Guest Interview, Todd Wenning at Ensemble Capital
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Guest Interview, Todd Wenning at Ensemble Capital
(Edition Number: 26)
A little over two months has passed since I last welcomed a guest as part of the interview series here at Investment Talk. After 25 great appearances (and one special edition), I am happy to report that the 26th edition of this series features an investor whose work I have been an avid consumer of for some time now.
Today I welcomed Todd Wenning, CFA, senior investment analyst at Ensemble Capital since 2017. Prior to that, Todd had spent his earlier career across a variety of roles with Johnson Investment Counsel, Vanguard, Morningstar, SunTrust Asset Management, and The Motley Fool.
Todd Wenning, Ensemble Capital
Ensemble Capital was formed in 1997 by Curtis Brown with a desire to become a truly independent firm, serving clients in a clear and transparent manner, and avoiding many of the conflicts of interest that were apparent at so many financial services firms. In 2004, the company was renamed ‘Ensemble Capital’ after Sean Stannard-Stockton became a shareholder in the same year. A decade later (2015), Sean would become the firm’s President and by 2020 the AUM of Ensemble would exceed $1B.
After having been in contact for a number of years, Sean would reach out to Todd in 2017 and suggest he apply for a senior analyst position at Ensemble.
I first stumbled across Todd when I discovered the Ensemble Capital blog, Intrinsic Investing. Here, the team share a wealth of informative articles which discuss all manner of investing related ideas. To this day, I am still working my way through the archives, and have found it to be a great source of education for my own process.
In today’s discussion, we discover how Todd went from History Major to investment analyst, his early career, Ensemble’s investment philosophy, and a number of questions surrounding the art of evaluating a company’s moat.
“The quality factor has a wide dispersion of outcomes. If you pay for a ruby but get a rhinestone, you’re not going to have a good outcome. And in the market, you don’t know for years if the ruby you paid for is actually a ruby or a rhinestone. Therefore, at the faintest hint of rhinestone, the market reacts sharply against ruby-priced businesses.”
For more insight into the team at Ensemble and their philosophy, you can find that here. Readers can find the disclosure, as well as a link to additional disclosures at Ensemble, at the bottom of this issue.
The Interview
Conor
Hello Todd, thank you for agreeing to answer some questions today, I greatly appreciate your time.
You have had an interesting variety of roles across your career. Like many great investors before you, there was a period of your early career spent at the Motley Fool. You also worked at SunTrust and Vanguard before moving to the sell-side at Morningstar. You have authored a book and now act as a senior investment analyst over at Ensemble Capital, where you have been since 2017.
So, to give context for readers, and to unwind that impressive career back to day 1, could you walk us through how that path progressed? Perhaps highlighting the moment in time (if there was a particular moment) that your interest in investing was sparked, and what factors allured you most?
Todd
Thanks, Conor. My entry into the industry did not follow the traditional path. I was a liberal arts major in college, with a major in history. Like most history majors, my career plan at the time was to either pursue law or teaching, but I didn’t do well on my law school entrance exams, so I started looking for other jobs near where I lived in the Philadelphia suburbs.
I came across a local company called Vanguard, which I’d never heard of, and they had entry-level customer service roles where they’d train you on the job and help you get your securities licenses. Fortunately, Vanguard took a chance on me because of my grades and my experience running a call centre in college. Vanguard sent me my licensing study guides before my first day and I had to look up what a stock was. That’s how little I knew when I started.
What I didn’t realize at the time was that investing is very much a liberal art. Robert Hagstrom wrote a great book about this topic, in fact. I was quickly gripped by the endless learning opportunities the industry provided and have felt that way ever since.
My interest in stocks specifically started when I got promoted to work at Vanguard’s brokerage services and talked with dozens of clients each day about their strategies and portfolios. One day I’ll never forget was the day that Howard Stern announced he was joining Sirius Satellite Radio. Absolute mania ensued with people falling over themselves to get into the stock. It was my first glimpse of the psychological side of equity investing.
In 2005, I relocated to the Washington, DC area where my girlfriend – now wife – was located and started looking for investing jobs in the area. At SunTrust, I helped some local financial advisors analyze client portfolios. The people I worked with were great, but I learned pretty quickly that working for a bank wasn’t for me.
Luckily, The Motley Fool was located a few miles from our apartment and I got my foot in the door there as a financial editor, fact-checking articles for financial accuracy. Eventually, I became an analyst on a Fool newsletter called Motley Fool Pro with a talented investor and good friend, Jeff Fischer. We were given $1 million in capital to manage and write about in real-time and we could go long/short the market and use options. Our account was funded in the autumn of 2008. As you might imagine, the ensuing 18 months or so navigating the financial crisis with that type of strategy was quite formative.
But I wanted to try something on my own and I knew The Fool’s international operations were a focus for growth, so I suggested that I start a newsletter in the Fool’s London office. In 2010, we launched a dividend-focused service for Fool UK and my wife and I sold our house in Virginia and relocated to London with a few bags and our dog.
Unfortunately, the UK adventure didn’t work out as expected and it was a huge disappointment for me and my wife. We planned on making the UK our home for at least a few years, but it only lasted about 11 months. Even though things have worked out, I look back on that period as containing my biggest career mistakes. As is often the case with mistakes, however, it was a tremendous learning experience, and we made some lifelong friends in London even though our stay was so short.
I had an interest in becoming more of an “institutional” investor and I thought becoming a sell-side analyst at Morningstar would be a great transition toward that path after my retail focus at The Motley Fool. We moved to Chicago in December 2011 – just in time for the brutal Chicago winter - and I started covered companies in the paper and packaging industry for Morningstar.
Being steeped in the Morningstar moat methodology was a gift, as it provided a useful framework for evaluating business quality. I was also lucky to be there as Morningstar developed its equity stewardship methodology on how to evaluate management quality and was later chosen to lead the department’s efforts on the subject.
In 2015, we relocated to my hometown of Cincinnati, Ohio where I started my first buy-side role at Johnson Investment Counsel – one of the largest independent registered investment advisors in the U.S. My primary job there was to select companies for Johnson’s small-mid cap strategy.
I’d been speaking with Ensemble Capital’s president and CIO, Sean Stannard-Stockton, for a few years. We’d followed each other’s blogs and Twitter posts and found we had a similar investment philosophy. In 2017, Sean suggested I apply for their open senior analyst job, helping manage the Ensemble equity strategy which is focused on finding between 15-30 of the best companies trading on the U.S. market. While Ensemble is based in San Francisco, the business had been part-time remote for a year or so and it was possible for me to remain in Cincinnati and work full-time remote. I’ve been doing that for about four years now.
Conor
You published ‘Keeping Your Dividend Edge’ back in 2016. In the book, you would remark that the dividend landscape had become more challenging after the rise in share repurchases as an alternative method to return cash to shareholders, as well as the increasing globalisation of the competitive landscape and the afterburn from the significant dividend cuts of the GFC.
A few questions on that. Firstly, what prompted you to write about the topic of dividends specifically?
Then secondly, how do you feel the dividend landscape has changed, at all, from when you originally published the book?
Todd
Perhaps because I felt like the work on the UK newsletter was incomplete, I continued to write about dividend investing on my blog, Clear Eyes Investing. One of the nice things about writing is that, after enough posts and articles, you’re halfway to writing a book. So with some editing of old material and writing some new material, I self-published (another mistake!) Keeping Your Dividend Edge in 2016.
It’s been a difficult five years or so to be an income-focused investor. Most dividend-focused ETFs have underperformed the S&P 500 over the last five years, as of mid-September. The market leaders have been large tech companies that have not historically paid large dividends. Younger companies without a dividend tradition don’t seem interested in paying out a large chunk of cash flow as dividends and setting that expectation with shareholders. Competition has indeed intensified, as well, and companies want to stay financially nimble, which lends itself to buybacks over dividends. Consider Disney, which suspended its dividend in 2020 and doesn’t seem to be in a rush to reinstate it while it builds its streaming service and competes with Netflix and other media companies for content.
As I mentioned in the book, investors should start with underlying business quality and then think about the dividend yield. Starting with a high dividend yield and working backwards can trick you into justifying an investment on faulty premises.
Conor
Before we dive into some more technical questions, I want to say that I had fun exploring your background. It was interesting to discover that you have long been an investment ‘blogger’ (if you will), both from your time at the Motley Fool as well as independently through your own blog. Obviously, now that output is now directed towards the Ensemble Capital blog, Intrinsic Investing.
This kind of outlet, whilst not new by any means, has recently seen a resurgence thanks to the likes of Twitter, Substack, Revue, Ghost, and the host of other service providers, not forgetting legacy names like TMF, Seeking Alpha, and so on.
My question to you is once again two-fold. Firstly, what is your perception of this resurgence, and then secondly what have been some of the greatest takeaways or learnings for you after having spent so many years writing publicly about investing, companies, and the overall process of this art we all enjoy?
Todd
The early Motley Fool message boards were an early taste of what FinTwit, blogging, and podcasting have become – a true meritocracy. Good ideas win, bad ideas lose.
It doesn’t matter if the person writing is young or old, in your home country or on the other side of the world. Twitter, TikTok, Substack and other platforms have only expanded that concept further. Prior to these mediums, you had to work for a formally published newsletter and there were only so many of those available. If you’re an independent analyst, you can now make a good living if you have good ideas by selling your personal newsletters. I think it’s great. In fact, the quality of the work I read on a regular basis from freelance analysts only makes me want to work harder.
I started writing my own articles for the Fool’s site in 2006 and that experience – putting your ideas out in public and getting feedback – was a true development accelerant. As I wrote the articles, I had to ask myself, “Okay, how might someone tear this idea apart?” before I published. It helped me appreciate both sides of an argument and building conviction in a thesis.
Conor
On that note, I must state that I am an avid reader of Intrinsic Investing. Since discovering it, I have enjoyed trawling through the archives, as well as reading any new issues that surface.
I wanted to highlight one from September 2019, where you (along with Sean Stannard-Stockton, Arif Karim, and Paul Perrino) shared the below diagram of Ensemble’s Investment Philosophy (full article can be found here).
I was wondering if you could paint a synopsis (as brief or as long as you like) for this framework?
Todd
Any company we would consider for the portfolio has to have an economic moat, a great management team, and the business has to be forecastable. We came up with the Venn diagram as a graphical representation of our North Star. You can have these agreed-upon ideas in your mind as you’re looking through companies, but it helps to have a picture in your mind to refer back to and keep you accountable.
Conor
At the time you would state that of the several thousand companies which may be in your investment universe there will only be between 15 to 30 that are deemed worthy of owning at any given time.
If anyone of the three crucial factors (Management, Moat, Forecastable) are missing, the business is deemed not fit.
To my understanding, a significant number of those 2,000 or so companies in your universe will not pass the test.
So, my question to you is, if there are, say, 100 companies that do pass the test, what allows you to widdle that number down to the 15-30 ideas that you feel are best suited to being a long term hold for the portfolio?
Todd
That’s something I struggled with myself when I first joined Ensemble.
I would present ideas to Sean that I thought checked off all the boxes and he’d reply, “I agree that it’s a good company, but we’re looking for great companies.” We’re not after the top 10% or 20% of all publicly traded businesses in terms of quality, we’re after the top 1-2%. We run a concentrated portfolio of 15-30 companies and we have to be selective.
One of the factors that we believe moves a company into the top 1-2% is that they have some type of unfair advantage. Their closest competitors are either unable or unwilling to match the model. Many times this is a cultural factor. Consider First Republic Bank. Banking is a highly commoditized business. As a customer, you’ll generally go with the bank paying you the highest rates on your savings (at least in normal times!) or the lowest rates on your loans. Customer service has traditionally been a low priority for banks. First Republic turns this approach on its head by leading with great customer service. Its success in turn attracts top talent to the bank and improves customer satisfaction even more. To compete with First Republic, traditional banks would have to reinvent their cultures and they’ve shown no interest in doing so, even while First Republic takes market share in their regions.
Another factor we look for is coming through a crisis stronger on the other end. Chipotle is a quick-serve restaurant focusing on freshly prepared food with Central American flavourings. It prides itself on not using freezers, microwaves, and can openers – all the food is sustainably sourced and served fresh. In 2015, they had a foodborne illness outbreak that became a national embarrassment. It turns out that scaling fresh food across 2,000 locations is hard to do. It was a story that should have crushed Chipotle’s prospects, but it didn’t – and like the dog that didn’t bark in the Sherlock Holmes case, that was the curious incident. We took notice in 2019 and started digging.
Conor
From buying decisions to the holding and potential selling decisions now. Earlier this year, you shared a quote in a piece titled ‘When Quality Companies Face a Reckoning’, which I have shared below:
“The quality factor has a wide dispersion of outcomes. If you pay for a ruby but get a rhinestone, you’re not going to have a good outcome. And in the market, you don’t know for years if the ruby you paid for is actually a ruby or a rhinestone. Therefore, at the faintest hint of rhinestone, the market reacts sharply against ruby-priced businesses.”
Now, assume we have conducted the initial research diligently, and we are convinced we have avoided a quality trap. What does it take for the thesis to shift from a hold to a potential sell over time?
Would this simply be an erosion of one of the three anchors of the philosophy (Management, Moat, Forcastable), or are there other ways to approach that topic? I would love to hear you extrapolate on that.
Todd
Yes, an erosion in one of our three anchors is the most likely red flag. We divide those three anchors further into seven categories – moat, relevance, customers, shareholders, stakeholders, understandable, and forecastable – and we rank each attribute by quartiles. We also rank them relative to each other rather than against the entire investible universe.
If our conviction plummets on any one of those categories and scores a zero, the stock would be ineligible for the portfolio. To illustrate, if we lost faith in a company’s ability to create products and services that are as least as relevant ten years from now as they are today, we’d sell. Alternatively, if a new management team comes in and has a completely different approach to running the business, we’d do a fresh analysis and may conclude they have the wrong strategy.
Ideally, this would get us “out” of the stock before things got worse and the market realizes the business is more rhinestone than ruby and prices it accordingly.
Conor
I think especially for newer investors, the majority of their investment philosophy is confined to the space in their brain. Why do you feel it is important for investors to have some tangible representation of their investment philosophy? Whether in a diagram or a personal investment policy statement.
Todd
As I noted earlier, it helps to have a shortcut, a brain hack, or whatever you want to call it to keep you focused. There are so many distractions as an investor now, so many narratives to consider, that your approach can drift here and there, chasing the latest thing. If you don’t write down your thoughts at a given time, your brain can trick you quite easily - “Oh yeah, I knew that was going to happen,” and so on. That’s another benefit of blogging, tweeting, taking notes in real-time is that you can look back and judge whether you stayed the course or lost track.
Conor
One of the core pillars of the moat segment in that framework relates to whether the business has a legacy vs a reinvestment moat. I have enjoyed reading both Ensemble’s and Saber’s writings on this topic.
To my understanding, and correct me If I am wrong, the legacy moat business is one that has a strong enough position in the market to support consistent healthy earnings, and attractive ROIC. However, at a certain stage, the reinvestment opportunities become constricted, and the excess capital is then distributed to shareholders.
The reinvestment moat business is one that has all the qualities of the legacy moat business, with the exclusion of a lack of attractive avenues to reinvest. These companies ideally have lengthy runways for reinvestment, supported by industry tailwinds, international expansion, or whatever it may be. Here, the capital earns a superior ROI in the hands of management, as such it is used for that purpose, and not allocated as heavily (or at all) to shareholders.
In a piece titled “Moat Erosion Starts Behind the Castle Walls” you (alongside Paul Perrino, Arif Karim, and Sean Stannard-Stockton) state that you “want to own companies we believe will maintain (and ideally widen) their economic moat for the next decade and beyond.”
If we think of a business like Apple for a moment. They have shown excellent ROIC over the last decade. In tandem, however, the composition of share repurchases and dividends as a percentage of free cash flow has elevated over that period. In each of the last three years (2020, 2019, 2018), the level of net share issuance and dividends have surpassed free cash flow.
Apple is undoubtedly a great business, and are exemplary stewards of capital, but how would you approach the discussion here? Perhaps speaking from yourself, rather than from Ensemble’s perspective if that makes more sense.
Todd
The best way to think about reinvestment versus legacy moat is the incremental return on invested capital. A company in the reinvestment phase generates high returns on each new dollar reinvested into the business, while a legacy moat perhaps can’t find any high return project for excess cash on hand. If a reinvestment moat company can find high return projects for all of its excess cash, management would be negligent to return cash to shareholders. Conversely, a legacy moat business generating free cash flow with few high return projects would be negligent not to return the excess cash to shareholders.
We think there’s money to be made in both reinvestment and legacy moat businesses. With reinvestment moats, what you’re planning on is improving ROIC as the company’s moat widens and the market has to re-rate its expectations. Why does the market have to re-rate its expectations in this scenario? Consider two companies in the same industry and both are growing 10% per year. Company A has a ROIC of 50% and Company B has a ROIC of 10%. Company B has to reinvest all its free cash to maintain the 10% growth rate, while Company A only has to reinvest 20% of its free cash to match that growth. The rest is available to shareholders. As such Company A should trade at a premium to Company B.
With legacy moats, you’re planning on persistent ROIC when the market expects ROIC to fade to the mean. Take a company like Fastenal, which has generated remarkably consistent ROIC for decades. You’d think the market would have caught onto this a long time ago, but Fastenal is one of the best-performing stocks in the U.S. markets in recent decades. In most cases, the market is correct to assume that a company’s ROIC fades to the market average, but there are companies that can beat the fade. These companies must continue to offer relevant products and services and be led by competent managers who are good stewards of shareholder capital.
Though I’m not an expert on Apple, I think you’re banking on their ability to generate persistent ROIC rather than widening their moat much more. If nothing else, a widening moat for Apple likely brings more antitrust scrutiny.
Conor
And then just generally, what are some of the most telling signs that a firm’s reinvestment moat may be coming to an end?
Todd
One thing you can look for is increasing shareholder distributions in the form of dividends and buybacks, as that likely means that management isn’t finding enough high-return projects to justify retaining all the capital.
Another framework we have at Ensemble is viewing management from a perspective of Visionary versus Optimizer. Visionary leaders are great for businesses where there’s not yet a blueprint for success. Steve Jobs at Apple is a classic example. They’re typically the best type of leader for a reinvestment moat business as they are creating value in ways others couldn’t fathom.
Optimizers on the other hand are the classic “Outsider CEOs” that value investors tend to gravitate toward. There’s now a blueprint for success and Optimizers are better at executing on that blueprint than others. John Malone is an example here.
Both types of CEOs can create tremendous value for shareholders but in different ways. If you notice a company transitioning to more of an Optimizer CEO, it’s a sign that the company is shifting toward legacy moat mode. They’re no longer rule-breakers, they’re rule makers and a different leadership type is needed.
Conor
Okay, thank you for all of those great responses. We can now wind down this interview with some more holistic questions.
What about your own personality, do you feel translates into your investment style?
Todd
I’m much more of a qualitative than a quantitative thinker. While that did not come in handy when taking the CFA exams – I failed Level 1 once and Level 2 twice before completing the program – I think being a qualitative thinker helped me appreciate the non-measurable factors about business and put them into frameworks.
For example, it’s hard to quantitatively prove the existence of a superior corporate culture, but we know from experience that corporate cultures can play a tremendous role in value creation. Because culture isn’t measurable, however, some investors might dismiss it as being irrelevant and that can create an opportunity for qualitative investors like myself.
Conor
In a world of information overload, the issue for most investors (specifically retail) has evolved from a lack of information to an abundance of information and deciphering which is noise and which is signal.
How do you approach the art of blocking out noise, whilst not running the risk of developing to an environment which leads to confirmation bias?
Todd
You’re right that information overload is a big challenge today and it’s increasingly important to curate what goes into your brain. In the thousands of years of human history, information has been scarce and our minds don’t know how to process this new reality. It’s still a work in progress for me, of course, but I started taking a day off from news and social media each week and found it to be useful for keeping things in perspective. When you intentionally step out of the cycle for a time, you can better see the absurdity of most of it.
Another benefit of having a clear investing philosophy is that it helps sort through the noise. We don’t aim to know minutiae about our companies and we think that exercise is counterproductive. If we can understand the key metrics that help us determine if the company is on track or not, that’s really what we’re after.
Conor
Lastly, I tend to round these interviews off with a quote or two. My favourite will forever be the weighting machine analogy shares by Graham.
What are some of your favourite quotes, investment-related or other?
Todd
The poet Richard Armour once wrote: “Shake and shake the catsup bottle. None will come, and then a lot'll.” I think that’s a great way to think about the compounding nature of returns.
One more I’ll add is a quote from Norman Maclean’s great story and later a movie, A River Runs Through It: “All good things come by grace; and grace comes by art; and art does not come easy.” If you want to create something beautiful and of high quality, you have to put in the work.
Concluding Remarks
I would like to extend my thanks to Todd for taking the time to respond to my questions today, as well as Ensemble for allowing this interview to take place and for the value the team has granted me over the years through Instrinic Investing.
After a brief hiatus in the guest interview segment, I am positive readers will welcome this one as a strong comeback. Thanks again.
You can find Todd on Twitter over at @ToddWenning, as well as Ensemble at @IntrinsicInv, and learn more about the Ensemble team and their process here.
Moreover, you can access Ensemble’s blog here.
Reminder to readers that you can access the full archive of Investment Talk Guest Interviews using this link.
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Conor,
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