Ensemble Capital’s chief investment officer, Sean Stannard-Stockton and senior investment analyst, Todd Wenning were recently interviewed by Tobias Carlisle on The Acquirers Podcast. Among other things, Sean and Todd discussed Ensemble’s interest in idiosyncratic businesses, Ensemble’s investment philosophy as illustrated in the team’s Venn diagram, and a number of the portfolio’s top holdings.

Click here to watch the video interview.

Click here to listen to the podcast.

 

For more information about the 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.

Earlier this month, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on The Investor’s Podcast to discuss Ensemble’s long time investment in First Republic Bank. During the interview, Sean discussed a wide range of topics including:

    • Why First Republic is not really a bank but a retail franchise that sells customer service to high net worth families.
    • How the company stands out from the competition to such a degree that it is clear they are engaged in a fundamentally different business model than the rest of the industry.
    • How we value the company and why it is deserving of a significant premium to other banks.

(If you are reading this in an email, click here to listen to the podcast)

For more information about the 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.

At the heart of value investing is buying an asset at a discount to its intrinsic value and – here’s the more challenging part – then selling it at a premium to its intrinsic value.

But whether your strategy includes investing in poorly-run businesses or great businesses, value investors must return to this first principle. It should hold that if you’re using discounted cash flow analysis to determine a buy price, it should also inform your sell price.

We can debate how much a premium is warranted, but you should be ready to sell at some premium. Maybe you don’t sell a wonderful business at a 1% premium, but if you’re not considering a sale at a 30% premium, what you’re doing is not value investing.

Let’s consider the math. If you had an asset worth $100 today and somehow knew its value would grow 10% per year for the next 10 years, it would be worth $259 in year 10. If someone offered you $130 today for the asset, their expected return would be 7% per year. And you should take that offer, assuming you can reinvest the proceeds in a higher-return asset of comparable quality.

To be sure, as business-focused investors, we like nothing more than investing in a great business at a discount and holding it for many years while it compounds its intrinsic value at high rates. In fact, eight of our current holdings (38% of the holdings in a typical Ensemble client account) have been held for over seven years. Yet at a high enough price, even those companies are for sale every day in our portfolio.

It’s true that great businesses often produce unpredictable value, making original valuations look quaint in hindsight. But as investors, all we can do is forecast what we consider to be a likely outcome based on what we think at the time. As we learn more or gain new insights, we adjust our forecasts accordingly.

To illustrate, we had strong conviction in Tiffany, as we communicated in a recent conference call. However, after LVMH announced an offer for Tiffany, we sold our position. Tiffany’s share price surged on the takeover news. Based on our fair value estimate, we decided the market price no longer offered attractive return potential. We reinvested the Tiffany proceeds into other holdings with higher expected returns.

As fellow investor John Huber noted in this excellent blog post on portfolio turnover, your portfolio returns are a function of the return of each investment and how quickly you turn over those investments. We’re not day traders, of course, but we’re also not “buy and forget” investors with single-digit turnover.

At Ensemble, our goal is to put capital into the highest-expected return outcomes, adjusted for conviction. Even the greatest business with continued fundamental growth can be a bad investment at the wrong price.

For more information about the 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.

In January 2017, we wrote a post on the opportunities and threats of investing in healthcare stocks over the next decade.

To recap, over the prior 20-year period, the U.S. healthcare sector outperformed the S&P 500 by nearly two percentage points per year, on average. Many companies reaped the benefits of a highly inefficient U.S. healthcare system, where prices surged without delivering proportionate value to patients.

We continue to believe this is unsustainable. Whether it’s through government action or market forces, changes are on the horizon for the U.S. healthcare industry to better align costs with outcomes.

As such, we demand two things when looking at new healthcare companies:

  • Do these products and services improve patient outcomes?
  • Do this company’s products and services help reduce system-wide costs?

Frankly, we have not found many companies that fit both criteria. Yes, there are many technological advances occurring in healthcare. In fact, PwC expects healthcare to have the most R&D spending in absolute dollar terms of any industry by 2020.

Unfortunately, innovation in healthcare doesn’t always translate into improved outcomes and lower system costs.

To illustrate, here’s what the Congressional Budget Office wrote in a 2008 study:

The added clinical benefits of new medical services are not always weighed against the added costs before those services enter common clinical practice. Newer, more expensive diagnostic or therapeutic services are sometimes used in cases in which older, cheaper alternatives could offer comparable outcomes for patients.

We think one of the intrinsic problems is that, because it’s the incumbents – i.e. the primary beneficiaries of an inefficient system – doing the bulk of the innovation spending, there’s little incentive for them to change the status quo.

California-based Masimo piqued our interest because it takes an outsider’s approach to finding healthcare solutions. Indeed, the company’s mission statement is “Improving patient outcomes and reducing the cost of care.” A natural fit.

But this isn’t just marketing spin. The company’s founders, Joe Kiani (current Chairman & CEO) and Mohamed Diab were electrical engineers by trade and started Masimo in 1989 after working with early versions of pulse oximeters that used sensors to measure oxygen levels in the blood.

Those early pulse oximeters were particularly unreliable when the patient was in motion – think premature babies, emergency situations, etc. Medical professionals would either use invasive procedures (via syringe) to get a more accurate reading or assume the reading from the sensor was correct and risk misdiagnosis.

We’ll get into more details in a moment, but fast-forward to today and Masimo’s pulse oximetry sensors are the standard of care in most of the country’s operating rooms, NICUs, and ICUs.

From our recent trip to Masimo’s headquarters for an investor day, we confirmed that the company’s engineering-first spirit remains a key differentiator in Masimo’s corporate culture. Each solution starts with first principles and a blank sheet of paper rather than starting with the status quo.

Put another way, Masimo is a technology company pursuing better solutions in the healthcare industry, rather than a healthcare company using technology as an avenue for higher-priced solutions. We consider Joe Kiani to be a Visionary-Outsider leader of a company that’s running circles around incumbents with eroding moats.

Okay, let’s take a step back. How does Masimo fulfill our first criteria to improve patient outcomes?

Starting with Masimo’s core business – Signal Extraction Technology (SET).  With FDA approval in 1998, Masimo’s proprietary SET was the first platform to accurately measure pulse ox when the patient is in motion (common in emergency situations) and low perfusion (low levels of oxygen).

With the use of LED sensors and encrypted algorithms, Masimo sensors obtain vital information in a non-invasive manner. In non-medical terms, it shoots a known quantity of light from one sensor and gets a reading based on the amount of light it receives on the other end. These are similar principles to how your Apple Watch or FitBit operate.

Impressively, SET’s alarm reliability during motion and low perfusion settings remains generations ahead of the other major player in pulse oximetry, Nellcor (now owned by Medtronic). One study showed that while Masimo SET had 3% missed true alarms and 5% false alarms, Nellcor’s N-600 sensors had 43% and 28%, respectively.

Despite such a wide lead in performance, Masimo announced at their investor day that they had made their SET even more accurate.

We think this speaks volumes of the company’s culture. With that type of lead, most medical device companies would declare victory, drop R&D spending, and harvest higher cash flows. Instead, Masimo pushes further. One false alarm is too many.

Now, even though Masimo’s technology has long been superior, it’s taken more than a decade to win half the pulse oximetry market share. This speaks to the switching costs involved in pulse oximetry.

It’s a classic razor-and-blade business model. The company sells technology boards that go into both Masimo-branded monitors and OEM-branded monitors. This equipment typically gets replaced every 10-12 years, so it’s a slow product cycle. Masimo then sells disposable sensors with a 5-7 year contract. About 80% of its sensors are single-patient use (one-week life), with the rest being reusable silicon sensors (six-month life).

Even after the hospital decides to make a change, new monitor integration takes another 1-2 years start to finish, which further adds to switching costs. On this point, Masimo boards already have all the various readings (SET and rainbow) installed and it’s up to the hospital to “turn on” various components.

Even though winning share is a slow process, once Masimo wins the business, it’s typically locked in. The company boasts a 98% customer renewal rate.

Though the SET patents have expired, Masimo successfully defended them over the past decade, winning a $265 million settlement plus royalties from Nellcor in 2006, followed by a 2016 settlement with Philips that resulted in a $300 million cash payment plus a multi-year business partnership to sell Masimo boards in Philips monitors. Philips has a 50-60% market share in the U.S. high acuity monitoring market, so this is a massive opportunity for Masimo to extend its installed base and establish more presence on the general floor of hospitals. (More on that in a moment.)

Masimo’s SET algorithms are also proprietary and encrypted, which will make it challenging for upstarts to match its current performance.

Finally, Masimo has smartly reinvested its SET cash flows in new products that leverage its expertise in sensors and monitors.

Masimo’s rainbow technology, for example, uses an upgraded sensor to provide medical professionals with a portfolio of critical health metrics. Among these additional readings are hemoglobin, carbon monoxide, and acoustic respiration rate.

Rainbow patents have 10-15 years remaining, which will help Masimo defend its lead over competitors in monitoring sensors.

Put simply, we think Masimo is generations ahead of its competition in non-invasive sensors. The other major players have shown more interest in milking their sensor business for cash flow rather than reinvesting in innovation. Upstart competitors will need to run the gauntlet of regulatory approvals and slow product cycles before they can go head-to-head with Masimo’s current offerings. So by the time they get into the arena, we think Masimo will have further extended its technology lead.

Masimo has already fully penetrated the critical care beds in U.S. hospitals, where patients’ vital signs are continuously monitored.  But this is not the case on the general floor – yet. Only 10% of general floor beds in the U.S. use continuous monitoring.

If you’ve ever been in a general floor bed yourself or assisted a loved one, you know the routine. The nurse comes in every few hours to check your vitals. He or she might jot them down on a tablet or laptop – but often it’s pen and paper.

This can result in transcription errors and may miss sharp, unexpected changes in a patient’s health, such as an opiate addict’s breathing capacity crashing in between nurse visits. Through Masimo’s Patient SafetyNet platform and sensors, the hospital gets real-time, non-invasive, and continuous patient monitoring solutions on the general care floors. This is a win-win-win for patients, nurses, and hospitals.

Rather than doing spot checks, nurses can monitor patient vitals 24/7 from a screen at the nurses’ station. If a patient’s reading turns from green to yellow or red, it’s time to check in on the patient. This saves the nurses time and allows them to spend more time with the patients who need the care.

For hospitals, continuous monitoring reduces liability risk. Why would you want to risk a patient crashing in between spot checks and deal the subsequent lawsuits that would surely follow? When you start from first principles, there’s no reason why hospital patients shouldn’t be monitored from the time they’re admitted until the time they go home.

Change at hospitals can be frustratingly slow, but we consider many of Masimo’s solutions to be inevitable.

I could write thousands of more words on Masimo’s innovative products – brain function monitoring, automating operating rooms, etc. – but I’ll discuss one more innovation.

Last year, Masimo announced it was one of eight companies (out of more than 250) selected by the FDA for expedited approval of a system designed to detect respiratory problems related to opioid overdose.

As I began to run some numbers on the market opportunity, I couldn’t believe the data I was seeing. Among them:

  • In 2017,  there were 191 million opioids prescriptions written in the U.S.
  • 92 million U.S. adults used a prescription opioid in 2015.
  • In 2017, there were 47,600 opioid overdose deaths in the U.S.; 17,029 deaths related to prescription opioids.

Those numbers are staggering.

One of the key risks of opioid use is respiratory depression where your brain is deprived of oxygen and you run the risk of cardiac or respiratory arrest. The scary thing is that people typically do not know beforehand how they will react to opioids.

Masimo knew from its hospital-based patient monitoring systems that its sensors could greatly reduce the risk of respiratory depression in patients prescribed opioids. So, it created Opioid SafetyNet: a take-home, direct-to-consumer monitoring system that connects to a smartphone and alarm to alert the patient, caregiver, and emergency services when respiratory depression is occurring.

Masimo believes it has a market opportunity of over $4 billion with Opioid SafetyNet, even under the assumption that opioid prescriptions are reduced by 30% as a preventative measure.

Beyond the market opportunity, the system has the potential to save thousands of lives – the benefits from which cannot be fathomed from a personal, familial, and societal standpoint. The Opioid SafetyNet product is currently pending FDA approval.

Okay, so we’ve seen how Masimo’s products are dramatically improving patient outcomes. How are they reducing systemwide costs?

First and foremost, the high accuracy of Masimo’s non-invasive sensors relieve doctors and nurses from having to extract blood via syringe, often while the patient is in motion, to get patient data. These invasive procedures raise the risk of infection and potential liability to the doctors, nurses, and the hospital. It’s also a win for the patient, of course, who doesn’t get stuck with more needles than necessary.

Second, Masimo’s sensors and monitors greatly reduce the number of false alarms and are more accurate with true alarms. False alarms are a waste of time for the medical professionals who rush into the room (at the expense of other patients) and do unnecessary procedures, which increase the cost of care.

Finally, by streamlining patient monitoring in all hospital settings, Masimo’s products help hospitals run more efficiently. Decluttering operating rooms, shortening patient time in ICU beds, and accelerating surgery times benefits everyone involved. Again, a win-win-win for medical professionals, the hospital, and the patient.

Medical devices have long been an attractive segment of the market – steady demand, long product cycles, high returns on invested capital, and so on. Indeed, since 2009, the iShares U.S. Medical Device ETF (IHI) has significantly outperformed the S&P 500 ETF (SPY).

Bloomberg, as of 11/3/2019

Despite medical equipment being an attractive industry as a whole, we think most of the industry fails to achieve both of our investment criteria – improve patient outcomes and reduce system costs. Masimo does both and does it in a unique way – by starting with first principles when developing a product and relentlessly innovating in pursuit of a higher standard. We think the innovative culture at Masimo will lead to unpredictable value creation – new products and services we can’t currently measure.

In short, we believe Masimo is doing well by doing good. Naturally, they’re profit-motivated like any business, but we also think the company has a rare intrinsic motivation to save lives and solve big problems. Kiani sets the tone for Masimo’s culture. During our visit to headquarters, we noted that there was a “founder’s pedigree” among the employees we met – someone who, like Kiani, is dedicated to saving lives, creating step-change products, and out-innovating stodgy competition.

And that, in itself – beyond the switching cost and intangible asset-based moat sources – could be Masimo’s most important moat source.

All images come from Masimo’s website and investor presentations, unless otherwise noted.

For more information about the 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.

Google (officially known as Alphabet) is a long time holding of Ensemble Capital. On Monday, our chief investment officer Sean Stannard-Stockton was interviewed on CNBC’s Squawk Box Asia about Google’s earnings report released that day.

In the clip below, Sean discusses why initial market disappointment in the results is misplaced, the fact that the core advertising business showed another quarter of accelerating growth, and why the apparent missed expectations for earnings per share were clouded by non-operating expenses and in fact came in just fine.


Click here to watch the video if you are viewing this in your 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.