Each quarter, Ensemble Capital hosts a webinar to discuss the current market, economic conditions, and a few of our portfolio holdings. This quarter, we’ll discuss these items as usual, as well as our long-time investment in First Republic.

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 Tuesday, April 11 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!

Last year, during the Q&A portion of one of our quarterly investment webinars, we were asked if we regretted selling pet insurance company, Trupanion in the summer of 2019 since the stock had gone on to outperform the market after we sold.

It’s a great question that applies to circumstances beyond Trupanion, so it is worth addressing at greater length.

We feel regret because we believe a decision we made (failure of commission) or didn’t make (failure of omission) produced a worse outcome than should have happened.

Regret has evolutionary purposes as a learning tool – “I really shouldn’t have thrown rocks at the hornet’s nest. I won’t do that again.” It is ingrained in our psyche for a good reason. Even so, regret doesn’t mix with good investing.

Morgan Housel once interviewed the legendary behavioral psychologist Daniel Kahneman for The Motley Fool, and Kahneman said something about regret that stuck with me.

“[Regret] is the killer. You’re losing, and then you decide, ‘Oh, it was all wrong. Let me stop,’ and that’s when disaster strikes, I think. It’s changing course…

You have to inoculate yourself against regret. You have to be prepared for things to go bad.”

It’s worth repeating. In investing, you have to inoculate yourself against regret.

Boy, that’s hard to do. None of us want to look or feel foolish for decisions we make or don’t make, and no one likes losing money. But unless we’re prepared for an adverse outcome and make peace with it, we stand no chance of achieving our goal of outperforming the market over the long term.

This doesn’t mean we shouldn’t care about our outcomes – of course we care! So how do we minimize regret as investors?

It starts with a well-designed investment process and careful consideration of qualitative and quantitative factors that inform our decisions.

Because of our team’s faith in our process, we can confidently say: “With perfect hindsight, would we have benefitted from holding Trupanion rather than selling? Absolutely. Do we regret our decision? No.”

Knowing what we knew then, we would have done the same thing.

That may seem like an odd conclusion, that we are avoiding responsibility for the poor outcome. But as investors, we don’t have the luxury of hindsight when making decisions. Instead, we must make forward-looking decisions based on our present analysis. No matter how thorough the process is, any decision we make will never have a 100% probability of proving correct.

Luck – good and bad – always plays a role in outcomes, which is something we can’t control.

In Michael Mauboussin’s book More Than You Know, he writes:

“Results – the bottom line – are what ultimately matter. And results are typically easier to assess and more objective than evaluating process.

But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field…all emphasize process over outcome.” (emphasis mine)

In a probabilistic field like investing, the focus should be on optimizing process rather than allowing outcomes to swing your emotions.

What’s more – and this is important – if we’re doing our job well and identifying great businesses in our portfolio, the odds are higher than average that a stock we sell will subsequently generate impressive returns. As such, we must be able to watch a stock we sold do well, knowing that it no longer fits our ownership criteria for one reason or another.

Conversely, if Trupanion flopped after we sold, it might have made us look “smart” to outside observers, but internally we would have questioned our process for including it in the first place.

And that’s what’s critical to us – we want to see our process identifying exceptional businesses that trade at attractive valuations. Over time and across many decisions, our process has produced strong results and we believe that this will continue.

Owning just 20 to 30 companies that we think are in the top-tier in terms of quality, we must be selective about what we include and keep. If we sell a company in our portfolio for reasons other than valuation, it most likely slipped below our threshold on conviction. This does not mean the sold company has suddenly become a terrible company.

Because of our confidence in our process, we don’t spend much time considering companies we’ve sold. If we do, it’s because the decision revealed something lacking in our process and the need for improvement.

We’ve written, for example, about learning from our mistake of selling Costco in 2012. As our process improved in the subsequent years, we more fully appreciated Costco’s business and eventually added it back to the portfolio. Costco’s stock performance in the interim bothered us far less than the shortcoming it exposed in our process, but it led to improvements, hopefully leading to better long-term outcomes.

In contrast, we have not given any thought to exiting Apple a few years ago despite its continued success. Years back, we wrote extensively about Apple, and Sean and Arif were both sought out by major media outlets for their opinions. Compared with our Costco decision in 2012, we feel we thoroughly understood Apple’s business. At some point, however, it no longer fit our process.

Investing is a decision-making business. Letting outcome-driven regret seep into your process grinds the machine to a halt, rendering it useless or destructive to value creation. At Ensemble, we’ll continue prioritizing process over outcome and think that’s the healthiest approach investors can take. In the end, results are what matters. But to reach the intended results, you must follow a process that works. That’s what we’ve done over the last nearly 20 years and its what we intend to do over the next 20 years.

“Growth and value are part of the same equation. Or rather growth is part of the value equation.” -Warren Buffett

In our first post on this blog in 2015, we wrote:

“The world of investing is traditionally divided into growth and value approaches. Growth investors favor buying stocks of companies that are growing quickly while value investors buy stocks that they believe are cheap. But this is a false dichotomy. All else equal, fast growing companies are more valuable than slow growing companies and so any sensible approach to investing will recognize that growth is a component of value, not the opposite of value.”

Today, we want to elaborate on the roles of growth and value in investing and explain how the growth vs value divide in the investment industry is based on a mistaken understanding of the value equation. A growth investor may put an emphasis on buying companies with high forecasted growth rates, while a value investor may put an emphasis on buying stocks with high current cash flow yields, but in both cases, it is the combination of cash flow yield and the growth in cash flow that drives investment returns.

Let’s start with how equity returns are generated. A simple model is to think of a stock like a bond. Start with the distributable cash flow yield, just as you would with a bond coupon. We can call that “Y” (for yield). Unlike most bonds, which have a contractually fixed cash payment, stocks have no fixed cash flows, and those cash flows can grow or shrink in any given year and over time.

Since the economy grows, the companies which make up the stock market will also see their earnings grow in aggregate. That growth (which we will call “G”) over time contributes to the return an investor will earn. So, while bonds will pay out their returns to investors in the form of fixed coupons, equity investors have a portion of their return tied to the growth of the company.

To demonstrate that this is true, we can use the Gordon Growth Model, an elegant and simple way to establish the value of a series of cash flows. It is important to note that the Gordon Growth Model assumes a constant, perpetual rate of growth*.

The Gordon Growth Model is as simple as it gets. It can be rearranged in various ways, but for our purposes we’ll use this formulation:

Y + G = Rate of Return

Y = Starting distributable cash flow yield

G = Growth rate of distributable cash flow

Distributable cash, or the cash flow left after funding any capital requirements needed to grow and reserving the cash needed to cover the eventual cash cost of non-cash expenses (such as stock based compensation), can be returned to shareholders via a dividend or share buybacks, used to pay down debt, or used to acquire other companies. For our purposes we’ll assume it is paid out as a dividend, but if the cash is used for the other purposes, the result is the same so long as the money earns its cost of capital (no less and no more).

As an example, let’s say you have a company that trades with a valuation in the stock market such that it has a distributable cash flow yield (Y) of 4%. And let’s say that the company is expected to grow (G) at 5% in perpetuity. Then the Gordon Growth Model says:

Y + G = Rate of Return


4% + 5% = 9%

9% is the historical long term return to equities, 4% has been the average distributable cash flow yield of the S&P 500 over the long term, and 5% has been the long term rate of growth for S&P 500 cash flows. So, while the Gordon Growth Model is a relatively simplistic model, it also accurately captures the way the US stock market has been valued over the long term.

But there are other ways to solve for this same 9%. Let’s consider two example investments, Growth Company and Value Company, which we will assume have the same level of risk of generating their forecasted level of growth.

Growth Company will grow at a 7% rate. So, what is a fair price for its stock? We can easily solve for the required cash flow yield to earn 9% by subtracting the 7% growth rate to get 2%. In other words, Growth Company deserves twice as high of a valuation (ie. half the cash flow yield) as the S&P 500.

Value Company will grow at a 1% rate. We can use the same process above to calculate that the stock of Value Company must offer an 8% cash flow yield for the stock to earn 9%. In other words, the stock of Value Company is fairly valued at half the valuation of the S&P 500, and just one quarter the valuation of Growth Company.

If you invert the cash flow yields you get these distributable cash flow multiples** as the fair value for each investment.

Growth Company 50x

S&P 500 25x

Value Company 12.5x

Many investors would look at the valuations above and conclude that Value Company is “cheaper” than the S&P 500 and much cheaper than Growth Company. But Warren Buffett rejects this line of thinking.

All three investments offer the same 9% rate of return. Value Company earns that 9% through a high Y and just a little G. While Growth Company earns 9% through a high G and a low starting Y. But they both offer the same rate of return and so they are valued equally to each other.

The Gordon Growth model makes clear that both the price you pay relative to current distributable cash flow and the growth of that cash flow are components of the value equation. In the opening quote to this post, Buffett explains the same thing in two different ways to make sure the listener gets it:

“Growth and value are part of the same equation.” Or in other words; Y and G are both part of the equation that drives investors’ returns.

“Or rather growth is part of the value equation.” In other words, Y is NOT value. Both Y and G combine to define value.

It is this second, nuanced clarification that Buffett makes that the investment community often doesn’t quite seem to appreciate. When most investors discuss a value stock or a value investing approach, what they mean is that the stock has a high Y or the investment approach invests in companies with high Ys. But this is a serious mistake that flies in the face of the teachings of Warren Buffett, an investor who has done more than anyone to popularize and explain value investing.

You can hear directly from Warren Buffett on this topic at the 2001 Berkshire Hathaway annual meeting.

The longest nine-inning Major League Baseball game took four hours and forty-five minutes to complete; the shortest took just fifty-one minutes. Suffice it to say the concession stands had a much better day for the former than the latter.

Baseball analogies are used too often in investing, but the concept of innings is a worthy one. Unlike most sports, where games have a time limit, baseball is measured in innings rather than time.

Investors correctly assume that every company has a lifecycle, as illustrated by the chart below. Business 101 teaches that after a phase of high growth and returns, the company eventually faces declining prospects due to increasing size or competition.

But there is no time limit on the x-axis. The cycle could take over a century – well beyond any reasonable investment time frame – or it could play out over a year.

How long those innings take across the cycle is critical if you hope to understand or forecast a business’s prospects.

If you think a company’s above-average returns could last for a century and they end up lasting a year – or vice versa – you will not be happy with the outcome.

This is where moat analysis comes into play. A company without a moat will not be able to keep competition at bay for long, and the game will end up being a brief affair.

You want to look for “ROIC machines” that continue to generate returns on invested capital above their cost of capital for long periods. For this type of performance to be possible in the first place, the company has to have some structural advantages that peers fail to replicate.

Just as important is analyzing the company’s relevance. How likely is it that the company’s products and services will be at least as relevant to its customers a decade from now?

It is not an easy question to answer, but it can make all the difference.

Relevance should be thought of in terms of depth and breadth. Depth is making each unit more valuable to existing customers, and breadth is acquiring new customers who will find the product relevant in their own lives.

Consider the following comment from legendary investor Peter Lynch in a 2019 Barron’s interview:

“You want to be in [the stock] in the second inning of the ballgame, and out in the seventh. That could be 30 years. Like the people who were really wrong on McDonald’s. They thought they were near the end, and they forgot about the other seven billion people in the world.”

Put differently, McDonald’s increased the breadth of its relevance to billions of customers outside of the United States and lengthened the innings of its game.

Similarly, much of Home Depot’s growth following the housing bust in 2007-2009 is due to its success with “Pro” contractors. In September 2008, for example, Pros made up 30% of Home Depot’s annual sales; 14 years later, that figure stood at 50%. Again, Home Depot increased both the depth and breadth of its relevance to Pro customers and lengthened the innings of its value creation phase.

Companies can also lengthen innings by delivering innovations that delight customers in ways that would have been unpredictable for any reasonable forecaster at time zero. If you researched Google at its IPO in 2004, for example, Google Cloud had yet to be created. YouTube wouldn’t be launched for another year and Google wouldn’t acquire it until 2006.

As my crude sketch replicating the Credit Suisse lifecycle chart at the top of this article illustrates, companies that introduce successful product launches and innovations can add new mini-lifecycles to their aggregate lifecycle.

When Procter & Gamble went public in 1890, it was already a 52-year-old company. The stock offering, as described in a July 16, 1890 New York Times article, noted that:

“The company has been formed for the purpose of acquiring and carrying on the well-known soap, candle, oils, and glycerine manufacturing business.”

133 years later, P&G is still selling soap, candles*, and glycerin, but if it were still just selling those items, it would have likely faded into obscurity by now. Major internally generated product launches like Pampers diapers, Swiffer mops, Tide detergent, and Crest toothpaste provided bursts of propulsion that extended P&G’s overall growth.

P&G’s original factory location in Cincinnati, Ohio

Conversely, just as companies can extend their innings by widening their economic moats and increasing the depth and breadth of their products’ relevance, innings can be shortened by eroding moats and fading product relevance.

As Lynch advised in the above quote, you don’t want to own companies in the late innings as it can spawn low-growth risks. Companies growing at stall speed – which we define as sub-GDP growth – may become desperate in their capital allocation decisions to regain growth status and are generally not exciting places where talented people want to work. Finance textbooks advise companies in this stage to throw off cash and accept that the business is shrinking, but in practice, few management teams or boards are comfortable admitting defeat.

Investors are right to be wary of owning stocks in the later innings when growth and returns on invested capital fade. A 2008 paper by Michael Mauboussin showed the companies that were in the top ROIC quintile in 1997 and ended up in the lowest quintile in 2006 had the second-worst stock performance of any other cohort, with -12.5% average annualized returns.

Another way to say this is that this group’s innings got shorter.

On the other hand, companies that started in the middle quintile in 1997 and ended in the top quintile in 2006 posted 16% average annualized returns. Their innings got longer.

In our experience as investors, our more significant mistakes have tended to come from thinking a company was in the seventh inning when it was actually in the fourth. Having cut our teeth as value investors, we are naturally inclined to ask ourselves what could go wrong rather than what could go right.

Why does this matter? As we’ve discussed in previous posts, the bulk of a company’s intrinsic value depends on its terminal value, or its theoretical steady state. Consequently, the more confidence the market has in a company’s ability to deliver a certain level of growth and ROIC in its terminal phase, the higher the multiple the market should be willing to pay for[…]

During our fourth quarter portfolio update, we profiled portfolio holding, Paychex (PAYX). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.


We’ve been long time shareholders of Paychex, a company that serves small and midsize businesses (SMB) with payroll, HR, and PEO services and technology. These are the types of services that are critical to the functioning of all businesses but not necessarily the core focus of their mission or value creation. And to do them properly in house with the right level of staff, without errors and in compliance with regulations, requires a level of scale we believe is in the hundreds to thousands of employees. It’s this market comprised of businesses with a handful to a couple of hundred employees where Paychex focuses its efforts to serve businesses with these mission critical needs.

Paychex was founded in 1971, went public in 1983 and has generated a 20% compounded annual total return since. It started with a payroll service offering and over time has expanded to HR services, employee benefits administration, employee management software, and then fully outsourced employee management services that now includes the 2nd largest Professional Employer Organization (PEO).

In its last fiscal year, it reported more than 730,000 clients and paid 1 in 12 private sector employees in the US generating over $4 billion in revenue, 40% operating margins, an adjusted return on invested capital of over 100%, and threw off nearly $1.4 billion in cash. This is a very lucrative business; one that is supported by a ton of value it creates for its clients doing the meticulous and important behind the scenes work that allows businesses to function every day. It’s the kind of business we’ve previously termed a “cash machine”.


Given how mission critical it is to pay employees consistently and correctly, withhold and submit taxes, gather, maintain, and update employee records, stay in compliance with regulations and provide great service to employees, it’s not hard to understand why clients would be very sticky after selecting a service provider – there are huge switching costs involved in the form of time and information burdens and the possibility of mistakes that impact employee paychecks and benefits in switching providers. Collectively the time across an entire employee pool spent to set these systems up and the risk of errors make it they type of service that you’d rather “set it and forget it” for generally risk adverse managers who are more keen to be working on delivering value for their own clients and generating revenue.

Switching from Paychex to another vendor only happens if there is a significant reason to do so – such as poor service quality, unacceptable numbers of errors, or much better capabilities. These are all factors that are within the company’s control with the exception of being able to “be all things to all people”, ie at some point some clients will grow large enough that their needs will get complex enough to move on to a more customizable platform or take the HR/Payroll services inhouse.

Paychex’ client retention looks optically low at 84%, but this has its underlying roots in a significant number of clients who go out of business in the small business market – about 20% of small businesses shut their doors in their first year, while only half remain in business after 5 years. We all know being a small entrepreneur is a risky venture, yet enough start new businesses to keep feeding the Paychex funnel of new clients to replace those lost. On the other hand, those businesses that continue to thrive fuel growth for Paychex’s business which prices many of its services on a per employee per month basis. So as retained customers grow the number of their employees and benefits, Paychex’ revenue also grows.

Paychex has seen revenue grow in the range of 5-7% in the decade prior to the COVID era. Results during the “COVID” period were surprisingly resilient aided by US stimulus packages for businesses, and then accelerated with the pent-up demand in the reopening afterwards. During this period, just like many other businesses who adapted to remote or hybrid work and offered new products as customers’ needs quickly changed, Paychex also managed to both accelerate changes within its sales and service organizations that made it more efficient and quickly brought to market new services to help customers efficiently utilize government stimulus programs such as the Paycheck Protection Plan (PPP), Loan Forgiveness, and Employee Retention Tax Credit (ERTC) programs.

Paychex’ ability to quickly build and deploy critical services that leveraged the customer employee data it already had during a tumultuous time helped a significant number of its clients survive thru the period and increase their loyalty, raising its retention rate from 82% in its May-ending Fiscal Year 2019 to 85% in FY21. In total, Paychex helped over 500,000 businesses apply for and receive $65 billion in PPP loans (9% of the total program payouts and an even larger proportion of loans disbursed to small and medium sized businesses), apply for loan forgiveness afterwards, and helped more than 40,000 clients qualify for and obtain $8 billion in employee retention credits.

In addition, the labor challenges of the past year or so have driven greater adoption of its HR services and software technologies in order to improve employee services in the form of mobile self-service options and employee benefits management for its clients. When it comes to benefits, small and medium businesses are structurally disadvantaged when competing in the marketplace to offer the best compensation packages vs large businesses. For example, many insurance offerings get cheaper per employee with scale and Paychex’s PEO service allows it to bring down the collective cost by pooling all its participating small businesses into one huge employee pool. Bringing automation technologies to its small business clients has also enabled them to work more efficiently during an inflationary period where productivity gains have been the key to preserving and growing their revenue and margins under tight labor constraints. The self-service capabilities and automation has helped also Paychex increase the productivity of its own customer service reps and salesforce, resulting in record core service margins.

The pandemic period has brought to light the importance of adaptability and resilience in business’ ability to thrive over time. The common adage, “the only constant is change”, was very much emphasized during that period. However, more broadly we’ve seen technology really start to penetrate all types of businesses especially over the past decade with the proliferation of the internet everywhere and smartphones in everyone’s pockets. Prior to the pandemic there was some worry that Paychex was too slow to adapt to the consumerization of business services and the self-service buying and control that an increasing proportion of a “digital native” business owners and employees have come to expect. However, despite the company’s origins in the 1970s mainframe era and its coming of age in the 1980s and 1990s PC period, Paychex has shown an ability to adapt at a[…]