Earlier this summer in New York City, I met up with Ben Hobson from Stockopedia, a U.K.-based stock market data subscription service designed for retail investors. Ben was in the States interviewing various investors and he and I spoke at length about economic moats – a subject near and dear to us at Ensemble.

Among other things, we discussed the dangers of investing in dividend-paying stocks with deteriorating moats, the increasing difficulty of screening for moats, and the intersection of moats and management.

Ben recently published a transcript of our conversation, which you can find here. Free registration may be required to read the article.

 

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.

Last weekend, Ensemble Capital hosted two educational events in the Bay Area with Maya Peterson, a 16-year-old investor and author of Early Bird: The Power of Investing Young.

In Warren Buffett’s famous article, The Superinvestors of Graham and Doddsville, he wrote that “the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation.” In other words, either you immediately get the concept of business-focused value investing or you don’t. Maya gets it.

As Maya explained during our Q&A sessions, she looks to become a part-owner of businesses with economic moats – and then be patient. One of the benefits of investing young is a multi-decade time horizon, and Maya is taking full advantage of this edge. She also advised young people to not be intimidated by the bells and whistles of the stock market, but to focus instead on becoming a part-owner in businesses you admire and understand.

If you weren’t able to attend, Maya wrote up her answers to my questions on her blog, which you can find here. If you hope to get a young person interested in investing, Maya’s blog and book are great places to start!

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.

Investors are suddenly grappling with the possibility that the economic expansion is nearing its end and a recession could be just around the corner. We discussed the context for these worries in mid-October, but today let’s discuss why even strong evidence of a relatively rare event such as a recession does not actually suggest a recession is likely. This does not mean a recession will not happen, only that investors need to be cautious about predicting relatively rare events even when the evidence is strong that they might occur.

In Nate Silver’s wonderful book The Signal & The Noise: Why So Many Predictions Fail — but Some Don’t, he explains the difficulties of forecasting and introduces the reader to Bayes Theorem. Bayes Theorem offers a formula for calculating the probability of an event, based on knowledge of conditions that might be related to the event.

For instance, declining homes sales is an event that has already happened with the number of homes sold so far in 2018 coming in below the same time period in 2017. This may be evidence that a recession is coming. Existing home sales declined in the late 70’s , the late 80’s and the mid 2000’s all in the lead up to a recession. However, in both 1995 and 2014, home sales also declined, and not only was there not a recession, but the years following 1995 saw robust economic activity. Further, home sales did not decline in 2000, yet there was a recession in 2001.

So what does this tell us about the probability that a recession is coming soon now that we know that home sales are declining? There have been four recessions in the last 40 years and three of them have been preceded by a decline in home sales. There have been five instances of home sales declining and three of them were followed by a recession. So it does seem that declines in home sales offer meaningful evidence that a recession may occur. But how much weight should we put on this evidence? That’s where Bayes Theorem comes in.

You might look at the data on home sales and decide that since 75% of recessions have been preceded by a decline in home sales, this means that there is a 75% chance of a recession occurring soon. But while this line of thought is intuitively appealing, it is completely wrong. It ignores the fact that recessions are relatively rare as well as the fact that sometimes home sales decline and no recession occurs (a false positive).

There have been four recessions in 40 years (10% odds of happening). Since recessions can last for more than one year, you might also say that the US economy has been in recession for about eight of the last 40 years (20% of the time). So let’s split the difference and assume that in any given year there is a 15% chance of a recession. (Note: these are estimated odds for illustrative purposes only). And don’t forget that there have been five instances of home prices declining and yet only three were followed by a recession.

So this is where the math gets interesting.

  • Recessions occur 15% of the time.
  • When a recession occurs, 75% of the time it is precede by a decline in home sales.
  • 40% of the time that home sales decline, a recession does not follow.

Now we can calculate the probability of recession given we know home sales have declined. It must be higher than 15% since that’s the odds of a recession happening any time. But how high? Remember 75% of recessions are preceded by a decline in home sales, but 40% of the time that sales decline no recession occurs.

Using the assumed probabilities above (remember, they’re being used for illustrative purposes, we’re not arguing that this simple math can predict recessions) Bayes Theorem, calculates a 15% probability of recession in any given year and a 25% probability of recession in the event that you observe homes sales have declined.

You can do the math yourself using the calculator below. If you don’t like the assumptions I used (15%, 75%, 40%) plug in your own. You can learn more about how to use the calculator here.

Only 25%? That’s higher than the 15% odds if you have no evidence either way. But why don’t the odds increase more? It has to do with the relatively low probability of recession at any given time as well as the meaningful frequency with which home sales decline and yet no recession occurs.

Here’s how Silver puts it:

“When we fail to think like Bayesians, false positives are a problem… As there is an exponential increase in the amount of available information, there is likewise an exponential increase in the number of hypotheses to investigate. For instance, the U.S. government now publishes data on about 45,000 economic statistics. If you want to test for relationships between all combinations of two pairs of these statistics—is there a causal relationship between the bank prime loan rate and the unemployment rate in Alabama?—that gives you literally one billion hypotheses to test. But the number of meaningful relationships in the data—those that speak to causality rather than correlation and testify to how the world really works—is orders of magnitude smaller. Nor is it likely to be increasing at nearly so fast a rate as the information itself; there isn’t any more truth in the world than there was before the Internet or the printing press. Most of the data is just noise, as most of the universe is filled with empty space. Meanwhile, as we know from Bayes’s theorem, when the underlying incidence of something in a population is low (truth in the sea of data), false positives can dominate the results if we are not careful.”

Bayesian probability analysis is not intuitive. And you weren’t likely to have been taught it in school where classical or “frequentist” statistics are taught (remember all those lessons about rolling dice and flipping coins?). But investing is dominated by Bayesian probability problems.

  • What are the odds that Netflix subscriber growth slows given that Apple has announced a new streaming service?
  • What are the odds that homes prices decline given interest rates have recently increased sharply?
  • What are the odds that electric vehicles will see mainstream adoption given that Tesla has shown the ability to take very high levels of market share within the US luxury car market?

These are tough questions. But the key insight from Bayesian logic is as Silver puts it “When the underlying incidence of something in a population is low (truth in the sea of data), false positives can dominate the results.” It’s human nature to weigh recent experiences with a higher probability than its actual chance of occurring in reality and it’s also human nature to connect events that memories recall being related. This can result in intuitive probability assessments by investors that dramatically depart from what a more robust mathematical analysis would forecast. For this reason a tool like Bayes theorem can help us better calibrate our intuition based forecasts so that we have a better ability to judge the true odds of important events and the decisions we’d make to deal with them.

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.

Consumer staples companies with high dividend payout ratios may have found a solution for their dividend problems.

Last week, AB InBev, the Belgian beverage giant, announced that it was “rebasing” – i.e. “cutting” – its dividend to “release approximately $4 billion of additional cash annually to accelerate deleveraging.”

AB InBev argued that by taking its leverage down to 2x net debt/EBITDA, it will reduce its cost of capital and “maximize total enterprise value.” All else equal, a lower cost of debt would in theory increase enterprise value, yet AB InBev already has solidly investment-grade credit ratings (e.g., A- from S&P). A ratings upgrade within the investment-grade space would likely only have a marginal impact on lowering cost of debt. Deleveraging could even increase its cost of capital, as more expensive equity takes a greater share of the capital structure.

So, what might really be behind the dividend cut…er, rebase? AB InBev is paying down debt following its huge 2016 acquisition of SABMiller. Despite annual free cash flow around $11 billion, AB InBev spent about $9 billion on dividends, leaving just $2 billion to reduce debt.

In short, the dividend was a handcuff. AB InBev had little financial flexibility to do more M&A, react to changes in the competitive landscape, or opportunistically buyback stock at attractive prices. These strategies could, if done prudently, benefit long-term shareholders.

Indeed, one of the reasons we believe HBO fell behind Netflix on streaming content was Time Warner’s stubbornness around its dividend. Rather than increase content investment, it protected its $1.3 billion dividend payout. The fact that AT&T, which recently completed its Time Warner acquisition, said it will ramp HBO content spending seems to validate this viewpoint.

What’s to come

At first glance, AB InBev’s decision makes sense. In fact, I think some other consumer staples companies may follow suit in the coming years.

Consider these blue-chip consumer staples companies’ high earnings payout ratios:

Dividend Yield Dividend Payout Ratio – Earnings (LTM) 1-Year Dividend Growth
Campbell Soup 3.8% 113% 0%
Kraft Heinz 4.6% 100% 3.1%
Kimberly Clark 3.9% 77% 4.5%
Procter & Gamble 3.3% 77% 3.8%
General Mills 4.5% 75% 1.0%
Coca-Cola 3.3% 73% 5.5%

Source: Bloomberg, as of October 26, 2018

While these blue chips could likely sustain their current dividends for years to come, like AB InBev, their generous payout commitments limit their ability to further raise the dividend, opportunistically buyback stock, engage in M&A, or reduce debt.

There’s also little room for error. And at a time when many blue chip brands are facing a new wave of competition, consumer staples companies may need to pivot their current strategies to adapt to changing industry dynamics. Further, if interest rates continue to rise, it will be more expensive for these companies to roll over their debt. The prospect of holding back some cash flow may become increasingly appealing.

Still, optics matter, and the blue chips will resist cutting without a catalyst. As such, I expect future merger activity in the sector to include dividend adjustments at the remaining company. This is what Pfizer did, for example, when it acquired Wyeth in 2009. And, with hindsight, it’s what AB InBev should have done when it initially acquired SABMiller.

Bottom line

Ultimately, a company’s dividend should be affordable, reflect the growth in shareholder value creation, and help management more prudently select high-return projects rather than pursue wasteful “empire building” deals. Dividends can be a problem, however, when they become too generous and handcuff management’s ability to invest in high-return projects and defend or widen the firm’s economic moat. When this happens, a dividend “rebasing” or “cut” would benefit long-term shareholders.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix (NFLX). This company represents 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.

Will Ashworth at InvestorPlace wrote an intriguing article highlighting 7 companies exhibiting pricing power as a core feature to their business models, including two that Ensemble Capital has owned for client portfolios, Netflix (NFLX) and Apple (AAPL). Pricing power lies at the core of most great businesses — a point often talked about by legendary investors Warren Buffett and Charlie Munger.

In his profile of Netflix, Ashworth quotes our Senior Investment Analyst Arif Karim’s recent Intrinsic Investing post discussing Netflix’s Pricing Power:

“What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since,” Arif Karim, senior investment analyst at Ensemble Capital, stated in a must-read October article in Intrinsic Investing. “Despite this increase in prices, it has continued to show very strong momentum  in signing up new customers for its service around the world.”

Ashworth goes on to note: “Since 2011, Netflix has grown subscribers by 30% compounded annually. In Q3 2018, it increased paid memberships by 5.4% from Q2 2018 and 25% year over year. While the U.S. growth has slowed, international streaming grew by 39% year-over-year with plenty of the world still to cover.”

Netflix’s pricing power has indeed been a topic that has not been discussed much in the public sphere, but one which we believe is an important driver of both the company’s future business strategy (helping fund the build out its moat and global subscriber base) and its future value.

In addition, Ashworth also discusses Apple’s pricing power and offers an apt recent quote from Warren Buffett, who is listed as the second largest owner of company shares [via control of Berkshire Hathaway (BRK/A) as of 6/30/2018]:

“I have a plane that costs me a lot, a million dollars a year or something of the sort. If I used the iPhone — I use an iPad a lot — if I used the iPhone like all my friends do, I would rather give up the plane,” Buffett said on CNBC in August. “Now it’s got competition so you can’t push the price, but in terms of its utility to people and what they get for a thousand dollars…you can have a dinner party that would cost that, and here this is, and what it does for you, it’s incredible.”

Arif discussed Apple’s iPhone franchise, the great utility it offered its users, and its positioning as a luxury brand with pricing power in our discussion about the sustainability of Apple’s iPhone franchise in 2016, when many public discussions were being had about the death of innovation at Apple with a market valuation that reflected those doubts:

“This brings the focus on the well-designed device, its capabilities couched in a simple intuitive interface, its elegance, and the daily needs it fulfills as well as aspirations it can help the user attain. It’s a brilliant strategy that emphasizes the brand and emotion that creates the connection with its users while de-emphasizing the technology that can be threatened by the latest, greatest, cheapest competing gadget… while expensive at a face value of $650-$850, the iPhone and smartphones in general, are the most important and personal discretionary device the consumer owns. They serve as the gateway to your entire digital life that has grown to be a very important part of yourself. It is your most used device and will only increase in importance over time.

And, with a life span of two to three years, the cost of the average iPhone translates to less than $1 a day. This is an incredible value per hour of usage for the average smartphone user in any developed country as well as a significant number of users in emerging market countries. Given how much time owners of smartphones spend using their devices and how important a part of their lives they play, paying up for a premium, more secure, easier to use smartphone is one of the most practical luxuries they can pay for.”

For other great examples of companies with pricing power, we invite you to learn more by reading Will Ashworth’s article posted below.

7 Stocks to Buy for Real Pricing Power

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of  Apple (AAPL) and Netflix (NFLX). The company represents 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.