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The Two Things We Look for in a Management Team

March 22, 2018 in Commentary, Curated, Equities, Idea Appraisal, Letters, Skills

This article is authored by Todd Wenning, senior investment analyst at Ensemble Capital Management, based in Burlingame, California. Visit Ensemble’s Intrinsic Investing website for additional insights.

Imagine you went back to 2007 and told investors that within the next ten years, General Electric would cut its dividend twice. You’d have been mocked and ridiculed.

At the time, GE was one of five U.S. industrial companies with AAA-rated credit, had just increased its dividend by 11% (its 32nd consecutive annual increase), and was one of the largest companies in the world by market capitalization. Such an outcome would have seemed implausible.

Yet here we are. The GE story is complex (which in itself is a problem), but one of the causes of its recent decline was consistently poor capital allocation decisions.

Here’s Morningstar’s take: “(GE’s) ambitious overhaul came with an overly aggressive midterm financial target of $2 in earnings per share by 2018, which probably colored management’s capital allocation decisions in a manner that ultimately exposed GE’s investors to unnecessary risk.”

As the GE story illustrates, the way management allocates capital can have a massive impact on long-term shareholder returns.

Simple doesn’t mean easy

At Ensemble, the two things we look for in a management team are their intent to optimize return on invested capital (ROIC) and their skill at allocating capital to maximize shareholder returns.

You’d think that these two things would be common, but they are more the exception than the rule. Indeed, our eyes light up when we see multiple mentions of ROIC (or return on equity) along with a discussion on capital allocation in annual reports, management meetings, or quarterly earnings calls. It’s that rare.

Why might this be the case? One reason is poor incentives. You never hear of a stock jumping 10% because ROIC beat expectations. No, it’s usually because the company reported better-than-expected revenue or earnings per share. Perhaps not surprisingly, two of the most common financial metrics used in management bonuses are – you guessed it – revenue and EPS. Unfortunately, neither of those metrics alone tell you if the company is creating shareholder value.

Revenue and EPS growth are essential, of course, but we believe that if the company aims to widen its moat (that is, optimize long-term ROIC) and thoughtfully allocate capital, revenue and EPS will take care of themselves.

Decisions, decisions

There are three ways a company can return cash to claimholders: pay a dividend, buyback shares, or reduce debt. There are smart and dumb uses of each. What we want to see is that management has thoughtfully weighed their options based on return opportunities.

To illustrate, at its 2017 investor day, Verisk Analytics showed how the firm allocated capital between buybacks and M&A over the previous 15 years.

As the slide mentions, Verisk decides on buybacks or M&A depending on the available opportunities. Even if they don’t always make the correct assessment in hindsight, we like that there’s a process in place.

We were further impressed that Verisk followed the above slide with IRR results from their capital allocation decisions.

Again, this level of transparency is rare, but we welcome it and would like more companies to follow suit.

Companies with moats are rare, as are companies led by thoughtful capital allocators. Companies that have both are exceptional and are precisely the kind of firms we want to own in our portfolio.

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Clients, employees, and/or principals of Ensemble Capital own shares of Verisk Analytics (VRSK).

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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EchoStar: Underfollowed Satellite Business Run by “Outsider” CEO

March 19, 2018 in Audio, Best Ideas 2018, Best Ideas 2018 Featured, Best Ideas Conference, Communication Services, Equities, GARP, Ideas, Information Technology, Jockey Stocks, Mid Cap, North America, Transcripts

Nitin Sacheti of Papyrus Capital presented his in-depth investment thesis on EchoStar (Nasdaq: SATS) at Best Ideas 2018.

EchoStar is an underfollowed satellite business run by a smart owner/manager (Charlie Ergen) with three core businesses, trading at 10x 2019E cash P/E and worth $88 per share, offering ~53% upside and three additional hidden options worth $93 per share, or $181 per share in total (~213% upside). SATS owns valuable intellectual property in their Ka-band high throughput satellites, which they can build at one-tenth the cost per bit of other satellites. While the product has, so far, generated IRRs in the high-20% in its first application (rural consumer broadband), 5G offers many more uses for the satellite IP, which means the company will likely launch JVs across the world or acquire a business with worldwide distribution, into which Echostar will plug its IP and generate significant value. Nitin believes the company will realize its intrinsic value over the next two to three years as 5G standards take effect.

About the instructor:

Nitin Sacheti is the Founder and Portfolio Manager of Papyrus, where he continues to implement a successful bottoms-up investment process, honed over 10 years, focusing on free cash flow generation over time. Prior to founding Papyrus, Mr. Sacheti was a Senior Analyst/Principal with Equity Contribution at Charter Bridge Capital where he managed the firm’s investments in the technology, media and telecom sectors as well as select consumer investments. At Charter Bridge and in his prior role at Cobalt Capital, he managed over 25 names in a ‘mini-PM’ capacity with significant autonomy ensuring a seamless transition to Portfolio Manager at Papyrus. Previously, Mr. Sacheti was a Senior Analyst at Tiger Europe Management, managing mostly the fund’s non-European investments. Mr. Sacheti began his investment career in 2006 at Ampere Capital Management, a consumer, media, telecom and technology focused investment firm, initially as a Junior Analyst, later becoming Assistant Portfolio Manager. He graduated from the University of Chicago with a BA in Economics and was a visiting undergraduate student in Economics at Harvard University.

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Update on Sandstorm Gold

March 19, 2018 in Ideas

This article by Jim Roumell is excerpted from a letter of Roumell Asset Management.

Sandstorm (SAND) reported a solid quarter of execution. The company continues to build a portfolio of high-quality royalties and commodity streams with strong counter parties. The company now has 70% of its revenues coming from mid-tier and large miners.

As we have articulated many times, we purchase SAND when it goes on sale on a free cash flow basis, buying when the yield exceeds 10% and selling when the price yields something closer to 6%. Our investment in SAND is never predicated on estimating future gold prices. Rather, it rests wholly on “what is” today in terms of free cash flow and what we’re paying for that free cash flow.

In what was our third outing in SAND, we successfully sold our shares at a yield approximating a 7% free cash yield (after backing out value we ascribe to non-income producing assets). Our caution lies in the company’s significant investment in Turkey, that country’s growing unrest, and possible “Cold War” with the United States. Long-time observers of Turkey are describing a political situation that gives us pause, particularly with the absence of a large margin of safety given SAND’s dramatic share price appreciation over the past few months. RAM exited all of its SAND shares. We will continue to monitor the company and the risk/reward relationship as it exists at particular price points.

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Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

The Death of (Many) Brands, Part II

March 17, 2018 in Letters

This article is authored by MOI Global instructor Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, based in Burlingame, California. Sean was an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

In August of last year we published a piece titled The Death of (Many) Brands in which we argued that there were two main types of brands in the world and that one of these types was collapsing as a source of competitive advantage.

“Brands created value by lowering search costs for consumers. Search costs are the costs incurred by a prospective buyer in trying to determine what to buy… It is important not to underestimate how powerful search cost brands have been in economic value creation in the past. Over the past 50 years, the top performing sector of the stock market has been consumer staples.

Now, however, the era of search cost brands is coming to an end. The moats are being breached. Over the long term, we do not believe that these types of brands will provide a significant competitive advantage to their owners…”

A recent Wall Street Journal article explored some of these same concepts through the lens of the role of Amazon’s Alexa virtual assistant and the risk it poses to consumer brands.

“Unlike in stores or online, where an array of brands get plenty of exposure, voice-search assistants like Amazon.com Inc.’s Alexa often steer shoppers to a single product, usually selected by an algorithm with no input from the sellers… In a test conducted in October, Bain & Co. found that for customers making a first-time purchase without specifying a brand, over half of the time Alexa’s first recommendation was a product from the “Amazon’s Choice” algorithm, which implies a well-rated, well-priced item that ships with Prime. Bain also found that in categories in which Amazon has a private brand, 17% of the time Alexa recommends the private-label product even though such products make up just 2% of volume sold.”

Branded consumer product companies recognize this risk, with the CFO of Unilever telling the Wall Street Journal, “Of all the disruptions that are taking place in all the things technology is bringing into our space, voice [search] is among the most disruptive. When it comes to voice search you go first position or you go home because beyond the first or second place there is no future.”

In other words, voice search means that even for the most powerful consumer product companies in the world, if Alexa doesn’t point consumers to you, there is no future.

Consumers’ need to quickly and easily identify products that offer solid quality for good value has not gone away. In our post we described the ways in which Amazon and Uber are in the process of supplanting the role of lowering search costs by substituting their own brand as a source of trust for consumer to make confident purchase decisions. Amazon has become such a trusted source of information for consumers that it is not just an online retailer but the vertical search engine of choice for products. If Amazon lists an item #1, most consumers will trust that it is of high quality and a good value. That’s why the #1 result for “batteries” on Amazon is not Duracell or Energizer, but a pack of AmazonBasics batteries that sell for less than half the price of the comparable Energizer batteries listed further down the page. For any consumer who might question if Amazon was just pushing their own product rather than the best option, the 18,975 ratings with an average score of 4.5 stars out of 5 will put their mind at ease.

Similarly, as described in our original article, Uber’s brand has become such a trusted symbol to consumers that they will “literally summon strangers from the internet to get in their car.”

Concierge brands are not new. They have existed in multiple forms in the past. Moody’s brand stamped on a bond rating tells investors that a bond on which they have done no due diligence of their own is of a known quality. Consumer Reports has steered consumers to high quality, value priced products for many, many years. When a mutual fund receives a five star Morningstar rating, the fund’s employees are ecstatic because they know this stamp of approval is the key to massive fund inflows.

The trusted reviews at TripAdvisor allows travelers to confidently book travel plans to far flung locations knowing that their experience will be great. Believe me, without TripAdvisor, my family never would have had the confidence to spend the night with a hilltribe in the northern mountains of Thailand. But TripAdvisor’s concierge brand provided a seal of approval to a small, family run tour operation that opened up a travel experience that would have been unavailable to us otherwise. And of course it was the highlight of our trip.

But our view that the end is coming for search cost brands does not mean the power has shifted decisively to the Amazons and Ubers of the world. The trust in a concierge brand is only durable if the recommendations made by the brand are good ones. Headlines about Uber drivers assaulting a customer are poisonous to the Uber brand because what they offer is not just logistics but the seal of approval that the random strangers who offers you a lift will deliver you safely to your destination. It only takes a couple of unhappy trips to TripAdvisor recommended hotels to ruin the site’s reputation and therefore whole reason for being.

So there is an opening for product companies to capture value as the concierge brands muscle their way into their industry’s profit pool: Make differentiated products that are great and sell them at a fair price.

The Death of Brands does not imply the death of great products. It implies the death of top brands that do not in fact represent an outstanding product at a fair price. The very worst thing the concierge brands could do is recommend products that serve the concierge’s financial interests, but are not in fact in the best interest of the customer. If Amazon’s Alexa starts regularly recommending Amazon’s own products despite superior, better priced products on the market, Amazon’s concierge brand will go down in flames.

Concierge brands are valuable because they reduce search costs. This isn’t difficult to understand. When you are in a city you’ve never been to and a friend who has been before recommends a great place to eat, you will choose that location confidently without doing extensive research on your own. This is what search cost brands offered in the past. Now we see the rise of concierge brands inserting themselves into the equation, delivering value to consumers and extracting profits from the legacy brands. But their power is not unlimited. There is a real risk that in the pursuit of profit maximization they will overreach, point consumers to products that serve their interests rather than the consumers, lose trust and lose out on profits.

There is only one path forward for product companies: Ship great products and force the concierges brands to point everyone your way.

This article originates from Intrinsic Investing, an Ensemble Capital publication.

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The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

Volatility: Fear Thou Not

March 17, 2018 in Asia, Asian Investing Summit, Letters

This article is authored by MOI Global instructor Ankur Jain, a registered investment advisor based in Kolkata, India. Ankur is an instructor at Asian Investing Summit 2018, the fully online conference featuring more than thirty expert instructors from the MOI Global membership community.

To paraphrase Darwin,

“It is not the most intelligent of investors that prosper, nor the most optimistic that prosper. Prosperous are the ones that handle volatility the best.”

What do we mean by volatility?

Academic finance describes volatility as Beta (β) or fluctuation in price of security with respect to the market. There is a formula to calculate Beta. There is variance, co-variance, standard deviation but β doesn’t account for intrinsic value of the security. If price of security changes more than the underlying market, β is high and the security is assumed to be riskier and vice-versa.

Is it correct to assess riskiness of a security without ascribing to its intrinsic value? I never understood β. I memorized its formula exactly for a day when I appeared for an exam in financial management and forgot it the moment I stepped outside the examination hall.

How do I think about volatility?

Volatility for me is the change in price of the security- measured with respect to its intrinsic value. The change can be up or it can be down. It can be gradual or it can be sharp.

If the security becomes cheaper with respect to its intrinsic value, the investment become less risky no matter what the β is. And that is the time to buy more of it -within the limits of prudent position size.

Volatility — How sharp can it be?

The below data from Bombay Stock Exchange shows that when volatility (downside) strikes- prices can fall precipitously from a cliff. In the period [1990-2011], Indians markets witnessed 3 instances of BSE Sensex dropping by more than 50% from its peak and additional 3 instances where the markets dropped by more than 25% from their peak levels.

How do I handle volatility?

To handle volatility, I think in terms of firewalls. Just like firewalls help to protect our machines from malicious software, we can design firewalls to protect our portfolio and our sanity in times of volatility. I have constructed 3 layers of firewalls around my portfolio.

Firewall 1: Liquidity at the personal level

I keep a liquid reserve of money in the bank – every time and always. That reserve is meant to take care of family living expenses for a certain number of years, if the markets were to hit a rough patch. That money is not available for investing.

“At the time of severe market disruption, cash is like oxygen. When you don’t need it, you don’t notice it. When you do need it, it is the only thing you need.” –Buffett

It seems simple but it is hard to practice. Investing annals have examples of even renowned investors who have found themselves in the centre of liquidity crunch. They had to sell their carefully chosen good investments at precisely the wrong time to tide over the crisis.

I feel that lack of liquidity robs us of the capacity to think clearly. Keeping a certain portion of money aside, quells any kind of anxiety- for me. This calm state of mind then helps me to think carefully about the money which is available for investing.

This reminds me of famous lines by the great poet Rabindra Nath Tagore – “Where the mind is without fear and the head is held high…” So, when my mind is free of any fear, I can think clearly about investments.

Firewall 2: Rock solid business investments

The second firewall I install is that of good quality businesses. I carefully choose good quality businesses which lie within my circle of competence, are managed by high quality people and are available at prices lower than their intrinsic values. Such businesses have the capacity to weather adversities of extreme nature. With a collection of such businesses in the portfolio, I feel that the probability of permanent loss of capital is low. Volatility can provide an opportunity to buy more of such businesses if prices were to become attractive.

I stay away from leverage and stay away from complex investment strategies. I only invest in rock solid businesses which act as the second firewall.

Firewall 3: Psychological firewall

This firewall is abstract and like the competitive advantage of a business — it takes time to build. We need to train and reprogram our subconscious.

Downside volatility hurts the most when investments are marked-to-market.

“Bad terminology is an enemy of good thinking.” –Buffett

I believe that mark-to-market is a wrong terminology to think about investments. Do we make investment decisions based on intrinsic values? If the answer is yes- then there is no reason to mark our investments to market prices and sulk when hit by severe price correction.

We should not mark our portfolios to market but we should mark them to intrinsic values. If our investment thesis is intact and we conclude that our investments are selling at discounts to their intrinsic values then the portfolio would be in fine fettle and there will be no reason to worry.

With the help of these firewalls, I prepare myself against volatility. I constantly review my processes with respect to the above and where ever I find gaps in my process, I plug them. With time, I hope this process fortifies my portfolio and my thought process. It’s not volatility but our preparedness and our responses to volatility that will determine our portfolio returns.

In the book “I am not an entrepreneur”, Mr R Thyagarajan, one of India’s foremost business creators talks about his analogy of ‘Varappu Uyara’. In Tamil, ‘Varappu Uyara’ means raising the ridge or walls around a field.

Avvayar, the great Tamil poet-saint blessed her king with high boundary walls in the rice fields. When the walls go up, there are a series of positive consequences: they can hold more water, the harvest is greater, and so is the overall prosperity.

I think just like the king, we (investors) are blessed to create our own walls. May all of us build higher walls, develop the capacity to face volatility, take advantage of it and prosper.

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Update on Rosetta Stone

March 17, 2018 in Ideas

This article by Jim Roumell is excerpted from a letter of Roumell Asset Management.

Rosetta Stone (RST) reported continued success in its turnaround efforts. On an overall basis, the company reported its 12th consecutive quarter of year-over-year expense reductions while the company’s sales near being 100% subscription-based. For the full year 2017, the company generated over $6 million in free cash flow compared to burning over $11 million in 2016. In fact, the company met or exceeded all of its 2017 targets publicly articulated one year ago.

Lexia continued to be the star performer as revenue increased 23% year over year. The company increased this division’s going forward growth rate to 25% to 30%. Consumer language’s profit profile continues apace as the company’s decision to pursue profitability over revenue pays dividends. E & E Language continues to underperform despite the company’s expressed confidence it in its new Catalyst offering, which was introduced roughly one year ago.

RST’s turnaround success has not gone unnoticed by the general market. The company is a far simpler, more focused, subscription-based, leaner company than it was two years ago. Anchored with a first-class literacy product in Lexia, the company’s language offerings are no longer the focus of most investors.

Clients are well aware that RST has been RAM’s signature investment, and by far its largest position over the past 2.5 years. The stock has appreciated roughly 80% from our average purchase price during our holding period. As was typical for RAM, we were early with our initial investment, but steadily averaged down as our due diligence increased our confidence in the underlying investment thesis despite the market “throwing in the towel” after having lost patience in the company based on headline language revenue declines.

At the stock’s lows of sub-$7/share, RAM’s position reached 10% of our AUM as our conviction that Lexia, plus the company’s net cash, more or less covered the company’s market capitalization giving us access to own the company’s two, albeit struggling, language businesses for next to nothing prices. Our strong belief is that our largest positions should not be the ones with the greatest upside, but rather the investments with the least downside. Although we did not know what the ultimate upside was going to be for RST, dependent as it was on a turnaround, we were quite confident that the company’s “scrap value” provided significant downside protection. It’s a true and persistent investment play for RAM – identify nascent high-conviction assets hidden within a company’s borders while the market reacts to struggling higher-profile legacy assets, held within a conservatively financed balance sheet, and be patient. We believe great investing involves sourcing free options. We are always in pursuit of finding free “stuff,” often hidden in the basements and attics of companies. RST was a classic free option investment narrative in our opinion.

The leadership of John Hass in ushering in RST’s successful turnaround cannot be overstated in providing the company its operational north star, making the tough decisions, and holding people accountable. John was supported by a strong Board. It should also be pointed out that John’s predecessor, Steve Swad, deserves great credit for having made the Lexia acquisition in 2014.

RST is now officially on lots of investment screens and attracting the attention of long-term focused growth investors. That’s the way it’s supposed to go as one group of investors hands off to the next group – deep value, to value, to growth at a reasonable price, to speculative growth.

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Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

Update on Marchex

March 16, 2018 in Ideas

This article by Jim Roumell is excerpted from a letter of Roumell Asset Management.

Marchex (MCHX) continued on its path to segue from a call-generating marketplace platform to one focused on call analytics to major corporations. The past three years’ heightened R&D spend is paying off: customer analytic wins are growing and the company’s cash burn has stopped. The company announced that it added more than 40 new clients in 2017 and we believe the vast majority are analytic wins. Moreover, Adjusted EBITDA in the fourth quarter was $1 million versus ($2 million) in the fourth quarter of 2016; 2017’s overall Adjusted EDITDA came in at $1 million versus ($6.6 million) for 2016. MCHX appears well on its way to pivoting to a leading call analytics platform generating recurring revenue that is no longer dependent on generating customer referrals for sales.

RAM had anticipated $10 million of cash burn in 2017. In fact, MCHX was free cash flow neutral for the year and confident enough in its business trajectory and liquidity profile that it announced a special $0.50/share dividend, or roughly $25 million of its $100 million cash hoard. This will still leave roughly $1.75/share in net, U.S. domiciled, cash.

On the product development end, MCHX continued to strengthen its speech analytics capabilities using artificial intelligence to help customers understand what is happening on inbound calls from consumers to businesses. During 2017 MCHX announced strategic partnerships with Facebook and integrated its software with Adobe. We met with Mike Arends, Chief Financial Officer in January and came away with renewed confidence that the company is executing on its plan to be a leading call analytics platform powered by artificial intelligence. We believe the company’s shares remain cheap.

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Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended and the reader should not assume that investments in the securities identified and discussed were or will be profitable.

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