be at least somewhat severe and/or prolonged.

But while it is perfectly reasonable to be concerned about the long-term economic impact of the virus, it is also perfectly reasonable to recognize that the virus may have little to no economic impact beyond 2020. Right at this moment in time, after such a sharp drop in the stock market, it is hard to believe that this might all fade in economic importance over time. But it is notable that in fact this is exactly what has happened with almost all past global virus outbreaks.

Here’s David Quammen, the author of “Spillover: Animal Infections and the Next Human Pandemic” writing in the New York Times:

“[This outbreak is] possibly even more dangerous to humans than the other coronaviruses. I say “possibly” because so far, not only do we not know how dangerous it is, we can’t know. Outbreaks of new viral diseases are like the steel balls in a pinball machine: You can slap your flippers at them, rock the machine on its legs and bonk the balls to the jittery rings, but where they end up dropping depends on 11 levels of chance as well as on anything you do.

Nobody knows where the pinball will go… Six months from today, Wuhan pneumonia may be receding into memory. Or not.”

This lack of conviction in making a prediction feels to the lay person like a sign the expert doesn’t know what they’re talking about. But in fact, research on decision making and forecasting demonstrate that the best forecasters are those who understand the limits of their ability to predict the future.

While Coronavirus feels very new and different, Quammen goes on to point out this isn’t the case:

“This Wuhan emergency is no novel event. It’s part of a sequence of related contingencies that stretches back into the past and will stretch forward into the future… The list of such viruses emerging into humans sounds like a grim drumbeat: Machupo, Bolivia, 1961; Marburg, Germany, 1967; Ebola, Zaire and Sudan, 1976; H.I.V., recognized in New York and California, 1981; a form of Hanta (now known as Sin Nombre), southwestern United States, 1993; Hendra, Australia, 1994; bird flu, Hong Kong, 1997; Nipah, Malaysia, 1998; West Nile, New York, 1999; SARS, China, 2002-3; MERS, Saudi Arabia, 2012; Ebola again, West Africa, 2014. And that’s just a selection. Now we have nCoV-2019, the latest thump on the drum.”

Ebola, Bird Flu, West Nile, SARS, MERS… each of these outbreaks were seen, rightly so, at the time that they were spreading to present very serious global risks. But in each case, from an economic perspective, these outbreaks have all “receded into memory” as Quammen points out may well happen with Coronavirus. Or not.

It is that “or not” that is so worrisome. It is that “or not” that is causing the stock market to plummet. It is that “or not” that is causing people to stockpile food and face masks. It is that “or not” that makes all of us worry.

But the world is full of “or nots”. Maybe a war will break out with Iran. Maybe the political party you support won’t win the next election. Maybe China will go into a deep recession for reasons entirely unrelated to Coronavirus.

In a world where every sensible person knows that there is simply a deluge of possible disasters always just over the horizon, while at the same time so many of these risks never come to pass, what are we to do?

The key is to recognize that many of the most important things that occur in the world are not forecastable. Even if they are forecastable, you need to be able to also forecast how they will impact the economy and in particular the cash earnings of the specific companies in which you are invested.

Lots of stuff matters. But only those things that matter and are forecastable are actionable in a way that can make investors money. So what can we forecast about the impact of Coronavirus on economic activity? Well we know that economic activity in China has slowed dramatically. In the last month. Starbucks, Apple, hotels and automakers have all closed many of their locations in China. There is no doubt at all that this will negatively impact their cash earnings this quarter.

But what about next quarter? Until yesterday, the market was assuming that the negative impact would be temporary. And indeed Apple announced today that they re-opening 70% of their stores in China while automakers have begun re-opening their Chinese factories.

So what matters and is actionable for investors right now is recognizing that earnings reports for many companies that sell into China are going to be terrible this quarter. But surprisingly this doesn’t actually change the value of the stock market by all that much. This short term economic damage has been known for at least the last few weeks and the market mostly ignored it because the value of a stock is based on how much cash earnings it will generate over the long term, not how much a company makes in any given quarter.

The fact is that the US stock market is only going to generate cash earnings of about 4% of the value of the market in 2020. This is the long-term average rate of cash earnings. So if the market collectively earned zero in 2020, but in 2021 and beyond it earned the same amount as it would have if Coronavirus had not occurred, then the value of the market should drop about 4%.

So what matters is not whether the virus spreads in the EU or in the US, or if Chinese based companies go back to work this week or next month or this summer. What matters is if the Coronavirus fades in its economic relevance over the course of time as all past virus outbreaks have, or if this outbreak is somehow different and the global economy grinds to a halt.

I wish I could tell you the latter outcome was impossible. But Coronavirus could be with us for a long time. Or not. It simply isn’t forecastable, which is exactly what the most informed experts on global pandemics will tell you. But this is true about so many important things. We can’t forecast the economy very well, indeed even the Federal Reserve board with all their PhDs and access to unlimited data and resources find forecasting the economy beyond six months to a year to be nearly impossible.

The reason stocks have generated returns of about 9% per year while government bonds have earned returns of less than half that level is because bonds are far, far more forecastable than stocks. The stock market earns higher returns because owning stocks requires that you accept uncertainty. It isn’t fun. We try our hardest to identify ways to better forecast the future. But we also accept that a high level of uncertainty is the price of earning the long-term rewards of the stock market.

The market falls by 5% or more, as it has this week, about three times a year. It falls by 10% or more about once a year. And it falls by 20% or more about once every seven years. If the market continues to decline until it drops by 10% or even 20%, this shouldn’t be surprising. It won’t be fun, but it is just part of investing.

We’ll continue to monitor the news about Coronavirus and we’ll continually update our own forecasts about how our portfolio holdings’ cash earnings will play out this year and well into the future. We’ll take action when we recognize that something important has occurred, that is forecastable, and which we believe other investors are missing.

But in all likelihood, the economic impact of Coronavirus will fade over time, just as it did for every one of the virus outbreaks of the past.

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.

Most of the products that were popular in your youth have faded into obscurity.

But you still remember them. You might even have fond memories of shopping at Sam Goody music stores, firing up your first Gateway 2000 computer, or developing photos on Kodak film.

You remember these products because they were at one time relevant to you. They provided some utility, some enjoyment that positively impacted your life and you were happy to spend money on them. 

But once those products lost their relevance and utility, they naturally became less valuable to you. Recognizability isn’t enough to get you to open your wallet.

Relevance drives attention, attention drives demand, demand drives pricing power. 

Unless products adapt to meet changing customer needs, they will become less relevant. And as they become less relevant, their companies’ moats begin to erode, even if the products remain highly recognizable.

Investors often confuse recognizability with relevance and by doing so overestimate the company’s pricing power and moat. This is a classic Quality Trap.

We find that quality traps are particularly common with blue chip companies and those with household name brands. Recognizability can obscure relevance decay.

To illustrate, a recent Wall Street Journal article discussed how big food brands are struggling to maintain shelf space despite having better brand recognition.

General Mills’ sales of baking mixes and ingredients have declined over the past five years. The company’s Betty Crocker, Bisquick and Gold Medal flour brands are losing shoppers to smaller rivals and store brands. For example, Kodiak Cakes LLC, a family-run maker of high-protein pancake mix, has taken market share from Bisquick and other competitors, according to market-research firm Spins. Even though Kodiak’s annual revenue is less than one-tenth of General Mills’ baking sales, Kodiak is gaining shelf space. (My emphasis)

It might be comforting to own the more recognizable General Mills’ brands, but ultimately, it’s not whether you recognize the brand or product. What matters is the product’s relevance to customers over time.

Relevance can diminish for one or all the following reasons:

  • Technological change: Massive and rapid technology change, such as music going from physical media to digital and streaming, can impair an established company’s strategy. Few successful businesses are willing to destroy their cash flow machines to chase what at first may seem to be a fad.
  • Customer preference shift: Similarly, companies that have built their brand or reputation on a certain image that was once treasured by its customers can find it difficult to pivot once that image is no longer in fashion.
  • Increased/new competitionIncumbents are often dismissive when a competitor launches a highly-relevant product that has yet to hit critical mass. Until the upstart impacts their profitability, incumbents are unlikely to adjust their strategy. And by then, it’s often too late.

Whatever the cause, as an investor, you don’t want to be on the wrong side of declining relevance.

Here’s why. If you’re doing a discounted cash flow valuation, between 70-75% of your fair value estimate is driven by your terminal value. Conflating recognizable with relevant products will lead you to overestimate the company’s moat and its returns on invested capital (ROIC) in its terminal year, which will in turn lead you to dramatically overvalue the business.

On the other hand, what you want to see is a company with products that can remain relevant to its customers over a long period of time.

Indeed, the popular products of our youth that maintained their relevance are the ones that we kick ourselves over not buying years ago. Companies like McDonalds, Disney, and Nike – all well-known brands and businesses for 30-plus years – have found a way, despite bumps along the road, to remain relevant and valuable to their customers.

If you could know nothing else about a business over a 10-year period, you’d want to know whether its products still mattered as much as they do today. As such, one of the questions we ask before investing in a company is whether we believe its products and services will be at least as valuable to its customers a decade from now.

Admittedly, it’s a tough question to answer. After all, a lot can happen in ten years. Consider RIM’s (Blackberry’s) global market share swing from 2007 to 2016. 

It would have been easy to think in 2009 that Blackberry would remain highly relevant for the next decade. The trends were positive at that point. But with hindsight, that would have been a terrible conclusion.

On the other hand, Starbucks has become increasingly relevant to global consumers over the last decade. Consider the Google Trends global search results for “Starbucks” since 2004.

Source: Google Trends, retrieved February 2020

Starbucks’ consistent relevance drives traffic and allows it to steadily raise prices on your favorite drinks.

You might be saying to yourself, “Great, but how might we be able to tell the difference ahead of time?”

We think a good starting point for evaluating future relevance includes asking:

Though uncertainty will remain, we believe answering these questions helps paint a better picture of the company’s relevance.

We are certain of one thing: a company will face multiple challenges over the course of a decade. As such, extrapolating the status quo is folly. What we want to find are companies that can survive and thrive in various environments and remain relevant. 

To be sure, these companies are rare. But those that maintain relevance maintain pricing power and therefore maintain their moats. Moat sustainability leads to persistently high ROIC, which usually surprises markets and leads to strong stock 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.

This past weekend, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on The Investor’s Podcast to discuss our long time portfolio holding Mastercard. During the interview Sean explained:

  • Why the company has seen such dramatic growth in revenue and earnings and why we think it will continue.
  • The economic model of the company that allows it to return so much capital to shareholders even as it grows.
  • Why we think the Chinese payment giants will make limited headway in developed markets even as they will be formidable competitors in emerging markets.
  • And more!

Click here to listen to the podcast if you are reading this in an email.

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.