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Investors who’ve studied the works of Warren Buffett and Peter Lynch know that so-called “boring” stocks can present wonderful investment opportunities.

There’s something to it. In Lynch’s One Up on Wall Street, for example, he writes, “Blurting out that you own Pep Boys won’t get you much of an audience at a cocktail party, but whisper ‘GeneSplice International’ and everybody listens.”

Boring companies typically don’t make for media darlings. Often there’s not much variance in quarter-to-quarter or year-to-year growth – due to high recurring revenue, pricing power, etc. – so there isn’t a lot to debate.

In a 2013 paper, the British asset management firm, Fundsmith, set out to explain how and why boring companies are consistently undervalued.

As the below chart shows, people tend to be overconfident in low-certainty events (e.g. lottery tickets) and underconfident in higher-probability events (60-80% certainty). As certainty approaches 100% (e.g. a Treasury bond), people become more correctly confident.

Source: Fundsmith

Many high-quality, low-volatility stocks find themselves in the 60-80% certainty category. As Fundsmith wrote, these stocks “have regular bond like returns and low share price volatility but they are still stocks with uncertainty about share price and dividend payments whereas bonds have the relative certainty of redemption values and coupons.”

Put another way, this set of businesses is about as fundamentally certain as you can get in the market, but investors have systematically underinvested in them relative to their level of certainty.

To be sure, patient investors in boring stocks have been handsomely rewarded. From June 1990 through mid-July 2019, the S&P 500 Low Volatility Index outperformed the overall S&P 500 Index by about 100 basis points per year (11% vs. 10% CAGR).

Source: Bloomberg, as of July 16, 2019. Normalized, total returns.

Now, during most bull markets, you would expect economically-sensitive, high-volatility stocks to outperform low-volatility stocks, as they did from December 2002 to October 2007, as measured by the S&P 500 High Beta Index (purple line) vs the Low Volatility index (white line).

Bloomberg, as of July 17, 2019. Normalized, total returns.

Yet here we are today, riding a 10-year bull market and hitting all-time highs, and low-volatility companies continue to crush high beta names.

Bloomberg, as of July 19, 2019. Normalized, total returns.

Don’t get us wrong – at Ensemble, we also love boring, defensive companies flying under Wall Street’s radar. They often have economic moats and get stronger during recessions.

Yet some of these companies’ valuations have been challenging to justify. In August 2016, for instance, we wrote about former holding WD-40 being a case study of the “bubble” in safe stocks.

Remarkably, since we wrote that post three years ago, WD-40 has further expanded its already-lofty P/E multiple and outperformed the S&P 500. In 2016, we would have considered this a low probability outcome, but here we are.

Bloomberg, as of July 16, 2019

WD-40 isn’t alone. As of this writing, the broader S&P 500 Low Volatility Index P/E (blue line) is four full turns above the S&P 500 Index P/E (brown line).

Bloomberg, as of July 16, 2019

So what might be going on here? Why are boring stocks trading with such high multiples?

We offer three suggestions:

First, as we argued in our 2016 WD-40 article, investors might be placing a premium on “safer” equities due to bad memories from the financial crisis. Having experienced 30%-50%-plus drawdowns in 2008 and 2009, many investment managers don’t want to mis-time cyclical stocks and look foolish when their peers are hunkering down in safe stocks. Some amount of herding behavior is at play.

Second, index funds, ETFs, and quantitative screens have changed the game. While active fund managers in Lynch’s day (the 1980s) were worried about bad window dressing by holding boring companies, machines are narrative agnostic. Machines could care less if Stock A is boring or exciting – they see businesses as a set of data points. Because boring businesses often have attractive fundamentals, they might get more demand from passive investors seeking quality, low-volatility, and/or dividend yield factors than they otherwise would with active managers.

(As we were researching this article, we found it notable that the S&P 500 Low Volatility and High Beta Indexes were launched in April 2011, just two years after the market bottom.)

Third, the continuation of the low interest rate environment. We think the debate between a return of the Old Normal or getting stuck in the New Normal is a critical one for investors to consider. If we are moving back to an Old Normal (a “normalization” of inflation, higher rates, etc.) then boring stocks are massively overvalued; however, if we’re stuck in a New Normal (persistent low rates, low inflation, etc.), boring stocks, along with the rest of the market, may be fairly- to undervalued, albeit – and this is a key point/trade-off – with expected equity returns below long-term historical averages.

Indeed, if you’re buying low beta/boring stocks at currently-lofty valuations, you’re making an implicit bet that rates will remain low and that future equity returns will be lower than historical averages. We’ve found we’d have to drop our cost of equity assumptions well below 9% to make current valuations work on some low-beta/boring companies.

All three factors are at play, with interest rates playing the largest role in boring stock valuations. In a low rate environment, the opportunity cost for that extra 20-30% certainty (illustrated in the chart earlier in this post) drops. If you’re getting 2% on 10-year government bonds with 100% certainty, you’re more willing to increase your bet on 70-80% certainty in the hope of getting 5-7% annualized returns. The systematic undervaluation of 70-80% certainty names gets “corrected” in a low-rate environment.

Our opinion is that we’re more likely to return to Old Normal than New Normal, though we’ve heard compelling arguments for both cases.

We have a bullpen of boring, high-quality companies that we’d love to buy at a better price. Though our concerns in 2016 turned about to be early and wrong on a few of them (WD-40 being one), we also know that even great companies can be lousy investments if you pay too much for them.

Boring stocks are beautiful, but only at the right price.

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.

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“There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” -Donald Rumsfeld, Secretary of Defense (2002)

Earlier this year, we wrote about our thinking on how many stocks an investor should own in their portfolio. While the average mutual fund portfolio holds in the range of 100-200 stocks, we argued that the ideal number of stocks in a portfolio is closer to 25 and that anything over 50 was likely a significant negative indicator of the portfolio’s potential to outperform. While there are strong theoretical reasons for why the optimal number of stocks in a portfolio is around 25, we also cited evidence that while most actively managed portfolios underperform, the top 25 stocks in the average actively managed portfolio actually tend to outperform. In other words, for all the talk of active managers underperforming, the real issue is that they hold too many stocks in their portfolios, not that they are no good at stock picking.

But even once you’ve decided how many stocks to own in a portfolio, you need to decide exactly what percentage of your portfolio to invest in each stock you’ve selected. So with this post, we’re starting a series on how we think about position sizing at Ensemble Capital.

We consider three inputs when we size our positions

• Return Potential: Higher return potential stocks get higher weights, all else equal.
• Conviction: Companies in which we have more conviction about their future get higher weights, all else equal.
• Research Stage: The longer we’ve actively researched a company the higher weight it gets, all else equal.

Return potential is pretty straight forward. We value companies based on the amount of cash we think they can return to shareholders over the long term. Conviction we’ll explore in a follow up post. So today we’ll focus on Research Stage.

Earlier in my career, I thought that it made the most sense to do all the research on a company up front and then invest the full amount you intended to invest at once. My thinking was that you shouldn’t invest at all if you haven’t finished your research and if you have finished your research, then you should make your full investment.

This makes good theoretical sense, but it ignores the way that humans actually collect information. The assumption I was making earlier in my career was that I could control what I learned or didn’t learn during the initial research phase on a company and thus I could collect all the needed information to assess a company prior to making an initial investment. But this isn’t how the human mind actually operates.

The short video below is a rather amazing demonstration of what we’re going to discuss in this post. Give it a view before reading the rest.

(click here to watch the video if you are reading this in an email)

Did you pass the test? If so, well done. But studies show that less than a third of viewers notice what’s most important in the video. So even if you passed, if you were to take a lot of tests like this one, you’d likely fail over two thirds of them. Of course, now that you know what to look for, if you rewatch the video it will be impossible to miss.

This concept shows up in a number of different contexts. The “cocktail party effect” for instance, describes the way that when you are at a crowded cocktail party you are able to filter out all the many sounds and visual stimuli, and focus your attention on the person you are speaking to. Of course, while this is an important skill for humans, this filtering also means that when you are focused on a particular person at the cocktail party, you won’t notice much about what is going on around you.

The psychological concept of “priming” plays a role here too. Priming is when your brain is prepared ahead of time to notice certain things (and thus, as we saw in the cocktail party effect, ignore other things). In the video, you were primed to notice the number of passes being made. But had the narrator not primed you, you would have been much more likely to notice what was really important in the video, as your focus would have been more diffuse. That being said, without being primed to count passes, you almost certainly would not have known how many passes had been made.

Importantly, these effects operate at an unconscious level. You might think that your conscious mind can overcome these effects and you can choose what to pay attention to. But all I have to do is say “don’t think about an elephant” to demonstrate that the conscious mind has little ability to override unconscious thought processes.

OK, so what does all this have to do with position sizing? Basically, the amount of relevant information you have about an investment opportunity plays an important role in the likelihood that your assessment of that opportunity is accurate. Unfortunately, your ability to gather a portion of that information is limited due to the effects above.

Prior to researching a company you can not know what is most important to pay attention to. Until you figure out what to pay attention to, some critical aspects of a company will be literally invisible to you no matter how hard you look.

An example: Years ago, we invested in ScottsMiracle-Gro (SMG). I owned a house with a lawn at the time, but I had never paid that much attention to it. After researching the company and making an investment I suddenly found myself noticing a lot about my lawn (in particular, how poorly I had been maintaining it). I also started noticing other people’s lawns. I began noticing ads on the radio for lawn and garden supplies and most importantly noticed that most of the ads for Scotts products were actually ads being paid for by Home Depot and Lowe’s. Why in the world were the retailers paying to advertise a manufacturer’s product? The answer to that question held the key to understanding Scotts.

All of this information had already been present in my life prior to investing in Scotts but had been effectively invisible to me. But actually making an investment in a company focuses the mind. While this type of information may not have been critical to the research process in isolation, it all worked together to help build the mosaic of understanding I constructed over time about Scotts. It broadened my context and helped me place critical information into a more robust understanding of the value proposition of the company.

The priming of our brains to pay attention to relevant information about an investment takes time. But it is critical to minimizing the scope of what Donald Rumsfeld called “unknown unknowns” in the quote at the top of this post. When you first start researching a company, most of the information is unknown unknowns and it is impossible to prime your mind to pay attention to things that you don’t even know about yet.

This process is not just about general information of the type I described in the Scotts example. It is also critical to absorbing the most important information from research reports and company data.

An example: When we first invested in Netflix in the summer of 2016 our thesis was similar to the same thesis we have today, with one key difference. We understood from our initial research that Netflix was building a moat around their business. And we understood that the more content they offered, the higher they could push up the subscription price while the higher they pushed the subscription price, the more content they could afford to offer. We knew that the company was underpricing their subscription offering and that it would move higher over time. But initially we didn’t have a robust view on where exactly pricing might go over time as we didn’t yet fully appreciate how massively important the assumption around long term pricing was to the value of the business. But as we spent more time as shareholders, we came to focus more and more on the long term subscription price and begin understanding data that we already had in hand in a new light.

As the video showed, the research stage position sizing process isn’t just about giving ourselves time to find new information, it is also about giving ourselves time to see the information that is right in front of our nose.

It seems like this should be so easy! But as George Orwell wrote in 1946, “To see what is in front of one’s nose needs a constant struggle.” This is particularly true because humans use “conventional wisdom” or “whatever the tribe believes” as an initial filter to process information. But investing is about building a differentiated point of view. Thus when we are first researching a company, you will not see what is in front of your nose, you will only see what everyone else says is in front of your nose.

Early in a research process, it is easy to recognize  “known knowns.” We can also establish the “known unknowns.” But by definition, it is impossible for us know what the “unknown unknowns” are.

Eliminating unknown unknowns takes time. Not time of detached contemplation and consideration, but time filled with the emotion rich focus that comes with making an investment and caring deeply about its outcome.

After coming to understand this dynamic, Ensemble moved to a three stage research process.

• Starter Positions: After performing initial research and coming to a conclusion that a stock is a buy, we will only take a very small position.
• Research Positions: After a stock is qualified as a starter position we continue researching, but now we’re better primed to process what’s most important and can better focus on the critical information and filter out the noise. After a period of time following the company in this phase, we will increase our position size to about half of a full size position.
• Core Positions: After following a company for a bit longer as a research position, we begin to build confidence that there are no significant unknown unknowns that will impact the outcome. We’ve established the known unknowns and determined that they are not critical to the investment thesis or that they constitute a level of known risk that is acceptable within the context of the overall investment thesis. At this point we take a full size position.

Unknown unknowns can of course be positive attributes or opportunities, but in limiting our initial position sizes we are focused on limiting our risk of exposure to negative unknown unknowns. Importantly, this process is not about “averaging into a position.” We do not increase our position over time in an attempt to pay a lower average price. Instead, the scaling into an investment is about increasing our position size as we become more confident that we have minimized the risk of unknown unknowns with potentially negative implications.

Next up in this series on position sizing, we’ll explain how we transform qualitative assessments about a company into a quantitative conviction score and then use these scores to size positions in our portfolio.

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.

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Below is the Q2 2019 quarterly letter for the ENSEMBLE FUND (ENSBX). This quarter’s Company Focus is on Fastenal Co (FAST) and Starbucks Corp (SBUX). You can find historical Investor Communications HERE and information on how to invest HERE. Enjoy!

Well it certainly has been an exciting first half of the year. It is amazing to think that just two quarters ago our letter focused on why we thought the market was already discounting a mild recession and it made sense for investors to stay long US equities. We appreciate your interest in hearing from us in good times and bad.

The performance of the Ensemble Fund (“the Fund”) this quarter was strong, showing the continued absolute and relative performance trends that we saw last quarter. The Fund was up 6.62% vs the S&P 500 up 4.30%. On a year-to-date basis, this brings the Fund up to 25.15% vs the S&P 500 up 18.54%.

As of June 30, 2019

*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.

The strength in the Fund during the quarter was driven by big moves from two of our largest positions with Broadridge (7.0% weight in portfolio) up 24% and Ferrari (7.1% weight in portfolio) up 22%. We also saw double digit gains from Starbucks (4.8% weight in portfolio), Mastercard (6.6% weight in portfolio), Trupanion (2.4% weight in portfolio) and Verisk (3.3% weight in portfolio). On the weaker side, Charles Schwab & Co (4.8% weight in portfolio) and First Republic (4.8% weight in portfolio) both declined as interest rates fell and Google (also known as Alphabet) (6.5% weight in portfolio) fell 8% as news broke that the company would be investigated by the Department of Justice on antitrust grounds.

Like most investors, we’ve spent a lot of time this year thinking about the ways in which a recession, and/or a heating up of the US-China trade war, might impact the economy and the companies in the Fund. However, at the same time we’ve advocated the idea that when it comes to recessions, the best approach is to invest in strong companies that will thrive coming out the other side of recessions rather than trying to guess when a recession is on the horizon and attempt to get out of weaker companies just in time. On the trade war, as much as we think what happens is quite important, we also think that a US-China trade war will likely be a key feature of the investment landscape for the next decade or more. So rather than trying to guess what short term changes might occur, we’re more focused on making sure we own companies that can navigate a shifting set of trade rules over the medium to long term.

But for all the focus on the trade war, when you look at the stocks that most influenced our performance, the trade war was not a material driver.

Broadridge, a service provider to banks and brokers, rallied 24% in the quarter as the company reported their third fiscal quarter and continued delivering the message that the quarterly misses of expectations that had occurred earlier in the year were due to timing issues, while their full year results continue to be on track. The stock has performed about in line with the market over the last nine months. But after hitting an all-time high last September, the stock sharply underperformed in the fourth quarter, dropping as much as 30% as investors got caught up in the optically weak quarterly reports. But as 2019 has worn on, it has become clear that the difficulties in quarterly results last year was entirely transient and was not at all an indication of a slowdown in the core business. This realization has led to the stock rallying 40% this year. While market overreactions to transitory issues are not always this dramatic and don’t always reverse so quickly, the decline and rebound due to the short time horizon of most investors offered us a great opportunity to add more shares during the weakness and then trim back our position after the huge, quick gains. While we are long term investors, we are also willing to opportunistically add to, or trim, our positions when market pricing swings as dramatically as it did recently with Broadridge.

Ferrari tacked on another 22% in gains after posting a 35% return in the first quarter. With the stock now up 64% this year Ferrari has been a big driver of our performance. But like Broadridge, part of these gains are a recovery of what we thought was an undeserved selloff in the fourth quarter of last year. In our view, the four quarter sell off was due to market worries about a recession and auto tariffs. But both of these concerns are misplaced. Ferrari is actually the most recession resistant of all car companies. This is because of the 18-month wait list to buy a Ferrari and the fact that people who have enough money to buy a Ferrari almost always still have enough money during a recession. And while Ferrari could be subject to auto tariffs, their buyers are not very price sensitive. We saw this dynamic at play last year when the company announced their Monza supercar would be sold at a price of “somewhere between $2 million and $3 million” and then promptly sold out before they ever revealed the final price. This dynamic of companies with strong pricing power having a weapon to offset the impact of tariffs is an important part of how we think investors should seek to insulate their portfolio from the very real risk of a prolonged US-China trade war.

The strong returns from Starbucks, Mastercard, Trupanion and Verisk were all related to these companies continuing to generate solid results. For many of our Fund holdings, it isn’t so much that we think they will generate surprisingly strong results relative to short term expectations. Instead, it is far more common that we simply think that the Fund holdings have such strong competitive advantages that they will resiliently bounce back from short term challenges and can continue to churn out solid results for far longer than the market gives them credit for. That’s why we are often most pleased by under the radar performers in the Fund that may not always be sexy and exciting, but which grind out results to be proud of for decades at a time. Later in the letter we’ll discuss Fastenal, a company that fits this description very well.

On the weaker side, we saw both First Republic and Charles Schwab & Co decline due to interest rates falling. Both companies generate a significant part of their earnings from their “net interest margin” or the spread between the rates they pay their clients for depositing cash with them vs the higher rate they earn from lending that money back out. Over the last quarter, not only have interest rates declined, but the yield curve has flattened or even inverted, meaning that there is little or even a negative spread between very short-term interest rates and longer-term rates. We are of the view that over the medium to long-term, the interest rate yield curve will be steeper, as it has typically been in the past, and that interest rates across the board will be higher. But we recognize that we could be wrong about this. Interest rates are not easy to forecast. However, one reason to only buy stocks when they appear cheap is because that cheapness can help offset weaker than expected financial performance.

In the case of First Republic, the company has long managed their interest rate risk in such a way as to make their net interest margin very stable, even during period of large changes in interest rate levels. They give up the opportunity to generate outsize returns during periods of attractive interest rates regimes, but they also protect themselves against tough environments like we see today. Charles Schwab & Co sees more volatility in their net interest margin, but the company has also proven themselves adept at figuring out multiple, alternative ways to monetize their customer relationships over the years. With both First Republic and Schwab winning tons of new customers in recent years, we know they are delivering on their value proposition. We believe that in both cases, the companies will generate significantly higher earnings in the future than they do today. But even if we are too optimistic in our interest rate outlook, we think both stocks are cheap enough today to perform just fine.

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.

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.

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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 Starbucks Corp (SBUX)

Excerpt (Sean Stannard-Stockton speaking):

While manufactures depend on Fastenal for inputs that power everything they do, the same might be said for the role that coffee plays in many people’s lives. Speaking for myself at least, without my regular dose of daily caffeine, the rest of my day pretty much grinds to a halt. Luckily for me and the rest of humanity responsible for consuming 400 billion cups of coffee every year, while caffeine is addictive, studies have continuously found it has very limited negative health implications with more and more studies pointing to its role in making people happy, healthy and productive.

It is for this reason that when we added Starbucks to our portfolio last year, we joked that the company was like Philip Morris and McDonalds rolled together but with the negative health implications removed. In our view, Starbucks is the premier global supplier of a key aspect of the human diet. Like all addictive substances, consumers of caffeine wrap their habit in a set of rituals. It is these rituals that provide an opportunity for Starbucks to cater to their customers desires in a way that is highly profitable.

The ritual of coffee consumption is important to Starbucks core customers. In the US, 40% of sales are made to active rewards members, those people who have the Starbucks app on their phone and use it to pay. Of these customers, half of them visit a Starbucks 16 times a month on average. In some ways, the Starbucks digital payment system can be considered the most successful digital currency of all time.

Katherine Fischer, who introduced the call today, has told me that she orders a Starbucks drink from their app on most work days. The app saves her preferred drink – a venti Americano with a regular splash of steamed soy milk – so just two or three clicks on her phone will have her favorite drink waiting for her to pick up on her way to the office. When I asked Katherine to review this part of our call script, she pointed out that she doesn’t only go on most weekdays, but often orders from Starbucks on the weekends as well and in fact had ordered twice this past Sunday. And in addition to her coffee-based drink, Katherine noted that she will occasionally add a spinach feta wrap if she needs an easy meal. Picking up a mobile order at Starbucks literally takes about 15 seconds. This is important to a parent of young children like Katherine who told me “When I’m with my kids the Starbucks mobile app it is such a lifesaver. It means I don’t have to wait in line and tell the kids no to pastries when all I want is my morning coffee.”

So what happens if a new coffee shop opens near Katherine and offers a modestly cheaper or even better product? Habits are powerful drivers of human behavior. Starbucks mobile infrastructure is designed to remove friction from the experience of buying from them. So while a casual coffee drinker out for a walk and planning to wait in line anyway might give the new shop a try, a mobile first, habitual Starbucks customer, of the type that generates as much as 40% of their revenue, experiences much higher “switching costs” to try something new. Add in the rewards they offer to these customers and competitors need to offer significantly superior value propositions to steal customers away.

There is one type of coffee retailer that is trying to do just this. Known collectively as Third Wave Coffee, these retailers lead by Blue Bottle and including many local and/or small chain stores, are attempting to offer a significantly higher end experience. Our bullish view on Starbucks is not based on a belief these efforts will fail, but instead only that they will take limited market share and that Starbucks own Roastery and Reserve concepts will win a segment of customers wanting this higher end experience.

Mike Navone, one of the advisors here at Ensemble, is currently on vacation in Italy and sent us back a report of his visit to Starbucks Milan Roastery location. Here’s what he wrote:

“If there was one takeaway from Starbucks Milan I’d say two words: an experience. It was beautiful inside and the place was packed. Upon entry, you’re greeted and directed to where you should go (food, coffee, or the bar). We had espresso martinis. The server recommended some other drinks but at over 20 euros each we stuck with our martinis. Drinks surprisingly came with a full cheese board with olives, a nice touch! The couple next to us ordered one of the expensive drinks and the server said we should watch the preparation for ‘the experience.’ It was neat. Very carefully made with a beaker to steep, then shaken with ice. They wheeled out a special cart just to make this drink. Everyone was watching and taking pictures.

Then a huge copper cylinder in the center of the cafe had all the panels open up, like a flower blooming, and it revealed the coffee beans being sent to be washed, roasted, and packaged. There were no less than 30 people filming with their phones. The cafe was great, not a place to grab and go but instead stay for the experience and the show. It’s pricey but felt worth it for the unique experience.”

Now many retail products have gone through a premiumization process in recent years. Whether it is high end chocolate, craft beer or organic, locally sourced produce, consumers have shown an appetite for replacing traditional mainstream products with higher end versions. Our contention is that this process has already happened with coffee and it was triggered by Starbucks successful efforts to premiumize coffee in the 1980s and 90s. While craft beer today still only makes up 25% of the beer market, Starbucks flipped closer to 80% of the coffee market to premium. What we see now with Third Wave Coffee is an ultra premiumization trend. For a small slice of the coffee market, some customers are willing and able to spend even more on their coffee and they seek a truly authentic experience. On our own research team, Arif is a fan of Blue Bottle and other Third Wave coffee shops. While he rarely visits a Starbucks on his own, he will admit that when traveling with his wife and children, they will often choose Starbucks because it offers a range of products to fit their varied needs. And so in the end we do not believe that the Third Wave trend is so broadly applicable that it threatens Starbucks in a meaningful way.

We’ve written in the past about the difference between search cost brands and identity brands. The former are those brands that offer a guarantee of a good product at a consistent quality level. The latter offers the purchaser a signal to them or their peers that reinforces the buyers’ self-identity. Our contention is that in branded consumer products, search cost brands are dying as consumers have come to depend on Amazon star ratings and social media recommendations to influence purchase decisions. But Starbucks offers a service, not a product. When you are in a new town, or in an airport or even just in a different part of your home city, Starbucks offers a specific, known and consistent value proposition based on delivering you the dose of caffeine you seek and wrapping the purchase with a range of healthy foods or tasty treats as the occasion might call for. Speaking for myself, being served a bad cup of coffee is really annoying. And like most coffee drinkers, I have strong preferences that map not so much to objectively high or low quality, but instead are driven by what I’m used to. I saw this preference on display recently when I was at JFK airport and found myself walking past five separate places offering coffee in order to buy from Starbucks, the brand I trust to provide me the coffee I crave.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Starbucks Corp (SBUX).

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 3^rd 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 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.

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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 Fastenal Co. (FAST)

Excerpt (Todd Wenning speaking):

Fastenal is a company that most people have never heard of, yet it touches nearly everything we see around us.

Fastenal specializes in the curation, management, and logistics of moving billions of low value parts like nuts, bolts, screws, rivets (collectively known as fasteners) and other products from their point of origin around the world to their destination at or near the factory floor in a timely and cost-effective manner.

Fastenal’s customers are manufacturers of end products we use every day, like cars, airplanes, furniture, appliances, electronics and so on.

While each of the parts Fastenal moves is low value, their role is essential in the manufacturing of high value products and the health of the manufacturers’ operations. Delays in their supplies or having the wrong type of fastener in inventory can mean millions of dollars in costs for the manufacturers in the form of slowdowns, shutdowns, or poor product quality, safety, and recalls.

Fastenal’s business is focused on making sure its customers have the right parts at the right time in the right place. If you’re missing one type of screw on a $10K or $100MM machine, you’re not shipping the product out today. At the same time having too many parts laying around can be costly and wasteful. Fastenal’s role is to provide the mission-critical but low value products efficiently and reliably to their customers’ factories.

Fastenal’s services therefore cater to customers who value its ability to deliver both reliably and cost effectively because it aggregates the demand of its customers to extract higher volume discounts from suppliers. As a result, customers see compounded savings across their procurement chain.

In many cases, Fastenal is so deeply tied into customers’ operations that it manages the real-time stock of inventory for their plants and takes on the burden of inventory costs on their behalf, helping them not only run their plants smoothly but also in managing their working capital more efficiently.

Over time, Fastenal has also expanded on the types of materials it provides on the factory floor beyond fasteners to include things like safety goggles, tools, metal suppliers, janitorial supplies, and other consumables that have similar distribution benefits and leverage Fastenal’s expertise and infrastructure. And in fact, these other materials now account for most of its revenue with traditional fasteners accounting for less than 40%.

In return customers have rewarded Fastenal with a healthy premium above the cost of supplied parts, which is what’s driven the 20% return on invested capital that’s underpinned the stock’s return over time. Since it went public in 1987, Fastenal’s stock has returned a compounded 23% per year.

While most people have never heard of the company, Wall Street certainly has. In 2012, BusinessWeek ran a story highlighting the fact that in the prior 25 years since the crash of 1987, Fastenal had appreciated by 38,600% making it the best performing stock during that time period. But it wasn’t just great fundamental performance that had driven the returns, there was also the fact that in 2012 the stock was trading near its all time high valuation, with a PE ratio of 37.

We took note of the company at that time but passed due to the valuation. Since then, the company has continued to execute very well, doubling earnings. However, from the time of the BusinessWeek article to our first purchases of the stock last summer, the stock only returned 40% (or 5% per year) while the S&P 500 returned 140% (or 15% per year). With rising earnings and a lagging stock price, we ended up being able to buy the stock last year at one of its lowest ever valuations, setting up what we hope will be a return to strong outperformance.

Fastenal’s growth is heavily tied to North American manufacturing growth, where its customers predominantly operate. It also grows by increasing its share of spend penetration by winning over more customer plants and selling adjacent consumables for the factory or its workers to keep the plants running smoothly. This also further entrenches Fastenal with its national accounts by getting even deeper into customers’ operations with tens of thousands of vending machines it directly manages in factories and hundreds of dedicated on-site stores within them. All of these bring Fastenal closer to its customers and deepens and expands its relationships, making Fastenal hard to displace.

Over the past decade, Fastenal has grown revenue by about 9% per year, with several points of that growth coming from market share gains. With only $5B in revenue in 2018, Fastenal still has a long growth runway available to continue increasing its share of a very fragmented market, estimated to be about $140B in the US alone.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Fastenal Co. (FAST).

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 3^rd 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 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.