The Non-Interchangeable, Non-Mechanical Elements of Value Creation

Today we are pleased to be joined by Mr. Sean Stannard-Stockton, CFA, President and CIO, and Senior Analyst Todd Wenning, CFA of the California-based investment manager Ensemble Capital. The two help oversee more than $800M in firm assets leveraging a long only, concentrated strategy under the following format:

Founded in 1997, Ensemble Capital Management is a Burlingame, California-based investment firm, which is 100% employee-owned with the CIO as majority owner. Our equity strategy holds between 15 and 25 companies. We look to own firms with widening economic moats, as this will have the most impact on returns on invested capital over time. Because firms with high returns on invested capital require less reinvestment to reach a certain level of growth and therefore produce more distributable cash per dollar of reported earnings, they should be more coveted by investors. We also want to invest alongside exemplary stewards of our capital that understand the key drivers of economic value creation and allocate capital in a manner consistent with maximizing long-term, risk-adjusted shareholder returns.

We reached out to the Ensemble team to discuss a major element of the firm’s investment process: Evaluating management. Given the eternal importance of the conversation and the broad relevance to our fundamentally-driven readers, we set-up a proper interview to share the insights we picked up in our private calls. Our conversation follows:

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SumZero: As background for this discussion on evaluating management, it would be helpful for our readers to understand the unique story behind the launch of Ensemble. Could you give us the quick version?

Sean Stannard-Stockton, CFA: Ensemble Capital was founded in 1997 by our now retired founder, Curt Brown. Curt had gone to business school with Chuck Schwab and when Schwab Institutional (SCHW:US) was launched, providing a platform for independent RIAs, Chuck encouraged Curt to start his own firm.

After three decades working in the financial markets, Curt founded Curtis Brown & Company in San Francisco. His desire was to form an independent firm, structured to serve clients in a clear and transparent manner. The business model was designed to remove the many conflicts of interest that plague so many financial services firms. I joined Curt in 2002 as employee #2. In 2004, I became a partner in the newly formed Ensemble Capital Management, the successor firm to Curtis Brown & Co.

SZ: What has running the business side of Ensemble taught you about evaluating other managers?

SS: The most important lesson you learn operating a business is that it is a very qualitative activity that does not lend itself to simple statistical measurement or standard rules. Businesses are much more like living beings than they are like machines. The big disconnect we see between investors and business owners is that investors too often behave as if businesses are interchangeable, mechanical systems that you can distill down using standard metrics and make investment decisions about based on simple rules. Nothing could be further from the truth.

Instead, business operators know that there is an enormous amount of “soft” information that drives effective decision-making and strategy. This type of evaluation can be difficult for outside investors to do well. But we think that attempting to understand the unique aspects of what makes a business tick is the most valuable research investors can do. Our own experience doing this has led us to find that idiosyncratic businesses that are doing something different than their competitors often provide opportunities for investors who are willing to evaluate these unique companies on their own, rather than trying to force them into standard analytical frameworks.

SZ: Who is a CEO that you admire that most investors are unfamiliar with?

SS: Jim Herbert, the Founder/CEO of First Republic Bank (FRC:US) is outstanding. In a highly commoditized business like banking, it is very difficult to create the sort of shareholder value that Herbert has. Especially through almost entirely organic growth. But Herbert recognized that while the banking industry primarily competes via pricing (offering premium yields on deposits or attractive rates on loans), there is a segment of customers who are more interested in superior customer service. By reorganizing the competitive playbook of a bank to put customers first, the company created a dominant offering that even the largest banks can’t match. The company’s customers routinely rank their service as being on par with the best consumer brands, such as Ritz Carlton, Apple (AAPL:US) and Nordstrom (JWN:US), while most banks rank near the bottom on customer satisfaction surveys. While First Republic customers gladly refer their friends to the bank, surveys show that even the employees of most banks wouldn’t recommend their company to friends and family.

Putting customers first, even ahead of shareholders, is a strategy that when executed well can have the effect of actually maximizing long-term shareholder value. Companies like Costco (COST:US) and Starbucks (SBUX:US) have shown how well this strategy can work and Herbert has also led a customer-first strategy that generated enormous shareholder value. And then on top of that, sold the bank just before the financial crisis and bought it back after the housing bubble burst. We think CEOs from all sorts of industries can learn a lot from leaders like Herbert, who refuse to accept the standard competitive playbook and instead play a game they can win rather than the game everyone else is playing.

Todd Wenning, CFA: North American investors may be unfamiliar with Kate Swann in the U.K., who took the CEO role at WH Smith (SMWH:LN) in 2003 when it was a struggling brick-and-mortar bookseller and news distribution business. Over the next nine years, Swann made some tough but important decisions, such as moving out of DVDs and CDs – which was controversial at the time - and into stationery and magazines, closed the gaping pension deficit, and spun-off the news distribution business. Perhaps Swann’s best move was putting WH Smith shops into airports and train stations around the world. Travelers are always looking for something to read and are more price insensitive. If you compare the performance of WH Smith and Barnes and Noble over the last 15 years, they are mirror images. To Swann’s credit, WH Smith has continued to do well since she stepped down in 2012. She was exactly the right mix of Optimizer and Visionary CEO for WH Smith at that point in time. Swann recently announced she’s stepping down as CEO of SSP Group, where she turned in another great performance. WH Smith was no fluke.

SZ: What is the most reliable metric to measure management efficacy?

SS: Return on invested capital (ROIC) is the most valuable metric, that also happens to be underappreciated by most investors. Since the value of a business is the distributable cash it can generate over time, investors rightly get excited about companies that have the opportunity to grow cash production over time. But ROIC measures the amount of cash that needs to be reinvested to produce a given level of growth. Companies with high ROIC can produce more cash today even while reinvesting for growth. Management teams that understand how ROIC drives shareholder value end up making different decisions than those who focus primarily on growth.

That being said, like most metrics, what matters is long-term trends, not a one-time measurement. Management teams may end up destroying long-term shareholder value if they seek to maximize ROIC, and in the process fail to reinvest in the business in ways that sustain their competitive advantage. One of the recurring mistakes we see legacy companies make is to overly focus on maximizing current cash flow in the face of new competition. For instance, we believe many media companies would have been better served by investing heavily to control the transition to streaming, rather than maintaining what we think was a mistaken focus on preserving near term cash flow to support their dividends.

SZ: What does your management due diligence process look like?

TW: First and foremost, we seek management teams that understand the business’s economic moat and allocate capital in a manner that widens the moat over time. If we’re looking at a luxury brand, for example, we want management to protect the long-term value of the brand and not look to maximize current earnings by going into the mass market channel. Second, we want management that understands proper ways of returning shareholder capital in the form of dividends, buybacks, and debt repayment. Is management opportunistic with buybacks? Is the dividend policy reasonable and reflective of the business’s long-term value creation?

To answer these questions, we read as many transcripts, interviews, filings, and presentations as we can. We typically speak with the company and others who know the business or management team well.

SZ: What are the biggest red flags in conversations with management?

TW: I always ask executives what they’ve been reading. The ones who laugh off the question or don’t say they have time to read anything other than a magazine – you’d be surprised how often I get that answer – make me skeptical of their ability to time manage and think critically. On the other hand, I am encouraged by executives who not only tell me what they’re currently reading, but then go on to give me three or five more recommendations. It suggests they are intellectually curious, thinking about the bigger picture, and can pull value-creating ideas from disciplines outside of their industry focus.

SZ: Can management ability be quantified?

TW: Once we’ve gathered our information, we score management on two questions, both on a 0-3 range. To get a “3” in both categories, management teams will have to both deeply understand the key drivers of economic value creation for their company and exhibit an ability to allocate capital in a manner consistent with widening the business’s economic moat. These scores, along with scores on other categories, ultimately drive our overall conviction rating and our position sizing.

SZ: How do you approach valuing companies whose prices may derive a premium based around the narrative of a celebrity Founder/CEO (e.g. Steve Jobs & Apple (AAPL:US), Elon Musk & Tesla (TSLA:US), etc.)?

SS: The only value of a stock is the present value of the company’s future cash flows. There is no value to “narrative”. However, we do think that there are critical distinctions between a “Visionary/Creative” CEO and an “Optimizer/Outsider” CEO.

TW: A lot of investors – including us – were influenced by William Thorndike’s excellent book, The Outsiders, which profiled eight CEOs with some common traits that work wonderfully at certain types of businesses. Outsiders improve operational efficiency, make opportunistic buybacks, bold M&A decisions, and so on. They work great when a business generates a lot of cash and has room to generate more. There’s a clear blueprint for success.

On the other hand, there are situations in which there is no blueprint for success – new and emerging industries or business models, for example, or trying to revive a company in steady decline. In these situations, an Outsider CEO will do more damage than good. Here, you’d rather have a Visionary/Creative CEO at the helm who inspires his or her staff, is mission-driven, and is willing to experiment with new products or services.

Limiting your concept of a “good” CEO to the Outsider archetype can lead to you missing out on opportunities in companies on their way to establishing or dramatically widening their moats.

SZ: Who do you credit as contributing most to your education as a value investor?

SS: It is almost nonsensical to cite anyone other than Warren Buffett, since so much of what is learned from other great investors is actually an output of what they learned from Buffett themselves. But I think that in a similar way, what I really learn from Buffett was his own take on what he learned from Phil Fisher and Charlie Munger. I’m an optimist at heart and I think deep value investors need to be hardwired for skepticism. Like Munger and Fisher, I’ve always felt that wonderful businesses were more interesting than wonderfully price stocks. But of course, there is a balance between the two that need to be respected and I think that the Buffett of “wonderful businesses at good prices” that was influenced by Munger/Fisher rather than the Buffett of “good businesses at wonderful prices” that was influenced by Ben Graham.

TW: Beyond those who Sean mentioned, I’d add two U.K.-based investors who have taught me a great deal: Nick Train of Lindsell Train and Terry Smith of Fundsmith. Both are fanatical about finding and understanding businesses that can survive and thrive in the coming decades let alone the next few years. Such long-term thinking is refreshing compared to what we see dominate the financial headlines. Train and Smith were both history students in university, which I believe contributes to their differentiated, long-term perspectives. As a history major myself, I know that discipline has contributed to my own appreciation for putting short-term events into context.

SZ: What advice do you have for investment professionals who may want to launch their own funds?

SS: Realize that even great investment performance does not sell itself. It is critical that you design a go-to-market strategy that aligns with your firm’s expertise and your personal interests. For much of Ensemble’s history, we marketed our strategy within the context of a private client advisory offering. This is primarily a referral-based business and it played well to Curt and my strengths in relationship management and clear communication. Only after building a very stable book of long tenured clients, did we launch a mutual fund and begin seeking out institutional clients.

I believe that too many talented marketing teams don’t actually have a great product, and yet too many great investment products are run by people who don’t think they should have to convinced anyone to invest with them. In my view, if you can’t clearly articulate why your investment strategy is compelling, it is likely you don’t actually have a compelling investment strategy.

Learn More About Ensemble Capital on SumZero Cap Intro


Disclaimer: As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of First Republic (FRC:US), Starbucks (SBUX: US), Apple (AAPL: US), and Schwab (SCHW:US). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.