(Ep.39) The Acquirers Podcast: Ensemble Capital – Competitive Advantage, Long-Only, Concentrated, High Conviction, High Quality

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Summary

In this episode of The Acquirer’s Podcast Tobias chats with Sean Stannard-Stockton and Todd Wenning of Ensemble Capital. The firm has a very traditional buffet style, highly concentrated high conviction, high quality investment strategy. During the interview Sean and Todd provided some great insights into:

  • Why Investors Should Consider Idiosyncratic Businesses To Generate Outsized Returns
  • Focus On Companies With High Returns On Invested Capital, Rather Than High Growth
  • Capital Light Compounders Have Cashflow That They Can Utilize, Especially In Down Markets
  • How Do Some Companies Achieve Successful Rollup Strategies
  • The Three Things You Should Target In A Potential Investment – Moat, Management, And Forecastability
  • If You Can’t Really Understand The Business – Then Just Pass!
  • Stock Screening Is Not Necessarily The Best Way To Find Overlooked Opportunities
  • A Truly Sustainable Moat Means – Is The Company’s Moat Going To Be At Least As Wide, If Not Wider, The Next 10 Years?
  • Search For ‘Quality’ Growth In Companies – Not All Growth Creates Economic Value For Shareholders
  • How To Take Advantage Of A Kelly Criterion Philosophy To Determine Portfolio Weightings
  • The 3 Core Reasons For Selling A Stock
  • Ferrari – The Ultimate Idiosyncratic Business
  • Blockchain Technology Could Be A Significant Risk To A Number Of Trusted Intermediary Businesses

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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Full Transcript

Tobias Carlisle: All right gents. Ready?

Sean Stannard-Stockton: Yeah.

Tobias Carlisle: Let’s do it. On Tobias Carlisle. This is the acquirers podcast, very special episode today. First time I’ll be joined by two managers. It’s the Ensemble capital. President CIO Sean Stannard-Stockton and senior analyst Todd Wenning, who I’ve known for quite a long time. Ensemble has a very traditional buffet style, highly concentrated high conviction, high quality investment strategy. We’re going to talk to them right after this.

Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons he will not discuss any of the acquirers funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of acquirers funds or affiliates. For more information, visit acquirersfunds.com.

Tobias Carlisle: Sean, Todd, welcome.

Todd Wenning: Thanks for having us.

Sean Stannard-Stockton: Thanks for having us, Toby.

Tobias Carlisle: I don’t know exactly how we’re going to handle this. But I’m going to just… We’re going to feel our way forward and see how we go. Maybe we’ll start with Sean. I think you’ve been with Ensemble the longest. So perhaps you could tell us a little bit about the history of Ensemble?

Sean Stannard-Stockton: Sure, absolutely. So firm was founded in 1997, registered investment advisor by the now retired founder Kurt Brown. He’d been in the business for a long time. And the ROI business was bearing fruit and growing and that was kind of what he wanted to focus on. So I joined him in 2002 as the second employee. We had 65 million under management. And then in 2004, we formed Ensemble Capital Management as an LLC. And I began partner, and through the firm since then. Kurt’s now retired with a handful of owners, about 15 people on staff and managing $940 million on behalf of 200 clients, so high net worth individuals and institutions.

Tobias Carlisle: And you’re based in the beautiful San Francisco Bay Area.

Sean Stannard-Stockton: That’s right, although we’ve really embraced remote work. So as Todd can tell you, he’s outside Cincinnati. We have staff in Southern California as well. And far from being kind of a detriment to overcome, we’ve come to really appreciate the value, especially in the research side of having team members across the country in different demographics and geographic areas and how that we think helps us make better judgments on stocks as opposed to being inside the Silicon Valley bubble.

Tobias Carlisle: Yeah, it’s a good place to be. I agree with you that you want to be away from the, you want to be away from Wall Street, you want to be away from all that as much as you possibly can. I love your strategy. It’s very traditional. What I regard is a very traditional modern buffet strategy long only concentrated high conviction, high quality. Do you want to just walk us through the strategy as it stands?

Sean Stannard-Stockton: Sure, so at the strategy level, we’re focusing on owning kind of 15 to 30 of the best businesses we can find that trade at a price that we think affords us market being returns over the longer term, if we do our job right. And most importantly, the organizing principle of our strategy is not to be value investors or to be growth investors, but to invest in highly competitive advantage businesses. And then once we find those, we think those businesses and really only those businesses are we well positioned to value better than the market. And so once we find them, we can establish an intrinsic value and at that point, understand what is a discounted price to pay. So a lot of people say well this growth stock that trades a 15 times earnings that’s good. We look at it and say what is going to allow this business to thrive for the long term. And that has to do with its competitive positioning in the industry.

Sean Stannard-Stockton: Todd has coined the phrase here, idiosyncratic businesses that maybe he wants to talk about now, because I think it really gets at the sorts of businesses that we look for, and why things like peer multiples and traditional market multiples is really irrelevant to the work that we do.

Todd Wenning: I mean, if you look at, a lot of times what happens is you have sell side analysts, and by side specialist covering an industry, and there’s benefits to having that depth of knowledge for the industry, no question about it. But what we find is that there’s opportunities a lot of times and companies that kind of straddle two different industries. Sometimes you have analysts covering the wrong, but they’re looking at through a different lens than we are. So one example would be Ferrari that might be a signed to an auto analyst. But in reality, it’s both a luxury firm and an auto. And, for example, First Republic is a bank, which is pretty much a commodity industry, but they layer on high level of customer service, which makes them more akin to a customer service business. And so we find mismatches in valuations and outlooks in those opportunities. And we really love to find some of those businesses that don’t really fit in and have a lot of peer to peer competitors.

Tobias Carlisle: One of the things that I noticed in your deck that I thought was very interesting. You talk about focusing on high return on invested capital, rather than high growth for the reason that high return on invested capital is more persistent. And folks have listened to my podcast and they know my philosophy. I talk about return on invested capital being highly mean reverting, so I’m very interested to know what do you mean by it’s more persistent or are you Looking for companies where that really can sustain that high return on invested capital?

Sean Stannard-Stockton: At the market level, return invested capital is highly mean reverting. So over the last 70 years or so return invested capital at the market level has averaged about 10%. And companies that use leverage to get ROE more like 13% or so. And though those metrics plus kind of a 5% growth rate in corporate earnings is what drives a kind of a 16 times multiple on the market. So you can kind of do the math on all of that. And that’s why that multiple has been so persistent over time, is that every time returns on capital start to accelerate, you have a pouring of capital into the industry into the market drives it back down again. And growth, you really can’t grow much more than kind of the natural area of the economy. So you have spurts of higher growth and lower growth, but it tends to mean revert. So we agree with all of that.

Sean Stannard-Stockton: But at the company level, that’s not true especially On return on invested capital. So you already see that just the sector level where consumer staples stocks say, have generated structurally higher returns on capital than the overall market for a very long time. Whereas energy stocks a lot of financials have not, right? And in fact, financials have to lever up to generate decent ROEs. And they’re able to do that, but their return on invested capital is not that high. So if you look at the research that we most frequently references, the book valuation by McKinsey, which they have many editions of, and they show return on invested capital by quintiles. So they basically break the market up into five quintiles, and they reconstruct portfolios every year. And they roll that back over the last 70 years.

Sean Stannard-Stockton: And what you find is that, in aggregate, what we just described is true. But within those quintiles, businesses that generate high returns on invested capital, do so persistently. You still see some decay. So companies that maybe have a 40% Return tangible capital, will see a decay down into the teens over time. But you still end up with a structural differentiation. And that’s kind of easy to see the economic level like a service company, a software companies, they all generate high returns invested capital. Whereas commodity based kind of capital intensive businesses typically don’t, right? So what we’re looking for is those sorts of businesses and most importantly, hires investment capital generates structurally higher valuation multiples. And so a high growth rate does not persist and a company growing 20% a year you can say, “Why? I can pay a high p for that.” But five years later, it’s growing the same rate as the economy, right? Whereas returns investor capital support valuations and much more structural long term ways.

Tobias Carlisle: One of the interesting things about your deck at the very back you have lots of different modes, lots of different structures for modes. Would you like to take us through those modes and how you identify each one, with the significance of each one.

Sean Stannard-Stockton: Yeah, so I think there’s two ways to think different types of modes. Maybe Todd can take the second one, which is types of modes and in the back of the deck, what you’re referring to is, we think that most businesses really don’t have a mode. They’re just competitive. That’s why the market overall generates these kind of market levels of return invested capital. And you can look and say, Well, why 10? Why not some other number? Well, the reason is, is that investors can generate about 9% returns on investing just by index fund. And so companies will reinvest in their business up until the point where they would just assume paid as a dividend and you can earn that 9%. So they drive the return investor capital down towards kind of stock market level returns equity, cost of capital level, so returns. And so we don’t invest in those sorts of businesses. That doesn’t mean they’re bad businesses or the stocks are going to do poorly. It just means their average an average is okay. Right?

Sean Stannard-Stockton: And what we look for most when our portfolio is most populated with is what we call capital light compounders. So businesses that are able to grow Without reinvesting a lot of cash into their business. So MasterCard is a great example. So the business just relentlessly is growing the top line in the double digits for many years, but doesn’t need to reinvest in the business because there’s not a lot of capital required to bring on more credit card payers on to a network they’ve already built. Right? Whereas a business like say Intel needs to invest heavily in capital equipment in order to keep growing their business. So those capital light compounders is the most common type. And then but also businesses that can reinvest a lot of capital at high returns in equity are great, right? We don’t object to those, but we like to capital light compounders in part because they can pay out dividends and buy back stock even while they’re growing. But just as importantly, during downturns, they don’t get into capital crunches, cash crunches, because of this cash production that they are able to produce.

Sean Stannard-Stockton: And so even the bombers recession’s they have cash flow that they can be opportunistic with. And then the last time we talked about is kind of what is referred to as platform companies. So businesses, like in our portfolio trends dime, that the internal business is not a very fast growing business. So they make aftermarket airline parts. And so the level of travel globally grows but not rapidly. And so they can’t drive growth through investing in the business, but they can acquire other very similar businesses and add to their platform. There’s a fine line between like a roll up and a good platform business. And so every business that does that is not a good business. But we look for specific types of those businesses.

Tobias Carlisle: Every roll up describes itself as a platform.

Sean Stannard-Stockton: That’s right. Yes. It’s a very important kind of nuanced distinction and not one that we think is just like a bright line where you can categorize the stock as one or the other.

Tobias Carlisle: Well, that’s an interesting question. How do you make the distinction?

Sean Stannard-Stockton: Well, I think a lot of it has to do with the management team and their understanding of what they’re doing exactly. So Adding new businesses just to achieve scale, which a lot of roll ups do, may not necessarily lead to good economic outcomes and in fact, can end up with a collection of businesses that are not well integrated and are just a mess, right? A business like trans diamond and other businesses that do this well have capital allocation teams that really understand what they’re doing. They tend to run decentralized organizations. In many ways Berkshire Hathaway is a platform company, Constellation Software of Canada is an excellent example. And so these are businesses where the management team understands their role as acquirers very well and is really focused much like Ensemble is on finding businesses to invest in at he right price. Which is very different than say a fast food chain or something, just buying up lots of competitors and hoping it all adds up to something more than the sum of the parts.

Tobias Carlisle: What would you say is your ideal target?

Sean Stannard-Stockton: Todd, why don’t you take a crack at that one?

Todd Wenning: Yeah, I think for us, it’s really three things have to be there. Has to be a mode, has to be good management. And we have to understand the business. We have to be able to forecast the business. Our evaluations are driven on this kind of cash flow, and distributable cash flow. And a big driver of that is terminal value. And so if we can’t get a good understanding of what the terminal value of the business might be, where margins might be, where ROICs might be, we’re just going to throw our hands up and say it just is too hard. Right? That’s either we lack a certain domain expertise or there’s a lot of inaccessible information that we can’t grasp. So we like to find businesses that one of us or all of us understand, intuitively. You can forecast and can work through the financials and understand how the financials work together. A lot of times one of those pieces won’t be there. And we’ll just have to pass on it.

Todd Wenning: We recently did the investing diagram on our website. And the combination of those three things is what we’re looking for mode, management and forecast ability. And a lot of times one of those things is missing. And that’s just unfortunate, but we’re a highly concentrated fund, we have to be selective. And that’s where we draw the line.

Tobias Carlisle: So that’s the Venn diagram, which I’ll put a link to that in the show notes. Do you want to just tell us a little bit about the Venn diagram?

Sean Stannard-Stockton: Yeah, sure. So I had done this for my personal philosophy before I joined Ensemble. And when I joined I said, this was a really instructive process for me. And we just, we’ve been kind of working with each other, trying to understand the process and kind of develop our process. And we’re kind of building off of already great process, just trying to get a really good definition of what we really believe in. And so the Venn diagram was a nice way for us to illustrate that and kind of go back to it put on our desks put on our screens, just to say, are we doing this with every business that we’re looking at? Is there something that we’re not staying true to? Are we getting too excited about the narrative and not looking at the substance and so on? So it’s just a good way to keep us grounded and focus on what we do.

Tobias Carlisle: Do you have any examples of companies that have fallen into that part where you just can’t understand what they’re doing?

Todd Wenning: Sure. I Think, off top my head. Now, we looked at Tencent. And started pulling the pieces apart and saying, okay, well we think it’s got a mode. It’s pretty clear there’s something going on there. Management seems fine. But there’s just a ton of moving parts in that business. And until recently, Sean just came back from China. And we had never been there to kind of see on the ground, what’s been going on. So it’s hard for us as kind of using the western internet to really get a good appreciation and understanding for what’s happening. So we didn’t say we will not Invest in Tencent, but it’s just that at that point in time we just cannot put it all together. Sean I don’t know if you want to elaborate on that.

Sean Stannard-Stockton: Yeah. And I think another example, is Qualcomm. So this is a business we looked at a long time ago. And we fully understood the business in terms of how they were generating economic value. But that economic value is really tightly tied to their patent portfolio. And we could read other people saying, this is a very valuable patent portfolio, and we knew that it currently was because of the cash they were generating from it. But we weren’t able to assess like, but are these going to be valuable in five years and in 10 years? And we realized that at some point, they would come under some pressure and doubts would arise in the market, whether or not certain IP was going to other people could kind of move gun front around the edges of it in some way. And that we would be unable to judge for ourselves with our own conviction. How strong it actually was, and there’s hedge funds out there that have patent portfolio lawyers on staff. Right? And we don’t. And so we looked at that and just said we’re just going to pass on that there’s other businesses out there.

Tobias Carlisle: What are your impressions of China as a value investor?

Sean Stannard-Stockton: So Todd led the research into Tencent and Alibaba and other businesses and came away with a conclusion, as he just said that they were uninvestable for us. But China is a huge economy, about half our portfolio has some exposure to China, either through selling into China, or in some ways, not selling into China. So we own Netflix and Google, which don’t do business there. They don’t do business in like a fifth of the world, right? I mean, this is a huge market, and they may at some point over the longer term. And so when we decided to pass on Tencent, Alibaba, we also said, we’re going to be doing this for a long time. We think that any investor in global businesses, which is the most of the US market or global businesses, right? 45% of U.S, S&P 500 revenue comes from outside the United States. And we feel very comfortable with businesses like Ferrari that are actually headquartered in Italy that sell into global urban environments and realize we need to get more comfort with China. So spending a week there is certainly not a solution. Right? It doesn’t we didn’t come away saying now we understand it all.

Sean Stannard-Stockton: But it was a great experience and the way we ended up bringing that together as we started listening to a podcast that I would really highly recommend for any investors that want to stay in China better called tech buzz, China. And the two women that run that one… They’re VCs and entrepreneurs. And they basically bill it as this is for an audience that understands business models understands business, but it does not speak Chinese and they really put it in kind of English language format, very understandable way. And so we actually engaged with the two of them to take myself and RF and other analysts here and about dozen other investors who themselves came from Singapore, the UK, India, US, Canada, and descended on Beijing and Shanghai for a week and visited with 28 mostly company representatives as well as US State Department and other kind of industry people, and it added great color to, what’s going on there. And I think our biggest takeaway is a recognition that for the kind of 200 to 400 million Chinese who live effectively a developed economy life not much different all from San Francisco or London, or Dubai, that environments probably investable for us.

Sean Stannard-Stockton: For businesses that we understand that are selling to those people. That’s just because it’s China doesn’t mean we have to say we can’t understand it. And yet for most of the rest of the country, it’s this is truly an emerging market and I wouldn’t want to own a business that had large exposure there. Not because it’s China, per se. It’s just that we think that emerging markets should be invested in by companies that have analysts on the ground that understand the culture extremely well. And, and for us, that’s outside our circle of competence.

Tobias Carlisle: That’s very interesting. When you’re generating ideas for portfolio, what’s the process for that, like are you screening or are you trying to understand businesses or both? How do you go about doing that?

Sean Stannard-Stockton: So we don’t do any screening. And I think that, you could think, well, geez, they like high returns invested capital, why don’t you screen for businesses that have high return on invested capital. But a screen of companies with high returns invested capital is a list of companies with a target on their back, right? These are businesses that are advertising to the world, we’re super profitable, you should come take a piece of our profits, right? That’s the mean reversion that you alluded to, right? This is the exact area that comes under excessive pressure. So we never start there. High returns in capital is an output of what we’re looking for, rather than exactly what we’re looking for specifically. And so we look for businesses that have these competitive advantages, which you can’t screen for, which is good for us. Because if you could lots of other people with bigger computing power than us would eat up all that alpha. The things we find are kind of idiosyncratic as Todd talked about. And Todd Maybe you want to talk about how we actually go at finding those businesses.

Todd Wenning: Yeah, a lot of times, it’s just as you know we’re pretty active on financial, Twitter, and Finch wit. And we have a network of people that we follow, and a lot of times they’ll talk about a company that we had never really considered. And we’ll start digging in and start peeling the layers back and see if they fit our profile. I’d say one out of 10 times, it’s probably a hit. And so it’s not just something to it, but just from reading, we read a lot of different industry reports, analyst reports and so on. We’re just constantly consuming information and sharing with each other. And so we find something that starts checking off all the boxes, we start digging in. But we don’t like Sean said screen for anything. Ideally for us the ideal situation, an alpha perspective, is trying to find companies that are growing into their mode. Moving from maybe the third quartile of ROIC into the fifth quintile of ROIC.

Todd Wenning: And I think Michael MOBAs was just on your show. And one of his papers talks about those are the companies from an alpha perspective that really take over because they go from a low quintile to a high quintile and surprise the market. And that’s where you can find great long term opportunities.

Tobias Carlisle: How do you find those sort of companies?

Todd Wenning: [crosstalk 00:22:21]. Go ahead.

Sean Stannard-Stockton: I was going to say I can give you a quick example, for business that we no longer own Scotts Miracle Gro, which is a business that like on the surface, I think we would never have thought of. Scotts Miracle Gro sells fertilizer and fertilizer is a commodity and it just seems boring, right? And how could this really fit our model? But in all this reading, like everybody reads an industry so saying, Oh, we read a lot isn’t really an idea generation idea except for it’s what we’re reading for. And that is signs about competitive advantage. It’s not signs for they’ve got a really hot new product or they’re growing so fast. And so with Scotts, it was I read a Barons article and it was actually about Home Depot. And the article mentioned that Home Depot was paying for radio ads, advertising Scott’s products. And I was like, that’s not common. Usually that product maker pays the retail or like shelf space, or are we willing we want to be at the IL cap or whatever, right? So why is it going the other way around.

Sean Stannard-Stockton: And as we… That was just the beginning that was like the idea generation. And it wasn’t enough to say we’re going to buy the stock. It just was something curious. And as we looked into it, we learned that for 10 weeks out of the year, kind of six weeks in the spring and four weeks at the end of summer, lawn and garden care products is the number one reason people go to Home Depot and Lowe’s. And so for those 10 weeks out of the year, Scott’s which has higher market share of lawn and garden than Coca Cola does of the soda business, is the dominant driver for why people go to these two huge retailers. And so both Home Depot and Lowe’s run radio ads and print ads and Television ads and internet ads of Scott’s products. They’re like door buster, right? To get you in the door and then they hope you buy a lot of other stuff. So Scott’s loses money 40 weeks out of the year and then mints money during those 10 weeks.

Sean Stannard-Stockton: And they’re basically a branded commodity. it’s not good if you have a commodity if other you’ll sell it. But nobody else sells what they do. They have like total market share, right? So you go into a Home Depot and you see Scott’s products and then you may see a local competitor like one or two bags off to the side. But it’s a really wonderful business. We don’t own it anymore because over the years of owning it, the eccentric CEO and many great CEOs are eccentric. We came to lose confidence in… They’ve moved into aggressively supporting the marijuana growing industry, which is not saying we object to on the face, California, it’s legal. But his engagement and all of that was done in kind of a wild wild fashion. He’s famous for cursing on conference calls talking about dropping acid and we were like we can’t partner with this person anymore.

Tobias Carlisle: Fair enough. That’s a fascinating story though. When you see you get the lead generation and then the next step is some sort of assessment of the company, which must lead to evaluation. So, can you describe that process for me? Do you start with the unit economics? Or where do you start? Todd

Sean Stannard-Stockton: All right Todd.

Todd Wenning: I was just going to say, okay. Just thinking about, well, for us, we really want to understand the business like we talked about. And a lot of times that is unit economics. We want to find some key variables in the business that we can keep an eye on to see if the results are following what we expect to happen. And so we do build DCFs as we discussed. We try to keep them as simple as possible without going any simpler. And we really try to understand the bulk of the business, not try to create this well narrative with the huge spreadsheet but just understand the economics of the business, how much cash flows and throwing off? How do we expect that to happen in the future? And a lot of that comes back and that’s all informed by our qualitative judgment. So thinking about modes, if we’re very confident in the company’s mode, one of the steps in our processes is to, we have six core questions that we ask. Two on mode, two on management and two an understanding.

Todd Wenning: And one is do we think this company’s mode is going to be at least as wide if not wider, the next 10 years. And so if we’re confident in that, we can be more confident in our ability to understand Okay, here’s where ROICs very well could be in the terminal year. If we don’t know that going back to understanding it all gets broken apart. So we all have to understand the business, understand the mode and understand the management.

Tobias Carlisle: Is part of that and assessment. This is the total addressable market. This is the lifetime value of a customer. This the customer acquisition cost. Is that part of the process?

Todd Wenning: For some businesses sure. if we’re looking at software company, those are the metrics we might use. We might find some sort of penetration rate for another type of business or. But those are typically when we’re looking at sort of more uncertain outcomes. We used to own a pet insurance company called Trupanion. which is a very, very controversial company on FinTwit. And one of the things we looked at was okay, well, how many pets are they addressing as a percentage of all pets coming through the Vet offices every year? How many of new puppies and kittens are going into Vet offices every year? And how many of those are they getting? And so that’s what for that company we were trying to understand.

Sean Stannard-Stockton: In addition to that, kind of top down level, the total addressable market which is important and also very widely used, we also think about the insider perspective in Danny’s academies work talking about, like you can analyze the company with the insiders. But then there’s also the outsider view and looking at this, well, what about classes of companies. And so I mentioned that return invested capital does not decay as much, but growth does. And so in making forecasts, we often will bound our forecasts by kind of class level decay rates to say this business is growing 12% a year right now it is bound to slow down just because this is what businesses do. And we hope to find businesses that will buck that decay rate that will outperform and that’s part of our margin of safety. We don’t count on that in valuing the business. Other times there’s things that are unique about the business where we say that decay rates just not applicable because of some very concrete level, not just because, look, it’s growing so fast, it’s going to keep doing it forever. But there’s something about the business that’s going to allow them to grow for a long time.

Sean Stannard-Stockton: Todd found a business called Massimo for us and that business has been kind of grinding out solid growth. And that’s because they are taking basically 100% incremental market share every time the hospital replaces the systems that they use. And so you can look at how much is left they’re eating all of it. It just goes slowly as the old units come at the end of life. And so you can very clearly forecast, this is going to grind away and grind away at a mostly high rate for a long time and decay rates not applicable in that situation.

Tobias Carlisle: One of the slides in your presentation talks about, and this is a nice segue but talks about finding quality growth at a reasonable price. What is quality growth at a reasonable price? Todd.

Todd Wenning: Sure.

Tobias Carlisle: I’m just sorry Sean. So you’re getting ready to answer that. I didn’t mean to cut you off there. Happy for either of you guys to do that.

Sean Stannard-Stockton: You take this one Todd.

Todd Wenning: Yeah, I think for us quality growth is, again, a merging of the three factors that we hold so dear management and forecast ability. There are many companies that check off those boxes. If we can find those companies, we’re very happy to put them in our bullpen, if not in the portfolio right away. Because they’re just so rare. And if you look back at some of the great growth businesses over the past 30 years, they were there in plain sight A lot of times. And there’s just people were all debating over 15 or 20 PE. Well you can, if you look back, I’ve seen some studies saying you could have paid 80 times earnings in 1970 for McDonald’s, and still made market returns. Obviously, as of time side, but looking it’s an elite business. And there’s so few of them out there that you really have to understand all of them. And we look at elite businesses, not just in the U.S, but internationally. Now, we don’t always invest in them. But we think about them and then kind of use them as learning and fodder to understand what businesses are in our universe.

Tobias Carlisle: Sorry Sean.

Sean Stannard-Stockton: I was going to say one element of quality to his growth that generates economic value for the shareholders. And not all growth does, right? So some businesses can force growth and generate revenue growth. But Derek Thompson of the Atlantic has an article out today talking about the kind of millennial subsidy project of all these kind of Consumer Directed or VC backed businesses and some of them are growing very rapidly because they’re basically like paying people to take their business, their products, right? But it’s not economically value generative. In some cases, it may become so in the future, but it’s unclear. That’s why return invested capital is so important that when you grow at high incremental rates of return invested capital, it’s wonderful for shareholders. But you can also grow in ways that’s not value creative, and so we just kind of pass some businesses that have low returns invested capital, because growth is like worthless, they should not grow, just pay all the cash out to shareholders.

Tobias Carlisle: That was one of the most interesting things about we work for me that it was regarded as some sort of magical company when if you jam a lot of capital into any company, you probably going to see some growth.

Sean Stannard-Stockton: Yeah, yeah.

Tobias Carlisle: Once you’ve identified these companies, and you’ve come up with a valuation for them, you’re trying to decide how much capital you put into each in the portfolio. And so you use some sort of Kelly criterion waiting to do that. So can you walk me through that process?

Sean Stannard-Stockton: So the Kelly criterion, it was designed to judge the size of bet that a better should place in any given situation. And what it says is, it’s not just the payoff amount, right? So like, if you’re, going to earn five times your money, if you bet, or 10 times that’s important. But the other is how likely you are to win. And so the kind of simple example is imagine if I said to you Toby, I have a bet for you. It’s a 50, 50 so the coin flip, right? And if it’s heads, you win 100 times your money. And if it’s tails, you lose everything. Well, that’s a great bet. Right? Would you bet your life savings on it? Well, Probably not because you have 50% chance of bankruptcy. And you’d say, Well, if I win, it’s great. My expected return is fantastic. But I can’t risk half my capital going bankrupt. But you would certainly bet on it. And you’d have to size that in some smaller way. Right? If you’re in another bet, that was saying well, it’s just two to one, you bet it you double your money, but there’s a 99% chance you win and 1% chance you lose, you might bet your whole net worth a 99% chance I double my net worth, right? 1% chance of bankruptcy.

Sean Stannard-Stockton: So the Kelly criterion says that the odds of success are just as important as the as the return potential. And so we go through that process and say, What are the odds of this business being successful, right? Over the long term. And businesses that we have higher confidence in I mean, this is a constraint portfolio. We have confidence in every stock in the portfolio. But we forced rank all of them to understand where do we have the most confidence. And then at any given appreciation potential. So you say you have two stocks, and we think that they both have 30% upside to their intrinsic value, we would own more of the one that we had more certainty about that and the certainty level actually drives our position weights even more so than the upside potential, although everything in our portfolio is trading at a discount what we think it’s worth.

Tobias Carlisle: I love the logic of Kelly, which is that you should never risk ruin and so it’s summarized into do not bet the whole world. And the other thing is that Kelly describes the outer limit of the geometric return possible and the size of your bid. So you should never bid more than Kelly because then over bidding is just as risky as under bidding.

Sean Stannard-Stockton: And just want one thing just to clarify for listeners, like we don’t use the Kelly criterion formula exactly in setting our position weights. But areas is like Kelly criterion inspired. It uses The same philosophy and inputs. But we don’t think that Kelly criterion as a pure mathematical equation works. Primarily because investors do not know the payoff amount and they do not know the likelihood of success. Those are both estimates. And therefore, the Kelly criterion fails, given that you don’t actually know the two key inputs.

Tobias Carlisle: Kelly’s also used in series when you’re investing in real life, you’re investing in parallel because you’ve got a portfolio. So that necessarily requires that you size down all the positions. When you’re in a position, so that’s sort of that does answer the question but you’re actively trimming and adding as the, as the portfolio moves along?

Sean Stannard-Stockton: That’s right. So every investment we make, we make on the basis that if we held it forever, ever return as a private business where we only receive the cash flow being generated by the business not through kind of flipping into another investor, that that cash return would generate our required rate of return. So we invest as long term investors in that sense. Our actual holding period has been between three and five years. And if you look at it over one year time periods, about 75% of market returns is explained by changes in the PE ratio. And only 25% is explained by earnings growth and the return of capital shareholders by backs and dividends. But over five year time periods, those flip and 75% is explained by the fundamentals of the businesses and only 25% in investor sentiment or PE ratio changes. So we think that our holding period of three to five years is basically just that when we buy it takes that long for the corporate results, which is what we’re investing into, to actually play out and other investors to get on board with that. Which of course, when we’re wrong means pricing down the stock to the less attractive fundamentals than we expected.

Sean Stannard-Stockton: But we’ve also owned businesses for a decade or more and there’s been times we’ve bought a stock and 14 months later it’s up 100% or we just realized we’re wrong. And so we’re not kind of buy and hold in the sort of like, well, this is just a good company and we don’t have to think about it anymore.

Tobias Carlisle: So that’s that’s an interesting question. How do when you’re wrong?

Sean Stannard-Stockton: There’re kind of three core reasons that we sell a business? And Todd, you want to walk through those?

Todd Wenning: Yeah, I think one is that our thesis just broke. Something fundamental about the business just did not match our expectations. Either we misread the management team, and we misread the mode or it got more complicated or more complex than we anticipated. Another reason would be that the stock price hit our expectations and went over our fair value and we sold it down. The third would be we have a better opportunity elsewhere. We look at opportunity cost very seriously. And so if you think about the stock that’s fairly valued, but you got one that you think of as an equal quality and opportunity that’s 15% cheaper, you should roll money into that new opportunity. And so we ideally, we’ll hold on the great businesses for a long time. We’ve held I think MasterCard for since close to the IPO. Right Sean?

Sean Stannard-Stockton: Well, since about 2010.

Todd Wenning: 2010. Okay, so we’re close 10 years now. And we’ve held a couple other of that long way before my time. So if that’s the ideal, doesn’t always happen, and it’s not always for bad reasons that we’re selling. Sometimes things just broke as we expected, and that’s good.

Tobias Carlisle: Or the CEO starts talking about taking asset.

Todd Wenning: Right, right, right. Yeah. Yeah, you don’t want that.

Tobias Carlisle: Let’s just talk about your top position. So you’re your top holding is booking. Can you walk us through the thesis there and tell us what’s happened since you put it on?

Sean Stannard-Stockton: Sure. So booking holdings is the largest OTA online travel agency in the world. A lot of Americans don’t know it as well. They know Travelocity and other businesses, most of which are owned by Expedia. And that’s because bookings kind of core markets are Europe and Asia. And so what’s interesting about agency businesses, you get a commission for somebody else’s business. It tends to be very capital light, and they tend to have high returns on invested capital. And but airfares because there is a relatively small number of air carriers in the world, and because most consumers say like, I just want the cheapest flight, I don’t really care which airline I travel on. And the margins are thin and OTAs don’t earn very high returns on sourcing flights. And then in hotels, branded hotels can draw travelers themselves.

Sean Stannard-Stockton: So Myriad and High [inaudible 00:39:38] can just say, well, you just keep coming back to Myriad. So if you go to New York, a lot of Americans will say like, I stay at Hilton when I go to New York, and they go to the Hilton website. But Europe and Asia has far lower hotel brand penetration since 20, 30% of hotels are actually branded, most of them are boutiques and small chains. And those hotels have no access to demand. They no marketing platform, and they must list on some sort of OTA. And so booking is the OTA of choice. So in America, you say like, “Well, I’m going to Google something.” But when you say I’m going to search it online. And in Europe like booking is how you book hotels, right? It’s actually the reservation system for many small hotels. So I was in Spain two years ago, and we went to a hotel, and booking was their reservation system.

Sean Stannard-Stockton: So if you’d walked in the door, said, I want a hotel tonight, they would book it on booking.com and pay the commission because they didn’t have their own reservation management system. So it’s super dominant in the very inefficient hotel market in Europe, and Asia, super lucrative. Expedia, we have zero interest in. They’re focused on the US, which is dominated by brand hotels and an airfare. The business is not so good. So this idea of idiosyncratic businesses we never look at booking and expediency they’re both OTAs which one’s cheaper. We have one we’re interested in one we’re not

Tobias Carlisle: Is that booking.com?

Sean Stannard-Stockton: Booking.com is their kind of flagship site. So the business was actually Priceline. So the kind of amazing story is Priceline was founded in IPOs. And the late 90s, when the hottest .com stocks, it fell, I think 99.8% from top to bottom during the .com crash. And then in the midst of the wreckage, they bought this little business called booking.com. And that turned into this globally dominant business with a $80 billion market cap today. Market cap we think is worth much, much higher. And so a couple years ago, they changed the name. They own part of sea trip in China, they own parts of all sorts of travel businesses around the globe.

Tobias Carlisle: The second position that you have listed is Ferrari. So Todd, do you want to take Ferrari?

Todd Wenning: Sure, I think we talked about for earlier being an idiosyncratic business being both luxury and auto. And we have just a tremendous amount of respect for the Ferrari brand. RF actually went to Italy for their unveiling of the one their latest cars and got the test drive it and Italy and I got to start following Ferrari instead of [inaudible 00:42:07]. Great trips but yeah, we when RF learned the great insight that we learned from our trip to Ferrari was that it’s basically like joining a billionaire’s club, right? The people at those events that were hand selected by Ferrari to come out, have just a massive amount of money and the disposable income. And to be in the same room as those people, think about the connections in those rooms. And so there’s a strong cult like following for Ferrari, and it’s among the elite, the entry level Ferrari something like $250,000 or something and the new ones were are a million dollars $2 million, and there’s pre sold before they’re even told the price.

Todd Wenning: So that’s not money that most people have to spend on a car and so really Ferrari is just, it’s the passion for racing at the passion for cars. And it kind of connects you to this network of highly connected like minded people.

Tobias Carlisle: So it’s a network? Just where’s the value? Ferrari looks like a middle bender to me, but there’s something more to it than that?

Todd Wenning: Yeah, I think it’s a luxury, right? It’s an identity. If you are able to drive around a Ferrari, it’s telling people around you something, right that this person loves racing, they love craftsmanship, they see it as an art. It’s, a very valuable piece of machinery. And in terms of the network, it’s really about if you are an exclusive person to be invited to these events you’re rubbing elbows with billionaires from Europe and Asia and all over the world. And so it can actually improve your own outcomes and your own net worth by connecting with great people that can put you in touch with other great people. And so it’s really buying into this club.

Sean Stannard-Stockton: And Toby, we’d have zero interest in car companies. And not because they sell cars, but because they have really weak profit margins. Because if you sell a Honda Accord, and you raise the price by $1,000, well, you’re selling $1,000 more than the comparable Toyota. And a lot of buyers will say like, why would I pay an extra thousand dollars for the Honda? It’s basically the exact same car, which it is. And because it’s a functional transportation device. It’s just about how much do I pay to get around. Right? Now, Americans in particular, care about what they get around in. Right? And so luxury cars have generated solid returns. But Toyota is in a whole nother universe. So lots of car companies might have single digit profit margins and Ferraris and the high 20s on the way into the high 30s. Right? So they actually talked about their peer group as the other luxury brands.

Sean Stannard-Stockton: And there’s an 18 month wait list to even buy a Ferrari. So If you’re a billionaire, you can’t stroll into a Ferrari and store and say I’d like to buy one. They’re like, I’m sorry, you have to go to the back of the line, right? And when you get to the front of the line, you can only buy the entry level car, you are not allowed to buy their more expensive cars. And if you get to the front of the line, and let’s say it’s a recession, and you say it’s just really not a good time for me to buy a Ferrari. So I’m going to wait till another time. No problem, you don’t have to buy one. You can’t ever get back on the list, though. This is your one shot. So somebody has enough money to buy a Ferrari still has enough money to buy a Ferrari in the depth of the recession. So it’s proven to be the most session recession resistant car company. Which you would think it’d be the opposite, right?

Sean Stannard-Stockton: This is the sort of stuff we’re looking for. You’d say like the ultimate discretionary purchase, right? But this wait list means that there’s 18 months of people who are willing to buy the car if you don’t buy the car. So Todd mentioned that elude this the idea that people buy cars, not knowing how much they cost. So when Eric was in Italy, they were launching a new supercar that they told only the people they invited to buy it. They talked about it as a gift to their customers, right? They were only making 500 of them. And they told their customers that they invited to the event that it would cost between two and $3 million. That’s all they said. And they sold out on that basis. So imagine not knowing how much anything’s going to cost, let alone a range of 50% upside from the two to 3 million and they sold out. I mean, this is a not a car company, right?

Sean Stannard-Stockton: And when people say, not a car company, you can apply that sometimes people say that like a narrative way, like, I don’t think of it like that. So therefore it deserves different evaluation. What we’re talking about is entirely different economics and cash generation to shareholders than your average car company. And that’s what’s worth more, not just that it’s Ferrari, and it’s special.

Tobias Carlisle: Yeah, that’s fascinating. That’s very interesting. I’ll have to tell my wife that there’s a business reason for buying a Ferrari so we can get to these events. MasterCard, so we raised that. You talked about a little bit earlier. It’s fairly well known what’s the thesis and MasterCard. And you still holding it 10 years after the initial purchase so, it’s still bearing fruit and working up.

Sean Stannard-Stockton: Yeah, I mean, it’s one of the most kind of inevitable businesses that we’ve come across, right? In that they and Visa built this payment network. And payment networks are extremely hard to build. Because let’s say you had a brand new card, Toby somebody reached out to you and said, I have this new card. It’s not Visa or MasterCard, it’s Brand X, and we can give you 10% cashback. Well, the apple card is a MasterCard. So the way that credit cards work is you basically have an issuing bank, in the case of the apple card, it is Goldman Sachs. And then you have a Visa, MasterCard, logo, always one of those, and that’s the processor. So you might hear about 2% credit card fees, but Visa and MasterCard are getting one 20th in the fee, the bank, which has the credit risk is charging the rest of that and sometimes they co brand like with Apple or American Airlines or whatever it might be. And building that that network.

Sean Stannard-Stockton: So If it was a MasterCard or visa, you could use anywhere and you would say great. I think JP Morgan said today on their call that the apple card was the most successful credit card they have ever launched, right? So it’s not so hard to launch a new credit card as long as it’s a Visa or MasterCard. But if it has some new payment network, and let’s say it offer you say, as a consumer will give you 10% cashback and you’d say, “Great.” And you go to every store and nobody accepts it, well, then you’re like, this is worthless. But the stores aren’t going to accept it until all the consumers have it. And if you don’t have it, it’s a chicken and egg problem, right? And so it’s very hard to build these networks, but Visa and MasterCard have done that. And at this point, it doesn’t make any sense. So across the whole FinTech area, there are so much innovation going on. And all of it is building on top of the rails that Visa MasterCard have laid down.

Sean Stannard-Stockton: Really nobody’s trying to develop a new payment network, except in China, where a whole new ecosystem has developed that we think will be mostly contained to China for a lot of reasons, but Visa and MasterCard, have no chance in China because they already have their own payment network.

Tobias Carlisle: That’s fascinated. That’s one of the questions that I had. What is the impact of Bitcoin, other crypto on something like that? You think about that will still need to be built on top of Visa or MasterCard’s network.

Sean Stannard-Stockton: So blockchain technology is clearly a potential end run around the Visa and MasterCard rails. And as much as we never invest in Bitcoin and we wouldn’t, we think blockchain technology is real. And I think the analogy is if you look at the late 1990s, investments in like.com, stocks were all zeros. But the internet was more impactful than I think even the biggest optimist of the late 90s actually thought. All bubbles are like that, right? They’re built on some truth, some core truth and they’re taking too far and often just too early in too fast, right? But their net was correct and a thesis was correct, right? It just didn’t mean that you should buy Pets.com. Blockchain technology allows for the removal of a trusted third party between two people that don’t know each other. And in our portfolio, first American financial, which helps does the title insurance. So you’re buying and selling a house, you don’t know the person, you need to trust the intermediary.

Sean Stannard-Stockton: Paychecks, payroll, processing, MasterCard, allowing me to go to Peru and swipe a piece of plastic and be given food and walk away. We don’t know each other, it’s like magic, but master cards that trusted intermediary, right? So we’ve been tracking blockchain very closely because we do think it’s a risk to a lot of business models, a lot of trusted intermediary business models, but we don’t think it’s near fruition.

Tobias Carlisle: That’s very interesting. Broadridge is a position that a lot of finance folks may know, a lot of investment folks might may know. But it’s not very well known outside those circles. So Todd, do you want to take Broadridge?

Todd Wenning: Sure. And Sean you can add on to anything I’m missing here. But thinking about broadridge if you receive a proxy statement from any kind company or any mutual fund that you have, that’s pretty much broadridge. I think it’s like 98% market share. And so it’s all kind of finance firm back office, flying under the radar. But super, super important to the financial firms that use the software and use it’s programs. In terms of wealth management they’re building into that business. Until we love those types of businesses where it kind of flying under the markets radar. No one’s outside of the finance industry really understands broadridge but, super high recurring revenues, very capital light, great margins, great returns invested capital in great management to checks off all the boxes for us.

Sean Stannard-Stockton: I think one thing… Broadridge when we first invested, I think in 2012, a lot of people are worried about regulatory risk. Like this is a financial right and what’s the SEC going to do and there continues to be those concerns. And broadridge’s CEO has said there has never been a regulation that has hurt our cash flow and a lot of people just kind of can’t believe that. But the way we think about it is that, the SEC is regulating banks and brokers and mutual fund companies. But Broadridge is basically the proxy tool to allow all of those other companies to obey regulations, right? So when the SEC says, “We want to make sure that shareholders are voting their proxies.” They are using Broadridge as a private sector actor to enable banks and brokers to help their shareholders actually vote their proxy. So rather than being the focus of regulation, they are the tool to enable regulation.

Sean Stannard-Stockton: And so they’re in a really, really beautiful place. And one small example of that was most of us all get electronic proxies now, or digital statements and broadridge was the one who was mailing it. If you have a Schwab account, and you get a statement from Schwab, or email saying your statements available, that’s all coming from Broadridge and so they’re required to send that and required to have it sent out the proxies and all of that. And the SEC said, if you can switch to digital, you can charge a digital service fee. So you I mean, it’s 100% revenue, there’s no cost to like emailing somebody. But they the SEC wanted people to convert to digital delivery. And so they enabled a fee to that Broadridge rather than losing business by switching everybody off of paper is actually losing revenue, but greatly enhancing their profit stream from moving everybody over.

Tobias Carlisle: Is there any sort of metaphysical risk from having 98% of the market, do you have too much market shares there’re risk that they have some sort of anti trust or some other issue like that?

Sean Stannard-Stockton: I mean, they didn’t get there through acquisitions or anything like that. We often look for businesses that have just overwhelming market share. And a phrase that we use is that some businesses might mortgaged their mode. And that means you start abusing your position, right? And be in a situation where you’ve trapped your customers. And you just say, well, we can just jack up prices dramatically. We’re very sensitive to that. Because even if you can, over the longer term, your customers will find some way around you like, that’s how capitalism works, right? So you keep raising the price umbrella, and you give room for disruptors to come in underneath that. Broadridge does operate within a regulated industry. And so while their own returns on invested capital are not regulated the way like a utility might be, and we think they’re quite sensitive to not overcharging people, and they’ve done a really good job demonstrating the value, the cost that they have saved their clients relative to what they charge.

Sean Stannard-Stockton: So yes, there’s that risk. And like, we looked at Live Nation, which owns Ticketmaster and years ago, and initially, I was like, “What a beautiful, beautiful business.” And then RF on our team, who I think probably goes more conscious than me was like, “Everybody hates Ticketmaster.” Like really, really hates them. And we looked into it like, well… Yeah, right? And why?

Tobias Carlisle: Customers and the bands and the comedians and so on.

Sean Stannard-Stockton: Everybody hates them, right. And so in looking into that, we said, well, why do they hate them? And we realized that and why do you do business with a business you hate? And that’s because there’s no other option. But there might be at some point in the future, because when everybody hates the business, and you’re charging dramatically, somebody out there in a dorm room, some places figuring out a better solution.

Tobias Carlisle: Yeah, that’s exactly right. I tend to agree with you there. And the final position that you have is Schwab.

Sean Stannard-Stockton: So that’s a really interesting one right now, right? Because they just took commissions to zero the stock fell 10%. But Schwab has over the years transitioned to their monetization model many times. So the earnings are going to drop about 10% for them because of the elimination of commissions which they eliminate. So you say, well, why would you eliminate commissions and hurt your earnings, right? But their major discount competitors are taking like 20 to 40% drops in earnings. Most of Schwab’s earnings come from asset management fees. So if you have a mutual fund listed with them, the mutual fund company pays for that right and, pays Schwab. And then also on the caching client accounts, they earn money on that cash through their bank. And so they have a beautiful business, but what we liked so much about the move, I mean, it’s painful when your biggest holdings falls 10%. But the analogy I give is it’s like in the action movie where the bad guy has his arms wrapped around the good guy and the good guy takes his gun out, puts to his shoulder and shoots through his shoulder and kills the bad guy. That’s what Schwab did most recent by eliminating commissions, right?

Sean Stannard-Stockton: It hurt them, but it destroyed their competitors, right. And they are in a much better, better position now, from a competitive standpoint. And if you look at most of the assets that they’re gathering, they’re growing organically. They have I think it’s $3.6 trillion in assets and they’re growing organically by 6% per year. I mean, it’s unreal, right? And, and on top of that, you get market appreciation and all those sorts of things. But assets are flowing out of kind of the wire house banks and brokers mostly to Schwab. And imagine that you are commissioned broker and now trying to explain not just to your clients, not just that there is a discount alternative, but there is free alternatives. And research is very clear, consumers behave very differently between free and cheap, right? So there’s things that we do, because I mean it’s free, that will behave totally differently if you just charge a penny or a nickel for the exact same thing.

Sean Stannard-Stockton: So we think the donation for commissions is really going to bring flows into the entire no longer discount brokerage industry, free brokerage industry. And that Schwab, in particular, with about half of their assets are with registered investment advisors acting as kind of asset gatherers for them. We think they’re very, very well positioned for the long term.

Tobias Carlisle: Thanks very much for that explanation gents. Congrats on fantastic 1, 3, 5, 10 inception returns. Really phenomenal work there. If folks want to get in contact with you, what’s the best way of doing that?

Sean Stannard-Stockton: Visiting our website at ensemblecapital.com. And we have all of our contact information people can reach out to us individually. Intrinsicinvesting.com is our blog. It’s available to the public, not just our clients, and then you can follow us on Ensemble Capital at Twitter as well.

Tobias Carlisle: And Todd your Twitter account, so on.

Todd Wenning: Sure my personal Twitter handle is at Todd Wenning, T-O-D-D W-E-N-N-I-N-G.

Tobias Carlisle: I’ll put those links in the show notes. Sean Stannard-Stockton, Todd Wenning from Ensemble capital. Thank you very much.

Todd Wenning: Sure thing. Thank you.

Sean Stannard-Stockton: Thanks, Toby.

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