Sean Stannard Stockton - A Renaissance Investor
We were fortunate to be joined by Sean Stannard Stockton, CIO of Ensemble Capital Management. Sean is one of the best generalist investors we know of. In this episode, Sean discusses:
Running an investment firm during COVID-19;
The need for companies to lead by example;
The willingness to remain open minded;
Thinking about serial acquirers;
The potential perils of low/slow growth investing;
His thoughts on position sizing;
And he provides the best answer we've ever heard to an error of omission.
We hope you enjoy this episode. You can find our more about Ensemble Capital Management at https://ensemblecapital.com/?gclid=Cj0KCQiA3NX_BRDQARIsALA3fIJGBM5kcERDGlwpAcPWjR2UtW6FSQCOY_6cSvZx56ss1CpDyXBAP7kaAntGEALw_wcB
Album art photo taken by Mike Ando.
Thank you to Mathew Passy for the podcast production. You can find Mathew at @MathewPassy on Twitter or at thepodcastconsultant.com
+ Transcript
Bill: Ladies and gentlemen, welcome to The Business Brew. This is Bill Brewster, your host, we are super fortunate to be joined with Sean Stannard-Stockton, CIO of Ensemble Capital. I'm looking very, very much forward to discussing his investment process. I think you're going to have your minds blown. Many of you already know him from Twitter. As a reminder, none of this is financial advice. We are not your financial advisors. We're not your fiduciaries, do your own due diligence. Everything expressed here is opinion based, and is the opinions of Sean and I. Nothing is an invitation or a solicitation to buy or sell any securities. Please keep that in mind as you listen. Sean, how you doing?
Sean: Doing very well, Bill. It's been a pleasure to get to know you over the years and very happy about your new podcast here. Listened to the first couple, they were fantastic and glad to be here as a guest.
Bill: It's been a fun endeavor. I sort of am making a podcast that I think I would want to listen to. It's been fun to know that other people that I really respect like it too. Hopefully, we can give them a good episode here. I'm sure we will.
Sean: Well, Bill, really, that approach is how you should approach everything in business. What is a product or a service or something that you would love and be passionate about? That's what you go build and bring to the world. I would say everything about our investment strategy, while it's evolved over time, was us trying to figure out, how do we want to run money? What works for us? And if there's people out there that that works for, that's fantastic. To me, that's how you build great businesses and great offerings and services, is you build things around passion. That's why so many companies are like founder-led companies that are successful, because the founder was like, “I believe in this, it needs to happen,” and you built it.
Steve Jobs talking about focus groups, don't use focus groups, people don't know what they want, you’ve got to build what is wonderful, and then hope people want it. If you have that product-market fit, people want, that's like something that you have to go figure out what's needed and do it. No, you build something wonderful in the world and you really hope it fits into the market.
Bill: Yeah. I'm going to ask you a somewhat tough question here. Did you stumble into a wonderful product in Ensemble, or did you really take over and build it? I don't know much about the person that you joined to join the firm, but you were employee too, right?
Sean: I was. Yeah, just like many people that build something, there was some very big stroke of luck and then hard work mixed in to lead to where were you got to. I was like a prototypical 13-year-old kid who read a book about stock picking. My father was a sociologist professor, my mom was a psychologist, and they weren't interested in Wall Street in the least. I came across this book. I won't even mention its name, it was a terrible book. It was awful advice, but I didn't care, I was a 13-year-old. It was like a get-rich-quick scheme sort of stock picking book, but it sent me on this journey. I went to college and got econ degree. I graduate in the late 90s, and went right into the investment world and then through a series of moves, was introduced to the founder of Ensemble Capital, man named Curt Brown, and he was managing about $60 million, and some friends and family money. He had a long career in Wall Street related jobs, and he was in his 60s when he founded what was then Curtis Brown and Company in 1997. I joined him in 2002. I think we had like 15-16 clients something like that, and we built it from there. Curt was somebody who very much recognized that he wanted to build a team, a group, a firm, it wasn't just him. About 18 months after I joined him, he said, “Hey, kid, let's go do this together. Let's make this a partnership,” and we renamed the company Ensemble Capital. I took a small ownership stake and at that point, I was a glorified operations person, but we built it from there.
Bill: I think I know, but why Ensemble?
Sean: Naming anything, you go through lots of different things and we had lots of ideas that we thought, “Hey, this will be great,” and we mentioned it, someone said, “Oh, my, here's this problem with it,” whatever. Ensemble came out of the blue. It was a car ride my wife and I were having and I knew somebody who was working at another asset management company that had a kind of a musical name to it, and we thought of Ensemble. Ensemble means a group of people or things deliberately put together to work in harmony. To me, that's what a portfolio is all about, and that's what a business is all about. It kind of fit and seemed like an obvious once we named it.
Bill: Something that I think has been really cool to watch about your firm over the last three years is you are almost set up for COVID without even knowing it because you guys are all distributed geographically, right?
Sean: Yeah, that too was just something happenstance in a way. We were not--- it was maybe I guess about three years ago or so, four years ago, we were all 100% in the office and everything. The traffic in the Bay Area is terrible. Every year, the commutes got longer and longer. We interviewed somebody who lives in San Francisco and our offices are in Burlingame, which once upon a time was a 20-minute drive down the 101 down the peninsula. These days, it could be an hour or pre-COVID, it could be an hour during traffic, and the person was like, “Well, it just seems like a too long of a commute.” We're like, “Gosh, if we can't hire people in San Francisco, [unintelligible [00:05:34] [chuckles] that's just the city up the street,” right?
We started doing remote and we started off one day a week, just saying anyone wants to come work one day a week, and then it was two days a week, and then we were like, “This is working great.” I think it was maybe two and a half years ago, we told people, “Look, just work where you need to work to get whatever work you're doing done.” That's where you need to work. This isn't about what do you [unintelligible [00:06:00], it's not a perk for the staff. It's about work where you need to work to get the most work done. That quickly evolved to about 40% office occupancy. Client-facing people are in the office more. The research team, Todd and Arif, analysts don't have a lot of need to be in the office or anything like that. Then we started hiring some full-time remote people, and so we went into COVID with, I think, maybe two people full-time remote and other people had desks, but they weren't in there all that much or anything. On March 16th, we flipped the switch and just turned off the office. I had some worries about like, “Can we onboard new clients and all that sort of stuff?” But we've actually had our best year in our history in terms of new client growth, new asset growth, and so everything's working well, but it sure helps that the whole client world got a crash course in Zoom as well.
Once upon a time, we might have been able to do it, but our clients wouldn't have been able to do it. Now everyone's able to do it. It was very quick, and we've actually onboarded two full-time remote employees since COVID started and never met them in person, and it's moving great, works really well. You just realize how many of the trappings of life that you take for granted aren't always needed. And yet, there's some that’s supercritical. Post-COVID, humans are social animals, people get back together again, no doubt about it.
Bill: Yeah, I think that's right. What have you encountered just running a business onboarding? I know you said that the onboarding process has gone well, but have there been any challenges that you as an operator have had to overcome? How did you figure out like-- bringing an employee on, how do you get them up to speed and meeting the team? Is Zoom a sufficient way to introduce people to the team? Or does it create its own, I guess, hardships, or I don't know if that's even the right word. But you know, what I'm asking, right?
Sean: Like anything, it has some things that are better and easier, and some things that are harder and more challenging. The most important thing about remote work is that if you have a remote work employee but the firm is not a remote-first firm, it's got big problems. They're always going be like second class citizens. I interviewed analysts before we were remote work firm, and the analyst, she was the only remote analyst on her team. She was saying-- it's like little things like, there's birthday cake in the break room on everyone's birthday except for the remote person, and their birthday just gets skipped, and it's not a big deal. But those things cumulatively create a culture in which the remote employees are secondary or separate from the real team in the office.
When I hear these CEOs of big companies saying, “Well, the whole executive team is going back to the office, but remote, everyone else you can work remote if you want to,” all those top-performing employees are going to what they hear is that the top performers are in the office, and if you want a career path, you will go into the office too. To me, it's really about if remote work actually works for your firm, which it will not for everybody, then it should be a firm-wide commitment. There's no reason why a senior person would need to be in the office any more than a junior person. Unless, of course, the day-to-day tasks require in-person activity for the senior executive. Yes, of course, there's challenges, but there's other things that are faster and better, and gosh, you’ve got to have a staff that that can write well and write fast and feels fluent in that way. I'm sure that there are certain employees who would not thrive in this environment, but our team, it seems to be doing great.
We also do intentionally a lot of social stuff. It's been hard to figure that stuff out, but that's important. We have a whole dedicated social chatter. We don't use Slack, use something else, but something similar to that, that's one of the most vibrant communication channels. We really go out of our way to celebrate each other and what they're doing here and each other's kids and none of that stuff changes just because you're remote.
Bill: Yeah. I've wondered coming out of this, I've heard some people say that -- the smaller businesses that I talk to occasionally, maybe 15 employees or less, where I talk about going completely remote, and the question that I've had is, “How are you going to handle the junior people that you onboard?” Because I think that, to me is like the real risk. There's a lot-- I say it in family times a lot. Quantity of time turns into quality of time, and I feel the workplace is very similar, it's going to be interesting to see how everything evolves coming out of this.
Sean: Yep. If the managers are all in office and the new junior people are remote, you’ve got a huge problem, but there's nothing that a junior person is missing, if their manager is remote and the junior person's remote. For this audience, of course, what's most relevant is the investment team, the research team here and how they're operating remote. To me, when we hired, Todd Wenning is one of our analysts who was our first full-time remote employee, he lives outside Cincinnati. At the time, Arif, who now lives down the San Diego area, but at the time, lived in Silicon Valley, where I live and where the firm's headquarters are, one of the reasons we hired Todd was to bring somebody on who wasn't in the Silicon Valley bubble. Just a quick story about that. We owned Starbucks at the time, we still do. Everybody I knew was talking about mobile ordering and rewards and digital and Starbucks is killing it, and Todd's like, “Drive-thrus are super important to the business model.” I was like, “What are you talking? There's no drive-thrus around here.” He's right.
He's talking about you install a drive-thru in Starbucks that needs a drive-thru, of course, and you significantly increase profitability and everything. What Starbucks talking about this whole year, we're putting drive-ins all through the Midwest and the Southeast, and this is a huge lift, and they talked about it on their Investor Day a day or two ago, and he's exactly right. In Silicon Valley, there are no drive-thrus for Starbucks. So, that kind of cognitive diversity from having distributed workforce in the research team is an advantage for us and one that I would never want to run money with a team of people all physically in the same geographic office all the time, I think you are at a deep disadvantage if your research team is all working out of one city from one office. They have too many of the same experiences, too many of the same networks they're part of, and there's some part of groupthink. For me, that's one of the key advantages, and COVID only didn't change any of that, we were already doing that as a research team.
Bill: Yeah, I thought that was super cool when you hired Todd. I got to know him through Twitter as probably many listeners have. Then, when I found out he was from Ohio, I liked him even more, because I have a Midwest bias. And then, when you guys hired him, and you said something about the fact that you wanted some geographical diversity, I thought that was a very cool move by you to pick a Midwestern person as opposed to the East Coast because the Midwest is honestly forgotten about a lot. The way that I think Midwestern people look at the world, they're not like an oppressed group or anything, but I do think that they're-- it's flyover country for a reason.
Sean: Yeah, everybody has different experiences, and I think that's a critical part of any research process, is for people to understand that the life experiences that you have informed the way you look at the world. You cannot take those blinders off. You can do your best to try and appreciate, have empathy for other points of view, and incorporate that. We own companies that sell stuff that I'm not a customer of, and that's okay, I'm not looking at buying companies that make this stuff for me. We start the interview talking about building products you're passionate about. As an investor, it's not just finding things that that I am passionate about or Todd's passionate about, it's about finding companies that sell something that have a match in a passionate way with their customer base, whoever they might be, and so having people with different life experiences and backgrounds is key.
Bill: When you're doing research on a company like that that maybe you don't have personal connection with or whatever, isn't completely in your direct circle of competence, so to speak, how do you get comfortable with-- Are you doing surveys of their customers? Are you talking to their customers? How are you getting into their customers’ mind?
Sean: Gosh, it can be so different for every sort of company.
Bill: Yeah, it's kind of generic question, isn’t it? Sorry.
Sean: No, it's not a generic question. It's just a different answer for every single company. I know that for instance, I personally have had a lot of interest and success in investing in b2b companies, and b2b software service providers. They're often undercovered by investors, unless of course, they're brand new SaaS b2b businesses in which they're overcovered. If you're talking about a lot of businesses that are-- they're just a little bit invisible in the grand scheme of things. And yet, many of them have this attribute that creates fantastic competitive advantage, which is offering some sort of product or service of the other business to the customer that is mission-critical to the functioning of that company, which is a super low portion of the overall cost structure.
If you look at a business, like Paychex, we've owned it for a number of years. If you as a company, the customer, the business that is the payroll customers of Paychex, if they don't process payroll correctly, they have an instantaneous crisis on their hands. Employers are not like, “Oh, no big deal, it's just a little bit of an error.” It has to be right 100% of the time. The IRS gets really rather pissed off, if you don't withhold correctly and everything. This is mission-critical, but it's also something that the company wants to forget about. You just don't want to think about payroll, it just wants to get done. No one would ever say like, “Well, my payroll gets done extra special well.” No, there's just a threshold, you need to get done 100% correct all the time. [crosstalk]
Bill: Yeah, it's either right or it's wrong. We're pretty binary here.
Sean: Yeah. Right. But there's not high end of payroll, it is what it is. If you look at a business like Paychex, if somebody comes along and says to the customer, the b2b customer that's buying the service from Paychex and says, “Listen, hey, we can do it for free, and just as good.” Then you talk to head of HR. Head of HR says, “Great, It’d be free,” and he say, “Well, guess what? It won't even show up as a rounding error on our financial statements, the money that we're going to save.” Yeah, but we might as well save the money, but could there be any issues? Well, maybe we have a couple weeks of problematic payroll, or somebody’s bonus isn’t getting processed correctly. And, oh, it'll be a ton of work for HR. Why are we doing this then? Just stick with what works. That can also lead to these b2b service providers becoming almost exploitive businesses, where they're like, “Hey, no one pays attention to us, let's just keep jacking up prices, and we won't invest in our product.” Over time, they mortgage their moat, this phrase that we talk about, where you take steps that make it look like you're getting more and more [unintelligible [00:17:10] things are great. But really, you're creating negative goodwill with your customers, by not investing in the product and overcharging for the service. But nobody really cares, it's such a small price, until one day people wake up and say, “This is ridiculous.” You lose tons of customers. So, you'd be very careful of that.
But when you have these companies that are mission-critical at a low cost, and they continue to improve the product and make it better, and they do all that, you can create very sticky, very sustainable, super lucrative high return on invested capital businesses. Here, I'm getting raving about these businesses, but you asked about the customers and how we get to know them. I've always thought these aren't that’s hard to understand, but somebody while ago is like, “Yeah, but Sean, you've been involved in building and running a business,” and it's a small one. It occurred to me that's true. Some of these things are, they just make sense to me. Running a 15-person firm does not mean that I'm an operator, and I understand these things at a high level. You can put yourself in the shoes of, if you are a manufacturer, and you're working with Fastenal, a business that we own, and they're supplying things to you and understanding that they're carrying inventory for you, off your balance sheet and getting into there just in time, all this stuff just kind of makes intuitive sense to me personally. Whereas Arif and our team has a huge interest in biotech and science, and he went to MIT, and initially, he was going to be an astrophysicist before he discovered economics.
Bill: Oh, wow.
Sean: He has a passion and interest and understanding the science behind a lot of this stuff that I'm like, up to this-- this is not my interest. I can read it, process it, do my best to understand it. I think everyone in the team has different companies that they have more interest in. Yeah, of course, we've talked to customers or read surveys, reached out to stuff, but if we feel like we are that distant from being able to understand it, we would probably move on to something else.
Bill: That makes sense. I got to ask you about a hot button company. You talked about b2b and a low portion of cost. I know in the past, you have had an affinity for a TransDigm, and it's such a controversial name. How do you reconcile those two thoughts? I own it, so I think that I'm closer to your camp than what the people that would argue that it's an exploitative business would argue. Probably the most-- I guess ‘cogent’ is the word I'm looking for, argument that I've heard is what you said that they deliver on-time service for the airlines, but I'm just interested to hear you wax poetic about it if you don't mind.
Sean: We owned TransDigm for many years and we fully exited the position in January or February this year, not with any foresight about the virus, the pandemic. We exited for valuation reasons, and sometimes it's a lot better to be lucky than good. I know the stocks come back dramatically, but it fell, and it would have been-- it was an existential-- like everyone's been talking about their debt levels. Well, this was the event that should have killed TransDigm that everyone said was going to kill TransDigm, and everyone said, or I said, “Hey, look the sustainability of passenger miles and it's going forever.” And then, this year happens. This year is a great reminder, and TransDigm is a great reminder, things have never happened before do happen, and this was one of those. We are long HEICO, and for anyone who follows TransDigm and HEICO, it’s like the dark side and the light side.
Bill: [laughs]
Sean: HEICO’s the good guy and TransDigm’s the evil one. While we own TransDigm, and our view is that the customers or the airlines, not the people, the shorts, the politicians who complain and say that TransDigm’s ripping off other people. The airlines, certainly you can find quotes people saying, “Gosh, they charge a lot.” But this is not a company that is constantly badgered by their actual customers saying, “You're really screwing us here.” The fact is that is really important that somebody keeps making these products that have been designed, effectively out of production, or they're still being produced. But I mean, like it's for an airline platform, is no longer in production, and these are older things. One of the ways I thought about it is, when I go down to the local Ace Hardware, and I want to buy a screw that fits a particular thing, and my house was built almost 100 years ago, I’ve got to find this odd screw or whatever. They have this huge racket that they use hardware with all these different screws. And I find it and I buy one, and it's 15 cents. Well, it's like a penny of metal. But I don't sit there and say, “They are crushing me on the profit margins here. This is outrageous.” You have 85% profit margins here. So, who cares? What am I really paying for with that 15 cents? I'm paying Ace for their service of maintaining this inventory, having it available, getting it to me just as I need it.
If you look at the product margins, you're paying attention to exactly the wrong thing. That's not what's going on here. They're not selling you the product. They're selling you the solution to your problem, and they're maintaining inventory of those solutions for you. That's how I think about TransDigm, is that they do this work that nobody else wants to do. They maintain all this stuff, and they get it there just in time. To me, much of the complaints were somewhat-- not appreciating what was actually being bought and sold in the situation. All that being said, we had many debates about this exact same issue. It's a controversial stock, and we don't own it anymore, but not because of this issue, but it was one we talked a lot about. The debate is a healthy and good debate.
Bill: I thought it was interesting when they were in front of Congress. I thought that Howley’s answer when somebody asked him about his margins, and he said, “Look, if you want to go build the product, go build it. We are not a cost-plus designer of product, like your typical government contractor. We are a commercial operator, and this is how the business works.” I don't know that was a lot more-- What's the word? It was more convincing to me than things that I-- I went into that hearing skeptical. When I listened to it and really processed how he answered it, I said, “This actually makes a lot of sense,” which was not what I expected.
Another controversial stock that you've certainly been right on from a price perspective, I'm going to argue that you've been right for the right reasons, is Netflix and currently is a pretty large holding in your portfolio. I have watched you over the years prove all the naysayers wrong, I think, for the right reasons, and maybe you can help us figure out what everybody else is missing when they're focused on current free cash flow.
Sean: Let me just start off by saying I was one of the naysayers in the past. One of the things that we do with idea generation is we don't pay any attention to valuation at all, as part of deciding what are we going to go look at. My view is that if you can actually value and have a sense of intrinsic value,before you've decided to do the work on a company, what are we all doing all day? The idea that people before they do the work could look and say, “Well, it's really expensive. Let's look at it later. It's not worth looking.” How could that be? The market’s pretty efficient. Well, it's challenging to outperform the market, which means that most of the time, most stocks are trading close to fair value. At least that should be your default assumption, even if they appear on the surface to look like they're overvalued or undervalued, and so we don't think about valuation when we first look at things. I and the other analysts all try and bite their tongue when someone else in the team starts looking at something that maybe we don't think is a good idea because that's the whole point of having this cognitive diversity, is different people have different ideas.
Arif was the one who started looking at Netflix, he'd followed it way before he joined Ensemble, but all I could remember was when they sold shares, and then they had the whole blow-up with Flixter and everything. Excuse me, they bought back shares like 150 or something, Flixter. Then they had to sell shares. To me, I was like, “Well, these are the worst capital allocators in the world.” But this is one of these-- I mean, I wasn't even following the story. It was like a Reddit headline, I don't even need to pay attention to them. They're terrible capital allocators. I don't have to think about this anymore. Horrible thing to do. It was one of those cognitive biases.
I brought that up to Arif, and he was like, “Yeah, but it was the right thing to do to issue those shares. Look what they've done. They made a mistake and then they corrected that mistake, probably faster than most companies ever correct mistakes.” I was like, “That's exactly right. What do I want more than anything for a management team, because they're all going to make mistakes, every single one of them? I want a management team that recognizes and corrects these mistakes as quickly as possible.” Once I realized it, I was like, “Wow, maybe I've got this exactly wrong. Maybe this management team is fantastic. It's just that I saw them make a mistake and wrote them off.”
We started working on the name. I think that the key insight that Arif had-- and other people talk about pricing power, I'm not suggesting this is like our own and no one else to talk about this, but the key thing that when he was looking at it and explained to me that we as a firm is, we all believe this is that the company is underpricing their product versus what it's worth in the market. If you think about how traditional tangible asset brick-and-mortar companies kind of thing grows, is you grow via Capex. You invest into Capex, and that gives you the opportunity to drive revenue. GAAP accounting lets you say all that Capex, it doesn't even count. It's not an expense, let's just take it off the income statement. Only depreciation runs through it. That's GAAP accounting. It doesn't even matter how old school you are, everyone understands it. Yes, of course, big Capex is not an expense. It's a future thing over time, and it's not an expense.
We, in the past, we've talked about how Home Depot had not only cash burn, negative cash, but accelerating negative cash burn all through its kind of early growth years, but at the time, it was also printed great EPS and had a P/E of 30, because GAAP accounting just let [unintelligible [00:27:31] all of that. What we realized was that what Netflix was doing to grow was underpricing their product, but there's no accounting system, rightly so, because it's like more art than anything you could quantify or account for, is that about how much are they discounting for? Nobody knows. They don't know. But we believe that was correct. When we initiated in the name, we believed all of that. It was a very small position, because we weren't 100% sure because they really keep raising prices, but over time, last I think, four or five years, it's been like an 8% CAGR on price. What big American company has been raising prices at 8% a year for the last four years in an inflation-free environment? This is crazy town. Apple’s one, but no one's going to debate that Apple has pricing power. Clearly, right, there's something going on here.
When you back into that, the big assumption we're making is an assumption on what it is the normalized-- What is kind of the true price, market-clearing price that they could move it to? Of course, they flip the switch today, they would lose some customers, but what is the price that is a sustainable price? You have to pick your own number, you have to figure out what you think that is and we've published some estimates of whether it's 15, or 17, or 20, or 25. What is that number? I can tell you myself. If I was going to lose access to Netflix, if [unintelligible [00:28:57] $50 a month, of course, I pay $50 a month. It's the primary way my family watches television. The average American household watches two hours a day of Netflix. That's 60 hours. So, $60 a month would be $1 an hour to watch TV. You're still cheaper than cable television, and everybody was paying way over $60 a month for television. We don't assume they're going to charge us $50, that's not the normalized price. But it's difficult to argue that where they price it now is somehow like, “Well, this is the right price.” Clearly to us, they're discounting it significantly.
We think that they're going to be able to raise it over time as they have in the US. You've seen their profit margins expanding dramatically in the US as they reached maturity and we think that's going to keep happening. To us that discount is like their Capex, so you have to understand that and think about how it plays out over time but to us, the stock’s cheap at $500, it’s not expensive.
Bill: It's been interesting to me through the pandemic is even when sports came back, they had a long-- I don't know what ratings are doing now, but it seems as though it's at least possible that the pandemic has somewhat changed. I don't know how much people value sports is the right way to frame what I'm saying, but it has been interesting that even when sports came back, people still seemed to turn to streaming for their entertainment. I don't know if it's because there weren't fans in the seats or it's not communal. I think there's a number of factors that could be contributing to that, but that has been a very interesting thing to follow from my perspective.
Sean: I think one aspect about the pandemic in the United States in particular, is that the overall shelter in place environment has persisted for a long time and is going to continue to persist for a while. What that means is that habits are being formed. Habits are hard to change. Imagine we had all gone back to work after two months and life was back to normal, we would not have new habits, all this stuff remote work [unintelligible [00:31:12], it would all just have gone back because it feels like, “Well, that was just this weird event, and now I'll go back to my old habits.” Now, you keep streaming. You keep playing video games with your kids, you keep using Zoom to talk to your family, you keep doing remote work, you actually bring on new employees who are full-time remote, and you've never met them before. All this stuff becomes habit. And then, the habit breaking is going back to how things used to be, and breaking habits is hard.
The pandemic and its impact on United States persisting for as long as it has means that the habits to break are these new habits are all forming right now. What's the relationship with sports? I don't know, for sure, but I have to think that televised sports have lower relevance to American video consumers in the future than pre-pandemic. There's different ways to look at the data right now, but right now, we just don't really know, there's so much changing. I do think sports are certainly not going away, they play a critical role for a lot of people's lives. I think there's a lot of human DNA and genes that drive interest in sports, but to your point, NFL football is not what a lot of 16 and 17-year-olds are thinking about the main thing they want to watch on Netflix or YouTube or Amazon or anything.
Bill: Yeah. To your point, let's say that the interest in televised sports is even coming out of this as compared to 2019, I don't think that you can possibly make an argument that the interest has increased. On a probability distribution, I think if you're relying on sports, you've got a negative skew to the assumption that you're relying on. I don't know how negative or whatever, but to not at least adjust your brain that way, I think, is not paying attention to reality.
Sean: Agreed.
Bill: How do you think through what Roku-- I don't know if you do, but I guess that the Roku bulls would say, “Well, Roku is going to be the new bundler,” and everybody else can sort of offer a substitute product to what Netflix can offer. HBO Max, you got Viacom coming out with their thing Discovery Plus, yada, yada, yada. How do you think through how Netflix competes with those offerings for people's mindshare?
Sean: Yeah, so relating that to the normalized price I talked about, the price that people pay for things is not what it's worth to them, but a blend of what it’s worth to them and the market-clearing price. We don't pay very much for water, but water is super important to us. The reason we don't pay very much to water is not because it's not worth very much to us, but because of the market conditions, we can get it for cheap, so that's what we get it for. So, just because something is valuable does not mean that it is going to be expensive, basically. It depends on the market conditions, and that's why we care so much about competitive advantages. You have all of these HBO Max coming in and Disney Plus and they were all supposed to kill Netflix, that was the whole deal. Just as a quick aside, all legacy media companies could have killed Netflix not all that long ago. They just made this huge mistake of thinking that it was incremental revenue for them. So, they said, “Hey, this is great. Let's just sell the content we're selling already, sell it second time to Netflix, how wonderful,” and they fed the beast that's destroying them now. It's just a classic mistake. It really surprises me that it actually played out that way.
You hear about different shows being pulled from Netflix and people say, “Well, it's going to kill Netflix.” Well, it would have in the past. But now, a lot of shows are big because they're on Netflix. It's not the people subscribe to Netflix they want to watch a show, the show gets big because it's on Netflix. And so now you have this feedback loop, and the power is shifting towards Netflix where you just want your content-- If you're a content producer, you want to get it on Netflix, that's where it's going to come ahead. As opposed to the other way around where Netflix is like, “I need this important content so I can sell subscriptions.” When Disney Plus was preparing to come out, and Netflix in the beginning of 2019 basically took two years of price increases. It was like 15%, I think, average ARPU increase like that, because they knew Disney was coming. And they were like, “We don't want to increase prices a year after Disney launches.” How amazing that you can say competitive threats coming, let's just jack our prices dramatically now. [crosstalk]
Bill: Yeah, that’s a powerful position.
Sean: [crosstalk] -wow, we're talking about preparing for yourself. When Disney Plus came along, and the stock did really pretty weak in 2019 as that kind of threat came along, Disney Plus has been an amazing success. It's seeming like every family with kids has Disney Plus. I mean their subscriber numbers are off the charts. Now they did a lot of that through just basically giving it away for free. It's still out there. They have huge subscriber numbers, and yet, it's been immaterial in terms of churn for Netflix. You can't exactly attribute what's going on but our estimates are 5% or less of people that subscribe to Disney Plus cancelled Netflix subscription. What that means is that Disney was a complement, not a competitive threat to Netflix. If Disney launched the bazooka to attack Netflix and failed to dent Netflix, that tells you something very important about Netflix.
We talk about moat attacks, one of the best indicators of a moat is when somebody launches a competitive threat and it is a well-resourced, well-executed competitive attack, and it fails. Disney Plus didn't fail for Disney. It failed to crush Netflix in any meaningful way. We think they're both going to do great over time, we are not negative on Disney Plus at all. They're making all the right moves. What they're doing is the playbook that Netflix laid out in the past. They're making it cheap initially, they're flooding it with content, they're getting it out there. They're just following the Netflix playbook because Disney recognized, “Gosh darn it, Netflix isn't playing the right playbook. And now we have to play catch up.” What's HBO Max doing now? I just got new iPhones, and they're like, “Oh, by the way, you get HBO Max for free for a year.” “Oh, okay. Great.” That's the right move because now I've been poking around, I wouldn't have before, but now I'm poking around.
Everybody else is desperate for scale, and what's Netflix doing? They've already conquered the US. They're going crazy internationally and just growing the content there. John Malone, the Cable Cowboy, years ago now was like it's already too late, global scale media, Netflix already won, and he was one of the potential competitors. I know he says different things at different times and stuff like that. It's not that we don't worry about competitive threats. It’s that the big bazooka was fired in the form of Disney Plus and it failed to hurt Netflix. Now, I know people will say, “Well, just wait, they're going to have more content later.” Maybe so, we aren’t sitting there and thinking, there's no company that's invincible, but we think they're very well positioned to maintain their hold, and there will be competition. This is not like a winner take all where there's only one streaming service and that's one that everybody uses. Of course, we're going to have multiple services. And so, our view is just that Netflix will be the first service that every home has, and that you may have other services in addition to that, but you always have Netflix.
Bill: Yeah, Netflix is the new core.
Sean: Exactly.
Bill: Yeah. I have massive love for John Malone. He has taught me a lot indirectly through YouTube and whatnot. I'm really happy that I found him. But I do think that they have a bit of a weak spot when it comes to looking out-- For instance, I was listening to them talk about Spotify with Sirius XM, and I understand why they have a bias towards current free cash flow. They run Liberty like a private equity shop might except they have a perpetual ownership. But I do think that sometimes that causes a bit of either a discounting of strategy that's different or saying this doesn't make sense. When it actually does, the incentives are just quite a bit different from the other player on the field. I don't know, that'll be interesting.
One of the things that I've really enjoyed you speaking about is First Republic as a customer service entity as opposed to a bank. I think following your thought process, what's very cool about how you see the world or positions that you take, at least my perception of it is you tend to see something-- you frame the business in a different light than what people perceive the business to be. Is that a fair characteristic, do you think?
Sean: Not in every case, but we definitely-- if you think about businesses that you like to find or the patterns that you're looking for, Todd coined the phrase idiosyncratic businesses in terms of that, that being what we're looking for. Not that he coined idiosyncratic business for anybody, but that's a vocab word that we use in talking about the businesses that we talked about which we had not previously used. Many of the businesses that we invest in, you can pull up a list of their competitors on Bloomberg and just say, “Oh, this is their peer group.” They are doing something fundamentally different than everybody else. That's what we're looking for, because what we're looking for are businesses that have competitive advantages. If you're doing something nobody else is doing and there's some reason why other people can't do it, then that's the recipe for a great business.
In First Republic’s case, as a regional bank, I’m kind of the view that banks don’t really competitive advantage, they buy and sell money as the ultimate commodity. Of course, the giant banks have different advantages by virtue of their size, and just the whole concept of too big to fail tells you something. Those [unintelligible [00:40:57] that have such opaque balance sheets, I have zero interest in investing them for the most part. But with First Republic, somebody else had pointed out and said, “This isn't a bank. It's a customer service retail franchise.” And I was like, “What does that mean?” But it was intriguing enough that I had to go poke around and figure it out. The easiest way to understand it is, you say, “Well, great customer service.” In a lot of businesses like retail or restaurants, things like that, that's table stakes, it's not a competitive advantage to offer great customer service. Everybody offers great customer service. But the banking industry is not known for having customers that love them.
Bill: Yeah. This is true.
Sean: We saw a poll from Gallup a couple years ago, in which they showed that only, I think, was 30% or 40% of bank employees banked at the bank that they worked at.
Bill: Yeah, I don’t think I banked [crosstalk] when I was there.
Sean: [chuckles] Even the employees are not saying this is the best bank for me. First of all, this whole thing is they are catering to high net-worth individuals who value their time over an extra couple basis points of yield. After doing the work, I know a lot of people say they find products that they like, and they go invest in the business, I tend to be the opposite, I tend to find a business that does something great and then I’m somebody that start buying their products, like, I got into lawn care after Scotts Miracle-Gro. After that, I was like, “Gosh, my lawn’s a disaster,” and I started doing all this stuff.
The First Republic, I learned after we bought the stock, I was like, “Why am I with this bank?” [unintelligible [00:42:30] this great customer service. One of the reasons, one of the pain points of switching banks is setting up your online bill pay again. I did that at First Republic, but one of them just wasn't kind of working. I couldn't get it to work. My old bank, I would have had to call an 800 number, stay on hold for like 20 minutes, talk to someone who might not know what they're talking about, probably get transferred to somebody else, told I was in the wrong department, then basically said, “Oh, you do these things, and then hope that it works.”
With First Republic, I just emailed Rachel. I didn't email an 800 number and they told me to call. It was Rachel. Rachel's my private banker. She's been my private banker ever since I first started with First Republic. So, I emailed Rachel said, “Hey, Rachel, I have a problem with this online bill pay setup. What should I do? Who do I call?” She emailed back 10 minutes later, and said, “Check now, it should be fixed.” So, I checked, and it was fixed. That's why I bank with First Republic. That's why people love First Republic. Their net promoter score’s gold standard, the best way to manage customer satisfaction. Banks are super low. They're there with telecom like Comcast, some of their approval ratings are like on the par with Congress.
Bill: [laughs]
Sean: First Republic's net promoter scores, it's like Ritz Carlton, Apple, Amazon. There's something they're doing very different. They've grown organically, they were the first bank to ever grow without acquisition to over $100 billion. They were founded in 1984-85 in San Francisco. They're still a pretty small bank in the grand scheme of things, but they're the number two bank in San Francisco. Living here, working here, we’ve got a lot of clients here because we work with a lot of private clients, and everybody loves First Republic, everybody. That's just weird for a bank. So, that was the idiosyncratic nature of what we were capturing. They've been able to grow their deposits at 15% on their loan book, 15%, 20% per year for many, many years. Anyone who's a bank investor knows you don't want to be in a high growth bank, because they're taking too much credit risk, because how else could they be growing quickly, right?
Bill: Yeah.
Sean: They’re going to give away loans to people who don't can't afford to pay them back. That's how you grow fast. First of all, it actually has the best credit metrics. It's unbelievable, but it's way better than all the big banks. How do you grow fast? With great credit quality, you're doing something different, and that's the customer service.
Bill: Yeah. That's very cool. Did you have early in your career-- were you always drawn to this quality? Stakeholder capitalism, I've heard you talk about. Have you always been into that or did you make mistakes in some sort of value traps that-- what brought you around to this way of looking at the world?
Sean: I started working professionally in investment business in 1999. The only reason that I didn't get caught up in dotcom boom sorts of stuff is, all I'd ever done was read about investing. All I had read was people like Warren Buffett. I naively was like, “Well, clearly this is the stock market bubble and I don’t have to participate,” not because I had any insight at all, just because I was like, well, the P/Es are 15, therefore it's overvalued, done. I was just a classic know nothing statistical deep value investor. When I say know nothing, as a 22-year-old, who says low P/Es, all you need to know sort of thing. I came initially from the value investment view of the world.
But Curt who I joined was just more growth oriented. He was always sensitive on price and everything like that. When I started working with him, up until maybe around 2010-2011, while we were seeking out businesses that had complete advantages and all of that, he might have described our strategy and we're like GARP strategy. Then I feel the financial crisis, if you managed money through that time, there had to have been some big lesson you learned. If you survived it, you have to be able to look back and think about what did we learn? What should we do differently? In 2008-09, and coming out in 2010, I just took a deep breath, and I went back and revisited lots of stuff I'd read early on in my career and said, “Okay, I’ve got some experience under my belt. And what do I know, and I've been doing this, and I survived this disaster?” Really, what stuck out to me was that these businesses that have competitive advantages, they are able to control their own destiny in a way that other companies are not able to.
Having gone through the financial crisis [unintelligible [00:46:50] totally out of company's control come along like a tsunami, you recognize you need to be the ones that have some control over their destiny. It may be limited. We are all subject to uncertainty. The world I think is way more uncertain than most investors appreciate. Yet, to outperform the S&P 500, to generate some good long-term returns, you just need to have companies that are more able to control their destiny, they don't have to have complete control over their destiny. I really started leaning into that. Today, when we talk about our strategy, competitive advantage is the unifying narrative behind every single one of our holdings. That's what we invest in. We look for businesses that are deeply competitively advantaged. We own a title insurance company that trades at eight times earnings, and we own Netflix.
We're not growth, we're not value, I don't care about low P/E, high P/E [unintelligible [00:47:41]. Competitively advantaged business, buy their stock for a price that is less than the present value of the cash flow that company is going to produce over the long term. To me, we're value investors because we only buy something for less than we think it's worth and when we think about intrinsic value, it just means cash flows. That's all you get as a shareholder is the distributable cash flow of that business. We're value investors in that every company in our portfolio trades at a price below what we think those future cash flows are going to be. Now, something like Netflix, and we were wrong, of course, but we don't own it, because we think, “Hey, they're going to have a great couple of quarters, and we can sell it to somebody else at $600.” We just think they're going to produce tons of cash flow well in excess of their market cap.
Bill: Yeah. The cashflow focus, that's the Bible, for me is Buffett's, “This is what you get.” You get the present value of all your cash flows. That is what enables the second way out on a lot of these things. If the stock goes against you, it just doesn't matter. That's the one thing the code of the value investor that I hope that everybody actually understands, because that is the foundational basis. It gets hard when you're parsing, okay, well, what's growth spend and what's maintenance spend, I have a lot of problems with some of these SaaS companies, because the cohort build in the land and expand, and that it seems to me like perpetually expanding SG&A. I at least recognize that there are a lot of people that don't have those constraints around them, and that they're doing rational things.
I used to say, “I'm not going to go anywhere near any of that stuff. Just give me cheap things.” And then, I found that I was touching stoves. Since I have oriented my way of thinking closer to the way that you look at the world, I still mess around and touch Wells Fargo occasionally and stuff like that. I owe a lot to Manual of Ideas. I owe a lot to FinTwit for pivoting the way that I look at the world. We'll see, I guess the skeptic would say-- Well, everything is balanced, so how much of it’s brains and how much of it's a bull market, but I think it's closer to the right strategy than not. It's the only strategy I’ll implement from here on out.
Sean: The thing is, it doesn't matter what you call yourself if you're a value investor, growth investor, anything else. If you are a long-term investor where you're buying companies and the mechanism by which you are expecting to make money is through the corporate performance of the companies you invest in, not because you're trying to arbitrage stock price moves, but because you're trying to participate in the value generation of the corporations in which you are a shareholder. If that is your strategy, it doesn't matter what you call yourself or what style you use. You recognize that you then have to pay a price that is less than what those future cash flows are going to be. If you look at something like, say, the price to book multiple that was a popular form of value investing for a long time and has failed for a long time, that was just a proxy for understanding current price versus future cash flows.
Once upon a time, in a tangible asset world, book value was a rather good way to create a stable estimate of future returns. If you look at the ROE on a company, that tangible book value sort of company, well, you build that book, that's how you keep growing earnings. That made a lot of sense, but it never meant the book value is relevant. Book value is only relevant when you're going bankrupt. I don't ever want to have a claim on book value on a company. Yes, in theory, we own some pro-rata portion of it, but I sure hope I don't get it ever.
Bill: Yeah. Things have gone horribly wrong.
Sean: Yeah, exactly. We're trying to invest in businesses that don't have a chance of going bankrupt. So, I don't really feel like I need a margin of safety on their balance sheet to cover me if they do go bankrupt. I've made a huge mistake, and we're going to be out of stock hopefully well before we're getting any claim on book value. But that doesn't mean that book value is irrelevant. In banks and insurers, still very a relevant metric, give me a break. Of course, it is, because these are tangible asset businesses. I think that the key thing is just understanding that when people say value investing has not worked for a long time, what they're really saying is the proxies that we used to use for evaluating these things no longer are good proxies. Or, they're just due for a monster comeback. I think the world's changed a lot. Those proxies, the ones that have failed, are going to keep failing because they're not good proxies of businesses today. That doesn't mean they're bad in every instance. The challenging thing is it's hard for investors to accept that what they're owning is something in the future, and that future is unpredictable, because we hate uncertainty, we create a proxy for the future, and we substitute with something current that we can look at and see and we say, “Oh, there you go, there's my value.” Look, it's 15 times earnings, that's cheap, but those are yesterday's earnings, you don't get a piece of those. You get tomorrow's cash flow. That's the key thing, is recognizing their proxies, proxies are super useful, but they are not-- don't substitute them for your real goal.
Bill: Yeah. When you own something like HEICO or TransDigm, I'm not trying to ask about them specifically, I'm more thinking about the idea of serial acquirers. How do you think through underwriting the acquisitions? How much of the value is accretive and when it's going to occur? Just high level, how do you think through that stuff?
Sean: When we first invested in TransDigm, at the time, if you had looked at it, and assumed to no acquisitions, it looked like it was an expensive stock. TransDigm is pretty much like a private equity company. Imagine buying a private equity company, but assuming there was no more deals they were ever going to do. That's actually what they do. It doesn't make any sense.
Bill: [laughs] Yeah, that’s not exactly reality.
Sean: Yeah. With TransDigm, we made a forecast of how much they were going to spend on M&A, and the returns they were going to get on that M&A and how it would play out over time. Just like anyone investing in a company that doesn't do M&A, you're going to forecast what your Capex is, or your gross spend, or whatever it is. This is just a mechanism which TransDigm was doing that. It was clearly an ongoing strategic part of what they did. That was their business, is their business. We modeled in future M&A. At the time was the only company that we had ever done that with, but we've never really thought about it like a roll-up, that's a nasty word in our shop back then. It was like you do the roll-ups, I don't want look at a roll-up, but then understanding what-- this is their business model, and no one called Berkshire Hathaway a roll-up.
Today, we are generally quite cautious to model M&A. If you think like the base rate on M&A for all companies, it's not good. If we don't model M&A-- we have companies that we know are going to do some M&A. By not modeling and all we're really doing is assuming they're going to earn their cost of capital on that M&A. Because if you earn your cost of capital on the M&A that you do, it is no different than, say, paying it out to shareholders or buying back your share price at fair value or whatever it might be. For us, it's like this is just [unintelligible [00:55:21] cash flow. When we explicitly are modeling M&A, what we're doing is, “Oh, they have this ability to reinvest cash into M&A at higher rates of return,” than just kicking it back to us as a dividend, so we can go reinvest in our strategy or something. That's pretty rare when you can find a company that can systematically over and over again, at a level and size that makes a material different, can keep doing that, and it's part of their ongoing business model. But when that's the case, well, you'd be silly to ignore it. That's how we go about doing that.
It's important, though, if you're modeling this for people that are analysts and is technical is recognizing that, that's going to get reinvested at the returns that they earn on their M&A, not the kind of returns on invested capital that maybe their core business is doing and is typically going to be lower. Understanding those differences is important. We own Broadridge Financial, and on their Investor Day today, they pointed out that they've grown-- they've added 2% to revenue growth for the last six years running. They calculate at 19% IRR on that M&A investment, and we think that's generally about correct. That's a value creative behavior for them, and they're very likely to keep doing that.
Bill: When do you think through-- because you and I have talked about a name offline that you-- you had said, “Well, they only grow through M&A and not organic growth.” How do you decide this is not a name that I'm comfortable with the acquisition side driving the growth because the organic growth isn't there? If there's no organic growth, is it just a nonstarter for you?
Sean: Well, let's throw TransDigm out. I think TransDigm is a special case and it's a complex situation and everything. In general, we want the core business to have its own kind of ongoing sustainable organic growth rate and that M&A should be on top of that really. We've written about low growth risk, that most investors think about high growth companies as being risky companies. A company that grows 3% every year feels like it might not be the grand slam, but this is a safe stock and it's not risky. But as we've shown in some of our publications, so if your terminal growth, if your long-term growth rate is 3%, not 4%, there is a huge impact on valuation. 2% versus 4%. Oh, my gosh, look-- [crosstalk]
When you're making a forecast for a stock, and you say to yourself, “Well, it can grow 4% per year for a decade or more.” What if you're wrong and it's only 3%? That's a very thin margin of error. Margin of safety becomes a real issue because you have to be forecasting down to one percentage point, differentials in growth rates make a difference. Just as a rule, are looking for businesses that we think can grow organically at or above nominal GDP, basically, in perpetuity. Then, obviously, perpetuity is a very long time, for the foreseeable future, because if they get below that we think of it-- we call it stall speeds. This idea that basically, you're losing share of GDP, if you're going slower than GDP, you are losing market share-- market share is not the word. Wallet share of total GDP.
What that means is it means you're becoming less and less irrelevant to the economy. We don't want to invest in businesses that are have declining relevance. We want companies are investing that have persistent and maybe even increasing relevance. Stall speed is this idea that when a plane hits stall speed, you crash. When you run the risk, once you start coasting at a growth rate slower than the economy, you're right at that stall speed. Maybe you aren't. If you could tell me-- treasury bonds don't grow, but I can value that, no problem, because it's guaranteed at a certain rate, that's fine. But most companies can't guarantee a low growth rate forever.
Bill: Well, I think that where a couple of these concepts can come together is if you're at your stall speed, and you have a management that is incented to grow earnings or something like that. There is a real possibility that they try to do so by mortgaging their moat. And then you start to get into this negative cycle where you'd look at a consumer product company that you guys wrote about. When was that, was that 2018 or 2017 when you first highlighted that you thought that there was risk in that?
Sean: I think it must have been those prestige brands. I think that was 2018, right?
Bill: Yeah, I think that's right. Now your thesis was somewhat different. It was distribution barriers are eroding, and there's going to be increased competition, but I think everything is a confluence. Like Charlie Munger’s Lollapalooza effect, where it's like everything starts to work against you all of a sudden if you’re hitting stall speed as opposed to if you've got that momentum, you can do things like Netflix is doing whether you're underpricing your product, and you're delivering joy to your consumer. Then, it's just like a virtuous cycle. Aligning yourselves on treadmills that are going the right way are probably a pretty smart strategy in life.
Sean: I think for us, I hope it's smart. Most importantly, it fits our personality as investors. So, it works for us. Most people don't want to be investing in super low growth or declining businesses. That suggests to me that there is a great opportunity for other investors who are wired differently and think differently, to go make money in those stocks. It's just we're not going to make money in those stocks. We have to play in the area where we think we are competitively advantaged. In theory, every company has value, every company could be a good investment, but not for us. We're very limited set of companies, I think we have any capabilities to analyze, understand, and then own for 5 years, for 10 years, for 15 years and not get shaken out at the wrong time.
Bill: Yeah, that makes sense. I think that the tough thing when you're on one of those that's at stall speed to your point is, if you then really stall, how are you the guy that's not shaken out, or girl, that's not shaken out at the wrong time, because it gets very hard to decipher-- thesis creep can be a very real thing. It's real everywhere. When you're in that situation, it can get very difficult. I read something that you wrote about position sizing, and I really liked how you frame this. You said if somebody offered you two to one odds that the sun would come up tomorrow, you should make that a much larger bet than if someone offers you 1000 to 1 that it will rain tomorrow. From a portfolio standpoint, that's a very, very smart thought, sir. I give you mad props for saying that. It may not quite be as prophetic as I thought it was, but it changed the way that I really thought about stuff.
Sean: When I said that coming out of financial crisis just revaluing what we did, what lessons we learned, I spent a long time really focused on position sizing and trying to think about it. What I found frustrating, but then also curious and interesting, and why I became so passionate about it is there is very little written about position sizing. All day, every day, CNBC, people come along and tell you what to buy, where it's going. Nobody tells you how much.
Bill: Yeah, by the way, it's 30 basis points in my portfolio.
Sean: Yeah. They will never recommend it. You look for books, there's a ton of books out there how to pick stocks or how to short stocks. They never tell you how much to buy. The Kelly criterion is everyone holds us up. The Kelly criterion is a fantastic mathematical philosophy around position sizing. For listeners that don't know that Kelly criterion, basically was about blackjack betting, and basically, it was this way to understand that what you cared about was not only what the payoff is going to be, which is everyone focused on Wall Street, how much the stocks going to go up, but also, how likely you were to be right. The Kelly criterion demonstrates mathematically, that is the likelihood of being correct that is far bigger driver of how big your bet should be or your position size should be than what the upside is. The analogy that kind of-- because I know the sun's going to come up tomorrow. I would bet my life savings for a two to one payoff that the sun's going to come up tomorrow, but because it may or may not rain tomorrow, no matter what the forecast say, I have to make a much smaller bet, even if the payoff’s really large, because I can't risk ruin. I can't get wiped out on a bet that might not play off.
What that speaks to is that position sizing should be driven far more by the likelihood that you will be correct than by how much you'll make if you are correct. They're both important, but that's the key piece. The problem with the Kelly criterion is that to use that formula, you actually have to know what those odds are. As investors, we do not know the likelihood that we will be right, we do not know what the payoff will be if we are right, and what will happen if we aren't right. None of that is knowable. Therefore, you can't just plug in these estimates into the formula and get your answers. But philosophically, that's what we did. Going into this evaluation, we had always run about 20-25 securities in our portfolio. Then, lo and behold, I did more and more research, I realized, well, there was a whole lot of academic and practitioner evidence that that's actually the sweet spot. That if you add, build a portfolio of randomly selected stocks, and you have five stocks in your portfolio and you go to 10, you will greatly reduce the volatility of your portfolio really significantly and greatly reduce the risk of ruin.
But as you get out towards 2025, and get towards 30, the incremental benefit is super tiny. That research that was first done for the book, Random Walk Down Wall Street, was written by somebody who believed in efficient market hypothesis, like full bull. Burt Malkiel was like, “Therefore, you just keep adding diversification because it's a free lunch,” but I don't have 100 good ideas. I don't think anybody does. The average mutual fund owns 150 securities. I mean, how could you care enough about those companies to do the work that we do to really understand something if you don't even have 100 basis points in your portfolio? We live and breathe the companies that we own, because we own them in size, but I'm given comfort by the fact that I know that by owning the number that we own, there's no reason we should be any more volatile than the market overall, and our track record suggests exactly that. It's not just the theory, but it's actually in practice. The one key thing is, remember, that was from randomly selected securities, and we don't select them randomly. You have to be very careful if you are an active manager running a focused portfolio that you don't have too many securities that are overly correlated to each other. We don't think that correlation as a stock market correlation, we think about it as demand correlation.
We did an analysis. We have a number of stocks that are in the housing industry in one way or another. We've done some analysis, they just don't actually trade as closely together as you would think. The reason is they're all in different demand cycles. New housing doesn't go the same patterns as home improvement, which doesn't go in the same way as installing services. You can participate in a concentration in an industry so long as the drivers are different. We hope, and I think our track record suggests that we have plenty of diversification in end-market demand within our portfolio despite the fact that sometimes our sector allocations can seem like super overweight or super underweight. We've owned a lot of industrials, and you think, “Oh, they must be long,” a ton of factories and stuff, but a lot of them are business service stocks serving totally different businesses. They're not correlated, and it's not really a concentrated bet on industrials.
Bill: Yeah. It's funny. I came in a traditional value way and cheap stuff, cheap stuff, cheap stuff. Then I realized after a little while-- I call myself I've been a professional for maybe four years. The other years were just me trying to figure out all the stupid stuff not to do anymore. I realized a lot of the stuff that I owned had completely-- it may have looked like 12 separate bets, but at the end of the day, the correlation was super high on that. I finally asked myself, I said, “Well, what am I so afraid of paying up for some of these better businesses?” Then it became, “Well, I'll add one to the portfolio.” And then, “I'll add two to the portfolio.” And then I realized, “Oh, my portfolio is performing much better because there's actually diversification in the portfolio.” I'm getting the portfolio benefits of being in different-- It sounds so stupid to say out loud because it's clearly what the research shows. But behaviorally, I had been so ingrained, avoid paying up that I think that I was taking way more risk than I appreciated at the time, which is part of why I started down this journey was to-- I had inherited some money, and I didn't control all of it. I said, “Well, I have to figure out how to run a small amount before I can be responsible for more.” I'm glad that I didn't inherit it earlier, because I probably would have blown it on a bunch of correlated bets going into 2008. I'd have been in a lot of the things that blew up because they were cheap.
Sean: Before we go on, let's dig a little bit more into conviction and position sizing because conviction is a phrase people throw around a lot, like, “I've got a lot of conviction in this stock,” which may just mean, “It's gone up a whole lot and I love it.” When it goes back down, I don't have conviction in stock anymore. When I say conviction, I don't just mean that we love a company. What I mean is that we rate all of our holdings across seven different elements on conviction, our confidence that we are right about that element of the business. That is the strength of their moat. How confident are we that whatever we think the moat is can protect them from competition, and then the ongoing long term, like decade-plus relevance of their product, how confident are we that this company's products or services will be as or more relevant in the future than they are today?
Then, we look at management and we want to understand how confident are we that they are going to be able to create value for their customers, create value for all of their stakeholders, and create value for us as shareholders. You can look at management just through each of those lens, and some of them will score well on some aspects. TransDigm is shareholder max. You can have some big arguments on how do they think about stuff stakeholders overall and maybe it's a lot lower. You have to look at these differently. You have conviction, different elements of it. Then we think about kind of how intrinsically forecastable businesses. Consumer products’ CFO can tell you what the next five-year price increases are going to be and be accurate within a couple percentage points, but an honest, oil CFO, the EMPC, is not going to tell you what the price of oil is for the next five years. It’s going to be off by a lot. Some businesses are intrinsically more forecastable. Then there's just our own circle of competence. How well can are we positioned to understand this?
We have a threshold level for every company in our portfolio to reach a certain threshold on all of those. Then within our portfolio, we force rank everything on those, which is a really tough thing is like picking between your kids. We love all of our holdings, otherwise, we would not own them. If we didn't love a holding, it's out of the portfolio. We love all of them. We force rank all of them on each of those questions. Then we're able to develop a quantitative score of conviction. When the stock starts going down, and we get worried, we don't just say like, “Well, I've lost conviction, I think we should lower the position size.” If we get worried, we go look at our ratings. We understand like, where is the worry? It's probably not on all seven issues. It's probably in certain issues. Then we zero in on that and say, like, “Are we actually have less conviction on that versus our other companies? What exactly is going on?” As an example, owning booking holdings during a global pandemic is scary. They had negative revenue in April of this year. Our conviction in the forecastability, it declined significantly. And it's still lower than what it was pre-pandemic, because we do not have as much confidence in what global travel patterns are going to be like for the next five years. If anybody thinks that they are as confident on what global travel patterns are going to be in next five years versus what they were pre-pandemic, they're crazy.
Our conviction, that element of booking lower, not because we got scared, but because, hey, realistically, we don't know. We also were like-- but humans, our DNA impels us to travel. That is why humans have covered the entire globe. We are certain that it's going to come back at some point. We kind of look at these different elements, but at the end of the day, even printing negative revenue, we were like, hey, the core things are all here, and we had to make sure can they get to the other side? That was our big analysis, starting in March was every business has to survive to be a long-term winner. Booking, which we did our own analysis, and they validate when they came out in April and said, basically, “Hey, look, everybody, we've raised some more cash, the markets only making us pay 4% for this new debt, they're making Airbnb at the time pay 11%, Expedia 11%, but they're giving it to us for 4%.” Amazing. We have negative revenue, and the market’s lending us money at 4%. That's how confident the market is, debt market is in us.
Guess what? We could have no revenue at the end of 2021, and we can still operate. That is an incredibly resilient business. For booking 60% of their cost structure pre-pandemic, was through marketing, but you don't need to do any marketing when there's no demand. Those costs just shut off along with the revenue opportunity. So, they had the ability to greatly reduce their cost structure in the face of very, very, very weak demand, but we were able to have very our conviction, even though we were scared, like any sensible person was in April, because there was nothing in our conviction ratings where were would say, “Yep, that's actually all that disqualifying level of a low rating. That just is too low for us.” That for us, that's become the lodestar, is that we understand quantitatively what our convictions are in business. We might be wrong, but that then allows us to quantitatively create position sizes. There is no discussion. I'm the CIO, but there's no discussion. I don't ever say, let's hold Netflix through earnings and see how it does, and maybe we should lighten up. Those discussions don't happen in Ensemble.
Bill: Do you have a devil's advocate? Sorry.
Sean: Let me talk about devil’s advocate in a second. When we talk about trading, it is that the formula that we use for position sizing, that's a function of conviction plus upside appreciation, Kelly inspired, is calling for a certain position size, and we're going to drive our portfolios towards that position size. To the extent that it feels wrong to us, as hopefully informed discretionary managers, we don't just say, “Well, let's just feel differently about it.” We say, “What's wrong with our model?” And we dig into that and understand what are we feeling. Sometimes, we recognize, “You know what? We haven't captured something in our formulaic model.” It's just a model. It's not reality, and so then we might adjust our model, which we do from time to time or we recognize. We’ve got to change these scores because we didn't appreciate something. Other times we just realized, nope, it's telling us trim and we just don't feel like it, but we're going to go with what we know is the right path to do. We actually have a very quantitatively implemented position sizing framework, which is the total opposite of the very, very, very qualitative work we do on competitive advantage analysis. I think that's right, because I think humans are way better than computers at understanding competitive advantages. Computers are way better than humans at understanding the statistical position sizing that you should own based on that qualitative input. For us, it's about, let's let the computer do what it's good at, we do what we're good at and that's been the right match for us.
Bill: Lives up to your name, sir. An ensemble of things working together.
Sean: Yeah, that’s right. You asked about devil's advocate. Let me just elaborate on that.
Bill: Yeah, just to make sure that you didn't fall in love with your quantitative ratings, if the three of you sort of like the business, I mean, do you put somebody in the room, shredded to pieces? Or say, “No way, it doesn't deserve that quantitative rating, you're too in love with it?”
Sean: It is a good thing that me, and Arif, and Todd enjoy each other's company so much, because we argue all day every day. That's basically what we do. It's incredible. Now, if any analyst in our team believes that a company in our portfolio doesn't meet a threshold level of conviction in any one of the areas, we will argue about it, but if they don't yield, it's out of the portfolio. It's not managed by consensus, we're not all deciding what we ought to be in. But if there's any aspect where someone's like, “Guys, this doesn't even meet our threshold level,” because we're only looking for 2025 stocks. If some of the team is pulling the ripcord, we'll go find something else. It's like return on brain damage sort of issue. Just go find something different.
We all have our own ratings. We review them regularly. When they are different from each other, we kind of dig into why that is, and we debate it. We sometimes will recognize, “Oh, one person wasn't thinking about that question the same way somebody else was,” and then maybe both our views get enhanced, and we might change or not change our ratings, but they've been improved. Other times, we say, we're all looking at the same facts, we just have different opinions, and that is fine. We roll those up and act on that. We don't have a formal devil's advocate kind of concept. For listeners, basically the idea that somebody on the team should be in charge of figuring out the bear case and advocating for the bear case. I think the problem with that approach is that everybody knows that's the devil's advocate. So, everyone's like, “I can dismiss that, because they're just doing their job.”
Bill: [laughs] Yeah, they have to do this.
Sean: Yeah, exactly.
Bill: That’s interesting.
Sean: It can really create, I think, an environment of confrontation. I know there's some businesses, some investors that have thrived through environments of confrontation. We argue a lot, but it is not emotional confrontation. There is no yelling at Ensemble. There's no name-calling at Ensemble. We have passionate discussions about how we view the world. We recognize that other people on the team are they're in that seat because their point of view is just as valid as the other person's, including mine, it doesn't matter that I'm a CIO. There's nothing about my point of view that is somehow more enlightened, or I don't have a better view of reality than other people on my team. I just have my view of reality. The idea of setting somebody up as being kind of the fall guy, that you say, well, I don't have to worry about the risks for me, because they got that covered, and since they're the risk person, then I can ignore them. We're all responsible for those risks.
But we absolutely challenge each other on different things. We absolutely have different opinions. One of us is the lead analyst, and every name including myself and other CIOs aren't actually analysts, but to me, this would be a boring job if I didn't cover stocks. That's why I got into the business. We cover about a third of the portfolio as the lead analyst, but they're just the lead. Leads can often fall in love with the company a little bit. That's a good thing. We want to love our company, but it's the job of all of us to challenge each other. Every quarter, every company, there's something that we don't like. If you think the company printed a perfect quarter, you're not paying attention.
Bill: Yeah. It's interesting. Well, I like that approach. We're coming up on time. My last question before I let you go. Errors of omission, what's one that really grinds your gears?
Sean: I was asked this question recently. I know that people say this, like, “Oh, errors of omission are more important than errors of commission.” If you're investing in 2025, stocks, you miss a ton of stuff, that's by design. It's not a mistake. I mean people ask us all the time, “Well, why don't you own this?” The answer more often than not, is because we've never done a deep dive on it. That's why. I think that it's not exactly an error of omission, but I think it gets at what you're asking about is that it really influenced how I think about valuing stocks and paying attention into different companies. When Facebook bought Instagram for a billion dollars, and they had 17 employees and zero revenue, I thought to myself, I don't even have to research this deal. Clearly, we're back in another bubble. This is silly dotcom era sorts of things. You don't pay a billion dollars for a company with no revenue. Clearly, I was terribly wrong. I just didn't know what I was talking about, but I told myself, “I don't have to do the work because I already can tell that this is an idiotic move.” What a dumb thing to say.
Facebook is a super successful company. Mark Zuckerberg is a brilliant individual. He wouldn’t do something that was just obviously incorrect that you could tell without even doing real diligence on it. When I recognized over time that, “Gosh, I had such a naive, dumb reaction to that,” and why was that? When I realized it just came down to, I held an opinion, despite not actually having done the work. We live in an environment right now where companies are going public and getting 100% pops in their IPO, and boy, is that a danger signal? I refuse to look at any of those companies and say to myself, I know they're overvalued. There's companies out there something like 200 times sales right now. I think they're overvalued. That'd be my guess. I don't know. Therefore, I shouldn't have an opinion. We work way too hard to have the opinions that we have on our stocks in our portfolio, for us to somehow seemingly be able to dismiss companies we haven't done any work on and say, “I don't even need to do that.” I think that the sin of omission for me was, I'm thinking to myself, I don't have to pay attention to Facebook or Instagram, because, gosh, this is just dumb stuff. That was so clearly wrong. I think that going forward over time, it took me a while to figure this out, is just realizing this is one of the reasons why we don't look at valuation when we start looking at stocks. You don't know. For us, we start to look at a stock because usually, we hear something about them that is kind of unusual, kind of idiosyncratic, something that doesn't make sense, and something that relates to competitive advantages. Then, we start digging a little bit. We dig into that more and more. We get asked by, especially institutional investors, what's your process for idea generation? I wish that I could tell them, “Well, we have the six-step process and pass it through. It's like a little factory here,” and stuff like that. But if that was the case, anyone else could do it too. What we're doing is a much more organic process. There is absolutely repeatable system to what we do. Otherwise, we wouldn't keep coming up with new ideas, but it is a very organic process.
What it is, is that we're looking for something that not-- I mean, other people look for completely managed businesses, of course, but that is our lodestar. What we're looking for is signals about that. Going back to First Republic, I didn't look at the stock price, I didn't look at their ROE. I just heard that this wasn't a bank, it was a customer service business. That just was intriguing to me. Then I very quickly realized, they have customer service stats that make them look like the most loved companies in the world, and the banking industry has terrible stats, what is going on here? I hadn't looked at valuation yet, I hadn't looked at their growth rate. This is what gets me digging, this is what’s gets me excited. But I just have learned, don't have opinions on any stocks until you've actually done the work. I really should have in retrospect said, “Why’d they pay a billion dollars for a company with no revenue? There must be something really interesting there.” Instead, I closed my mind to it, and I said, “I don't even need to pay attention because it's obviously dumb,” and I was the one who was dumb.
Bill: It's one of the best answers I've heard to that, and I'm not just blowing smoke, I did the same exact thing, and it triggered two thoughts for me. One, I quote him a lot, because what he says makes sense to me, Adam Robinson once said to Tim Ferriss, he said, “Look in places that are glaringly obvious, and places that don't make any sense.” So, if you see a headline and it's perfectly obvious, or just doesn't make any sense, dig. Don't form an opinion. And then, the other one’s Tony Robbins, “Ask better questions to get better answers.” Sean, I really appreciated your time, man. I hope that everybody listening has too, and I look forward to many conversations in the future.
Sean: Bill, thanks so much for having me. It's fun to have this sort of conversation as opposed to 20 minutes of some stock questions and playing this all out and covering the ground we did. Best of luck on your podcast. I've really been enjoying them and look forward to hearing from a lot more people.
Bill: Thank you. Take care, man.
Sean: All right, Bill.
