Venn Diagram Investment Framework

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When you research a stock, the challenge isn't finding information. It's filtering through endless data, news, and opinions to identify what actually matters.

But what truly matters?

Ensemble Capital uses three overlapping criteria to answer this question:

President and CIO Sean Stannard-Stockton presented the framework during the firm's 2023 client day presentation.

The firm filters for: (1) strong management teams, (2) strong economic moats, and (3) forecastable businesses:

Businesses that meet only two of the three criteria fall into one of three traps:

Only businesses that satisfy all three criteria are considered investable.

The rest of this post focuses on eight companies from Ensemble's late-2023 portfolio to demonstrate how these criteria work in real businesses.

The first circle examines how management teams create and distribute value across shareholders, employees, and other stakeholders.

Management teams need to act in shareholder interests by driving economic profits, not just revenue growth or market share.

Perimeter Solutions (PRM) demonstrates this alignment through its compensation structure. The vast majority of management compensation comes in stock grants received only if the stock price sets a new high at year end.

No annual positive return for shareholders means next to no additional compensation for management.

Corporate value creation is driven by employee skills and talents and how executives coordinate employee activity and match it with capital resources.

A company that maximizes shareholder profits by sharing as little value as possible with employees might succeed short term, but over the long term employees are critical inputs to producing goods and services that meet customer needs.

First American Financial (FAF), a 136-year-old title insurance company, regularly win awards including best workplaces for innovators (Fast Company), 100 best companies to work for and best workplaces for women (Fortune Magazine), and company that cares (People Magazine).

Beyond shareholders, customers, and employees, a broad range of other stakeholders can undermine investment returns if they feel exploited. Vendors, regulators, or society at large can damage returns when their interests get ignored.

Most fast food restaurants sell frozen and reheated industrial meat with ultra-processed ingredients. Chipotle (CMG) sells real, natural, fresh food. There are no can openers or microwaves in Chipotle kitchens.

To source the sustainably raised meat and healthy vegetables their customers want, the company invests in local and organic farming because their success runs through helping vendors scale production.

The second circle focuses on competitive advantages that prevent rivals from stealing profits. When one company generates attractive profits, competition emerges to capture those returns.

You should invest in companies that possess the structural barriers that make replication impossible.

Ferrari (RACE) maintains an 18-month waiting list even among the wealthiest buyers.

When the company announces a new ultra high-end supercar, it often sells out before Ferrari names the price.

If Honda tried limiting production to create artificial scarcity, buyers wouldn't wait. They'd buy a Toyota.

Ferrari's brand represents something no amount of engineering talent or manufacturing investment can replicate.

Competitive moats only matter if products remain relevant for years.

Illumina (ILMN) offers genetic sequencing equipment and controls about 90% of global market share. Medical and scientific experts agree genetic research will keep growing significantly for years to come. Illumina essentially provides mission-critical tools with no substitute.

Masimo (MASI) sells patient monitoring sensors that doctors depend on in hospitals. Beyond this stable business, a massive opportunity exists for home monitoring. Keeping someone in the hospital costs about $2,000 per day, so sending someone home even a few days early creates huge savings.

Both stocks performed poorly in the one to two years before the 2023 presentation, even while generating outstanding returns over the previous 15 to 20 years:

The issue was not the core business but large acquisitions outside core operations. These acquisitions became a distraction while the core businesses remained just as competitively advantaged with the same long-term growth opportunities.

This pattern isn't unusual in investing. A small segment hits problems, becomes the central focus of shareholders, and they lose sight of the main business value.

The third circle distinguishes between understanding a business and forecasting its results.

Some businesses are easier to understand than others, and the more understandable a business is, the more likely investors can correctly assess how valuable it is and how much more valuable it will become.

Understanding differs from forecasting. Oil companies are easy to understand. They drill for oil and sell it. But forecasting is hard because even industry experts can't predict oil prices.

Landstar (LSTR) offers one of the most understandable business models. The company works like Uber for big rig trucking, except they were founded 35 years ago.

Landstar owns no trucks. They broker connections between truck drivers looking for loads and shippers looking for trucks.

The revenue model is straightforward:

While these metrics fluctuate short term, truckloads are among the most correlated industries to GDP growth. As the economy expands, more goods need shipping, so trucking demand grows alongside it.

After the trucker gets paid, 50% of remaining revenue becomes profit for Landstar. On average, 70% of each new dollar of net revenue becomes profit, so margins keep increasing.

Broadridge (BR) runs America's corporate voting systems and sends client statements and trade confirmations.

Stock market performance doesn't matter much to them. Trading volume doesn't matter either. What matters is position count.

If one person owns 100 shares and another owns 1 million shares of a stock, that's still two positions. Each gets one set of statements and one voting ballot. Broadridge earns fees per position, not per share value.

Over the last decade, position counts in stocks, ETFs, and mutual funds have grown every year as barriers drop for small investors to enter markets. More positions means predictable revenue growth for Broadridge.

When Ensemble rapidly updated forecasts across the portfolio during COVID in 2020, Broadridge was the only company whose forecast never changed materially. Even during a global pandemic, people still needed brokerage statements, trades still settled, and corporate elections were held.