Below is the Q3 2019 quarterly letter for the ENSEMBLE FUND (ENSBX)This quarter’s Company Focus is on Mastercard Inc. Class-A (MA) and Tiffany & Co (TIF). You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of the Ensemble Fund (“the Fund”) this quarter was approximately in line with the overall market. The Fund was up 1.48% vs the S&P 500 up 1.70%. On a year to date basis, this brings the Fund to up 27.01% vs the S&P 500 up 20.55%.

As of September 30, 2019

3Q19 YTD 1 Year 3 Year Since Inception*
Ensemble Fund 1.48% 27.01% 6.95% 14.84% 12.82%
S&P 500 1.70% 20.55% 4.25% 13.39% 11.56%

*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.

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

One of the more important drivers of equity returns recently has been something that did not happen. The US did not go into a recession. Back in the 4th quarter of 2018, many investors began to fear that a recession was near at hand after strong levels of economic optimism had characterized the first nine months of 2018. But as we pass the one-year anniversary of these fears exploding into the public consciousness, the unemployment rate has remained at low levels, solid rates of economic growth continues, even as the US laps quite strong levels of growth last year, and corporate revenue and earnings continue to grow.

Notably, the decline in home sales that began last summer and was a key sign of potential economic weakness, has now reversed and returned to growth. As we discussed in a blog post in November of last year examining the housing weakness, even indicators like declining home sales that have a decent historical record of predicting recessions, are not by themselves actually strong evidence that a recession is coming.

While the overall US economy has not gone into a recession, the manufacturing and industrial segments of the economy have slowed to a crawl and are running at near recessionary levels. This is actually the third such slowdown over the last ten years. During both of the past slowdowns, as well as so far this time, consumer spending, which makes up 70% of the US economy, has remained resilient.

In the fund, we have Mastercard (6.2% weight in portfolio) trading near all-time highs as the company directly benefits from consumer spending with management saying they see continued growth. On the other hand, we have Landstar Systems (4.7% weight in portfolio), which facilitates transportation of goods shipped via big rig trucks. The company’s flatbed segment specializes in moving heavy equipment used in manufacturing and industrial industries and the slowdown in these end markets is evident in the company’s financial results.

But as is normal, the drivers of the Fund performance this past quarter were primarily company specific items, rather than macro trends. Notable areas of strength in the Fund during the third quarter included TransDigm (3.3% weight in portfolio) up 14%, Google (7.2% weight in portfolio) which rallied by 13% and First American Financial (4.7% weight in portfolio) which gained 11%. TransDigm’s gains were driven by positive updates from the company on the integration of a large acquisition they completed recently. The strength in Google came from a strong earnings report, which calmed market concerns related to the previous quarter in which the company missed earnings expectations. And First American’s stock benefit from the rebound in housing sales.

The primary source of weakness in the Fund was Netflix (6.0% weight in portfolio), which fell 27%. We also saw modest declines of 5% and 3% respectively in Ferrari (6.6% weight in portfolio) and Oracle (4.5% weight in portfolio). The decline in Netflix’ stock was caused by weaker than expected new subscriber additions in the most recent quarter and investor concerns about competition from Disney Plus, launching in November. We’ve written extensively about Netflix, but in short, we believe that the weaker than expected subscriber results was within the range of normal volatility seen when the company raises prices and we believe that Disney Plus will do well, but a slate of blockbuster movies and kids TV shows will be an addition to, not a replacement for, a Netflix subscription. The declines in Ferrari and Oracle were relatively modest, with Ferrari’s decline more a consolidation of gains earlier in the year (the stock is still up over 50% this year) while Oracle declined some on renewed concerns about their shift to a software-as-a-service business model, and yet the stock remains up over 20% so far this year.

Later in the letter, we will be discussing two of the holdings in the Fund in more depth. However, in addition to investors being interested in the positions in the Fund, we are often asked why we don’t own certain companies. Given the Fund is a focused portfolio of 15-30 stocks, we spend a significant amount of time researching any company before it enters the Fund and then we continue to engage in rigorous research as long as we are shareholders. So, sometimes the answer to why we don’t own a certain stock is as simple as the stock in question has never made it to the top of our priority list. But we also research and ultimately pass on many potential investments that are perfectly good companies.

CLICK HERE TO READ THE FULL LETTER

DISCLOSURES

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.

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.

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 Friday, October 4 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.

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.

“I do believe in simplicity. It is astonishing as well as sad, how many trivial affairs even the wisest thinks he must attend to in a day… So simplify the problem of life, distinguish the necessary and the real. Probe the earth to see where your main roots run.”

– Henry David Thoreau

According to a quick Bloomberg screen, there are about 2,000 companies in our investible universe. At any given time, we’ll own between 15 and 30 of them.

To narrow down the list of potential portfolio holdings, we employ a framework borne out of both our personal and team experiences.

Over the past four years, we’ve written dozens of blog posts that have elaborated on this framework. We wanted to boil all of that down into a one-page diagram that shows, as Thoreau put it above, where our “main roots run.”

Before we invest in any company, we must believe that three key factors – management, moat, and forecastability (which informs our valuation) – are present These factors are of equal importance.

Indeed, if even one of the factors is missing, we consider the idea a trap. We haven’t written specifically about traps yet, so here’s a summary.

  • Commoditization Trap: If we have concerns about a company’s moat durability or its relevance over the next decade, we pass on it. This is true even if we like the management team and can understand the business model. Sure, great management teams can turn around struggling operations, but these examples are often best discovered with hindsight. An eroding moat or a low-growth business both hint at the company losing relevance, which we believe are underappreciated risks.
  • Stewardship Trap: An award-winning garden left in the hands of an absentee caretaker will eventually grow weeds. To remain in top condition, the garden needs constant attention from a caring steward. We don’t want to invest in businesses that, as others have put it, “any idiot” or “a ham sandwich” could run. In an age of rapid innovation, global competition, and cheap and abundant capital, every company needs competent leadership to remain relevant.
  • Complexity Trap: At times, we’ll identify companies with Visionary or Optimizer leadership and a wonderful track record of high returns on invested capital (suggesting the presence of a moat), but we don’t find the business intrinsically understandable. Sometimes key information is inaccessible or technically challenging to understand, making it difficult to fully appreciate downside risks. Other times, the business model operates in many competitive arenas and we can’t get a firm grasp of unit economics to make confident forecasts.

The majority of companies do not satisfy all three of these criteria, and are thus un-investable for us. This does not mean these are bad companies. On the contrary, most of the companies we look at fall in the top quartile of public businesses.

Indeed, it’s rare when moat, management, and forecastability are all present. But those are exactly the types of companies we want to own in our concentrated portfolio. We won’t always get it right, of course, but by setting a high standard for our portfolio, we believe we increase our odds of achieving better outcomes.

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.

Ensemble Capital’s chief investment officer, Sean Stannard-Stockton recently appeared on the Investing City podcast. The interview is a deep dive into Ensemble’s investment strategy, the history of our company, how we analyze investment opportunities, mistakes we’ve made in the past, and even an explanation of what led teenage Sean to give up on his dream of becoming a major league baseball player to go all in on investing.

Click here to listen to the podcast.

For more information about positions owned by ECM 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.

“The son of [Reed Hastings] must not become a Jedi.”

Much to the chagrin of the traditional media Empire industry, Netflix has become the leader of the global direct to consumer (DTC) streaming media (OTT) business it founded with a staggering 150MM subscribers globally. We believe the global scale it’s built up in the business makes it too big for all but a handful of traditional media and global tech companies to compete with. For a more in depth look at its business and strategy, please refer to our deep dive Netflix report.

The market will become much more exciting with the launch of new competitors over the next year, especially offerings from the largest traditional media companies. The new Disney Plus service will launch in November 2019 in the US, Canada, Australia, New Zealand and the Netherlands, with plans to expand globally over the next couple of years. Disney’s DTC service will be followed by Apple’s TV+ and Time Warner’s HBO Max (reboot of HBO NOW plus more TW content) services in soon thereafter.

In our view, the global market is large enough to accommodate 3-5 global media players and many consumers will subscribe to 2 or 3 services offering their favorite content. We believe direct streaming services are redirecting the Pay TV industry’s traditional value chains around the world while expanding the market by leveraging global scale economics and modern low cost distribution via “smart” devices and 4G/5G connectivity.

Having said that, it is important to separate Netflix’s US (maturing) and international (nascent) markets.

“Do. Or do not. There is no try.”

In the US, as the pioneer in streaming video whose odds looked very long only 7 years ago, Netflix has already won. More than half of all Americans subscribe to Netflix, which is more than all the Cable TV subscribers combined (which are in slow steady secular decline). We don’t think there is a ton of growth left in the number of subscribers in the US, especially since a significant fraction share passwords, but we do think Netflix can continue to raise the price they can charge (we also believe password sharing is intentionally leveraged as a viral customer acquisition strategy and, in fact, paid for by its service pricing strategy).

Netflix is already quite profitable in the US, with an estimated operating margin of 25%*. Last quarter they raised the price in the US by 13% and still kept 99.5% of their subscribers, resulting in an 11% q/q increase in net US revenue. You can imagine what that does to enhance profitability given that a substantial portion of the increase falls to the bottom line (profits grew 20% q/q). Compare that with the narrative that “Netflix lost 200K US customers in the quarter, they’re losing their pricing power!”

As we’ve discussed in our post on Netflix’s pricing power, immediately after past price hikes, there have been one or two quarters of increased subscriber churn followed by a bounce back in subscriber growth. The June 2019 quarter was just the latest quarter to see a similar, expected phenomenon though the exact magnitude of the impact is always hard to forecast. We believe the churn is due to initial “sticker shock” and Netflix’s customer friendly policy of clearly alerting people to price increases with a simple button to cancel. But about a quarter or two later, most of these churned-off subscribers hear about a show that all their friends are talking about or realize how wonderful the convenient advertising-free service had been and sign back up, realizing that it is still an amazing bargain at $13/month for essentially a mini-cable bundle offering thousands of hours of instantly on-demand shows and movies.

“I’ve got a bad feeling about this.” 

Investors are quite worried about Disney’s new steaming services, and for good reason, given its well-regarded global brand with strong marketing capabilities, popular IP based video franchises (Disney characters, Star Wars, Marvel, Pixar, etc.), and its multi-year commitment towards global expansion of its streaming services. But Disney is very late to the game and has a lot to learn about going direct to consumer with a subscription business, the execution of which is tougher than most realize. No doubt, Disney will figure this out through years of dedicated experience as Netflix has over the past 2 decades.

“Be careful not to choke on your aspirations, Director.”

After everyone thinking Netflix was bound to fail, the iconic Disney has smartly and humbly realized that their only choice is to try to copy Netflix’s strategic playbook (literally!) to scale quickly and stay relevant in the long run. We believe Disney’s new service is likely to be a big success. But the “product” it is delivering to its subscribers is primarily going to be Disney’s brand of movies and shows. So, it will be more like HBO (a great niche premium channel) while Netflix has a broader set of content akin to an entire cable bundle (a broad selection, cable TV replacement). Disney is hoping that by bundling Hulu with Disney Plus for the same price as Netflix that they can compete directly, but Hulu is not new and has attracted about 30 million compared to Netflix’s 150 million.

That said, it would not be unexpected to see a quarter or two of impact to Netflix’s gross subscriber additions in the US, as a certain proportion of new to streaming video customers give Disney Plus a try, and churn rates to increase, as those Netflix subscribers who value it the least get over their inertia (inertia is a beautiful thing in subscription businesses!) and try a big new competitively priced service instead. A couple of quarters later, we believe we’ll see the playing field become more balanced, with the vast majority of Netflix’s subscribers keeping their service while many of Disney Plus’ new subscribers will be adding it as their second streaming service.

The bigger impact to the entire market will be that the surge of streaming service options, each with its own package of unique content, will finally kill cable television service model. If for $25-40/month you can get Netflix, Hulu, Disney Plus, ESPN Plus and Amazon Prime video, who will keep cable TV? This will free up $100/month of video spending for most households and, while Disney and others will certainly win some of that, we believe Netflix will remain the default service and the de facto leader while the traditional cable companies’ ongoing businesses will be to supply the broadband pipes connecting them.

“The Force is strong with this one.”

Despite its scale and leadership advantages in streaming video, Netflix isn’t sitting still. They are taking their large US profits and reinvesting in dominating international markets where they are far ahead of everyone else. This makes the company look less profitable overall since they grow via income statement spending (outsized content and marketing budgets), not capex as a physical assets company traditionally would have. And though its international business just turned the corner on profitability, we believe it has a long way to grow as the US market has done. Longer term we expect they will raise prices in their international business just as they have successfully done in the US .

At today’s $16/month for their top tier service with four 4K simultaneous streams, people can share the service and pay as little as $4/month each (or subscribe separately to a single mobile stream in some emerging markets like India), which is a bargain for all the billions of dollars of great content they get access to so affordably and conveniently. However, the fixed cost nature of content makes each of even the lowest priced marginal subscribers very profitable and their aggregated spending continues to feed the Netflix content engine that benefits all existing subscribers, even as they scale the add grows the Netflix’s overall margins.

“You can’t stop the change, any more than you can stop the suns from setting.”

So bottom line: we do think competition is ramping up and Disney will be successful, but we never expected that the other media players would fail to compete forever. The fact that they are now recognizing that Netflix has successfully pulled the rug from under their businesses and must be copied doesn’t change our positive view on the company, especially since we believe it is far ahead of the competition on its ability to recruit and retain subscribers, source a variety of locally and globally relevant content, and access deeper into the global market with local partnerships, and most importantly, its culture of customer focus and innovation.

Netflix has already grown to become a global scale media company, so the onus is on the competition to execute and invest billions (in the form of losses for years) in order to do the same to be viable long term competitors.

*Pro forma ECM estimate based on reported US contribution margin and geographically proportionate operating expenses.

For more information about positions owned by ECM 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.