Risk Assessment: Kinsale Capital & Chewy

Investors need to understand risk. In this podcast, we run through a 25-point system for assessing the risk of losing money on an investment.

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This video was recorded on January 24, 2024.

David Gardner: Risk. A lot of people talk about it, but especially in the investment world, I've never found that talk very satisfying. First of all, how do they define risk? What does it even mean to say that's a risky stock? The definitions are often unclear and then some analysts in the risk section of their stock report will say stuff like medium as in this is a medium risk stock, what does that mean? Well, more than a decade ago, I developed a 25 point risk rating system that I've used as a Rule Breaker investor ever since. I defined risk, well, at least what that word means to me as an investor and we went on not just to put a word to the riskiness of the stock, not just a word like medium, but to go on to put a number on that stock's risk, a number to give you a much more specific understanding and that number is itself based on 25 questions asked of each stock. You know what? We're going to cover the whole thing this week. Joined by my two friends, Andy Cross and Emily Flippen, we three are going to teach you the entire system, help you rate stocks yourself along this very important dynamic of risk, only on this week's Rule Breaker Investing.

Welcome back to Rule Breaker Investing. This week, joined by two all star Motley Fool advisors, we're diving into assessing investment risk using my 25 point risk rating system. Now for those keen on exploring further, I've covered this in March 2016's Risk Month series, which I did for this podcast nearly eight years ago, now available through a quick Google search if you just Google Rule Breaker Investing, risk ratings. These podcasts, although featuring companies that may no longer be public, provide a deep dive into this same material and speaking of that, in 2021 we did episode two in Calculating Risk Foolishly, in which we use the same approach to risk rate, Chegg and Toro, so if you enjoy this week's podcast and you want more examples, there you go.

Risk in equity investing, as I define it, is the potential loss of a substantial portion of capital over a significant period, like say at a minimum three years, so understanding this risk at both an individual stock and portfolio level is crucial. Our system created to provide clarity and risk assessment moves away from vague terms like medium risk. The system is straightforward, we ask 25 yes-or-no questions. My favorite type of test, growing up as a kid, yes or no, you know multiple-choice start to get stressful, let alone short answers. Yes or no questions, 25 of them about a stock and each time we answer no, that indicates higher risk, so each no adds a point making the higher the score, this is logical, the higher the risk. This approach is not just for individual stocks, it can also be applied to entire portfolios by calculating the weighted average risk score of all holdings. This method challenges the conventional belief that high risk equates to high reward. In fact, I found anyway, lower-risk stocks can offer greater returns, and that is a truly rule-breaking realization. Well, without further ado, let's now delve into the system with our advisors and explore its application with two example companies. Andy Cross, how are you doing?

Andy Cross: I'm great, David. Thanks for having me. It's great to be here to talk about risk.

David Gardner: Thank you. It's a good topic. In some ways it sounds like a downer, it's a word with a negative connotation, Andy. But this is actually a beautiful important topic.

Andy Cross: Well, it certainly is if you just think about life in general, there's just risk all over the place and understanding, having a great fundamental playbook and a way to think about addressing risk, managing risk, my company, I'm going to talk about deals in risk every single day and that's what they specialize in, and I think that's a great topic to share with investors.

David Gardner: Well Andy, thank you so much for joining me again here at the start of 2024, our Chief Investment Officer, it's an honor to have you.

Andy Cross: Thank you for having me, David.

David Gardner: Emily Flippen, how are you doing?

Emily Flippen: I'm doing well. Thank you also for having me.

David Gardner: You bet. Emily, what are you working on these days around the Fool?

Emily Flippen: Yes, a lot of my time has been devoted actually, to Stock Advisor. Still working on your legacy portfolio.

David Gardner: Thank you.

Emily Flippen: David and Blast Off as well, but mostly focusing on businesses that when we talk about risk, have well balanced risk and reward profiles for our main service, Stock Advisor.

David Gardner: Thank you, Emily, and thanks for all the good work you've done here. How many years now at The Motley Fool, you can include your summer internship?

Emily Flippen: That's a good question. I believe my summer internship started in 2016, but I don't think I was hired on full time until 2018, if memory serves, I say that very tepidly, but I'm not positive.

David Gardner: I'm going to say something like lucky seven, so wonderful again, Andy and Emily, welcome. Andy, what is the company you'll be bringing to our risk rating assessment this week?

Andy Cross: David, I'm talking about Kinsale Capital, which is an insurance company, so I mentioned risk they deal with risk in a very unique part of the property and casualty market, so Kinsale Capital, KNSL.

David Gardner: Thank you very much. KNSL, the ticker symbol. Emily Flippen, what company are you bringing to risk assessment week here at Rule Breaker Investing?

Emily Flippen: Well, I'd be remiss if I didn't bring one of my favorite businesses, Chewy, The Pet e-commerce retailer.

David Gardner: Excellent, ticker symbol?

Emily Flippen: CHWY.

David Gardner: I really appreciate both of these companies and the contrast that we have between them because I can't really imagine two much more different businesses, I guess maybe I could, maybe one of them could literally be still try to be selling, I don't know, horse and carriage solutions and somebody else is going to outer space, but this is still a pretty good contrast, an insurance company and a popular pet food retailer, so this is going to be fun. It's the same system, the same 25 questions, without further ado friends let's get started. The first five of our 25 questions, deal with the company itself in this case, the companies and question number one, which I entitle, each one has a brief title. This one's called Profitable. Was the company profitable during the previous quarter and the past 12 months? We're going to go Kinsale, Chewy all podcasts long. Andy, was Kinsale Capital profitable both in the last quarter and the last year?

Andy Cross: David, yes, it was very profitable with net income margin around 25% for both the past year and the past quarter.

David Gardner: Emily Chewy?

Emily Flippen: Well, I don't want to split hairs here Andy, but define profitable? [laughs]

Andy Cross: Well, exactly, for my company, I'm talking net income bottom line. Your company may be a little different.

Emily Flippen: I'm not going to try to cheat here, I'll also use those same metrics. Although I will note that if you use something like adjusted EBITDA margins or operating margins, the answer may change, but in the case of Chewy, no, it was not profitable. It was over the trailing 12 months, but in the most recent quarter, they did swing to an operating loss. Now a lot of that was non cash expenses, but the business has also been investing pretty heavily in fulfillment and logistics, so this is a company whose margin profile has changed over the course of the last few years.

David Gardner: Thank you. I should have said this up front, but I'll say it right now. When we rate risk, we're not rating whether you should be buying this stock or not. We're not saying this is an amazing company or a bad company, we're just looking at what I perceive to be the risk of an investment again, the higher the rating, the higher the risk. Some of my best stocks ever have been quite risky, and some of my worst picks have been not that risky and so it doesn't rate quality and we're not cheering one of these companies on over the other. Although Chewy fans, how can you help yourselves? But with that said, let's move on to question number two. I will note then that Chewy got a plus one from question number one, so at present, and I'll keep score throughout. Chewy is a one and Kinsale is a zero. Let's move on to question number two. Not that far off profitability friends, but this one counts two and they're separate, cash flow, is the question yes or no? Question number two, was the company cash flow positive during again, the previous quarter and the past 12 months? Andy?

Andy Cross: Yes, it was David. Insurance companies, because of the way their business shapes up with all the accounting and the estimates, the best way to measure cash flow is really through profit that we talked about in the first point. But still, because Kinsale is so profitable, it does generate that cash that their team can use. So yes, for the past year and the past quarter, it did generate positive cash flow.

Emily Flippen: On the complete flip side, Chewy is the exact opposite, which is, they're growing e-commerce company like this. A little bit easier way to evaluate their performance is by cash flow, and cash flow for Chewy is also positive over the last quarter and the last 12 months. So they are self-funding.

David Gardner: Emily and Andy, why do you think I say both the previous quarter and the past 12 months? Why do we do that?

Emily Flippen: I think to get a sense about how a business has performed over time, no single point in time is really indicative of how a company is doing. You can have one quarter or one year that looks really good and then that trend, how it has changed, could paint a completely different story.

David Gardner: Absolutely. Let's move on to question number 3. This one's entitled brand. Does the company's business rely on recognizable branding truly valued by its buyer base? Kinsale Capital, Andy Cross.

Andy Cross: This is a difficult one for non-insiders insurance experts to really understand. As much as I love Kinsale, I can always learn a little bit more. David, I'm going to say no. Kinsale's business does not rely on a recognizable brand. It's the 20th largest insurance company in the excess and surplus, the E&S market that it serves. There are lots of other larger companies: Lloyd's, Berkshire Hathaway, Markel, others. Insurance is more of a commodity business, so I'm going to say no for this. They are exceptional operators, but in a commodity business that is so price-sensitive, brand doesn't quite play as well as it does in other parts of the market.

David Gardner: I agree with you, Andy. So let's give plus 1 to Kinsale right there. Let me ask you. Who strikes you as pretty good at brand in the insurance world?

Andy Cross: Well, it's interesting if you look at the property and cash of those PNC large companies, that are spending an enormous amount of advertising. My kids love watching the Liberty Mutual commercials. The Liberty Biberty guy who comes up there and the guy with the Emu, those commercials and of course, GEICO owned by Berkshire Hathaway is so iconic. Kinsale, I should say, deals mostly with small and medium-sized businesses. Those other companies deal a lot with consumers, and so the consumer brand love is more recognizable and needed in those companies than in a company like Kinsale.

David Gardner: Emily, Chewy, have you ever heard of it first of all?

Emily Flippen: Yeah, I never heard of it before I started researching this. [laughs] I had never seen its boxes sitting on doorstep, so really, one that I think clearly fails this test and I'm teasing. Andy, I'm surprised you didn't say Chewy for an insurance company that has a good brand, because Chewy does, through its partnerships with Trupanion and Lemonade, actually have a burgeoning pet insurance business. But one of the benefits of being a pet-focused consumer-facing brand is, yeah, people love their animals and they love the people who sell them pet food.

David Gardner: Well said. We're 3 of the 5 questions through our company section. Both companies have 1. Again, plus ones are bad. I know plus 1 is like a thing out there in social media. Now, plus 1 Andy, like I'll plus you up, not for our risk rating system. The higher the number, the worse things get. You want to have as many zeros, as many yeses that give you zeros as possible, noes generate plus 1. I won't have to say that again. I think we're all clear on that now. Let's move on to question number 4. Diversification is the title of this one. Andy Cross and Kinsale Capital, has the company diversified its buyer base so that no single customer accounts for more than 20% of revenue?

Andy Cross: Yes, Kinsale Capital has a very diverse buyer client base and it's a specialty of what they do. Insurance companies tend to have diverse client bases, but Kinsale has specialized in serving small, medium-sized businesses in a way, at scale using technology the way that other companies competing in that space really haven't been able to do and it's one of the secret sauce I love about Kinsale and the reason we continue to support it. It can do this and serve lots of different clients across lots of different parts of the insurance market because of the technology it's built. So yes, a diverse buyer base.

David Gardner: Emily, what about Chewy?

Emily Flippen: Well, I do buy a lot of pet food off of Chewy, but luckily, I don't think I've quite reached that [laughs] 20% of total sales for the business yet, so obviously, yes, no. Because of the consumer-facing nature of this business, no customer is responsible for the majority of their sales nor suppliers, so a good sign for this business.

David Gardner: Andy, why do you think diversification is important, just when we're assessing risk?

Andy Cross: If you think about the influence and who best impacts, the buyer or the seller, being able to negotiate price, being able to have influence on the business. If a company has a large client who wields a lot of power, and we do have some wonderful businesses that do have a more concentrated client base, Arista Networks is an example that has a very concentrated client base, with Meta and with Facebook, for example. Concentrated client bases do pose a little bit more risk because those clients can have a lot more say in pricing and what gets done to the business that you really want the operating company to have instead of the buyer.

David Gardner: Well said, and in fact, it's really part of our Motley Fool history. Andy, especially you who've been with us 20+ years will remember this. But at one point, our business model was to please advertisers. We had a few huge advertisers. This is like 1990s AOL, early web experiences for us. We only had a few customers, they were our advertisers, big discount brokers, and all of a sudden, when things went south hard for our whole society in 2001, that hurt our business very badly. We're a much stronger business today. You'd hope that for us three decades later, because we have many different members, many subscribers, many Fools, not just a few people writing big checks, definitely recognize it's a safer business model. Let's move on to the final question about the company. There's some overlap between these. For example, often profitability and cash flow have overlaps. There's also an overlap between brand, which was number 3 and number 5, raving fans. Now, they're related, but they are different. Raving fans, does the company overall, question number 5 asks, receive positive word of mouth from its customers? Andy Cross.

Andy Cross: Well, I'm going to say no again from this one and it's not that Kinsale doesn't serve its clients very well. It does and the team that runs Kinsale, I have a lot of respect for Michael Kehoe and the business he has created with his team. But in general, insurance, at the business side, doesn't get the raving fans. Emily, you mentioned Lemonade which has a wonderful brand recognition with so many of its customers. It's had some challenges actually running the insurance part of their business, but it does have that great brand and loyal fans and raving fans. But Kinsale not quite as much. Again, I'm sure there are businesses out there that love their relationship with Kinsale, but it is that those businesses, those small medium-sized businesses, are looking for the best price and the best operator, and that's what they appreciate more than really trumpeting who they are spending insurance with.

David Gardner: It would almost be a weird world if Kinsale Capital did have legions of raving fans. In some ways, Berkshire Hathaway got there through a brand that was non-descript at the time and a business that it took a long time to build into a massive place. But I think Berkshire does have raving fans for lots of different reasons. Kinsale though?

Andy Cross: Well, for lots of different reasons. Not so much for their insurance business Ajit Jain and what he has built and Warren Buffett, obviously, but not so much for their clients raving. Although I'm sure there are clients who are very happy with Berkshire Hathaway.

David Gardner: But they're investors and people who are selling the stock, you're right. Emily, let's move to Chewy. Would you say that Chewy has raving fans?

Emily Flippen: I'll use an example that CEO Sumit Singh highlighted during Chewy's Investor Day last month when he talked about what customer service means for Chewy. He used an example of a customer, an elderly woman in an apartment in New York who called in because her Chewy box got delivered downstairs and she was unable to bring it up to her apartment. What that customer service representative did was call a pizza for that woman. Asked the pizza delivery driver to bring the box up with him when he delivered the pizza, which of course he did. That's how you get incredible raving fans. It's also how you get a lack of profitability occasionally, but we'll leave that aside. In this specific case, I think it's fair to say that people who are shopping on Chewy generally do so because they associate with the brand and they become raving fans of the company as well.

David Gardner: Very well said and we're going to call it right there after our first five questions. That was our, the company section. We're about to move to financials section. Every one of these 25 questions counts for the same. Now, you could easily make this whole process more complex if you wanted to say, well, actually I think question 3 is twice as important as question number 1. I want to make it very clear that anybody is welcome to take the system and warp it into whatever way you want, and in fact, part of the system, we'll see this later, is designed to allow you to customize it some to yourself. These are radically different businesses. We're using the same general approach. I think there's a strength to that, a lingua franca, that you can use the same system across vastly different industries. But I also want to say, in some ways, it's intentionally over simple. I think both of my talented advisors here would recognize that. But they're being polite, not saying that, and playing the game with me. Now, before we move on to financials, I do want to mention we talk a lot about stocks on this show, this being yet another example. It's just a peek into The Motley Fool's investing universe. This is a quick ad read on behalf of my favorite company in the world.

This year, The Motley Fool is rolling out a new offering, and it's called Epic Bundle. The service includes seven stock recommendations every month, model portfolios, and stock rankings, all based on your investor type. Now we're offering Epic Bundle to Rule Breaker Investing listeners at a reduced rate as a thanks for listening to this podcast week in and week out. For more information, head to fool.com/epicbundle198. Secret number there, that's fool.com/epicbundle198 to get more information about Epic Bundle and a reduced rate as a thanks for listening to Rule Breaker Investing. We're also going to include a link in the show notes for you. As we start the financials, I want to note Chewy is at 1 right now, Kinsale Capital, surprisingly, similar because I would just think an insurance company is clearly going to be safer and less risky than an internet-based pet retailer that has a lot of raving fans picking up their pet food and lockers in different places. Right, Emily, is not part of this?

Emily Flippen: You'd think so? Yes.

David Gardner: We'll now brass tax time onto the financials. Question number 6 is entitled growth. Did the company increase its sales by 10%-40% annually in the previous three years?

Andy Cross: Yes, Kinsale has been a wonderful growth company, especially for an insurance company, and its three-year average compound growth rate is more than 30%. They have consistently been able to generate high levels of growth.

David Gardner: Wow. Part of this is there's an upper bound that I placed there at 40%. Because the thinking goes, if your annualized three-year sales rate is rocking at above 40%. While that's amazing and I may well want to be a part owner of your company, it does entail more risk. It's going to mean that there are a lot of expectations that big growth is going to continue, and so that's why there's an upper parameter bound here, 10%-40%, three-year annualized sales. Emily Flippen. Chewy. Did this company increase its sales by 10%-40% annually over the last three years?

Emily Flippen: I'm going to say no. Now if I use a compound annual growth rate over the previous three years, that comes out to a nice, beautiful 20%, and I could easily say yes. But I think that misrepresents exactly what's been going on with the business. In 2021, sales growth was 47% so above the above bound, and in the last quarter, sales growth was 8%. You can see how business has massively slowed down in the post-pandemic world.

David Gardner: I really appreciate, Emily, that you're using nuance. You could mechanically answer this, as you said, 20% yes. Anybody who takes up this approach is welcome to do that if in their minds, that is good, steady sales growth and they esteem that and like it, then keep it at a zero. But Emily gave the company a plus 1 here because of its jumpy nature up and down, and a little bit less reliable. Here you're using your own brain, Emily. Not just checking boxes on somebody else's test, and that's absolutely the spirit of rating risk for stock. Thank you. Got that. Chewy moves up to a two-tying Kinsale as we move into Question 7. This one is entitled independence not political independence, which is very much on our minds in 2024, but no, financial independence. Andy and Emily, can your companies operate their businesses without relying on external funding?

Andy Cross: Just a little riff on this question, David. I've always loved this question as part of the risk ratings, because of the way we phrase it. The way that you created the intention of it, can a business operate without relying on external funding? That brings in all different ways to support the business. That perspective, I think, is very healthy for investors to have across all of their investments. Of course, we've seen what happens when companies can't sustain their own operations and they have to go out and borrow, raise capital through share issuances and how that dilutes current shareholders. I really think this is a great question when it comes to risk. Yes, Kinsale, while insurance companies relying a lot on different puts and takes when it comes to moving capital around and funding their business. Because it is so profitable. Because it runs so operationally efficient. Yes, it can operate its day-to-day business on its own with independence.

David Gardner: A happy yes for Kinsale Capital. I can't say I'm surprised on this one, financially strong company. Emily?

Emily Flippen: It may be surprising for some investors, but for Chewy this is also a yes. The business has been consistently free cash flow positive even during their logistics and fulfillment build-outs over the last couple of years. They have no long-term debt aside from their leases. They've not issued more equity since going public, although they do rely on share-based compensation as many businesses do. They have nearly a billion dollars in cash.

David Gardner: Yeses for both. Let's move to question number 8. Disclosure. Does the company maintain a high standard of disclosure consistent with SEC guidelines?

Andy Cross: I'm going to say for Kinsale, yes, it does. When you check through the way that they communicate to shareholders, what they file, not having massive risk disclosure about this and about with the SEC, Kinsale is pretty clean when it comes to this. I'll say yes, the company does maintain a high standard of disclosure.

Emily Flippen: I also say yes for Chewy. I think this is one of those questions where I read as innocent until proven guilty. There's nothing in their financial statements that would make me think that anything is a miss. They have independent auditors, they've never missed deadlines for filing with the SEC, no history of fraud here. I will give them a yes until they tell me that that should be a no.

David Gardner: I like that approach as well. I generally prefer to lead with trust. It works in life, it works in investing too. Sometimes you get burned and Archer-Daniels-Midland has gotten hit this week because of some questions about its own transparency. I think the spirit of this question is very much, is the company communicating forthrightly? I also want to add, Andy and Emily, that I do believe that the United States and our approach to disclosure 10Qs for a year, a 10K is a world standard. I won't even say a gold standard. Maybe the Europeans think that they have a better approach. But especially in the Western world, I think that there's a tradition of transparency that is a real strength and something that I expect as an investor. That's really what this is about. I would say without trying to be chauvinist in the traditional sense of the word, like Chauvin who thought the French were the best ever and all his things were the best things. I do think we should appreciate the standard of disclosure that the Securities and Exchange Commission has built up over time in this country.

Andy Cross: I think if a company is going to cheat, lie, steal, embezzle, commit fraud. We've seen time and time again it is possible for insiders to do this. But I agree, David. I think the way the SEC monitors, enforces, how companies have to rely on those rules, how technology is playing into play, more and more about this. How communities like The Motley Fool and social media is on top of these companies. It is becoming harder and harder.

David Gardner: We're watching.

Andy Cross: Exactly as we should as investors David, when we of course first started, it took forever. It was very hard for us to get on conference calls. We used to have analysts be yelling at companies to try to get access to conference calls. Now that disclosure is all now more public. It is more difficult and the spotlight is brighter. But if they want to cheat, lie, embezzle, as we've seen time and time again, it is possible to do.

David Gardner: Well, that was number 8 disclosure. Unfortunately, both Kinsale Capital and Chewy, according to my friends Andy and Emily get yeses on that question. I was fudging it a little bit. I started to use a word that we use for the next question. I started to say transparency at different points in the last few minutes of this podcast. Well, that's actually a separate thing from disclosure as Question 9 makes evident. Yes, both of these things count for us. Here we go. Question number 9, transparency. Andy, Emily, would an intermediate investor find your company's financial statements and management ownership disclosures relatively easy to sift through and understand?

Andy Cross: What is a game show when you can ask for a life line?

David Gardner: Yeah.

Andy Cross: This was the most difficult one for me, with Kinsale and Emily.

David Gardner: Who wants to be a millionaire?

Andy Cross: Yes. Who wants to be a millionaire? I believe that's right.

David Gardner: It's been a while.

Andy Cross: It has been a while. I need a lifeline for this with Kinsale. Again, nothing against the company more about just the depth of this because the way this question is phrased, relatively easy to sift through and understand. Insurance companies are not easy, that they are complex, they're very regulated, so it's difficult for even an intermediate investor to truly understand. I said no on this. Nothing against the company or the disclosures per se. It's more about the insurance market and business. If an investor relatively knew was going to start, I wouldn't necessarily encourage her to learn everything about insurance. Although I know that's how Warren Buffett and many other investors have started. It's a great field to understand, but it's not relatively easy even for the intermediate investors. I'll say no with this one, but I could use a lifeline.

Emily Flippen: You know, interestingly enough, I'm also going to say no. Chewy should be an easy business to read about and understand and unfortunately, it's not. Chewy has a somewhat complicated relationship with its former parent company, which was PetSmart. The founder and CEO, former CEO of Chewy, sold the company to PetSmart in 2017 for just over $3 billion and since then, PetSmart has since spun the company off to go public. They're in the process of selling off that ownership stake, which is now owned by private equity which has the vast majority of voting shares within the business itself, so not super shareholder friendly. The dual class share structure that Chewy does have, I think dilutes the value of buying their public shares. For that reason, it's not exactly transparent. Not super easy to understand the organizational structure of this company, despite the fact that the business is pretty easy to wrap your head around.

David Gardner: I really appreciate what you both said. What we just discovered is that they get yeses for disclosure. They're obeying the rules, they're being good soldiers here. But when you actually watch what they're doing, it's hard to read or understand. That doesn't mean anything is amiss and it does mean that if you are not an intermediate investor, and we have a lot of people listening right now who are advanced investors, we have a few around the table as well, then that's probably not a risk factor for you. But for a lot of the rest of us, yeah, a stock is riskier if we have a hard time understanding what we're reading when we go through their legal well timed disclosures. An important point about the contrast between Questions 8 and 9 let's close it out Financials 5 here as well, just like company, so that means number 10 is the last of the financials. It's entitled well managed. Here's the question, Andy and Emily, did the company report a return on equity of 15% or more in the previous year? Andy, as our Chief Investment Officer, perhaps you could briefly define the term and convey, especially to those who don't use it. I don't use this very often, but I like this as a risk question which is why I inserted it here in number 10. But, briefly orate on return on equity and then give us the Kinsale answer.

Andy Cross: Well, and it's a high bar too. Return on equity is the profits a company earns on the shareholders equity, the book value of the company, which is simply the assets a company owns, minus of liabilities. That's the equity, that's the book value. Return on equity, what is the return on shareholders equity that they invested into the company? Because Kinsale is so well managed in the way it's build its business, it is comfortably above this. It's return on equity pretty consistently is in the 20-30% range. Basically, $0.20-$0.30 of every dollar that is invested into the business from an equity side for shareholders is returned back to them in profits.

David Gardner: Emily, do you spend a lot of time looking at return on equity as you're picking your next stock for Stock Advisor or Blast Off?

Emily Flippen: No, it's funny. I think a lot of investors would think, yeah, of course you do. But I can't look at the historical performance of return on equity until I have an understanding about where I expect that business to be long term. Typically, return on equity will fall in line with expectations for business performance. When I'm laying out, where do I expect say Kinsale capital or Chewy to be in five years it's probably possibly, Kinsale may be less so Chewy, definitely different than it was five years ago. I tend to look at it in the context of my business expectations for the go ahead period.

David Gardner: What's the answer here for Chewy?

Emily Flippen: With that in mind, the answer is no for Chewy, I do think that will change. I want to remind investors that while they may not have a return on equity above 15% in fact, I think it may have been negative in the most recent quarter, although it's had periods of fluctuating between the low single digits to the high double digits. This is a business that requires a lot of intensive capital build outs in the initial phases of its expansion before we start to see even those low single digit net income margins and earnings really start to lift up. This is a business that is still pretty heavily in investment mode. Don't penalize Chewy too heavily, our businesses in general too heavily on return on equity when you expect that the previous trends could reverse in the future by the nature of its business.

David Gardner: Fair again, and we're going to give it a plus one. But I do want to make it clear this system is for all of us. Use it or lose it in any way you want. You could give a half point, I tend not to, but you know, half points are perfectly fair. We're not going to do that this week, but anybody who wants to give a half point, certainly you're allowed to do it. We've just finished the first ten of our 25 questions. We've covered the companies themselves, and their financials. We have Kinsale Capital at a three right now and Chewy at a four. Let's move on to the next section. There are three questions when we think about the all important topic of competition, which certainly factors in to our thoughts about the riskiness of a stock that you might be buying. Question number 11. The first of competition is entitled underdog and it reads this way: Is the company free of any direct competitors that have substantially greater financial resources? That's what I call underdog. Basically, are they competing something bigger that can do more stuff than they can with more money than they have?

Andy Cross: Well, David, listeners may predict the answer to this one for Kinsale, because I had mentioned it's the 20th largest player company operating in the E&S market, that excess and supply market. Many of the competitors are much larger than they are, so no, Kinsale is not free of any direct competitors that have substantial, greater financial resources. It's a great company and a $9 billion company market cap, so fairly good size. But there are lots of larger insurance companies that I have mentioned, Berkshire Hathaway, Markel.

David Gardner: Yeah. Those do represent threatening competition in some context.

Andy Cross: Yes.

David Gardner: I don't know how much it does in the insurance industry. I would even say when there are a lot of bigger fish than you, there's a chance you could get bought out at a premium at some point if you're the number 20 player. Although I often don't root for that in my companies because love my companies, I want them to persist and grow on their own, not get swallowed up at some early stage by somebody else. But it's worth looking at the other side of that coin briefly as well. Emily, what about Chewy?

Emily Flippen: As any pet owner will know, the answer here also has to be a no. Chewy is in the specialty retail market, competing with not just PetSmart, PetCo, but with virtually any retailer that carries any pet goods. In addition to all of the smaller businesses has like pet insurance being a good example or pet healthcare. Amazon itself has autoship sales, very similar to Chewy's that competes with them on price and ease of delivery. There is certainly plenty of large, well-resourced, well-financed companies that will attempt and have continued to attempt to knock Chewy off its pedestal.

Andy Cross: I actually receive the same product for our dog, green Chewy bones from both Chewy and Amazon in different months. I have them on autoship, on both, and so I just play each other.

Emily Flippen: Will be less efficient.

Andy Cross: I use both of them. But I do that really because of Chewy's customer service and the personalization they bring.

David Gardner: But why Amazon then Andy, I get the Chewy half of it?

Andy Cross: Well, sometimes because Amazon is a little bit more efficient and quicker if I really need to up it. I already have it like in my history that I can just be like, oh, please send me that right now.

David Gardner: Yeah, no shame there.

Andy Cross: I use them both. I'm only a shareholder of Amazon not Chewy.

David Gardner: You bet. Well, that's the company is underdog. Question number 12 goes the opposite direction. Let's do this one. Number 12 is entitled Goliath. Here's the question: Is the company free of any disruptive upstarts, visibly challenging its business model? Andy.

Andy Cross: David, I think visibly is the key word that I always go to in this question. I'm going to say that Kinsale, yes, even though they were an upstart and continue to be an upstart in the way they've built their business, I'm not aware of a upstart, younger company that is taking share and going after Kinsale in fact, it's Kinsale doing that to its larger competitors.

David Gardner: Emily?

Emily Flippen: I really debated with myself on this question because I do think I can make an argument, especially for Chewy's growth initiatives in pet healthcare, that there could be upstarts that are challenging its business model. But I agree. I think the key here is visibly challenging it. For now, I think my answer is yes for Chewy, which is that they are free of that challenge. To Andy's point if anything, I think what Chewy is doing is disrupting the pet industry as it exists today. They are the upstart and a lot of sense that could change in the future, but as for now, I say yes.

David Gardner: Both of those answers make a lot of sense to me for those companies. There are other companies we're not talking about now, some of which may be stocks we own and like where there is somebody coming in very in your face, Clayton Christensen, disrupting what they're trying to do. We always find those situations fascinating and if we decide those are rule breaker upstarts, then we'll often buy or recommend those stocks. Some of my best picks have been those disrupters. I appreciate that you both in this case have brought to us this week companies that are a little bit more the underdogs trying to disrupt, not really in danger of disruption, which means we move to the final question about competition. I see. Plus one for 11, underdog. But you both gave zeros or yeses for number 12. Let's go to number 13, Moat. Would potential new competitors face high economic, technological, or regulatory barriers to entry? For Kinsale, I'm going to say yes, technology has certainly helped Kinsale in the way they've built that business out. The actual insurance writing and pricing is very difficult, and it's highly regulated. The E&S part of the insurance market is less stringent on a regulatory environment from the forms, or the pricing that other parts of the PNC market is. But those companies are still very regulated and watched over by all the regulatory bodies at a state level. Yes, that is a high barrier or entrance for a company like Kinsale.

Emily Flippen: Chewy may not have Kinsale's regulatory hurdles, but the answer for Chewy is also yes. If you look back at how Chewy got started, they had to lean on PetSmart's fulfillment logistics, and supplier relationships, who heavily just to get off the ground. New competitors would need substantial partnerships like that to even begin to compete. Those would be challenging to get in a world where Chewy has been so dominant in the pet retail, e-commerce market. In this case, it's yes.

David Gardner: All right, well that's something like half time. We've covered 13 of the 25 questions, and before we move on to the next section which is entitled The Stock, we have three questions about The Stock. I do want to say what do these numbers mean? We're now Kinsale Capital at four, and Chewy at four. We're only about halfway through. We'll see where they end up. In general, I have favored companies in the 6-9 range. When we look at risk ratings, that feels like they're taking enough risk to give me some good return, but not so much that they're doing silly stuff. Lots of companies, especially rule breakers, are more early stage development stage companies, they're not going to have profits or cash flow but they might be disrupting the world in a most interesting way. Every stock is different, and no system can capture everything. But at least for me, somewhere in that 6-9 range has often been the sweet spot for the stocks I'm looking at. If you find yourself saying no 15, 16, 17, 18 times, you're probably looking at something like a penny stock, or something that I would have very little interest in, highly risky. Risk is still a neutral term. It doesn't mean low risk is inherently better than a high risk. Most of us, if we found out we could get the same return either way, we'd rather have low risk, on the way to good return than high risk. But with those things said, let's move on now to questions 14 through 16 about the stock. Market cap. That's not a topic we need to explain on this show, because we have a legion of adoring fans of the market cap game show. You both have been stars of the market cap game show. We don't need to define market cap on this show. I sure hope not. Let's go right into it. Here's the question. Andy and Emily, does the stock have a market cap of more than $10 billion, Andy?

Andy Cross: So close. Kinsale's market cap is not above 10 billion.

David Gardner: Did you say nine earlier in some other context?

Andy Cross: 9.4 about right now.

David Gardner: The market trades up on Wednesday. We always tape this podcast generally on the Tuesday afternoon before it comes out. It could change.

Andy Cross: You got to call it like it is, and it is below 10 billion, so no, that stock does not have a market cap of more than 10 billion.

David Gardner: Before we go on to Chewy, let me say briefly that in general, the reason we asked this question with the rather randomly chosen number that I've added to it, is that I do think that the larger something gets, the less risky it gets. Other forms of risk can start showing up, like the risk of inertia, the risk of complacency. But in general, when you're a larger company, lots more employees, lots more customers, lots more resources, that's safer than a smaller company. For me anyway, 10 billion feels about right here in 2024 as we think about, what are the companies where you'd say that's big enough, where it's a little less risky than that, smaller size, hilarious Andy, that Kinsale Capital is 9.4. What I'd say quite seriously is, if and when it does trade up, which it probably will, it'll feel a little less risky to me at that point. I hope it never looks back from that point, because you like this company. Let's move on to Chewy. Where does Chewy clock it on the market cap dial?

Emily Flippen: If this is the market cap game show, I would have missed this one. I was ready to answer yes, and then I double checked. Unfortunately, there was a point in time when Chewy would have been yes with flying colors. But this business has taken a massive fall from grace in terms of its market cap and its share price, and now it falls below that $10 billion. It's at around 8.5 billion now. It is a no for Chewy.

David Gardner: I didn't check ahead of time. You both sort of brought the companies in to me today. We didn't really pre talk about much of this. I didn't actually know the market cap game show answers for these two companies. Therefore it's fun that we've ended up with two companies that have about the same market capitalization. I was playing up earlier the contrast, and there are many, between these two companies. But that's so interesting and one of my favorite things about market cap is, it's a number that cuts across everything and gives you a way to look at the world. It's very interesting to me. I never would have known. I think the world doesn't know how close in size, at least in value, Kinsale Capital and Chewy are. Let's move on to question number 15 about the stock again. This one's entitled beta. Is this stocks beta less than 1.3 over the past 12 months? Andy Cross, in addition to being a friend of mine and, a wonderful stock picker and advisor is our Chief Investment Officer. Andy, I asked you earlier to define return on equity. Would you briefly define beta for those not yet aware?

Andy Cross: It gives a sense of the volatility of the stock relative to the market. Very simple terms, if the market is moving 1% and a stock has a beta of about one, it's going to move about the same as the market over time, and then stocks with a higher beta will be more volatile relative to the market, and lower beta will be a little bit lower, less volatile. It's more about the stock trading activity relative to the market over certain periods of time.

David Gardner: Yeah, and 1.0 beta therefore is exactly the same as the stock market's average movements. The S&P 500 or the Dow, if you will, it depends on what you're looking at. But basically, high beta means that stock moves a lot more up and down than the overall market, and low beta means she moves with less volatility than the overall market. Of course, the question is sussing out whether this stock is not so crazy volatile with that 1.3 parameter that we're using Andy, for Kinsale is, Kinsale's beta less than 1.3 over the last year?

Andy Cross: Yes, David. A couple different ways and different sources, and The Motley Fool and other sources looking at the beta of any company. Kinsale is less than 1.3, it's actually at or less than one. It has over time been a relatively less volatile stock in the markets.

Emily Flippen: In the case of Chewy. Now I want to say, I have not done the regression analysis myself, but, and I was surprised when I saw that, yes, for Chewy, their beta also on both a one-year and a five-year basis, depending on which source you use, falls below 1.3. That's surprising to me, because as a Chewy shareholder and as somebody who has watched the performance of this company in the last few years, it's one that routinely moves 10, 20% in a day when there's relevant news. I was surprised to see that.

David Gardner: I'm wondering, just for the fun of it, what source do you each consult? Andy, you did mention our Fool.com site a little bit earlier. A lot of arm chair investors tuning in this week are listening in part for how you each find the information that you find. You don't even need to talk about beta here, how about this, real quick. Andy and Emily, what are a couple of your favorite sites or tools on the Internet that help you research stocks?

Andy Cross: Well, we've been featuring here at The Motley Fool and across our premium sites that have been featuring things like beta for volatility and also our recommendations just to give that context. Certainly, The Motley Fool, our site's for that and then the one we use a lot internally is Capital IQ, which is owned by Standard and Poor's, as a wonderful data repository with lots of different data that our analyst team uses.

David Gardner: That's a premium site and service, right?

Andy Cross: Yes, that is a premium.

David Gardner: I can't just go capitaliq.com and get stuff for free?

Andy Cross: No, I don't believe so. In fact, they a lot of times will use their data on lots of different sites.

Emily Flippen: It's funny, you've mentioned Cap IQ because I've been using Cap IQ less and less frequently, because of an internal tool that we've developed here that is going to be available to those Epic members we talked about earlier, David. That's Fool IQ, it's available at stockdata.fool.com for those subscribers. It provides a lot of the same information, including things like beta, as well as some uniquely Foolish metrics. One of my favorite being revenue per employee, which kind of gives you a sense of the efficiency, how much a company is doing with little in the case of employees, or much in the case of too many employees. That's one of my favorite resources.

David Gardner: Thank you both. What I heard is both of these companies, Kinsale and Chewy, not crazy volatile, they get yeses for that beta question. Let's do the final one for the stock. It's about the PE ratio. The price-to-earnings ratio is one of the first things that many investors, as they transition from novices to intermediate level investors, one of the first things they're often taught or notice, and of course the price to earnings ratio is looking at the value of a company. It's price per share, as a function, as a multiple of the earnings per share that company is generating. Basically, how much are you trading above the value of what you earn each year? It usually expressed as a multiple. When I was growing up with Peter Lynch books, and a lot of people have joined investment clubs and they learned about low PE companies, and there's a lot of culture and a lot of especially tradition around the idea that, it would be crazy to pay more than 20 times earnings for a company. Andy and Emily in the last era, I would say in a lot of ways, that's gone out the window. We don't have time or focus this week to discuss why that is now. But the question number 16 reads this way, does the stock have a positive price-to-earnings, multiple IE doesn't make money, a multiple that is less than 30? Now, some might laugh at how old school that is, the idea that 30 when a lot of very fine companies trade well above that. But I'm going to stick to my knitting here and I'm going to stick with that 30 PE, and I'm going to say if a company has a positive price-to-earnings ratio that's lower than 30, that is safer than one's above 30, Andy.

Andy Cross: David, for some context, the S&P 500 multiple is about 17-18 times, and again, I'm going to talk about trailing multiples, not forward multiples. So looking at the earnings they've made over the last 12 months relative.

David Gardner: Would be an old school like this one.

Andy Cross: Exactly, because you mentioned Peter Lynch and he was always looking for companies that sold less than a 30 PE, but were also growing at very high rates. All that having been said, sorry to aggress there, Kinsale does not have a price-to-earnings ratio on a trailing basis that is less than 30, it's actually 35 times earnings.

David Gardner: That's a no for Kinsale. How about Chewy?

Emily Flippen: Well, if you felt that 35 times earnings was too much to pay for a company. [laughs] Can I sell you on 770 times earnings? [laughs] This is a solid no for Chewy. But as you were mentioning, Chewy is very early and its margin build out, and this is a company that only very recently reached somewhat of sustained profitability, which as we already talked about, was actually negative in the most recent quarters, so the PE ratio, unfortunately, does add an element of risk to this investment.

David Gardner: Well said, and we've just finished Questions 1-16, we have nine left. The scores right now for these two companies, they're tied, they're both at six. Let's move on now to the next two questions which are about the people. Some people use that cold phrase, human capital at the companies, but let's get into it. Question number 17, founder. Andy, Emily, do any of the key insiders still have at least a 5% stake in the company?

Andy Cross: For Kinsale, the answer is no. It is still founder-led. I mentioned earlier, CEO Michael Kehoe founded Kinsale in 2009 after having a great career at a competitor for writing this kind of an insurance. However, he owns slightly less than 4% of the company, worth about 360 million.

David Gardner: Not too shabby.

Andy Cross: Not too shabby. Combined, those other insiders and he has some other founders that joined him, own more than 5%. But from a single person, the answer is no.

David Gardner: Well, that's how we stick with this question, so thank you for that, Andy. Emily, Chewy?

Emily Flippen: It's an unfortunate comparison because this is also no for Chewy. But to compare Kinsale and Chewy in this category and say, well, both are noes, I think doesn't quite highlight the differences, which is, as I mentioned earlier, Chewy's founder sold out in 2017. Sold his entire stake in the business to PetSmart and the current CEO Sumit Singh, who I think is done a wonderful job, still only owns around a quarter of a percent of shares of Chewy, so this is not a founder-led nor highly insider owned business.

David Gardner: Well, the reason this question exists and the reason we answer it and care about the answers is because usually you have a little less risk if somebody has skin in the game, as is often said. If somebody has a significant stake, often the founder, but I made it key insiders because there are lots of different situations, and you just gave a good example. Emily, the founder of Chewy sold out their whole holding to another company, which doesn't necessarily say anything. It doesn't mean it's a bullish thing or a bearish thing. I mean, in a lot of ways it's impressive who bought them. Very important component of the industry anyway. Looking in the end at who actually owns stock in these things and how much stock do they own, and they probably care a lot more if they own more than if they don't, that's the purpose of this question. Let's go to number 18, tenure. Question number 18, do the top three officers have more than 15 years of combined leadership at the company?

Andy Cross: Well, I mentioned Michael Kehoe founded Kinsale Capital and he alone has 15 years.

David Gardner: That's it. Didn't you say 2009?

Andy Cross: 2009, but Brian Haney, who's the President and CEO has also been there for 15 years as has the Chief Financial Officer. So they have loads of experience in the business, as well as the industry.

Emily Flippen: Unfortunately, for Chewy, this answer is no. Now, what if have been a yes if it wasn't for a recent turnover in the C-suite. CFO Stacy Bowman, who's been at the company for eight years, combined with the seven years from CEO, Sumit Singh, could have reached that goal. But recently, management announced plans to bring in a new CFO, Bowman staying on as Chief Accounting Officer. But because of that turnover, it didn't feel fair to get this a yes.

David Gardner: I appreciate that, and it is a little riskier when new people come in. Sometimes they have better ideas, but there can be culture shock, sometimes other reasons. So on the whole, and I hasten to add, by the way, I built the system up over time, so I don't want either Andy or Emily to feel bought into this. If you like it, you're part of my team and I want you to love it and use it. But this is actually the view that I have. I'm asking you guys to conform briefly to it, and in fact, very shortly, we're going to have a couple of the questions that you each have invented yourselves for the companies that's part of the system too. But anyway, I did just want to mention that not everybody would necessarily agree with each of these questions, including the people joining me this week. I do think tenure matters and I like it when I see people who are at a company stay there, especially in leadership for a long time, I think that's less risky. Let's move on to the next two. There's two final sections of risk ratings. The first is called Go-twos, that's what I call it, I'll explain that in a second, and the last is called Foolishness, and that probably also needs an explanation. But let's get right into it. Number 19, go to question number 1, again, there are two, Andy. I've called the Stock Advisor way now. Is that a phrase, Andy, that conjures up anything for our Chief Investment Officer?

Andy Cross: Sure it does, David, just thinking about Stock Advisor. Emily and I do it every day. You did it for so many years when you and Tom created the Stock Advisor, trying to find great businesses. Great businesses with great financials or improving financials, but they're some of the most proven businesses and we look across the Stock Advisor scorecard, you'll see them on there.

David Gardner: Thank you, and in fact, Stock Advisor way is a number of principles that we've published on the site. Emily knows them as well. We're not going to quiz either one of you on them, but at their heart, well, here's how I put them in question form for question number 19. Friends, is this a solid business with proven management and a stalwart balance sheet?

Andy Cross: One hundred percent for Kinsale, proven ability to innovate and grow successfully, and has a very solid credit score rating from AM Best, and that's important for an insurance company.

Emily Flippen: For Chewy, I think the answer is also certainly yes. I look up to Sumit Singh, the CEO, I think he's managed the business with a really prudent, organizationally driven eye. That comes from his experience helping with fulfillment at Amazon, and the management team in general has strong capital allocation skills. They're always thoughtful about where they spend capital, and as I mentioned previously, their negative net debt position, which is to say they have a ton of cash on their balance sheet. Very little debt does give them a lot of financial flexibility.

David Gardner: Excellent. So yeses for both and the other go two, and the reason I call these go-to's is because this is heart and soul, like this is your gut, these are go-to questions that you want to be able to say yes to these, but if you can't, and not everybody is researching stocks that they admire yet or maybe even like, you might just be picking up. Maybe you're a stock analyst yourself and somebody gave you this company to research and you're looking at it, I would encourage you probably not to favor that stock. If you can't give yeses to these two go-to questions. The second one is entitled conscious capitalism. We don't have time today to explain it long term listeners of this podcast will know exactly what I mean when I say conscious capitalism, as do Andy and Emily. Google the phrase if you like. I'm on the national board. Here's the question number 20, is management looking out for the interests of all stakeholders, customers, employees, shareholders?

Andy Cross: Yes. For Kinsale, for sure, it's been very active in supporting its culture in a one location spot in Richmond. Bringing everybody back to the office and building collaboration and encouraging that since its IPO in 2016, the stock is up more than 2,100% versus about 120.

David Gardner: That's not bad.

Andy Cross: Percent, very good for the market. It thinks about pricing and serving its clients, as I mentioned before, from an operational efficiency to be able to provide them the best pricing for their insurance.

Emily Flippen: Yes, for Chewy as well. If investors have any doubt, I encourage you to listen to the investor day, that very first investor day Chewy had just last month. You can feel how the ethos of the company is built around stakeholders. While that hasn't returned shareholder returns quite to the level of Kinsale. Hopefully that mentality will drive in that direction.

David Gardner: Conscious Capitalism, I think is the only way to do capitalism, at least sustainably, especially in our world today going forward. For me, it's a real competitive weapon. Those who really understand that business is there for all of us. It's not trying to just make shareholders rich. It needs to treat employees well. It needs to make customers excited to buy its product. It needs to treat partners and suppliers well and the environment too, depending on what type of business we're talking about. If this sounds like a fairy tale, please don't think that there are companies that have been doing this every day for decades. In some cases, they don't always make the headlines, but these are the kinds of companies we favor at The Motley Fool. We just went through 20 questions. By my tally, I have Chewy at 9, right now I have Kinsale Capital at 7. Our final section is Foolishness. Now I'm going to shortcut this a little bit because Questions 21 and 25 for those who know the system, you know where I'm headed here. They are intentionally written so that you have to say no. You have to say no because I did not want to have a risk rating system that could potentially spit out the final number of zero looking at the risk of any stock. I intentionally loaded two questions that try to make their own point. They'll always be answered no. I'm going to read them out right now, Andy and Emily. You can give me chorally your group answer as I finish the second one. Here they are. Number 21 is entitled Immaculate. Is the company certain to be fault free and fraud free, certain in all its corporate statements and deed?. That's the first one. That's Immaculate Number 21 and Number 25 the very final one is called bullet proof with the question mark. Here's that one. Andy, Emily, can you be certain that this company is invulnerable to external world or macroeconomic events such that you're sure you can get all your capital back?

Andy Cross: There's a lot of uncertainty in both of those questions and that's the thing about investing, There is equity investing, there is no certainty in anything.

Emily Flippen: Yeah. You have to be comfortable accepting the fact that with any investment, you could lose your shirt.

David Gardner: Answer those questions, let's do this together as a choir that stays together for only three seconds. Three, two, one. No.

Andy Cross: No.

Emily Flippen: No.

David Gardner: No is a really important answer because I have come across some people, sometimes they're on our forums, at The Motley Fool or at cocktail parties, or in the world at large. They are sure that management is always being honest with them. They're very convinced that the future is so bright it couldn't change for this company. It's very important for me with the risk rating system to make those two points. We've gotten rid of those two. I'm going to ask you Number 22 now as well. Then we're going to go to the last two which are the heart and soul of these. That's where we're going to end this week. But number 22 is about you. The real quick point, well, let me read it first. Do I want to know more about this company? Am I willing to dig deeper, learn more, and ask questions on the forums to actively try to understand this company. Now, Andy, would you say that of Kinsale? Would you say yes?

Andy Cross: I absolutely would say that, yes.

David Gardner: Emily, would you say the same of Chewy?

Emily Flippen: I would.

David Gardner: The reason this question is asked is because this is subtle, but part of the risk of any investment isn't the company and it isn't the world at large, it's you, it's your degree of interest. You create more risk for yourself if you're investing in things you don't really know what they're doing or you're not that interested in what the business is. You create less risk for yourself when you care. Question Number 22 is you, well, we've done 21, 22, and 25. There were yeses for those. Let's close with these final two questions may be my favorites. The most important in the whole system. Question Number 23 asks anybody rating the risk of any stock. Here it is. Write the single best, most beautiful and illuminating question you can about this company and answer it. Now the second one, Question 24, is the second most beautiful question you can ask. The reason we have these two is because it gives an opportunity for any analyst, anybody looking at something to dream it up and think about what is the most important thing this whole system may have missed, that really matters when we're weighing risk. Let's do 23 with both of you, then 24. Andy, what is the single most beautiful illuminating question you can ask?

Andy Cross: Does your company rely on acquisitions funded with shares to grow the company?

David Gardner: For Kinsale Capital repeat that question one more time and answer it.

Andy Cross: The question is, does Kinsale Capital rely on acquisitions to be able to grow the company and acquisitions funded with shares? The answer is no. Kinsale has not had any acquisitions. Very minimal, unlike many insurance companies. It's a huge advantage to their business because they have been able to grow from the ground up everything about the business. They own pretty much soup to nuts the entire insurance process. Which is much different than other insurance companies.

David Gardner: Not just in the insurance world, but many industries. Somebody's trying to roll up that industry grow by acquisition. It does create more risk and so I'm really appreciate that question. Emily, what's the best question you can ask for Chewy right now?

Emily Flippen: Am I 100% confident that management is capable of keeping their eye on winning the long game? In the case of Chewy, my answer is actually no. I think the business has had a lot of pressure as a public company to continue to grow at a post pandemic rate, especially its active customer counts. My fear for the company is that this will lead them to drive away from their previously strong capital allocation skills in the name of driving growth that could impact their margin profile.

David Gardner: Really appreciate that. You asked yourself a question, phrased it in such a way, and everyone's encouraged to do just this, that you would answer no, which adds plus one to Chewy's risk rating, making it now at ten. We're going to close with the second best question you each can ask about your respective companies. Andy Cross, the second best question you can ask of Kinsale.

Andy Cross: Will AI, or artificial intelligence enhance the ability for Kinsale to write their insurance business more profitably and at larger scale? I thought about this and while I don't know for sure around the AI, because of the trust I have in that management team around technology, I'm going to say yes, I think they will be able to utilize artificial intelligence in smart ways to be able to improve their business.

David Gardner: Thank you. Well done, I'm going to call it out then. Kinsale Capital ends up with a risk rating of seven right now. Before we go to Emily's second best question of Chewy, let me just point out, typically I like to rerun these quarterly, especially for stocks that you really care about or are following, and chart the change in their risk over time. It can be very educational. So seven, a very strong number for a strong company. It's been a heck of a good performer. I wish I'd owned the stock, Andy. But we're not judging the stock right now or saying what we think is going to happen next. We're looking at what we perceive to be the risk of losing a substantial part of our capital in one of these stocks over a significant period of time, and it's looking pretty low for Kinsale Capital. Emily, what is to close for Question 24? What is custom Question Number 2. Your second best question you could ask of Chewy.

Emily Flippen: Does Chewy have the potential to be a high margin business? My answer is also no. You can see I'm swaying the risk ratings here a little bit upwards. I think investors, even with all of Chewy's expansion and aggressive plans for healthcare and insurance, etc. I think they need to accept that at its heart. This has been proven time and time again by different e-commerce and retail businesses. This is going to be a single digit net income margin business at scale. If you can't make the math work there, then you shouldn't be investing.

David Gardner: Well, thank you for that, Emily. I like how unsparingly, even though I know you're a fan and a shareholder, I like how unsparingly you're able to look at things and be objective, as objective as we can. We end up with Chewy with a risk rating of 11. Based on what I think of the world, thanks to my talented observers and friends, it looks to me like Chewy is a riskier stock than Kinsale Capital. I think a lot of people might have come in agreeing with that. But it's awfully nice to have it expressed not just as a number, although it is, which is a lot better than medium. But that number, every single question behind it, underneath it, explains the number. That's maybe my favorite thing in the end, about our risk rating approach. We do give a number when many other people give bland labels, but that number is arrived at through a rigorous process of asking important questions about the quality of companies.

Thanks again this week to my friends Andy Cross and Emily Flippen for their work on Kinsale Capital ticker symbol KNSL, and Chewy ticker symbol CHWY. I hope that we've contributed, dear listener, to your general overall understanding and development as an investor, especially if a lot of this material was new. What we're really doing with this system is I think we're looking at the quality of companies. Yes, on the face of it, we're assessing the risk. I define risk at the start this week. You now know how to score risks around companies. I think that's a wonderful innovative breakthrough. There aren't a lot of services or people who have real risk ratings on stocks. They might have risk ratings on debt or risk ratings on, I don't know their NFL fantasy draft, but who has risk ratings for stocks? I would say not nearly enough people. I hope this has been a fun view. I sure did have a lot of fun with you. Again, thank you, Andy.

Andy Cross: Thank you, David.

David Gardner: Thank you, Emily.

Emily Flippen: Good to be here.

David Gardner: Dear listener. Thank you. Fool on.