We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Prestige Brands (PBH)

Excerpt (Sean Stannard-Stockton speaking):

Another position we established in our portfolios in early 2017 is Prestige Brands. Prestige Brands is a small company that owns big brands in small markets. While their competitors include huge companies like Novartis, Johnson & Johnson, and Procter & Gamble, within the niche markets where they compete, their products generally hold #1 or #2 market position and often have market share of well over 50%. As a comparison, Coke holds 42% market share in carbonated soft drinks and so Prestige’s market share in their niche markets can be seen as more dominate than the hold Coke has on the soda market.

The company sells over the counter consumer health products that typically do not have any kind of prescription competition or any direct relationship with the health care or health insurance system. This is important because it means that the health insurance system, which we view as fundamentally broken and likely to undergo significant changes in the decades ahead, has not inflated prices in their end markets (in other words, customers pay 100% out of pocket for Prestige’s products), yet the demand dynamic is driven by the same steady, non-cyclical growth dynamics that drive the health care sector.

With no prescription competition, the company operates in markets where customers use brand as a key signal of quality and effectiveness. If you have a sore throat, itchy eyes, a wart, or your kids are car sick, you want to be sure that what you buy works and buying an established brand is the best way to make sure you get what you paid for. Whether you go to the drug store or order online to treat the conditions I just mentioned, you are very likely to buy products from Chloraseptic, Clear Eyes, Compound W, and Dramamine. All of these brands are made by Prestige and every one of them has the #1 market share position.

Owning these strong brands, in small niche markets, results in Prestige generating the highest profit margins in their industry. While Procter & Gamble and Johnson & Johnson might be a lot more well known, Prestige Brands turns every dollar of revenue into 34 cents of profits while P&G and J&J manage to squeeze our just 26 cents of profits.

We believe the company will continue to use its prodigious cash flow production (generated by outstanding returns on tangible capital of over 100%) to acquire brands that fit their criteria (those that have been orphaned by a larger company or bought from a private equity firm that has been underinvesting in the brand and/or which has untapped market extension opportunities). While Prestige Brands is a small company, it owns big brands. Five of its brands do over $100 million of revenue each year. Over the counter health care brands this big are rare and despite Pfizer and Johnson & Johnson having market caps over 100 times larger than Prestige, these companies do not have any more $100 million OTC brands than Prestige does. While we own Prestige in our portfolios due to how attractive the returns will be to shareholders on a standalone basis, it seems likely to us that at some point they will be acquired by a larger competitor after they have further built out their portfolio of brands.

It is important to recognize that Prestige is a brand management company more than a product producer. They outsource most of the capital-intensive production aspects of the business. This capital light, outsourcing approach means the company only employs 520 people, generating an amazing $1.7 million per employee. In comparison, most health care and consumer staple companies do closer to $500k per employee and Apple, which has the highest revenue per employee in the technology industry does only slightly more at $1.9 million. Until their acquisition of Fleet a year ago, Prestige had only 259 employees and was doing an amazing $3.1 million per employee.

In managing their brands, they look to drive usage through new form factors or use cases. For example, when they acquired Dramamine (the #1 product for motion sickness) it was marketed only to adults. After doing market research they learned that parents were cutting the pills in half manually to give to their young children for car sickness. So they successfully launched a children’s version and increased distribution in gas stations, where parents were stopping during road trips with their kids. They also learned that the main reason people did not want to take Dramamine was the fact it makes you drowsy. So they launched a natural version (using ginger) for people to take when they are concerned about this side effect. These actions have driven 10% annualized sales growth since they acquired the brand.

When they acquired Hydralyte, it was simply the leading product in Australia to address vomiting and diarrhea-induced dehydration. Over the last three years, they’ve driven over 60% sales growth by extending the marketing message to position the brand as the best way to deal with excessive alcohol consumption, heat exhaustion, pregnancy, fever, and travel. Google searches show that so-called “mommy bloggers” in Australia were touting the hangover relieving effects of Hydralyte at least as far back as 2006, so this is a case of Prestige recognizing an opportunity through market research that the former owner just missed.

Prestige operates in slow growth end markets. The number of people who have a sore throat or itchy eyes is not going to grow dramatically. But it also isn’t going to shrink. In order to be an attractive investment, the stocks of slow growth businesses must offer investors high levels of current free cash flow yield. With Prestige’s free cash flow yield hitting 10% in November, we added significantly to what had been a small position for us. We believe the stock offers the potential for steady, dependable returns over the long term that exceed the market. Importantly, these returns are not dependent on a strong economy as even in the midst of a recession, demand for their products is unlikely to drop significantly.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Prestige Brands (PBH).

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Nike (NKE).

Excerpt (Arif Karim speaking):

Nike is a globally recognized brand for performance shoes and clothing with $34 billion in sales and 35% return on invested capital (ROIC).

This brand is built on the strength of its product innovation and performance, innovative marketing tactics, and global capabilities in manufacturing and distribution. All of these aspects of the company provide it with a moat that allows the company to charge premium prices, earn strong profits, and stay resilient in light of new and existing competitors and waves of fashion trends that have threatened it over time.

Its sales are 50% larger than its closest competitor Adidas and it is more than twice as profitable. The next few competitors, like Under Armor and Puma both at $5 billion, are markedly smaller in scale. When Nike was founded in 1964 by Phil Knight, Adidas was a much larger incumbent in the sneaker business and Nike was the scrappy startup. Knight was a passionate competitive runner and recruited others passionate about running or Nike’s business to build its early success, with a strategy that eventually centered around leading product innovation and more aggressive and creative marketing tactics than the incumbents’ as described in his memoir, Shoe Dog. In time, Nike opportunistically expanded to other sports like football, baseball and basketball.

Over the years Nike successfully built its moat as its brand came to represent innovation, performance, style, and, in the spirit of its namesake, winning. Winning meant partnering with winners, which became a hallmark of Nike’s marketing – signing endorsement deals with athletes who were stars or showed potential to become star performers. They used Nike’s products and their fans bought the shoes their heroes wore to feel connected with their favorite athletes and teams. As more people wore Nike’s shoes in and out of their workouts, fashion became an increasingly important part of the successful shoe formula, blending the utility of performance with fashion elements of everyday style.

As the success of the company grew, it was able to get more stores to carry its products, increasing distribution. Nike got its wholesale retail customers to even commit to advanced orders to secure the most popular styles for their shelves 6 months out. This gave Nike increasing visibility into demand but also created a symbiotic relationship between the company and its key retail partners in both driving and managing demand, which allowed Nike to better manage its supply chain and costs.

As its scale grew towards becoming the largest shoe company in the world, Nike was able to leverage its scale to control the relatively few shoe manufacturers in Asia. Making a shoe is a much more complicated process, with more specialized manufacturing, than making clothing, which is why there are generally fewer opportunities for competition in footwear by new companies. Innovative performance materials, efficiently scaling manufacturing techniques across thousands of SKUs (stock keeping units), comfort, fit, and durability are all key aspects in succeeding in the shoe business at scale. This makes companies with a greater emphasis on footwear, like Nike with 60% of sales from footwear, much more durable than competitors like Under Armor whose sales are much more skewed towards clothing, which is more easily penetrated by new players. You’d rather be the brand leader in athletic shoes while pulling in ancillary clothing sales than the reverse because your core is a much more competitively protected business.

In retail’s age of disruption, this is a key distinguishing characteristic under the constant threat of e-commerce’s behemoth, Amazon, with its crushing scale, speed, and resources, while on the other end are the plethora of smaller startups leveraging social media and fast turn retail techniques to disaggregate markets into smaller tailored niches they could better serve. Through this disruption, we believe the survivors will be those companies with strong emotionally charged brands that can connect with customers, with quick global product design, manufacturing, distribution, and marketing capabilities, efficient scale, and a resilient and adaptable organization.

All of these represent strong aspects of Nike’s moat that position it to continue doing well over the long term, from its world-renowned brand that connects with its customers across channels (via stores, web, mobile apps, and social media), the scale to invest in innovation in product, production, marketing, and distribution, and its ability to seek out and retain the top athlete endorsements in the world in a variety of increasingly global sports like basketball, soccer, running, and tennis.

As an example of the symbiotic cobranding appeal of Nike and its roster of athletes, its most successful partnership with Michael Jordan still drove $3 billion in revenue for Nike’s Air Jordan line in its last fiscal year (about 10% of total Nike brand sales) reportedly netting Michael Jordan royalty payments over $100 million in 2017 some 15 years after his third and final retirement from the NBA. Most of the NBA’s top stars are still signed up with Nike in large endorsement deals worth hundreds of millions with notable exceptions being Stephan Curry and James Harden. The scale needed to compete for these endorsement deals across global sports makes it increasingly difficult for new brands in retail to compete and increasingly irrational for the very top athletes to sign with brands that may not be able to endure over time.

While a brand like Amazon also has emotional ties with its customers, it is inherently based on higher level utilitarian, rational appeals. Amazon is great at executing in retail areas where selection, price, convenience, and reliability are paramount. Undifferentiated retailers just cannot compete. However, Amazon has not been able to develop brands that have ties to deeper, lower level emotions that are potentially more powerful such as team loyalty, hero-worshipping, self-confidence, and self-identity that a company like Nike appeals to. It is no easy feat to create a brand that does this effectively and the impact this has on its consumers is powerful because it’s hard to quantify or articulate that emotional boost, giving the company the upper hand in pricing negotiations in the consumer/company relationship at the purchase point moment of truth.

We got our opportunity to start buying the stock about a year ago as growth began showing signs of slowing from the double-digit range in the prior 5 years to more like the mid to high single-digit range that we foresaw over the next 5 years. The reset in market expectations in spite of continuing strong returns on capital caused the stock to fall from a high in the $60’s to a low of about $50 a share. Its valuation went from a 29x price to earnings ratio to 20x. Our research and valuation work suggested that in our normalized reasonable baseline scenario the stock was meaningfully undervalued given the durability of the brand franchise and returns on capital, as well as the global growth opportunity ahead in underpenetrated regions like China, Europe, and the emerging markets.

While the previous 5 years had seen strong growth from the more mature North American market with the trend towards causal/“athleisure” wear and the emergence of a stronger fashion and collectability trend among “sneakerheads”, 2016 and 2017 saw a plateauing of this trend and, in fact, a shift towards a different style of casual streetwear that corresponded with Adidas’ strategy of partnering with popular celebrities and its retro-styled sneakers. In addition, channel shift has been an ongoing theme over the past couple of years as brick and mortar stores have seen declines in foot traffic and ceded share to e-commerce players, disrupting traditional sales and ordering patterns. While this sort of shift is always a threat especially when the market leader like Nike accounts for half the market, we believe the shifts are a short-term dynamic which will stabilize.

The bigger growth opportunity going forward comes from the international markets, where Nike expects 75% of its future growth to come from and now accounts for about 60% of sales. In addition, this growth is likely to be more profitable over time as its direct to consumer business via its own stores, website, and app will account for a greater percentage of its total sales while creating a more direct relationship with the customer. What excites us is that Nike has oriented itself to take advantage of technological and cultural changes to improve its customer connection, brand experience, and retail position in contrast to most brands that are finding themselves in more defensive positions in adapting to these changes. Its recent shift to its “Triple Double” strategy – 2x Innovation, 2x Speed, and 2x direct customer connections – while reorganizing itself from an organization comprised of functional teams towards a more agile one centered around the 12 most important local influence markets it serves (12 major cities across 10 countries around the world), are examples of the company’s resiliency and adaptability.

The success of this positioning is already showing up in Nike’s latest quarterly results in which its digital sales grew 29%, total direct sales (about 30% of total sales) grew 15%, and international sales grew 14% driven by growth in China and Europe.

While the past couple of years have seen some challenges to Nike’s growth expectations, we believe that the next few years will see a return to healthy growth with improving profitability as a result of the changes management has made to its tactics built on the foundations of the company’s existing moat.

You can read the full transcript HERE.

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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Weekend Reading

6 January 2018 | by Paul Perrino, CFA®

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

Tight Trucking Market Has Retailers, Manufacturers Paying Steep Prices (Jennifer Smith, @jensmithWSJ, WSJ)

Truck drivers were not prepared for the new Federal regulation that started December 2017. Most trucks are now required to “be equipped with electronic devices that monitor drivers’ hours behind the wheel.” This has caused a large imbalance between the number of trucks available and the number of trucks needed. “By the end of last week, just one truck was available for every 12 loads needing to be shipped, according to online freight marketplace DAT Solutions LLC” This caused less urgent cargo to not get delivered and others to pay a premium to move their goods.

California Bill Seeks Ban on Fossil-Fueled Vehicles by 2040 (Ryan Beene, @RyanBBeene, Bloomberg)

Back in September 2017, China announced a deadline for automakers to end sales of fossil-fuel vehicles. California is looking to do the same. Both deadlines focus on the incremental car added to the road. Existing fossil-fuel vehicles will be permitted to run. The hope is that it cuts down on carbon emissions immediately, then dramatically over the long-run. “If adopted, the measure would eliminate a huge chunk of carbon emissions as part of the state’s quest to slash greenhouse gas emissions by 80 percent from 1990 levels by 2050.”

Brooks Needs Runners Who Hate to Run (Claire Suddath, @clairesuddath, Bloomberg Businessweek)

Brooks went from a bankrupt company producing a variety of footwear to a running shoe specialist. They had more runners that wore Brooks at the 2016 Olympic marathon trails, than any other brand. Fruit of the Loom, a Berkshire Hathaway company, acquired them, but soon got the attention of Mr. Buffett when they were doubling in size every three years. Specialization and focusing on their brand was instrumental in that.

Cash Might Be King, but They Don’t Care (Andy Newman, @andylocal, NYT)

With the rise of credit card reward points/perks and convenience, shoppers are opting to use their credit card over paying with cash. This has allowed retail stores and restaurants to no longer accept cash, which can save management time “counting (and recounting) cash drawers that could have been spent coaching new employees and making sure customers have a great experience.”

Ten years in, nobody has come up with a use for blockchain (Kai Stinchcombe, @KaiStinchcombe, Hackernoon)

As crypto-mania reaches new highs, the underlying technology (blockchain) might not be as useful as some projected. Even the main use of blockchain, cryptocurrencies, isn’t working as smooth (users having issues converting back to dollars) or at the scale of existing systems (“ Visa can handle sixty thousand transactions per second, while Bitcoin historically taps out at seven”).

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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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 Monday, January 8 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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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It’s a pleasure to join Ensemble Capital. I couldn’t have asked for a more welcoming and supportive group of colleagues. I look forward to seeing what the team can accomplish together.

About three years ago, Sean reached out after reading one of my articles. I’ve since learned a lot from the team’s Intrinsic Investing blog and social media posts. With time, it became clear that we shared a core investment philosophy – specifically, seeking companies with durable economic moats.

For my first post on Intrinsic Investing, I want to share how my investment philosophy developed and how it is aligned with Ensemble’s approach.

Getting started

My introduction to economic moats came through Morningstar’s 2004 book, The Five Rules for Successful Stock Investing, written by Pat Dorsey. As a liberal arts major in college, qualitative business analysis came more naturally to me than quantitative security analysis. The economic moat framework just made sense to me. See this post that Sean wrote about the role of the liberal arts in investing.

Later in my career, I spent three-and-a-half years at Morningstar as a sell-side analyst. While there, I was immersed in the company’s economic moat methodology.

Warren Buffett, of course, coined the term “economic moat,” but Morningstar developed a framework for analyzing them. Morningstar sought shared characteristics of firms that consistently generated high returns on invested capital (ROIC) when the nature of markets suggests that competition should have eroded those returns.

Specifically, Morningstar identified five economic moat sources:

  • Network effects: With each new user, the company’s service or product becomes more valuable to existing users. A classic example here is Mastercard and Visa – as new consumers sign up, the network becomes more valuable to merchants; and as additional merchants sign up, the network becomes more valuable to consumers.
  • Intangible assets: This bucket includes patents, brands, regulatory licenses, and other factors that allow a company to consistently charge a premium price relative to similar products from peers. Brand awareness, for example, is not enough to have a brand-related economic moat. Everyone has heard of General Motors and Ford, but few would be willing to pay up to own one over the other. Ferrari, on the other hand, can get big markups on its supercars due to its luxury image and the scarcity factor associated with the brand.
  • Switching costs: Firms that use mission-critical products and services in their day-to-day operations are unlikely to change providers to save a few pennies. The expense, whether in dollars or time, outstrips any added benefit from making a shift. Payroll and HR solutions company, Paychex, fits the bill here. Once Paychex is ingrained in a business’s payroll, employee services, and tax form processes, switching providers is costly. Human resources and employees need to be retrained. There’s a risk of messing up benefits or payroll during the transition. As a result, Paychex customers will more than likely renew their contract each year than jump through hoops to switch providers.
  • Cost advantage: Some firms can consistently produce products and services well below their competitors. If peers are aware of this edge and still can’t match it, a durable, low-cost production moat probably exists. Wal-Mart, for instance, has significant bargaining power with suppliers. This advantage allows it to acquire goods at a lower cost per unit than most of its peers. In turn, Wal-Mart can offer its customers low prices while maintaining attractive margins and inventory turnover.
  • Efficient scale: This moat source is relatively rare. There are some niche markets, however, where a new competitor would eliminate the economic benefits for all participants. Three companies dominate the global beverage can industry: Ball, Crown Holdings, and Ardagh. In most cases, can plants owned by these three adequately service the major beverage firms’ filling needs in Europe, North America, and South America. In turn, they typically earn long-term supply contracts and generate low double-digit returns on invested capital. An upstart competitor would need massive amounts of capital and time to enter the market. Even if that were successful, they would likely drive everyone’s ROICs below acceptable levels. This acts as a deterrent to new entrants.

Knowing these moat sources also helps you quickly sort through ideas. If you can’t determine which moat source accounts for a company’s high ROIC, the company probably doesn’t have a moat.

Stewardship

During my time at Morningstar, I led the department’s equity stewardship methodology, which analyzed a management team’s capital allocation skill. More specifically, it looked at the relationship between moat and management. Once we understand the company’s moat source, we can better judge management’s decisions.

Let’s say you think a company has a switching cost advantage. It would be a good sign, for example, to see the firm’s management acquiring complementary technologies or services (at favorable prices, of course) that improve its existing offerings and therefore better attract and retain customers.

On the other hand, management may acquire a firm that doesn’t complement its current offerings. This decision could lead to a narrowing of the switching cost-based moat.

Beyond that, I spend time looking for management personality traits that I believe are common among the top 1-2% of capital allocators. Briefly, I think that CEOs and CFOs who are insatiably curious, can think and act rationally, and behave with integrity are precisely the personality types that you want looking after your investment.

One Pager

A few months ago, I summarized my investment philosophy on a single page and shared it on Twitter. Unexpectedly, it went viral in the FinTwit (aka Financial Twitter) community, reaching over 117,000 Twitter users.

My goal was to have a graphic to help me stay focused on the right type of companies. It’s also led me to dig deeper into situations where only two of the three factors – moat, management, and price – were present.

For example, if management and moat are present, but the stock seems expensive, I need to consider how I might be underestimating the business (i.e., optionality) and be on guard for quality traps.

Onto Ensemble

Just a few weeks on the job, I’ve already learned a lot from Sean and Arif. Their passion for finding and investing in top-shelf companies is energizing. The three of us speak the same language when it comes to moat analysis, and each person has unique experiences that make the team stronger together than we would if we were each working alone.

Clients, employees and/or principals of Ensemble Capital own shares of MasterCard (MA), Ferrari (RACE), and Paychex (PAYX).

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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