“I did mention one thing at the meeting, which I don’t think people appreciated at all… So you have close to 10% of the market value perhaps of the United States in five extremely good businesses that essentially take no capital. Now that was not the case in the past.” -Warren Buffett

Starting on September 24th, Apple is the only technology stock in the market leading group of stocks referred to as FAANG. Instead, FAANG will be dominated by Communication Services stocks, a new market sector that Standard & Poor’s and MSCI have developed to better categorize what has emerged as one of the most important segments of the US economy (more details here and here).

Much of the media coverage on the creation of this new sector has focused on the short term impact of index rebalancing and investment flows between sectors. With $260 billion invested in sector ETFs, this focus makes sense. However, the coverage glosses over the far more important issue; what has given rise to the emergence of a new economic sector? Over 10% of the market cap of the S&P 500 will be represented by the Communication Services sector, making it the 4th largest sector of the market. Some of the most important companies in the world will be in this sector, with many of them coming into existence over just the last 15 years. This is an unusual development and one that investors need to understand if they hope to understand the changes that have roiled the global economy and seek to achieve superior investment results in the future.

With the launch of the Communication Services sector, Standard & Poor’s and MSCI are recognizing that unlike technology companies that compete with each other based on product specs and speed, many of the dominant businesses previously categorized as technology stocks simply utilize advanced technology as they offer communication platforms to their users. The fact is, “technology” isn’t even really a type of business sector, the way health care or finance clearly is. Today, almost all businesses deploy significant technology. Car companies, for instance, which clearly sell a piece of technology, are not included in the tech sector because of the maturity of the technology they sell. This is why Apple is a tech company, but a company selling toasters is not. Toasters were once “technology”, but today they are basic consumer products.

One of the striking characteristics of the current long bull market is the way it has been led by a group of very large companies that have continued to grow revenue and earnings at unprecedented rates. While bull markets are often powered by a relatively small number of stocks, the so called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have been unusual in that they are huge companies (all with market caps over $100 billion) growing far faster than large companies typically grow.

Collectively these companies grew revenue in 2017 by almost 20% to well over half a trillion dollars. Excluding Apple, which grew at only 6%, the rest of them grew at an astounding 30%.

Big companies aren’t supposed to grow this fast. According to Michael Mauboussin’s Base Rate Book, only about 6% of companies as large as the FAANG stocks have grown at this rate for even just one year. Yet these companies have been growing this quickly for some time and are widely expected to continue this heady growth in 2018. Mauboussin’s data shows that the percent of companies this large that have historically grown this quickly for a three year period is just 1.7%.

So what’s going on here and what does it mean for the stock market? One common refrain is that we are seeing a new stock market bubble, a replay of the technology boom of the late 1990s. But these companies dwarf the tech companies of the late 1990s. Their average revenue is almost six times larger than the revenue that was produced by Cisco, Intel, Microsoft and Dell (the so call Four Horseman of the tech bubble) in the year 2000 and yet, except for Apple, the FAANG companies are growing even faster!

It is also notable that while many top investors refused to buy technology stocks in the late 90s, many of the great investors today are heavily invested in FAANG stocks. Indeed, Warren Buffett was mocked for having fallen behind the times for refusing to invest in the 90’s Four Horseman, but last year he referred to FAANG as “ideal businesses.” When CNBC’s Becky Quick asked Buffett, “Would you like Berkshire’s businesses to be more reflective of that sort of new paradigm?” Buffett said “I’d love it.”

So we have the official categorizers of companies, industries and sectors recognizing that something different from “technology stocks” has emerged in recent years and we have the greatest investor of all time, one not prone in the least to falling in love with new fads, validating that we are indeed faced with a new paradigm.

So what does all this mean? These are the questions we think investors need to be wrestling with.

  • Tech stocks have historically been characterized by rapid competitive cycles, industry leaders that are replaced regularly by upstarts, and limited regulation. But communication businesses around the globe have often operated within stable competitive environments, stable industry leadership, and significant regulation. Is this the future for Alphabet, Facebook, Netflix and other communication services businesses?
  • The idea that “tech stocks” have been leading the market is simply wrong. The stocks shifting from the tech sector to communication services have outperformed the remaining tech sector in eight of the last nine years. With the remaining tech sector dominated by older companies like Intel, Cisco, Oracle, Microsoft and IBM, is “tech” still a sector investors will want to overweight? Will “tech” analysts and “tech” focused hedge funds become a relic of a previous era?
  • Historically, communication businesses that require little capital, such as media content companies, have enjoyed high earnings multiples even once they are mature, while mature tech stocks often get assigned low multiples. This is related to the duration of competitive advantage periods with technology-based moats often decaying much more quickly than the network effect-based moats found in communication business as old as AT&T and as new as Twitter. Do investors need to re-evaluate the appropriate earnings multiples for both the new communication services stocks and the remaining technology stocks? Given the stable industry characteristics of communication businesses and the still high growth rates of the current leaders in this sector, might these businesses offer the potential holy grail of low volatility and high returns?

These are hard questions. We know that we don’t have all the answers. But we do know that it is often half the battle in investing just to make sure you asking the right questions. “Are we in a second tech stock bubble?” is now objectively the wrong question as the stocks most frequently cited in these discussions aren’t even tech stocks. But that by no means suggests that the FAANG stocks or Communication Services sector stocks are sure things. For all we know, communication services businesses of today will come and go as quickly as many tech companies do. Maybe they do not have the durable competitive characteristics and industry structure that has led so many communication businesses of the past to remain good businesses over long periods of time.

Because humans need to be able to categorize information and fit it into a broader narrative in order to understand it, it is critical that the mental models you use to do this are kept current. The fact is that for all the market commentary about “tech stocks,” other than Apple most of the largest, top performing companies today are not tech stocks. The rules and assumptions that investors apply when investing in tech stocks are not going to work with these companies. Yet what rules and assumptions will work is not yet know. But the spoils will go to those investors who are quickest and most effective in grappling with these questions. Step one is recognizing that new questions need to be asked.

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

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

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

Reading old articles about Amazon’s 1997 IPO is predictably amusing. The most common critique of the time was that Amazon’s valuation was absurdly expensive. It was just an online bookstore, the thinking went. Traditional competitors were going to eventually crush it once they figured out how to sell online.

The thing is, these arguments were totally valid at the time. There were decent odds that Amazon would struggle to branch out beyond books. Indeed, Amazon may have been saved by a well-timed convertible bond issuance in early 2000, just before the dotcom bust accelerated.

So what happened?

As Steven Johnson notes in his new book, Farsighted: How We Make the Decisions That Matter the Most, there are three types of “unknowns” we should consider before making any long-term decision:

  • Knowable unknowns: Uncertainties we should be able to identify with available information or experience.
  • Inaccessible unknowns: The information is available, but, for whatever reason, we don’t have access to it.
  • Unknowable unknowns: Uncertainties that result from the inherent unpredictability of the system being analyzed.

When researching a new company, an investor should be able to map out the knowable and inaccessible unknowns. Because they can be mapped, these risks are already priced into the stock in some manner.

However, it’s the third factor – the “unknowable unknowns” – which cannot be fully considered from the outset, that have an enormous impact on the company’s value, both positively and negatively.

Sure, financial commentators in 1997 could have read Bezos’s now-famous 1997 shareholder letter for a sense of where he wanted to take the company. But this was years before Amazon Prime or Amazon Web Services were even on the table. Prime and AWS were two major unknown unknowns that had a positive impact on Amazon’s current valuation. In 1997, neither investors nor perhaps even Bezos could have predicted them.

Unknown unknowns are particularly critical in driving value in intangible asset-dependent businesses. There’s far less “option value” with a tangible factory than there is with a brand, for instance. Consider the following passage from Capitalism Without Capital by Jonathan Haskel and Stian Westlake:

“Intangible investments tend to have synergies…(which) are often unpredictable. The microwave oven was the result of a marriage between a defense contractor, which had accidentally discovered that microwaves from radar equipment could heat food, and a white goods manufacturer, which brought appliance design skills.”

Naturally, luck has a lot to do with it. As with most situations where luck is a factor in outcomes, however, the more skilled operators often find more luck. To illustrate, Joe DiMaggio had a lot of luck during his famous 56-game hitting streak, but the streak sprang from the fact he was one of the best hitters in history.

Another way to say this is that good things tend to happen to good companies. If we went back to 1997 and re-rolled the dice on Amazon, the ultimate outcomes would likely be different.

In reading Bezos’s 1997 shareholder letter, however, we can see there were signs that it was creating fertile ground for unpredictable value creation. Namely, the letter showed that Amazon was long-term focused, mission-driven, and had a large market opportunity. These factors alone don’t always lead to unpredictable value creation, but they improve the odds.

Amazon is admittedly a cherry-picked example, but we’ve also seen these factors lead to unpredictable value creation at companies like Google, Apple, and Charles Schwab. These companies were lucky, but they also provided fertile ground for innovation.

By focusing our research on what we consider to be wonderful companies – those that have or are building a moat, are long-term focused, are great places to work, etc. – we think we can increase our odds of benefiting from unpredictable value creation.

 

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

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

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

Weekend Reading

1 September 2018 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Late to the Driverless Revolution (Lawrence D. Burns, WSJ)

Auto manufacturers have been focusing on delivering attractive vehicles for so many years, so when the self-driving unit of Google went to them to discuss their software, they received a bit of resistance. Ride-sharing companies didn’t have the same reaction once they learned of the technology. “Mr. Kalanick knew that a ridesharing business that operated driverlessly could provide its services for much less than a human-operated rival; the human driver accounted for a reported 70% to 90% of Uber’s cost per mile.” Detroit executives didn’t start paying attention until Uber virtually hired the entire team at Carnegie Mellon University’s National Robotics Engineering Center.

How Netflix outsmarted everyone else in TV (Eric Johnson, @HeyHeyESJ, Recode)

A number of smart people in the media industry have expressed their humility and admiration for what Netflix was able to accomplish. Jason Hirschhorn is one of those people.

How Netflix Redesigned Board Meetings (David Larcker and Brian Tayan, @StanfordCorpGov, Harvard Business Review)

The information deficit in the board room can hinder their ability to “make fully informed decisions on key matters, such as strategy, succession, and performance monitoring.” Netflix implemented two different, but simple practices to help overcome this issue.

‘Overtourism’ Worries Europe. How Much Did Technology Help Get Us There? (Farhad Manjoo, @fmanjoo, NYT)

Current technology, rising wealth, and cultural trends have increased foreign travel. Airbnb is one of the companies being blamed for this rise. Politicians in these countries are trying to pass laws to help curb this growth. ” In Amsterdam, the authorities are pushing to slash the number of nights that residents can rent their homes to 30 from 60. Several other cities, including London and Barcelona, Spain, have also instituted stringent home-sharing rules.”

Parts Shortages Crimp U.S. Factories (Doug Cameron and Austen Hufford, @dougcameron and @austenhufford, WSJ)

There is a boom in U.S. manufacturing. Companies are reporting strong sales and profits, but that may start to slow because their suppliers aren’t able to keep up with them. “Machinery giant Caterpillar Inc. and power-equipment maker Eaton Corp. are among those struggling to keep up with orders as supply-chain kinks join labor shortages and cost pressures from transportation and import tariffs as threats to the sector’s recovery.”

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

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

In the early years of the Great Recession, PIMCO economists coined the phrase the “New Normal.”  The New Normal posited that the economy would not see a sharp recovery as it had after previous recessions (i.e. the “Old Normal” behavior), but instead would have a prolonged period of slow growth as the country worked to pay down debt levels accrued during the housing bubble.  While this view was not the consensus when PIMCO announced it, it has become the standard economic outlook for many investors. Indeed, both the Congressional Budget Office and the Federal Reserve make assumptions about future economic trends that align with a New Normal view of the world. Mostly simplistically, the New Normal view of the world suggests nominal GDP in the US will grow at around 4% a year going forward vs pre-Financial Crisis growth rate of around 5% that persisted for much of the post world war II period.

At Ensemble, we’ve been talking about the potential end of the New Normal and a return to the Old Normal economic pattern a lot this year.  While PIMCO’s view has been spot on the last few years, we never believed that the New Normal would persist forever. The housing crisis was a huge deal –  the worst crisis in 100 years – but it didn’t make sense to us that this crisis had permanently changed the country’s growth potential.

Our outlook was less of an economic prediction than a belief in mean reversion. Since our assumption has been out of step with the consensus, it means we’ve shifted our portfolio into more economically-sensitive companies as the market has priced in less long-term growth potential than we have. Since interest rates are positively correlated to growth (interest rates are higher when growth is strong), we’ve also implicitly assumed that rates will move up over time causing us to prefer short term bonds and avoid conservative, high-dividend paying stocks.

Economists Rogoff and Reinhardt wrote a book in 2011 related to the New Normal thesis in which they showed that long periods of low growth are not seen after normal recessions, but are common after a debt-related financial crisis. Their work, looking at 500 years of economic data, showed that these low growth periods lasted about 10 years on average.

As we’ve approached the 10-year anniversary of the Great Recession, we’ve been hopeful that the New Normal conditions would dissipate and the Old Normal paradigm of higher economic growth, higher inflation and higher interest rates would return. And that’s exactly what we’ve been seeing play out over the past year.

This  chart of year over year nominal GDP growth in the US shows clearly how since the end of the last recession, US GDP has grown at average rate of 4% while mostly staying in a 3%-5% channel with the most recent GDP report showing the growth rate moving out of the post-recession range.

Still, it is difficult to know if we are just witnessing the relatively-strong final throes of a New Normal expansion or if we are seeing the reemergence of the more typical growth rate of an Old Normal economy. If the former, we’re likely close to the next recession. If the later, economic conditions will likely persist or even continue to strengthen in the years ahead.

Today, real economic growth and inflation is running near Old Normal average levels. However, interest rates are still well below normal. While it seems hard to imagine, if we assume Old Normal economic growth and inflation has returned, it suggests the Federal Reserve rate should be approximately 4% instead of the current 2% and the 10-year treasury should be around 5% rather than the current 3%. This is likely the logic Jamie Dimon, the CEO of JP Morgan, was drawing on when he said recently that he thinks the 10-year treasury could reach 5% over time and should already be at 4% today.

We’ve been watching closely for signs of which ways things are going.  Recently, however, Mohamed El-Erian one of the former chief economists of PIMCO who developed the New Normal thesis said in an interview that he believes the US economy has exited the New Normal and is reentering an Old Normal paradigm of higher growth, higher inflation and higher interest rates.  We sure hope he is right!

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

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

In June, Ensemble Capital’s president and chief investment officer, Sean Stannard-Stockton, discussed our investment in third-party logistics platform, Landstar System (LSTR) at the Manual of Ideas Global Wide-Moat Investing Summit.

You can discover more of Sean’s thoughts on Landstar System by reading this earlier post on the Intrinsic Investing blog.

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

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