Interview: The Qualitative Genius of Sean Stannard-Stockton

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Of all the interviews I've published, my first interview with Sean Stannard-Stockton, the president and chief investment officer at Ensemble Capital, was one of the most widely read. And rightly so! Sean is wicked smart, has a learning mindset, and is a great investor and investing teacher. To see what I mean, check out Sean's blog, Intrinsic Investing, or his recent presentation on Sensata Technologies for the MOI 2019 Best Ideas Conference.

In that first interview, we discussed Sean's investing philosophy and process. We discussed legacy moats, reinvestment moats, and capital-light compounder moats. We also discussed incremental returns on tangible invested capital, distributable cash flow, discounted cash flow valuation, and so much more.

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Today, we discuss Sean's qualitative checklist and why he avoids adhering too closely to most quantitative metrics in his search for idiosyncratic businesses. We also chat about asset turnover as a driver of returns on invested capital, free cash flow yield as a valuation tool, and the concept of stall speed. We talk about Giffen goods. We even discuss body mass index. There's an excellent lesson there -- you'll see! Every time I chat with Sean, I'm wowed not just by his knowledge, but by his ability to share that knowledge in an easy-to-understand way.

Oh yeah. In this interview, we also talk stocks. Awesome stocks! We discuss several companies that I think deserve more attention, including Ferrari N.V. (NYSE: RACE), Broadridge Financial Solutions (NYSE: BR), First American Financial (NYSE: FAF), and Landstar System (NASDAQ: LSTR). And we go deep into Starbucks (NASDAQ: SBUX) and explore the valuation of both Mastercard (NYSE: MA) and Netflix (NASDAQ: NFLX).

Here we go ...

John Rotonti: It's been almost two years since our last interview. Can you remind us what investment criteria (or qualities) you look for when analyzing businesses?

Sean Stannard-Stockton: We have three general sets of criteria that we use as a lens for analysis of every company we own. Most importantly, we are looking for competitively advantaged businesses that we think will see those advantages persist and which offer products or services that will remain in demand over the very long term. We believe this requirement eliminates approximately 70% of publicly traded companies from consideration.

Then we look at management behavior on two key issues: one, the management team's track record of creating economic value and our assessment of their ability to continue to do this well into the future, and two, the management team's track record on capital allocation and the degree to which we trust them to continue to allocate capital in the best interest of shareholders. We place just as much weight on the decision-making process the management team uses for both. So, a poorly timed stock buyback, for instance, doesn't concern us so long as we believe that at the time the company made the decision and based on the information they had at that time, that they were making an intelligent decision.

Finally, we assess our own ability to make relatively accurate forecasts about the future of the business. This analysis is partly driven by the intrinsic "forecastability" of the business (for instance, even oil industry CEOs can't forecast the price of oil, while an expert on consumer packaged goods can forecast price trends quite accurately to within 1% or so of what actually occurs), as well as our team's ability to understand the business in question. As a team of generalists, we are comfortable investing across a range of industries. But there are some businesses that are better suited to our specific expertise, while we will pass on an investment if we believe that our own circle of competency is not well aligned with the company in question.

Rotonti: Do you codify these criteria into a formal investing checklist? In other words, does Ensemble Capital put each company through an investing checklist before deciding to buy stock in that business?

Stannard-Stockton: Yes, although the checklist is a list of qualitative assessments rather than quantitative checkboxes. We think that idiosyncratic businesses that don't fit typical quantitative checklists are actually some of the most fertile hunting grounds for alpha. But we have a rigorous checklist related to the criteria I described earlier, and we convert these qualitative assessments into quantitative rankings that play a direct role in determining which companies we invest in and the position size we will hold.

Rotonti: You recently published one of the best investing articles I've read in a very long time, titled "The Risk of Low-Growth Stocks." I think it should be required reading for investors! Can you please summarize your main point, and explain the formula "Free cash flow yield + expected growth = A rough estimate of expected annual rate of return"?

Stannard-Stockton: That's nice of you to say, John. That article had a couple of key points. First of all, we described how most people focus on the risk of high-growth stocks, but a key risk to a stock's valuation is its terminal growth rate. Even small changes in the long-term growth rate of a business greatly affect its value. So, the article detailed how, for instance, consumer packaged goods companies seeing their historical 5% or so growth rates slowing to 3% or so would drive a downward revision of their intrinsic value of 30% or more.While this isn't an entirely new idea for us, it is something we have focused on more in recent years as this risk cropped up in a couple of our holdings; for one, Prestige Brands, we wrote a case study about what went wrong. The element of this analysis that I think we have come to better appreciate is the concept of stall speed: the idea that companies, much like biological organisms and ecosystems, rarely remain in a state of equilibrium. Instead, most living things (and companies are just collections of people) are either growing or declining. Or, as William S. Burroughs put it, "When you stop growing, you start dying." We're big fans of cross-disciplinary thinking, and so I'd note that Albert Einstein was touching on a similar concept when he said, "Life is like riding a bicycle. To keep your balance, you must keep moving."

The math is really quite simple. The Gordon Growth Model, probably the most basic valuation model, shows that a series of cash flows is worth your initial cash yield plus the growth rate of the cash flows. So, if you pay $100 for a cash flow stream that starts at $4 (4%) and grows at 5% a year, you'll earn a 9% (4% plus 5%) rate of return. Since the Gordon Growth Model only holds in a case where the growth rate is perpetual and there is no volatility, it isn't very useful for directly valuing stocks. But it does make clear how to value a company in a theoretical terminal state.

Historically, the stock market has offered a 4% cash-flow yield, and cash flows have grown by about 5% a year. That's why the stock market has historically offered an average annual return of 9%. But as we described in the article, if a company's growth slows to 3% or 1%, then the cash-flow yield needs to spike higher, to 6% or 8%, in order for investors to earn 9% going forward. This spike in cash-flow yields is achieved by a sharp decline in the stock price, and that's the risk we tried to highlight in our article.

Rotonti: The last time we spoke, you said that most of your portfolio holdings were growing faster than GDP, but that GDP-plus growth was not a requirement. Is this still the case, or do you now require that all of your new investments be growing the top and bottom line at a certain rate?

Stannard-Stockton: We actually have very few quantitative requirements for companies to enter our portfolio. While many quantitative requirements, such as a minimum growth rate, a maximum debt level, or the existence of a dividend payment, might be good rules in general, we are looking to assemble a focused portfolio of outstanding companies, not pass judgement on all companies. So we have high standards related to the ongoing relevance of a company's products and services, the management team's prudent use of debt, and shareholder-friendly capital allocation decisions, but we don't attempt to distill our judgement on these matters down to a simplistic, quantitative rule. In fact, we think doing so is dangerous, because we know that any alpha-generating factor that can be quantified into a simple rule will quickly have that alpha captured by massively resourced quantitative trading algorithms. So, we're far more interested in idiosyncratic businesses that may break some well-intentioned quantitative rules but which actually do meet the qualitative meaning that those rules are attempting to capture.

I think this focus on qualitative meaning over quantitative measure gets at the heart of how we generate alpha. Some people might push back on this concept because they rightly assert that simple quantitative rules have often been shown to outperform even expert-level qualitative judgement. But it is important to recognize that we are still monitoring many quantitative metrics -- we just do not blindly follow them, but instead seek to get at the qualitative meaning that those rules are trying to capture.

A quick example. A person's body mass index (BMI), a weight-to-height ratio that is calculated by dividing a person's weight by their height, is a reasonably good indicator of obesity. In general, it is perfectly accurate to decide that anyone with an BMI over 30 is obese. But guess who else tends to have BMIs over 30? Professional athletes. While the average person with a BMI of over 30 is quite likely to be unhealthy, you can also get to a BMI of over 30 by having professional-athlete levels of muscle mass. But the qualitative meaning behind the BMI index is about health. So, while we don't set a quantitative rule like "BMI must be under 30" as part of our process, we do set qualitative rules like "people who are extremely healthy and fit," and we of course may consider a BMI score as part of our health assessment. But we make sure to never mistake the quantitative measure for the qualitative meaning that we're seeking.

Getting back to your original question, yes, it is still the case that we do not have a requirement that a company's growth rate must be GDP-plus. But we have always been focused on seeking out companies that will have robust and resilient profit streams over long periods, and in recent years we have become even more aware of the risks associated with sub-GDP-growing businesses and how these companies have a tendency of hitting a "stall speed" in which they go into a downward spiral.

Rotonti: Ferrari N.V. is the largest holding in the Ensemble Fund. What is your investment thesis on Ferrari?

Stannard-Stockton: Ferrari sells cars, so a lot of people assume it is a car company. It is not. It's a luxury goods company. Sometimes people use that type of categorization comment to justify a high valuation, but what I mean is that Ferrari's financial statements look and behave like [those of] a high-end luxury company, not a car company. Profit margins are fantastic, returns on capital are sky-high. Pricing power is amazing. Demand is not very cyclical. Because of the long wait list to buy a Ferrari, even during recessions the company sees steady demand. The fact is if you have enough money to buy a Ferrari, then a recession isn't going to change your mind.

As an example, when we went to Italy last year for Ferrari's Capital Markets Day, the company was announcing the launch of their new, limited-edition (499 units) Monza supercar. They told potential customers that it would cost between $1 million and $2 million, and on that basis, they sold out. Only after they had sold out did they announce the price ($1.85 million). Despite the huge demand, the company refused to allow any buyer to purchase more than one car. They even referred to those customers selected to have the privilege of purchasing a Monza as the "lucky few." We met one of these buyers at the event and it would be fair to describe him as "giddy with excitement."

This consumer behavior bears no relation to how people buy "cars." It is more accurate to say that what Ferrari actually sells is membership into one of the most exclusive global clubs for the ultra-wealthy. Membership in this club is such a big deal that a Ferrari owner who was refused the chance to buy the LaFerrari Spider supercar actually sued the company, saying that his inability to buy the car harmed his reputation and held him up to ridicule, disrespect, and disrepute among his friends and business associates.

A "Giffen good" is one where demand increases as the price increases. That's the opposite of what economics tells us is supposed to happen. But while this seems crazy, most people are familiar with this concept based on how they buy wine. Most people aren't going to buy a $3 bottle of wine. If you change the price to $10, a lot more people will buy it. As the price moves higher, people view the product as being more and more desirable. Part of the appeal of a high-end Ferrari is the very fact that it costs $1 million (for example). So, by creating a product that commands super-high pricing and which people want in part because it is super-expensive, Ferrari is one of the rare companies that has created and maintained a Giffen good.

Ferrari is able to generate such high returns on capital because they generate luxury-good-type profit margins, not the low profit margins of an automaker, and because they generate so much revenue per car, they generate high asset turnover as well.

The Ferrari thesis is pretty straightforward. We think it is near-impossible for any other company to create the sort of ultra-exclusive club that Ferrari manages. The competitive moat around their business is essentially impenetrable. We simply think that they will continue to generate outstanding returns on capital with steady growth on existing models, and we think they will ramp up their unit sales in the years ahead to create significant growth. The company only sells about 9,000 cars a year globally, which, if you assume their target market is people with over $10 million in wealth, means they have only penetrated about 0.5% of their potential market. Limiting sales is one of the most critical aspects of managing their business. But we think they can increase production, and that because they only run their factory at about 35% capacity, incremental production will have gross profit margins of 70% to 80%, leading to a large increase in profit margins and earnings power.

Rotonti: Over the past three years, from 2016 through 2018, Mastercard's constant currency organic revenue grew at a 15% compounded annual growth rate (CAGR), and EPS achieved a whopping 28% CAGR. According to S&P Global, over those three years, Mastercard generated an average ROIC of about 40%. And over the next three years, 2019 through 2021, Mastercard expects a constant-currency organic revenue CAGR in the "low teens" and EPS growth in the "high teens." This financial profile is next-level amazing. But does it justify Mastercard's stock selling at a next-12-month P/E of nearly 30?

Stannard-Stockton: Yes. Mastercard's financial profile truly is "next-level amazing." But a P/E ratio isn't justified because a company is "amazing." The value of a business is nothing more than the present value of the cash flow that it will distribute to shareholders in the future. And future cash flows are related to the rate of growth a company can achieve and the amount of cash the company needs to reinvest (i.e., not distribute to shareholders) in order to achieve that growth. The amount of cash needed to fuel growth is directly related to the return on invested capital a company achieves, which is why we focus so much on this metric.

In the case of Mastercard, the company has minimal need to reinvest in their business to fuel growth. They only spend about 2% of earnings on growth capex and have negative working capital excluding cash, meaning that they actually generate cash as they grow rather than needing to reinvest it. They also don't need to invest much into their income statement. For instance, the amount they spend on advertising is essentially unchanged over the past 10 years, even as revenue has grown by 300%. The vast majority of companies need to reinvest most of their cash flow and even obtain outside financing to grow at the rate Mastercard has grown over the last decade. But Mastercard has basically hemorrhaged cash even as they've grown quickly.

We think that, in general, investors overpay for high growth. But many investors don't fully appreciate the value generation of businesses with high returns on invested capital. When you combine high returns on investment capital being applied against a large growth opportunity that is likely to persist for a very long time, the combination makes for a very valuable business expressed in a higher-than-average P/E ratio. Mastercard certainly doesn't have unlimited value, but we believe it continues to be worth a good deal more than the current market price.

Rotonti: Broadridge Financial Solutions is a company I cover at The Motley Fool, and it's currently one of my highest-conviction ideas, with the stock trading for about $105, down from its 52-week high of $138. Broadridge reaches 80% of North American households, yet I would guess that a good portion of those households have never heard of the company. Can you tell our readers what Broadridge does and please explain your investment thesis?

Stannard-Stockton: Broadridge is the most important financial-services company that you've never heard of. They process the settlement of stock and bond trades, manage proxy voting for 98% of listed companies, mutual funds and ETFs, and provide statement delivery and other investor communications on white-labeled businesses. If you invest in stocks and bonds, Broadridge is involved in multiple aspects of your account despite you never seeing their name.

Broadridge is a good example of one of the types of businesses that we regularly find attractive. They provide a mission-critical service to their customers (which includes almost all of the top Wall Street firms), and yet the cost of their services is immaterial to their customers' financial results. For instance, if a large brokerage company decided to switch from Broadridge to a cheaper competitor for statement delivery, the cost savings would be so small that no one would notice. But if during the switch some client statements were produced incorrectly or not sent, the broker would have customers and regulators all over them.

One of the worries that crops up from time to time among investors is whether a new SEC regulation will hurt Broadridge. But in their long history, they have never experienced long-lasting, material negative impacts from regulation. While the company does operate under SEC regulations, we think they are better understood as a private-sector partner to regulatory bodies. Broadridge's services help Wall Street firms meet regulatory requirements, rather than Broadridge's services themselves being the focus of regulators.

Rotonti: I'm torn on Netflix, and it's fair to say that it's a company I've been very wrong on every step of the way (that's not the case with my colleague Jim Mueller and Motley Fool co-founders Tom and David Gardner, who have been very bullish for a very long time). I think the company has reached escape velocity, and that it will be very difficult for the competition to catch up. But Netflix currently generates negative free cash flow (FCF), and according to S&P Global, it trades at a next-12-month P/E of about 87. What is your investment thesis on Netflix, and how do you think about its optically high valuation?

Stannard-Stockton: If you think about a traditional business that requires a lot of capex in order to grow, the growth investment does not run through the income statement, it runs through the cash-flow statement. This results in solid earnings per share, although free cash flow might be near zero. This sort of business, where the stock price is supported by current earnings and investors cheer the reinvestment of earnings as long as return on invested capital is solid, isn't the sort of thing that needs to be defended.

But in Netflix's case, one of the key ways they are investing in growth is by maintaining an artificially suppressed price for their service. Netflix won the most Oscars and most Emmys of any content producer. And they have a simply massive library of content for every taste. Yet even at the newly raised price of $12/month, Netflix costs less than HBO, which is just one channel. It costs much, much less than any cable TV package. In fact, it costs about the same as a single movie ticket. With this huge gap between the price being charged and the value being received, both on an absolute basis as well as in comparison to other quality content providers, we think Netflix has tremendous pricing power.

While we don't think they could add $5 to the price overnight without losing customers, they've been steadily raising the price for years at a rate in the high single digits with their most recent price increase the largest yet. While they do lose some customers from the sticker shock of higher prices, it seems most of those people who quit end up missing the service and come back again later, because there has simply been no material slowdown to their net subscriber growth.

If you apply a $15-$20 price to their current subscriber count, all that incremental pricing falls to the bottom line, and the P/E ratio would plummet to about 17. Selling content on a global basis is a hyper-lucrative business. We think Netflix is making the smart strategic move to minimize pricing as they race to become the dominant provider of quality video content to the whole world. It is possible that other players can catch up now that they've finally realized that Netflix has turned the tables on them and left them far behind. But John Malone, known as the Cable Cowboy for helping build the cable industry and having the best investment record of anyone in the media space, has said that "it's way too late" for anyone to catch Netflix.

When a company is spending capex to grow, it is reported directly in the financial statements. But in underpricing their product, Netflix is engaging in an approach where it is not clear how much they are really "spending" on growth. Is the true market-clearing price the current $12? Or $15 to $20 as we think? Or might it be much higher? Why isn't Netflix worth $25 a month? That's still half the price that many people pay for basic cable. We can't know for sure just how much Netflix can command for their monthly service. But we're confident that it is more than the current rate, and we're very aware of how the economics of the business flip from "cash-flow-burning" to "spewing out buckets of cash to shareholders" as the monthly price moves higher.

Rotonti: I feel like First American Financial, a company in which my colleague Philip Durrell has high conviction, flies under the radar but deserves more attention. According to S&P Global, its returns on equity (ROE) have increased in each of the past five years and it has an attractive 3% dividend yield. What does First American do, and what is the source of its moat?

Stannard-Stockton: First American is one of the two dominant providers of title insurance. When you buy a house, you want to be sure that the person selling it to you actually owns it and no one else has placed a lien against the house (such as an unpaid contractor). Assuming you use a mortgage to purchase the house, the lender will require that you obtain title insurance. First American and Fidelity National have an effective national duopoly on this industry.

Under American law, the title of a house is not recorded in a centralized government database. Instead, title records are held in a wide variety of local databases, with disputes settled in the legal system. First American and Fidelity National have built what are referred to as "title plants," or detailed records of title history. This allows them to validate and revalidate title histories. Unlike, say, stocks and bonds, which are standardized records, housing records stretch back a hundred years or more, without many standard record systems and with things like property boundary lines found in scanned, hand-drawn maps. This makes these types of records particularly difficult to attempt to standardize [in order to] automate the title underwriting process.

First American earns lower returns on invested capital than most of the companies in our portfolio. But on the other hand, there is next to no disruption risk, and we think people will [continue to] be buying and selling homes and requiring the services of a trusted third party to validate the legitimacy of what is almost certainly the largest purchase the buyer will make in their life. While some people have raised the risk that blockchain technology may represent to title insurers, to date this seems to be mostly a theoretical risk, and First American themselves appear to be leading the experimentation with blockchain technology in their industry.

We like First American in particular right now because while home prices have broadly recovered, the number of home sales occurring each year is still well below what we believe the normalized rate will be. A big reason home prices have increased so much is because the amount of inventory on the market is constrained. New homes continue to be built at a very low rate, and a number of factors are conspiring to keep homes off the market. But the nature of markets is that they rebalance over time. We expect that over the medium to long term, the number of home sales will increase significantly and First American will earn a fee associated with each of those transactions.

Rotonti: Landstar is a fairly low-margin business with five-year (2014-2018) average free-cash-flow (FCF) margins of 5% (note that I'm calculating FCF as operating cash flow less capital expenditures). But according to S&P Global, the company has net cash of $56 million, and over the past five years it generated average ROIC of 22%. Overall, its business economics look quite exceptional. How is Landstar able to generate such high returns on invested capital?

Stannard-Stockton: Profit margins are only half of the equation that drives return on invested capital; the other thing is asset turnover, or "asset turns." Most everyone is familiar with profit margins, but asset turns are a little less well understood. Let's say that you are a retail store and you buy $90 million of inventory that you sell for $100 million, and on average it takes you one year to sell the items. Excluding all other costs (like rent and salaries, as well as taxes), the retailer invested $90 million and earned a $10 million profit for a 11% ROIC. But what if the retailer was able to sell all that inventory in just three months, went out and bought another shipment of the same products, and thus was able to "turn" their inventory four times in a year. Now their $90 million investment has earned them $40 million for a 44% ROIC. Now that's a super-attractive business.

So, while Landstar has low margins, they have high asset turnover, and this creates a high level of ROIC. Their high turnover comes from the fact that they don't actually own a lot of assets. Unlike a trucking company that owns trucks, Landstar is a logistics company that provides a service to shippers and truckers. By being an asset-light business, they can turn modest profit margins into great ROIC.

Most of the businesses we own have pretty high profit margins. High margins mean you are adding a lot of value on top of the raw costs of creating your product or service, and this suggests you're making something truly valuable and differentiated. So, one important thing to do with Landstar is to calculate the net revenue (or gross profit) they generate and look at profit margins on this basis. Eighty-five percent of the cost of shipping a load via Landstar goes to the trucker and/or agent who moved the load. Fifteen percent goes to Landstar. That's what they earn for providing logistics. They currently earn about 50% profit margins on this net revenue and 70% incremental margins on each new dollar of revenue. So, while the company is producing about 7% reported operating margins, this is better understood as 0% margins on the pass-through costs of transportation and 50% profit margins on their logistics service. You can see that they are both providing a tremendously value-added service and generating fantastic ROIC.

Rotonti: What sort of long-term growth profile does Landstar have? At what rate (roughly speaking) do you think Landstar can grow revenue and EPS over the next five years?

Stannard-Stockton: Revenue for Landstar is primarily a function of how many truckloads they move and the average price per load. These metrics are both cyclical. So while any given year can see wide volatility, over a five-year period we would expect load growth across the country to be about 2% per year, with Landstar growing loads by around 4% a year as they continue to take share. Now that pricing, after many years of being well below trend, has come roaring back; we think from these levels, you probably only get about inflation-type increases. So that adds together to about 6% revenue growth per year.

I mentioned earlier that incremental profit margins on a net revenue basis are about 70%, versus the 50% level they reported in 2018. Therefore, over the next five years, we would expect profit margins on a net revenue basis to expand to about 55%. This would lead to operating income growth of about 9%.

Landstar has a history of doing opportunistic buybacks with their heavy excess cash flow. We would expect share count to decline by about 2% per year, leading to about 11% EPS growth over the next five years.

Rotonti: A significant portion of Starbucks's future growth is expected to come from China. On the one hand, the market opportunity there is large and growing. I've seen estimates for the size of the Chinese middle class ranging from about 300 million to 400 million people. Statista estimates the number of middle class in China will reach 700 million by 2020. A recent report from Diamond Hill says that China plans to move 250 million people from rural areas to urban cities by 2026. And Starbucks has been building its stores and scale in China for 20 years. According to Starbucks, its new stores in China generate the highest ROIC across the company, and Starbucks is opening more than one new store every day across China. That all seems very positive. But on the other hand, China is not traditionally a coffee-drinking culture, and its per capita consumption is only five to six cups per year, compared with more than 300 cups in the U.S., according to Sanford C. Bernstein (via The Wall Street Journal). There is also currently much higher demand for coffee delivery in China than in the U.S., and Starbucks is facing intense competition from Luckin Coffee (a venture-backed startup) and McDonald's on the delivery front. Are you comfortable with Starbucks's competitive position in China and its ability to increase prices as it has in the U.S., and are you confident in the long-term profitable growth opportunity that China represents for Starbucks?

Stannard-Stockton: There is no doubt that China is an emergent economy with consumer preferences and competition in flux. But we think Luckin is wrongly characterized as a material threat to Starbucks. Luckin was founded by a former executive of a ride-sharing company, and we think they are more of an on-demand consumer company that is using coffee as their initial core product. Hopefully, their efforts to make coffee a ubiquitous beverage option in China -- and the fact that they are highly subsidizing the price to help lure non-coffee drinkers into trying coffee -- will increase the total addressable market of Chinese coffee drinkers for Starbucks. For readers interested in learning more about Luckin and the degree to which their efforts are competitive, or not, with Starbucks, I would strongly recommend this TechBuzz China podcast on the topic.

Certainly, if the coffee opportunity in China is as big as it appears, there will be multiple winners. Starbucks is a dominant force in the U.S. coffee market, but even here, McDonald's, Dunkin Donuts, and so-called "third wave" coffee shops such as Blue Bottle own significant parts of the market. We believe strongly that Starbucks's coffee offering is differentiated and [that the company] will continue to grow market share in China as the size of the total addressable market also grows.

Rotonti: In a sort of related question, Starbucks built its brand as the "third place" where people can spend their time away from home or work and enjoy a daily delight. But it seems as though some of its new growth initiatives, including drive-through stores, delivery, and a virtual store in China, are moving the company at least partially in a new direction. This is probably inevitable given the growth of the digital economy/e-commerce, but do you think this changes the Starbucks story in either a positive or negative way?

Stannard-Stockton: Good question. With every investment, it is important to understand what exactly the company's actual value proposition is. For Luckin, for instance, it is fast, cheap coffee available on demand at kiosks all over the place. Starbucks has a relatively nuanced, multifaceted value proposition, and it is important to understand what that is and whose needs it meets.

For me personally, I count on Starbucks to provide me my expected dose of the drug caffeine at a reasonable price and in a comfortable location that I can find almost anywhere I go. The fact that the company is also able to meet my potential desire for a relatively healthy fast-food option at the same time makes their value proposition even stronger for me. The "third place" element of the value proposition, the idea that they provide a comfortable, public space in which I can meet someone, pause during my day for a break, or catch up on work while I'm traveling, is a great bonus. But for me personally, the third-place element is not core to the company's value proposition.

On the other hand, Arif, one of the analysts on our team, primary goes to coffee houses because he wants to sit down for awhile and enjoy a special treat (a handcrafted espresso drink). For him, third-wave coffee houses offer a better value proposition, and while he might stop in to a Starbucks, the third-place element of their stores is inferior to higher-end third-wave coffee concepts. That being said, Arif would agree that Starbucks's ubiquitous presence makes it a great solution for him to grab a cup of coffee or stop in with his family for a healthy fast-food and beverage experience that he, his wife, and their kids all appreciate.

Todd, another analyst here who lives outside Cincinnati, has highlighted for us the importance of drive-through options in the Midwest and South. Outside of metro areas, and in particular in areas with weather extremes, drive-throughs solve a lot of customer problems. Starbucks has noted the same thing, and has highlighted on recent calls that stores that feature a drive-through window in the Midwestern and Southern parts of the U.S. generate about 20% higher sales per store. So, while Starbucks popularized the third-place concept as a core part of their value proposition, we think that today it makes up one part of a multifaceted value proposition.

In China, at this moment in time when the country is only beginning to see the rise of the café culture that has been available in the U.S. and Europe for many decades, we think the third-place element of Starbucks is particularly important. It is no accident that the company recently opened one of the largest Starbucks in the world in Shanghai. The 30,000-square-foot store is one of the company's high-end Roastery concepts, offering sit-down meals, alcohol, and a range of ultra-premium coffee drinks not available in their traditional stores. So, while the company has smartly partnered with Alibaba to provide a much stronger delivery option in China to meet consumer needs, it is also important that they stay focused on the third-place element of their value proposition and not get pulled into competing head-to-head with Luckin on the efficiency/delivery/low-cost value proposition.

Rotonti: In December 2018, Starbucks lowered its long-term guidance for the second time in about a one-year span. Starbucks now expects global comps growth of 3% to 4%, revenue growth of 7% to 9%, and non-GAAP EPS growth of at least 10%. Are these reasonable expectations?

Stannard-Stockton: Yes, we think they are. Realize that the company should be able to drive 2% comps from inflation-based price increases alone. So adding 1% to 2% to comps from increasing the volume of purchases can be achieved by getting people to come to Starbucks more frequently (especially in the slower afternoon time slot), increasing the sale of food, and, especially in China, increasing the amount of customers per store, which we think will happen naturally once they stop growing their store count so aggressively.

Rotonti: Howard Schultz is one of the all-time great business builders and CEOs, and he's beloved and admired by so many (including myself). I think he really showcased that creating a great workplace culture (that provides full health care, stock ownership, and opportunities for development) and sustainable sourcing of coffee can supercharge growth and ROICs. But politics can be polarizing. Are you concerned that if Schultz decides to run for president, particularly as an independent, that it could reduce traffic to Starbucks stores and pressure U.S. same-store sales (or comps)?

Stannard-Stockton: You know, it's funny, but when we first invested in the company, it was being criticized by President Trump, and we had some concern that politically conservative clients of ours may object to owning the company. Now the tables have turned, and with Schultz considering running as an independent and thus potentially siphoning votes away from the Democrats' candidate, we have had a few politically liberal clients voice their concerns. While Schultz's campaign is certainly a bit of a wild card, we don't expect him to play a material role in the next election and so don't expect his activities to impact the company's results. If we're wrong and he does play a central role in the election, we still don't really think it will have a long-term impact on the company's financial results.But that being said, we are well aware that there is a risk to companies when they or their major shareholders and/or executives engage publicly in politics. But we think it is relatively rare for these political activities to have a lasting impact on the company. For instance, our portfolio company Nike was in the political news last year after they made Colin Kaepernick the face of their anniversary ad campaign. But while that caused the stock to bounce around for a couple weeks, it hasn't actually had a major, lasting effect on the company's results.

Rotonti: Is there anything else that you'd like us to know about Ensemble Capital?

Stannard-Stockton: Thanks so much for taking the time to speak with me, John. At Ensemble, our core focus is on identifying and investing in competitively advantaged companies. Some of these may be considered "growth stocks," while others might be labeled "value stocks." But to our way of thinking, we don't care what labels they get; we just want to find companies that have strong and durable competitive moats, have management teams that understand value generation and capital allocation, and which we think we as a research team have the capacity to understand and make reasonably accurate forecasts about their future. I appreciate the opportunity to speak with you about what we do.

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John Rotonti owns shares of Broadridge Financial Solutions and Mastercard. The Motley Fool owns shares of and recommends Broadridge Financial Solutions, Mastercard, Netflix, Nike, and Starbucks. The Motley Fool has a disclosure policy.