Weekend Reading

28 April 2018 | by Paul Perrino, CFA

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

Electric Buses Are Hurting the Oil Industry (Jeremy Hodges, @jeremylawhodges, Bloomberg)

China is in full speed in deploying electric buses to combat pollution. Shenzhen replaced all 16,359 buses with electric buses. China is rolling this out in other cities throughout the country. “Every five weeks, Chinese cities add 9,500 of the zero-emissions transporters—the equivalent of London’s entire working fleet, according Bloomberg New Energy Finance.” Buses fuel consumption is approximately 30 times cars. This is starting to impact the oil industry. “BYD estimates its buses have logged 17 billion kilometers (10 billion miles) and saved 6.8 billion liters (1.8 billion gallons) of fuel since they started ferrying passengers around the world’s busiest cities.”

Insight: Waymo – Google’s self-driving division (Jim Holder, @Jim_Holder, AutoCar)

Waymo’s CEO says “We are not the enemy. Yes, you can have self-driving cars and enthusiasts’ cars.” The goal appears to be to “disrupt the utilitarian market, because we can likely cover those needs in a cost-effective way.” Unlike other car start-ups, they quickly realized that building their own car was difficult and “is best left to the experts.”

Expensive stocks may not be so dear after all (John Stepek, @John_Stepek, MoneyWeek)

Financial metrics offer a quick and easy way to talk about a company. Be careful about creating an investment strategy focused on them. In a study of companies from 1993 to 2017, Travis Fairchild at O’Shaughnessy Asset Management, shows that “firms with negative book value (ie, liabilities apparently worth more than their assets), and companies that looked expensive on a p/b basis, but cheap on other measures, tended to beat the wider market. In other words, if you avoided these stocks on the basis of the p/b, you’d miss out.”

Visa, Mastercard Talk About Cooperating in Online Shopping (AnnaMaria Andriotis, @AAndriotis, WSJ)

To compete against PayPal’s payment tab and the growing competition in the payment industry, MasterCard and Visa created their own in 2012 and 2014, respectively. After years of testing they got together and decided to adopt a single pay tab for both MasterCard and Visa.

 

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Google (GOOGL) and MasterCard (MA). 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.

Before joining Ensemble, I wrote a book called Keeping Your Dividend Edge, which discussed ways investors can identify promising dividend-paying stocks and avoid at-risk dividends.

Over the past decade, three factors changed the game for dividend-paying companies.

  • The financial crisis years saw the most dividend cuts since the Great Depression, including some dividends once considered sacred.
  • Rapid innovation created disruptive products and technologies that challenged blue-chip dividend payers with legacy moats.
  • Boards and management teams have increasingly adopted share buybacks as an alternative to cash dividends.

As a result, it’s essential that investors keep a close watch on their companies’ financial strength, competitive position, and capital allocation practices. While dividends can represent a commitment from the board of directors, they are never guaranteed.

Blue chip blues

Blue-chip consumer packaged goods (CPG) stocks have long been steady dividend payers. Indeed, Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive are members of the “Dividend Aristocrats” list for having raised their annual payouts for over 25 consecutive years. The group also broadly avoided dividend cuts during the financial crisis due to regular demand for their everyday consumable products like tissues, toothpaste, and laundry detergent.

More to the point, these impressive dividend track records were made possible by the CPG companies’ brand- and scale-based economic moats.

But moats are not static – they are either widening or narrowing each day – and management’s capital allocation decisions play a massive role in determining moat trends. Unfortunately, it seems many CPG firms focused too much on returning capital and not enough on reinvesting it.

In the last ten years, CPGs have been particularly impacted by technology, which lowered both barriers to entry and barriers to scale. The Honest Company and Dollar Shave Club are just two examples of companies born after the financial crisis – both in 2011 – that quickly challenged the old guard.

Upstart competitors are also leveraging low-cost social media marketing to target customers (thus sidestepping traditional advertising) and engaging with customers in a highly personalized way, leaving CPG firms scrambling for a response.

Finally, the rise of online shopping – primarily via Amazon – moved consumer dollars away from grocery stores where CPG firms had the best shelf space to a platform where the customer has many choices.

These factors are starting to show in CPG financial results and are reducing dividend safety.

Tighter squeeze

As the following chart shows, earnings cover (earnings/dividend) has declined significantly at Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive over the past twenty years.

Source: Bloomberg, as of April 25, 2018. Red line = breakeven.

Meanwhile, the companies have slowed dividend growth rates.

Source: Bloomberg, as of April 25, 2018

Each company has also made regular share repurchases on top of their dividend payments, leaving little – if any – free cash flow left over to fund acquisitions or fuel innovation.

Total FCF Payout Ratio
Kimberly-Clark 93%
Procter & Gamble 119%
Colgate-Palmolive 97%

Source: Bloomberg, as of April 25, 2018. Based on latest trailing twelve-month figures.

Yes, all else equal, you should expect maturing companies to pay out a higher percentage of earnings and cash flow, but things are not equal in the CPG world. The CPG companies will either need to find a way to make their traditional business models work in the new landscape or revamp their strategies to address competitive threats.

As P&G alumnus and venture investor Dave Knox notes in his book, Predicting the Turn: The High Stakes Game of Business Between Startups and Blue Chips: “The companies which remain on the Fortune 500 ten years from now will be the companies that leverage a mixture of tech acquisitions, investments in startups, innovative partnerships and even their own disruptive launches to transform their companies. While it will not be a single strategy that enables their survival, it also will not be a single effort.”

If true, this will require both a cultural change and a change in the way the firms allocate capital.

Gimme shelter

Ultimately, companies cut their dividends for one or some combination of three reasons:

  • Creditors demand it (e.g., breached covenant).
  • They can’t afford the payouts (e.g., energy company reacting to plunge in oil prices).
  • They need the capital for a new strategy.

Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive all have excellent credit ratings and shouldn’t run into any trouble with creditors. But a strong credit rating alone doesn’t mean a safe dividend. Pfizer and General Electric, for instance, both carried top-notch credit ratings when they cut their payouts during the financial crisis.

The CPG firms could technically afford their payouts for some time by issuing debt or selling assets, but this is not a sustainable strategy and may deprive the companies of future earnings power.

If blue-chip CPG firms cut their payouts, it will likely be because they feel “handcuffed” by the commitment of capital to dividends, which restrict their ability to compete and defend their moats.

Dividend cuts by blue-chip CPG companies would be wildly unpopular among investors who rely on the companies’ dividends to supplement their income. The companies will also be reluctant to break their multi-decade dividend increase streaks, as they would drop off popular dividend-based indexes. As such, I do not expect such a decision to be taken lightly.

Final thoughts

Management’s goal should be to optimize capital allocation to improve return on invested capital and create long-term shareholder value. The ability to sustain a dividend springs forth from smart capital allocation decisions that defend or widen the company’s moat.

Dividends can indeed play an important role in capital allocation by limiting management “empire building” risk, but generous dividend policies can also be a problem when they become burdensome. Efforts to sustain an unsustainable dividend come at the expense of long-term shareholders. In the coming years, CPG firms may have some tough decisions to make.

 

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.

Below is the Q1 2018 quarterly letter for the Ensemble Fund (ENSBX). This quarter’s Company Focus is on Netflix (NFLX) and NOW, Inc (DNOW). You can find historical Investor Communications here and information on how to invest here. Enjoy!

The performance of the Ensemble Fund (“the fund”) this quarter was modest on an absolute basis, while being relatively strong when compared to the broader market. The Fund was up 1.93% vs the S&P 500 which was down -0.76%.

As of March 31, 2018

1Q18 1 Year Since Inception*
Ensemble Fund 1.93% 19.13% 13.11%
S&P 500 -0.76% 13.99% 12.23%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at www.EnsembleFund.com.

Last quarter, in reviewing our performance for 2017, when we slightly trailed a very strong level of market performance, we discussed that we expect our strategy to deliver a better downside capture ratio than upside capture ratio, meaning that we expect to perform better on a relative basis during down markets than during up markets.

After a strong first few weeks of the quarter when the S&P 500 rallied 7.6% and the fund continued to trail slightly, the market experienced its first real bout of selling pressure since early 2016. From the market high on January 26th, the S&P 500 declined by 7.72% through quarter end while the fund declined by 4.87% for a downside capture ratio of 63%.

While we seek to produce strong, long-term absolute returns, we know that losing less during market declines is an important element of reaching our long-term goal. Since it takes a 100% gain to reverse a 50% loss, a solid defense leaves us in a better position to play offense when the tide turns.

The most notable driver of the fund’s performance in the quarter was the over 50% rally in Netflix, which we’ll discuss later in this letter. We also saw positive performance in 14 of our 24 holdings, with double digit positive performance from Broadridge Financial, Mastercard, Ferrari, Transdigm and our new position in Booking Holdings (previously named Priceline), which we initiated during the last week of December.

On the negative side, we saw continued negative performance from Prestige Brands (which we added to in February after the stock declined sharply on a weak quarterly earnings report), as well as L Brands, which unfortunately reversed much of the very strong gains it posted in the second half of last year, and in DistributionNOW, which we exited after their disappointing earnings report which we will discuss in more depth…

Click here to read the full letter

DISCLOSURES

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix (NFLX), Broadridge Financial (BR), Mastercard (MA), Ferrari (RACE), Transdigm (TDG), Booking Holdings (BKNG), L Brands (LB), Prestige Brands (PBH). 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.

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. 

Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Please refer to our current 13F filing or contact us for a current or past copy of such filing.

Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

Fund Fees: No loads; 1% gross expense ratio.

Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.

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 his memoir, Shoe Dog, Nike founder Phil Knight described how difficult it was to raise capital in the 1960s.

There was no such thing as venture capital. An aspiring young entrepreneur had very few places to turn, and those places were all guarded by risk-averse gatekeepers with zero imagination. In other words, bankers.

Around the same time, Sam Walton (as described in Made in America) struggled to get funding to build Wal-Mart.

Nobody wanted to gamble on that first Wal-Mart…I had to put up 95 percent of the dollars…We pledged houses and property, everything we had.

In other words, in the 1960s, access to capital was a massive barrier to entry for potential disrupters. Incumbents with established banking relationships and access to credit markets had a clear advantage.

Over the coming decades, however, venture capital and private equity sprouted up, and banking deregulation commenced, making it easier for promising start-ups to acquire funding. Today, access to capital does not impede a motivated entrepreneur with a quality product or service.

Entry vs. scaling barriers

Economic moat sources – low-cost production, network effects, switching costs, and intangible assets – may remain constant, but ultimately what determines a moat is how those sources build entry or scaling barriers for competitors.

Once a barrier to entry is lowered, what matters is how quickly the entrants can scale. Dollar Shave Club wasn’t remarkable only because it sold a quality blade at a lower price point, but because of how rapidly it scaled and challenged Gillette’s dominance in the space.

On the other hand, the barriers to entry in the North American containerboard industry aren’t insurmountable, but it is much harder for an entrant to scale. The major incumbents – International Paper, Georgia-Pacific, WestRock, and Packaging Corporation of America – account for about 75% of domestic production and own the majority of the corrugated box plants.

Even if you produced containerboard, you’d still likely need to sell through one of the incumbents’ box plants. Regional efficient scale advantages limit new box plant construction and enable the integrated players to act rationally.

Tangible vs. intangible

One of the biggest differences between traditional and “future” moat analysis is that the former is primarily rooted in tangible assets (plants, brick-and-mortar stores, etc.), while the latter is based increasingly on intangible assets (relationships, customer captivity, etc.).

With traditional tangible asset-based moats, barriers to entry are typically high (need for capital, expensive factories, etc.), but economies of scale are more achievable as expansion allows the spread of high fixed costs over a broader base.

The opposite is true with intangible asset-based moats. It’s easier to enter a market but much harder to scale in capital-light businesses. You could start a new social media company in your garage on a shoestring budget, but you’re up against significant network effects and switching cost advantages held by the incumbents. Further, it’s not always apparent which capital-light company is prudently scaling because they are expensing reinvestment, often resulting in near term, low reported profit margins.

You may find the following framework useful in navigating tangible versus intangible asset-based moat analysis.

Barriers to entry scale

 

Bottom line

The nature of moat analysis is shifting from a tangible-asset based evaluation to one that’s increasingly driven by intangible assets. Adapting to the change is not always easy for those brought up in the traditional value school, but we think it’s essential for investors to do so if they hope to succeed in the coming decades.

 

Clients, employees, and/or principals of Ensemble Capital own shares of Nike (NKE).

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.

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 Friday, April 6 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: 1-800-895-1549
  • 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.

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.