Sean Stannard-Stockton is the president and chief investment officer of California's Ensemble Capital, which manages about $500 million on behalf of high-net-worth households, private foundations, nonprofit endowments, and charitable trusts. In interviewing him, I found that while Sean's investing philosophy is similar to Inside Value's: He brings a fresh perspective and some new ideas we haven't heard from previous interviewees. (He also really understands the math behind returns on invested capital!) Below, we discuss reinvestment moats and capital-light compounders, owner-operators, the Kelly Criterion for position sizing, baseline decay rates, his thoughts on businesses including Mastercard, and much more.
John Rotonti: How do you define a high-quality business?
Sean Stannard-Stockton: The most important indicator of quality is the strength and sustainability of a company's moat. A moat is a set of competitive advantages that protect a company from competitors. The fact is that most businesses do not possess much of a moat, and so while they may experience good results – or even great results for periods of time – if their business prospects are compelling, they will attract aggressive competition.
High-quality companies, with significant and sustainable moats, are much more in control of their own destiny. While they will face unpredictable challenges, their moat protects them and provides them with the room to adjust to changing conditions and maintain long-term profitability.
A good example is Tiffany (TIF), the jewelry company. This 150-year-old business controls an amazing brand in the form of their little blue box. Despite operating through huge recessions, periods of inept management and even world wars, the company has been able to thrive because the power of their brand gives them the staying power to recover from missteps. Competitors who might hope to steal their profits have found that Tiffany's brand is such a strong competitive advantage that it is extremely difficult to win Tiffany's customers away from them.
JR: How do you define a high-quality management team?
SSS: We look for two primary traits -- "How focused is a management team on running the business to optimize long-term return on invested capital?" and "How focused is management on maximizing shareholder value?"
The first trait is relatively rare, because many management teams primarily focus on growth. Growth is generally a good thing, but the value of a business is the amount of cash it can distribute to shareholders over time. Management teams that understand this focus just as much on maximizing profit margins and capital efficiency as they do growing the top line.
Return on invested capital isn't just an accounting metric. It is the key driver of how much cash a company can distribute to shareholders relative to its earnings. Companies that focus on growing accounting earnings, rather than distributable cash, will not maximize the value of the business. We believe that one of the most persistent areas of mispricing in the stock market is the fact that most investors link valuation (P/E ratios, for instance) to growth rates, rather than recognizing that it is both return on capital and growth that determines valuation. We want to be sure that we're invested with management teams that understand the importance of ROIC.
The second trait seems like it should be automatic; the whole point of a company is to operate in the financial interest of its shareholders. But many management teams actually have little financial incentive to maximize shareholder value and are instead rewarded based on short-term financial metrics that may be only tangentially related to maximizing shareholder value.
It is important to note that we want to partner with management teams who exhibit these traits over long time scales. Effective management teams recognize that it is not uncommon for the best course of action for maximizing long-term returns on capital [to also be] damaging to short-term results. But managing through this short-term pain for long-term gain is critical for success.
Similarly, in seeking to maximize shareholder value, the best management teams recognize that providing value to all stakeholders – shareholders, employees, customers, and the broader community – is a key element of maximizing long-term shareholder value.
JR: Can you please briefly explain the difference between a legacy moat, reinvestment moat, and a capital-light compounder moat?
SSS: Just because a company has a moat that prevents competitors from stealing their profits doesn't mean they have an opportunity to grow. Companies that have a protected business, but little opportunity to reinvest their earnings in growth, can be said to have a "legacy moat." So long as management recognizes their lack of growth opportunity and sends cash earnings back to shareholders, these businesses can be great investments. The ultimate "legacy moat" investment might be thought of as a Treasury bond. Its future cash payments to owners are known and secure, but there's no opportunity for the cash payments to be reinvested so as to increase par value and future cash distribution power. But even a "no-growth" Treasury bond is a wonderful investment if you pay a cheap enough price.
Companies that do have growth potential come in two flavors: "reinvestment moats" and "capital-light compounders." Reinvestment moat companies have the opportunity to reinvest earnings in the form of capital expenditures or working capital to fuel growth. A good example would be a retailer that needs to build new stores and buy inventory to increase revenue and earnings. These companies can be great investments, but during their growth period, they will have little in the way of excess cash to distribute to shareholders. Indeed, distributing cash would be a poor choice by management if they can reinvest all of their earnings at high returns on capital.
Our favorite type of company is a moat protected "capital-light compounder." This type of company has a growth opportunity, but there is little need to reinvest their earnings to fuel that growth. Service-based businesses often exhibit this characteristic because they sell an intangible service and have limited needs for tangible capital to run their business. These companies grow not by retaining earnings on their balance sheet, but by adding more customers to a business model platform that doesn't need to be invested in to sustain a larger customer base. These businesses produce significant excess cash even while they grow. This is attractive because it means they can return cash to shareholders as well as grow, and because the cash production provides protection against financial issues during recessions.
While the concept of a moat has been articulated by many investors and originates in the writings of Warren Buffett, we'd point to our friend Connor Leonard of Investors Management Corporation for best articulating the concepts underpinning these different types of moats.
JR: Please explain how you narrow down your investable universe and how large that universe is.
SSS: Our investable universe is all U.S.-listed companies with a market cap in excess of our equity assets under management (currently about $450 million). Because we run a concentrated portfolio of 15 to 25 companies, we generally would not invest in a company with a market cap less than our AUM, because doing so would require us to own a large enough portion of the business that liquidity would become an issue and we would feel a need to actively engage with the board, which is something we have not done historically.
However, while this investable universe is very large, we only invest in companies that pass our rigorous requirements that they have a strong and sustainable moat, have a management team focused on generating strong returns on invested capital and maximizing shareholder value, and operate an understandable and forecastable business.
While these requirements are not complicated, they eliminate the large majority of companies. One way to estimate the percentage of companies that we might deem investable after completing our full due diligence process is to note that Morningstar, the only sell-side research organization that rates companies based on their moat, assigns their "wide moat" rating to just 10% of the over 1,500 companies they cover.
JR: Your portfolio is stocked full of owner-operated companies, which is a key criterion that our co-founder and CEO, Tom Gardner, looks for in his search for multi-baggers. Is high inside ownership by the founder and/or CEO a key factor that you look for when researching businesses and stocks?
Interestingly, while about half our portfolio might be deemed to be run by an owner-operator, depending on how you define that term, vs. only about 10% of the companies in the S&P 500, we do not actively target these companies. Instead, we target companies that have the attributes described above, and it just so happens that many of those are run by owner-operators.
We think this is due to the highly aligned financial incentives between owner-operators and shareholders, which makes building a moaty business, optimizing returns on capital, and maximizing shareholder value the only rational choice for an owner-operator to pursue. But we also think it is more than just these management teams having "skin in the game," it is also what [value investor and fund manager] Sanjay Bakshi has referred to as having "soul in the game." Owner-operators generally built their business from the ground up and have devoted their entire lives to their company. They aren't motivated so much by earning more money – indeed, they are by definition already financially independent – but by the fact that their mission in life is to nurture and perfect their company. These sorts of managers often build corporate cultures where employees across the organization understand that these are their true goals, not simply hitting some financial metric.
JR: Are there any industries you tend to prefer? Or avoid?
SSS: We don't categorically avoid any industries, but some industries do not give rise to the sorts of companies we are seeking. For instance, commodity-based businesses do not typically exhibit strong moats, and some businesses, such as large banks and early stage biotech companies, do not typically have understandable (to us) and forecastable business models. But Warren Buffett's recent investments in the airlines industry highlight how previously uninvestable industries can undergo changes that may make them interesting in a way they were not in the past.
JR: How do you approach valuation?
SSS: We think that for the sort of companies we target, the only reasonable way to think about valuation is as the present value of future distributable cash flow. As shareholders, this is really the only claim you have that makes your shares valuable.
Of course, discounted cash-flow analysis is sensitive to a range of factors that allow people to abuse this tool to generate whatever fair value they have in mind. At Ensemble, we have a disciplined framework for generating these inputs that protects us from backing into the valuation we want and instead keeps us focused on the true intrinsic value of a business.
But at the end of the day, our valuation process results in an implied P/E ratio, which provides us with a sanity check. If the implied P/E ratio doesn't make sense to us, we'll stress-test our valuation model to understand what assumptions are driving the unexpected output.
In general, because our portfolio is full of "capital-light compounders" that can distribute cash to shareholders even while they grow, the fair-value P/E ratio of our holdings is higher than the P/E ratio of the market as a whole, since the market is made up primarily of companies with mediocre returns on invested capital and average growth potential.
JR: For those companies that are generating high returns on invested capital (ROIC), do you look for a minimum growth rate of revenue and earnings or free cash flow per share?
SSS: As my example earlier about a Treasury bond being the ultimate example of a "legacy moat" business suggests, even no-growth businesses can theoretically be attractive at the right price. But in practice, most of our portfolio are companies that we believe can grow revenue and earnings at rates higher than nominal GDP. These companies are taking share of the overall economic wallet and thus by definition are seeing an increasing relevance of their offerings. This is an attribute we like to see, but it is not a requirement.
JR: Do you have a preferred measure for the returns a business is generating?
SSS: We care about incremental returns on tangible invested capital. This is the metric that reveals how high of a return the company is earning on each new dollar they are investing in their business. Of course, businesses that can sustainably carry low-cost debt will report even higher returns on equity, which increases the value of the company. But returns on invested capital are the raw fuel that allows debt to be used to enhance returns on equity.
JR: Do you have a particular measure of cash flow that you prefer when analyzing most businesses?
SSS: We focus on long-term distributable cash flow. This is the cash a company generates in excess of any amount they need to reinvest to grow their business. This cash can be returned to shareholders via dividends or buybacks, or can be deployed opportunistically for value-enhancing M&A.
JR: How long do you typically research a business that you are not familiar with before you have enough information and conviction to decide whether you want to add shares to your portfolio?
SSS: Our process typically takes about a month or so of dedicated research by one of our analysts. The output is a written initiation report that articulates an assessment of the key areas I discussed earlier, provides an overview of the business, and includes a 10-year historical and five-year forward financial model that reconfigures the financial statements to conform with the way we look at business models.
If the investment team agrees that the company meets our criteria and the valuation is attractive, we will initiate a position at half the size we would expect to take over time. Then, during the next six to 12 months, as we get to know the business better, we will make a determination of whether our conviction has risen to a level where we will take a full-size position, or if that doesn't happen, we'll exit the stock.
We take these smaller initial positions simply due to our awareness that no matter how much due diligence you do, once you own a stock, you learn a whole lot more as your mind becomes attuned to noticing relevant information. This dynamic is familiar to anyone who has been pregnant or whose spouse has been pregnant, when all of a sudden you notice pregnant women everywhere. Or to someone who has bought a new car, and starts noticing the same make and model everywhere they go. The human mind is able to focus only by being blind to much of the world. But once your mind decides to focus on a new type of data, you'll be amazed how often you start seeing things that are relevant.
My favorite example of this phenomenon is this video that demonstrates visibly just how shockingly blind we all are to information we are not actively looking for.
JR: How important is it to invest in companies that can grow predictably and profitably in this low-growth world?
SSS: The whole reason to identify companies with moats is because these companies have a protected business model that gives us confidence in projecting what their longer-term financial results will look like. We don't believe that we, or any investor, can predict future financial results exactly, but companies with moats give us reason to believe we can make judgements about a reasonable range of outcomes.
However, "predictable" doesn't necessarily mean that results should be stable over short time periods. While all else equal, we would rather a company produce stable and growing earnings, we are comfortable investing in cyclical business models, as long as that cyclicality is a form of volatility around a longer-term stable trend.
In the market today, we believe that the stocks of many non-cyclical businesses are overvalued, and investors too often conflate low-volatility financial results with quality business models. Our portfolio is currently made up of a greater mix of economically sensitive companies than we've held historically, because we've found that these companies are currently more likely to be undervalued. A large portion of our portfolio is currently in the technology, industrial, and consumer discretionary sectors, and while we don't seek to make investment decisions based on sector exposure, we note that these three sectors are currently trading very close to their long-term average valuation levels, while less cyclical sectors such as consumer staples and utilities are trading near the very high end of their historical valuation ranges.
JR: Do you have any performance metrics that you prefer management compensation be based on?
SSS: We love to see performance tied to return on capital-type metrics such as ROIC, ROA, ROE, etc. For capital-light compounders where little capital needs to be deployed, performance tied to profitability can often achieve the same effect. At the end of the day, we want executive compensation tied to the degree that management drives up the intrinsic value of a company and/or returns capital to shareholders.
However, we believe that Total Shareholder Return (stock appreciation plus dividends) is often not a good metric unless it is measured over long time frames, as management should not be incentivized to try to prop up the stock price in the short term.
JR: How do you try to avoid big losses that could interrupt the compounding of your portfolio?
SSS: First of all, every company we invest in has a moat, and our hope is that when we are wrong on valuation, we will end up recovering at least some of our investment by the company successfully increasing its intrinsic value over time. In these instances, we may underperform, but not see a permanent impairment to capital.
After limiting our investments to high-quality moats with sustainable competitive advantages, we believe our framework for position sizing is our most important tool for controlling risk. Position sizing is one of the most underappreciated aspects of investing. Everyone on CNBC will tell you what stock they think you should buy, but no one ever says how much to buy!
Our position sizing framework is built on the insight of John Kelly, whose collaboration with Ed Thorp resulted in the Kelly Criterion. The Kelly Criterion shows that it isn't just the amount of potential upside an investment has that should influence position size, but the degree of likelihood of a successful outcome.
The logic of this is easy to see. No one would bet their life savings on a coin flip, even if being correct meant winning 10x. The 50% chance of losing everything means that this very attractive proposition should only be taken with a relatively small amount of your wealth. Whereas a bet that paid you 2x, but promised a 99% chance of winning would quite reasonably justify putting down a much larger stake.
In our portfolio, we rank our holdings based on our level of conviction in a successful outcome on the one hand, and on the degree of expected upside on the other. At any given level of potential upside, we'll take a larger position in a company that we have more conviction in. This framework results in taking positions at cost in the 1% to 7% range. After accounting for appreciation, we don't let any position size get to over 9% of the portfolio. Our practice of taking half-sized positions at initiation is essentially a way for us to recognize that our conviction is more limited until we've spent more time learning about a company as actual shareholders.
In addition to limiting the amount to which appreciation can inflate a position size, we are also cognizant of the risk that adding more and more money to a stock that keeps declining can present. So to guard against being stubbornly wrong on a stock -- avoiding "value traps," as they are often referred to -- we cap the amount of total capital we will invest in a stock at the same percent that we cap a position size based on appreciation. So if we buy a 5% position, and believe it should be capped at 7% if it appreciates, we will similarly stop investing more capital into the position if, after successively buying more as it declines, our capital investment at cost reaches 7%.
JR: When do you sell? Will you hold a high-quality company that is fairly valued?
SSS: A key element of our valuation process is that our forecasts of future revenue growth and returns on capital are bounded by historical baseline decay rates seen by public companies. Using research by McKinsey, we estimate the rate at which revenue growth will slow and return on invested capital will decline over time. We use this data as a base rate in making forecasts, and then use company-specific analysis to shift our estimates away from these base rates.
This "base rate" forecasting methodology comes from the esoteric-sounding field of Bayesian statistics. But political forecaster Nate Silver offered an excellent layperson explanation of this process in his book The Signal & The Noise: Why So Many Predictions Fail -- But Some Don't, and it is discussed in the book Superforecasting: The Art and Science of Prediction by Philip Tetlock. The fact that most equity analysts ignore base rates and instead make forecasts based only on their company-specific analysis is the reason why equity analysts as a group systematically overestimate growth rates. You can see this illustrated by looking at the way that total revenue and EPS growth rates for the S&P 500 systematically start the year off at excessively optimistic levels and decline over the course of the year.
What this approach means is that our fair values are based on the company in question experiencing competitive pressure on their results that is similar to the average company. Since we seek out companies with strong competitive advantages, we hope these base rates and the resulting valuation are conservative.
Therefore, we are willing to hold stocks that have appreciated to a level that we believe is fairly valued, unless we have better use for the sales proceeds (i.e., a more undervalued stock that we do not have a full position in). But if a stock appreciates to 10% to 20% above our conservatively calculated fair value, we'll exit the position and go to cash if needed. This isn't unlike the behavior of the companies we invest [in]. Very few management teams of great companies would sell out for fair value. Instead, they would require a premium bid to sell. As shareholders, we feel the exact same way.
JR: What common characteristics or patterns do you recognize in some of your biggest winners?
SSS: Our biggest winners over the last five to eight years, such as Mastercard (MA 0.77%), Apple(AAPL 0.48%), and Broadridge Financial (BR 2.85%), all exhibit a similar pattern. We bought them at a discount to fair value based on our conservative outlook for their results at the time, and then actual financial results significantly exceeded our expectations, leading to the intrinsic value growing quickly, such that even after very large increases in the share price, we still believe these securities are undervalued.
This is a big reason why we favor capital-light compounders or reinvestment moats over legacy moats. A legacy moat business can be bought cheaply, but without the ability to reinvest capital at high rates, the intrinsic value of the business isn't going to appreciate very much. Whereas a capital-light compounder like Mastercard, which has grown earnings at a mid-teens rate even while paying a dividend and buying back significant amounts of stock, has seen its price appreciate by almost 700% since 2010, even while being, in our judgement, significantly undervalued the entire time.
JR: What lessons did you learn or patterns do you recognize from some of your losers?
SSS: Unfortunately, one mistake we've made a number of times is buying into a company whose financial results were inflated by an unsustainable tailwind that we did not recognize at the time. Our investment in National Oilwell Varco (NOV 6.75%) in 2010 is a good example. We believe that the major decline in the rig counts since oil prices crashed is a cyclical event, and rig counts will continue to rebound back toward previous highs. But we underestimated the extent to which purchases of ultra-deepwater rigs, which produces far more revenue for National Oilwell Varco per rig than a shale oil rig, were inflating National Oilwell's new orders when we first purchased the stock.
Since we typically don't try to time industry cycles, and instead focus on identifying normalized levels of demand, this mistake isn't so much related to the cycle turning faster or slower than we expect, but rather us not recognizing a driver of current results that is unsustainable.
Charlie Munger has discussed how he and Warren Buffett made this type of error when they bought COIT, a furniture rental company, during the dot-com boom. What they didn't realize at the time was that dot-com companies were greatly increasing the demand for renting office furniture, and so while COIT seemed nothing like a speculative tech stock, in fact the company's financial results were being unsustainably inflated by the bubble in technology stocks.
JR: According to S&P Global Market Intelligence, Tiffany has generated an average ROIC of 13% and grown revenue at a 2% CAGR over the past five years. Would you rather see Tiffany boost growth or boost returns?
SSS: Increasing growth and increasing returns on capital both enhance the value of a company, because both actions result in the production of more long-term distributable cash flow. An interesting mathematical fact is that companies with high returns on capital can increase their intrinsic value the most by increasing their growth rate, while high-growth companies should focus on increasing returns on capital.
If you imagine a grid with growth on the x axis and ROIC on the y axis, companies should seek to drive the business toward the upper right quadrant. If they are in the lower left, they should direct their attention equally toward increasing growth and ROIC. Those in the upper left should seek to grow faster while those in the lower right should seek to increase returns on capital.
JR: What are your thoughts on current stock market valuations?
SSS: We spend very little time thinking about market level valuations. If you own 20 companies, you focus your attention on the valuation of those stocks and don't worry too much about where all the rest of the stocks in the market are trading.
But as a generalization, we think the market is within the relatively wide range of what we would consider fairly valued. Given [that] the trailing P/E ratio of the market is above average, the current valuation suggests that earnings growth over the medium term will be faster than normal, or that interest rates will stay permanently low. In the latter case, low rates make it reasonable for investors to accept a lower rate of return on equities. A high valuation does not imply a coming fall in stock prices; it simply implies that future long-term returns will be lower than historical returns.
Both of these outcomes, which would support current market valuations, seem plausible to us, given the fact that the US economy is operating well below its historical level of trend growth, and so a cyclical reacceleration in the economy could be coming as the headwinds from the financial crisis recede. And while we think interest rates will move higher over time, we may be wrong in this outlook. Certainly, they have been persistently lower than we have expected them to be, and so it is not unreasonable to think we may be in for a very long period of low rates.
JR: Your Intrinsic Investing blog is one of my favorite resources on investing. What are some of your favorite things to read online?
SSS: Aside from The Wall Street Journal and The New York Times, which together provide an excellent overview of what's going on in business and the world at large, we find the writing of other bloggers to be an excellent resource for exposing ourselves to new ideas, opposing points of view, and thoughtful, in-depth analysis of topics we care about.
Some of our favorite blogs include Abnormal Returns, Fundoo Professor, Market Folly, Philosophical Economics, Base Hit Investing, Punch Card Research, and the writings of Jason Zweig and Morgan Housel.