One of our favorite investing scenarios is finding a company with a remarkable culture taking share from incumbents that seem unwilling or unable to change.

We’ve talked about identifying companies with virtuous corporate cultures, but today we’ll discuss the other side of the equation: incumbent laziness.

This is important because a culture’s value is relative. If every company in an industry has a positive corporate culture (i.e. customer-focused, willingness to change, etc.), the value of any individual culture is null. There can be no predator without prey.

Source: BBC

To be sure, incumbents are incumbents for a reason. They’ve been successful. They’re filled with smart people. But according to Richard Rumelt in his book Good Strategy, Bad Strategy, two themes expose incumbents’ weaknesses: inertia and entropy.

Inertia of routine

When there’s a blueprint for success, you want an Optimizer leader to establish processes that maximize efficiency. If the status quo persists, then “this is the way we’ve always done it” works just fine. Problems arise when there’s a shock to the system – a disruptive technology, a new regulation, or a change in consumer behavior. The processes and routines that carried the company’s success now have declining value.

On paper, these routines can be remedied, but as Rumelt notes, “The barriers are the perceptions of top management.” In practice, managers are reluctant to fire or reassign employees who oversee obsolete processes. (And who can blame them? We’re all human.) A generous dividend policy can be sacrosanct to shareholders and any effort to change it, even when strategically necessary, can be futile. This is especially true today, as dividend-paying stocks are trading at a premium in low-interest rate environments.

Indeed, one of the reasons we sold our position in Time Warner a few years ago and bought Netflix was it became apparent that Time Warner was unwilling to change its dividend policy to keep up with Netflix on streaming content spending.

Inertia of culture

When the status quo changes, the values and norms exuded by management and followed by tenured staff may not be what the company needs to compete and thrive. In 2018, the average U.S. bank had a Net Promoter Score (NPS) of 35 out of 100, according to SATMETRIX, implying their customers were unlikely to recommend them to their friends. A 2016 survey by Ernst & Young of 55,000 banking customers found that only 26% have “complete trust that their banks will provide truly unbiased advice.”

One explanation for low customer satisfaction is that most banks – large banks in particular – are driven to minimize overhead costs. This often results in a lack of personal service.

First Republic Bank flips that model on its head. By focusing on customer service (it boasts an 81 NPS when considered the customer’s “lead bank”), including getting assigned to a personal banker, First Republic doesn’t have to spend as much on customer acquisition. Between 2007 and 2018, 75% of the bank’s growth came from existing clients and referrals.

Inertia by proxy

Rumelt writes that “A business may choose (author’s emphasis) to not respond to change or attack because responding would undermine still-valuable streams of profit. These streams of profit persist because of their customers’ inertia – a form of inertia by proxy.”

We’ve written extensively about the decline of many consumer brands that relied on search cost advantages established and perpetuated by superior advertising and distribution. It can be tempting for companies who benefit from customers’ inertia – e.g. buying the same brand again and again – to raise prices too much and risk mortgaging their moat.

Gillette razors are a classic case in point. With a market share over 70% in 2010, Gillette felt it could raise prices without sacrificing market share. And that worked for a while. But it also opened up the opportunity for direct-to-consumer upstarts like Harry’s and Dollar Shave Club to dramatically underprice Gillette. Their rapid growth showed underlying customer frustration with Gillette’s prices.

In 2016, with its market share down to 54%, Gillette cut razor prices by up to 20%.

Entropy

Moat erosion typically begins behind castle walls. Without proper stewardship, a company – like an untended garden – will become disordered. Well-positioned competitors have a chance to storm the castle if management isn’t widening the moat.

Last year, we wrote about how the medical device company Masimo has been slowly taking market share in the pulse oximetry market from its once-dominant competitor, Nellcor (owned by Medtronic). We believe poor stewardship at Nellcor, when contrasted with Masimo’s exemplary stewardship, is a key reason this has occurred. Various owners passed Nellcor around over a 25-year period. In 2005, a federal court found that Nellcor (then owned by Tyco) had engaged in anti-competitive behavior to secure its then-70% market share in pulse oximetry.

Masimo capitalized on the opportunity to chip away at Nellcor’s dominance. Today, Masimo has about a 50% share of the U.S. pulse oximetry market.

Bottom line

It’s not enough to identify a company with a great corporate culture. For that culture to deliver consistent value, it must be up against competitors with weak cultures or poor stewardship. Knowing how to identify weak competition is critical to understanding the opportunity for strong companies.

 

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.

On Monday, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on CNBC to discuss Netflix and the threat of Disney Plus. In this clip, Sean explains why we see Disney Plus as more of a complement than a substitute for a Netflix subscription, and offer an explanation for why Netflix has rallied 17% since Disney Plus launched.


If you are reading this in an email, click here for the video.

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.

Each quarter, Ensemble Capital hosts a conference call with investors to discuss the current market, economic conditions, and a few of our portfolio holdings.

This quarter’s call will be held on Thursday, January 9 at 1:00 pm (PST)

We’d love for you to join us on the call, which you can do by REGISTERING HERE or following the dial-in information below:

  • Dial: 1-877-830-2590
  • Conference ID: Ensemble

If you’d like to listen to our previously-held quarterly calls, an archive can be FOUND 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.

“We built this company on pay per performance to begin with and its no secret that we did it with Google. Google and us have had a very good relationship together. We’ve both benefited tremendously.” -Glenn Fogel, Booking Holding CEO

Google is the gatekeeper to the internet. Once upon a time we had web “portals” that served as the “home page” where internet users started any exploration of the internet. But today it’s just Google. Whether you go to Google.com or type a search term into the URL bar of your desktop or smartphone browser, you are accessing the internet through Google.

We are a long-time shareholder of Google and have stated before that the company’s services “have become a required part of modern life, almost a form of oxygen for internet connected populations,” as well as claimed that “Google’s opening up of the collective knowledge of humanity to anyone with an internet connected device at no cost to the user can easily be seen as one of the most important social benefits ever created by any nonprofit or for-profit organization.”

But a lot of people just think of Google as a monster that devours profits that have historically accrued to other companies.

(Source: Robert Scott Lawrence)

Devouring other companies’ profits is not a bad thing. It is how capitalism is supposed to work. But if you are one of the companies whose profits are being devoured, you’ll take no comfort in this philosophical view. As Google shareholders, we are well aware of the company’s extremely powerful position and its ability to change the fortunes of other companies at a whim.

So it may seem irrational that one of our largest holdings is Booking Holdings, the leading online travel company operating in a space where Google has recently thrown its weight around. But while we agree that Google will continue to capture the largest portion of the online travel profit stream and grow their share, we think Booking is uniquely advantage within the publicly traded online travel peer group as being well positioned to dodge this threat.

Booking Holdings is an online travel agency (OTA). This means that it actually books travel related reservations. Expedia is the other big player in this space. The other main type of online travel company offers “metasearch.” Metasearch websites like Kayak or TripAdvisor are designed to search across multiple travel related sites to find the best deal and then earn ad revenue for sending users to those other sites to then book a reservation.

Both types of companies provide a type of service known as “vertical search,” which searches the internet, but within a limited domain of information. Vertical search services are not limited to traditional search engines. Amazon can be thought of as vertical search for shopping. More product searches start on Amazon then start at Google. While Google’s general search offering is outstanding, some categories of information can benefit from specialized search services. In certain niches, vertical search services from companies such as Yelp, Zillow, and LexisNexis have thrived despite Google’s dominance in general search.

But the thing about the travel-related vertical search industry is that it is big, big business. According to research by Skift, one of the leading travel industry research groups, Google’s travel related advertisements generate so much revenue that this one segment of Google business is more valuable than any of the standalone online travel companies. It is generally thought that Booking may well be Google’s single-biggest customer and that travel overall is one of Google’s biggest sources of advertising revenue.

But that’s not enough for Google. Like any good competitor, they aren’t happy being first. They want to win and win, and then win some more. They don’t just want to generate the most profits in the industry, they want to maximize profits, period.

One strategy Google has deployed to win a larger share of the travel industry profit pool is create their own vertical search products. Back in 2011, the company launched Google Flights, and today this search product is considered the gold standard for the vertical search category for finding airline tickets. Unlike general Google search, which returns a list of links to other websites, Google Flights allows you to search for flights using flight specific queries and returns results in a format that is most useful for comparing flights. This is the same service that other travel metasearch products offer.

Obviously travel metasearch companies think this is terrible! They were used to having the best product and capturing the ad revenue that airlines paid them when a potential customer clicked on a link to a flight. But Google Flights has been widely viewed by consumers as a fantastic innovation.

Scott’s Cheap Flights, is an online service that identifies when airlines put flights on sale or other deeply discounted airfares and alerts their subscribers. The service has been widely praised by many media organizations and I use it personally. And what does Scott’s Cheap Flights tell its subscribers is the very best tool for finding cheap flights? Google Flights.

But what have online travel companies said about Google Flights? They say Google is “increasing the ad load” and “degrading the user experience.” The implication of this point of view is that Google Flights is an ad product (which it is) and by putting it at the top of the search results they are pushing further down the page “organic” (ie. free unpaid links) search results that point to the travel companies’ own websites. Under this worldview, “paid” search results are “bad” for users and “organic/free” search results are what users are looking for.

But that’s wrong.

Google Flights is a paid search product, but it is also the best search product to find the best flight. Users aren’t being forced or tricked into using Google Flights simply because they have to scroll further down the page to see organic results. They are using Google Flights because it does a better job of getting them the information they seek.

But Google Flights isn’t a big deal to Booking Holdings, because the vast majority of Booking’s revenue comes from booking hotels. And very importantly, most of their hotel booking revenue comes from hotels in Europe and Asia, not the US, which we’ll explain the importance of a bit later.

About a year ago, Google rolled out Google Hotels. And guess what? It is a really good tool for searching for hotels.

Over the summer, Google began “optimizing” their travel products. Said more bluntly, they have been strategically updating their algorithm so that users are more likely to go through their paid travel search products.  When TripAdvisor, Expedia, and Booking reported their 3rd quarter results, the market did not like what it heard:

(Source: Bloomberg)

TripAdvisor and Expedia fell by 20%-30%. Booking declined as well, but the commentary from each company could not have been more different.

Here’s Skift’s analysis of what happened.

“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact.

“We believe our most significant challenge remains Google pushing its own hotel products in search results and siphoning off quality traffic that would otherwise find TripAdvisor via free links and generate high-margin revenue in our hotel click-based auction,” TripAdvisor stated.

Expedia Group CEO Mark Okerstrom in Bellevue, Washington, said Google is taking “more revenue per visitor, and I think it’s just the reality of where the world is in the Internet, and the importance of Google at the top of the funnel.”

Both Okerstrom and Kaufer complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”

But here’s what Booking Holding CEO Glenn Fogel said at RBC’s analyst conference a few weeks later:

“We built this company on pay per performance to begin with and it’s no secret that we did it with Google. Google and us have had a very good relationship together. We’ve both benefited tremendously.”

While all three of these companies are online travel businesses, there is something idiosyncratic about Booking Holding’s business model. And this distinction is the critical key to why Booking and Google should best be understood as engaging in a mutual beneficial relationship. Sure, they might both want to maximize the profits they each earn, even at the others’ expense. But their relationship is not a zero-sum game. They both can win over the long term, which is why at Ensemble we’re very comfortable being long in both stocks.

Key Distinction #1

Unlike TripAdvisor, which is primarily a metasearch site which earns advertising revenue by sending users to hotels or hotel OTAs to reserve a hotel room, Booking is primarily a hotel OTA. Google is in the search business. They don’t book reservations in either their Flight or Hotel product. For that matter, across Google’s entire search related business they don’t enable users to engage in transactions on their site for the most part. They are in the advertising business and they earn their profits by generating advertising revenue in exchange for sending users to other companies’ websites to engage in transactions.

So, Google Hotels is a direct competitor to TripAdvisor. However, the search results inside of Google Hotels includes hotel websites, but also Booking and Expedia listings offering the ability to reserve a hotel room that fits the search.

Key Distinction #2

Booking and Expedia are the two leading OTAs. But while Booking is mostly just hotels and mostly in Europe and Asia, Expedia has more exposure to airline tickets and far more exposure to the US.

Empty hotel rooms are like perishable inventory. If you don’t sell a hotel room one night, you can’t ever sell that room on that night again. This is why hotels are willing to pay OTAs a large commission for finding a traveler to book a room.

In the US, where Expedia is more exposed, the market is dominated by big branded hotel chains such as Marriott, Hyatt and Hilton. When a traveler heads to New York, rather than going to a metasearch or OTA website, they might just go right to Marriott or Hyatt or Hilton’s website. These companies have strong loyalty programs and are well known to customers. Their hotels tend to run with higher occupancy rates and so they aren’t particularly dependent on the incremental demand that OTAs can provide. Indeed, OTAs have had to negotiate much lower commission rates with the big brands.

But in Europe and Asia, where Booking is more focused, independent hotels are the norm. If a traveler is going to Milan or Bangkok or Paris, they are much more likely to stay at an independent hotel. These hotels don’t have loyalty programs or global brand recognition. They tend to operate with lower occupancy rates. With more “perishable inventory” going bad every night, independent hotels are much more dependent on OTAs and pay a much higher commission rate than branded hotels.

For independent hotels, Booking and other OTAs effectively act as outsourced digital marketing companies who are paid on commission. This is an incredibly valuable service for independent hotels who simply don’t have the resources or expertise to run global digital advertising programs.

This is why the hotel listings inside of Google Hotels will typically be direct links to Hyatt or Hilton or Marriott’s own website (bypassing the OTAs), but for independent hotels the links will typically be to Booking or other OTAs’ listing for the hotel.

Key Distinction #3

If TripAdvisor, Expedia and Booking all have their hotel listings inside of Google Hotels, why are Expedia and TripAdvisor moaning about it while Booking doesn’t seem to care?

Remember those “organic” or free links that TripAdvisor and Expedia are saying are being moved further down the page as Google “pushes” users into the Google Hotels product (or rather users choose to use Google Hotels because it is a better experience than general search)? That traffic is referred to as SEO (search engine optimization) traffic. TripAdvisor and Expedia have been free-riding on Google’s service while Booking generates its earnings stream from paid Google links.

This is the most important distinction of all.

While the companies’ do not disclose the amount of traffic they receive from organic vs paid links, the above analysis by Cowen & Company aligns with the companies own past comments and our analysis of the companies’ business models.

TripAdvisor and Expedia are dependent on Google’s free search results for the majority of their earnings. While Booking uses Google’s paid advertising search results to drive the vast majority of their earnings.

TripAdvisor and Expedia complain that Google is “increasing the ad load,” “degrading the user experience,” “pushing its own products,” and “siphoning off quality traffic.” But there is another way to think about what’s going on.

Here’s venture capitalist Chamath Palihapitiya speaking in his typically bombastic manner at the recent Phocuswright travel industry conference:

“If you are a business that thrives inside of this Google environment… you are f***ed. Ratably, tick for tick, every single person that feeds off of them, will see their profitability erode. That’s the unvarnished truth of what’s happening. If you are in the business of being a parasite on top of Google, your medium and long term prospects are terrible. You are an impaired company, even though you don’t know it.”

While Palihapitiya is prone to dramatic statements, venture capitalist Bill Gurley who is more balanced in his public comments retweeted Palihapitiya’s statement saying simply “this is accurate.”

Bottom Line

Booking and Google are not at war. Booking is one of Google’s biggest customers. Booking built its business model around paid links from Google. Google has found a way to offer metasearch for hotels in a way that offers a superior user experience and has the benefit of Google getting paid for sending users to other sites to book rooms. This is hugely disruptive to companies built on the idea that somehow they deserve to get free traffic from Google. But it is not disruptive at all for a company like Booking that has figured out how to pay Google even while it earns fantastic profits.

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.

This is Part 7 of our series on position sizing. PART 1PART 2PART 3PART 4, Part 5, Part 6.

Over the course of our multi-part series on position sizing, long-term readers will note that we’ve described a far more quantitative process than the more narrative driven descriptions we’ve offered for why we own the companies we do. This difference is driven by the type of decision making that informs what to own, versus the type of decision making needed to decide exactly when to place each trade.

In Part 4 of our series, we wrote:

“Annie Duke explained the need for decision makers operating under conditions of uncertainty and time pressures to align and reconcile what Kahneman called System One, or reflexive decision making, and System Two or deliberative decisions making.”

From Kahneman’s seminal book Thinking Fast and Slow:

“System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration… The highly diverse operations of System 2 have one feature in common: they require attention and are disrupted when attention is drawn away… [But] System 2 has some ability to change the way System 1 works, by programming the normally automatic functions.”

(Source: Ameritest)

We believe that System 2, deliberative decision making, is at the heart of analyzing companies. It is extremely time intensive to understand a business at a deep level, which is why we think (and the evidence strongly supports) that managing a focused portfolio of holdings is a key attribute of most successful fundamental, equity investing strategies.

But every day, the price of every position in our portfolio changes continuously. At the same time, news flow on our companies, their competitors, and the economy can influence our calculated fair values and our conviction ratings. In addition, we offer our investment strategy not only in the form of a mutual fund, but also as separately managed accounts, where cash inflows and outflows can impact the weight we have in each position we hold.

Compounding the need to make complex, continual judgments about specific buy/hold/sell decisions (the decision to do nothing and just hold is still a decision) is the fact that investors face significant cognitive biases. We believe that cognitive biases are more intense the closer you get to trade date. If you ask investors what they expect the market will do over long periods of time, they often will provide an estimate that is closely related to the historical base case of 8%-10% annualized returns. But under conditions of stress, investors’ time horizons shrink, causing them to make fundamentally mistaken forecasts due to a range of cognitive biases.

Recognizing that we need to make continual optimization decisions across multiple holdings and multiple portfolios and that these particular types of decisions are often clouded due to cognitive biases, we deconstructed our more standard, qualitative position sizing framework and designed the algorithm we’ve spent this series of posts describing.

This process builds on the research described in Roy Baumeister’s book Willpower, in which the author describes techniques to reconcile System 2 deliberative strategies you craft to reach your goals with the need to make in the moment decisions where System 1 reflexive processes take over.

“We often think of willpower in heroic terms, as a single act at a crucial moment in life… [But our] analysis of a large set of published and unpublished studies on people who scored high in self-control… [showed] the people with high self-control were distinguished by their behaviors that took place more or less automatically.”

In other words, by building an automatic position sizing formula, based on deep, deliberative thought to articulate what decisions we would want to make under all sorts of future conditions, we have created a system under which we can effortlessly, but relentlessly, stay true to our disciplined approach. At the same time, by handing off the cognitive load to an algorithm to decide things like “do we trim this stock at 6.5% or should we let it ride up to 7%?” or “do we buy now or after earnings?” we free up cognitive and attention resources to focus on deliberative System 2 processes that are key to uncovering alpha opportunities.

In many ways, the Ensemble Capital investment strategy is good old fashioned stock picking based on the qualitative judgments of human analysts. We use this process because we think it is superior to more quantitative approaches. But when it comes to tick by tick trade decisions and determining exactly how much of any stock we want to own in a portfolio, we think qualitative judgments become overwhelmed by cognitive biases.

We think we have a competitive advantage when it comes to assessing the long-term cash generation potential of companies. But when it comes to short term buy/hold/sell decisions in the context of rapidly moving prices and opportunity sets, we know that algorithms have humans beat and we’ll happily focus on designing and refining our algorithm instead. In doing so, we’ve made our best effort to follow Duke’s advice to “align and reconcile” System 1 and System 2 thinking.

Please click here for Part 6

Please read important disclosures 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.