21 June 2020

On today’s show we have the senior investment analyst from Ensemble Capital Management, Arif Karim. Arif talks about how his portfolio has changed with COVID-19 and then he provides an intrinsic value assessment of Intuitive Surgical (ISRG).

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  • How to manage your portfolio during COVID-19.
  • How to profit from secular trends.
  • How to value a high growth company.
  • What is the intrinsic value of Intuitive Surgical?
  • Ask the Investors: Why is the economy not the stock market?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Intro  00:00
You’re listening to TIP.

Preston Pysh  00:01
Hey, how’s everyone doing out there? I think you guys are going to really enjoy today’s show. We have the talented Arif Karim, who’s the senior investment analyst from Ensemble Capital Management, with us.

In the first part of the show, Arif talks about how he has adjusted his portfolio based on the impacts of COVID-19. Then, in the second half of the show, he provides an intrinsic value pitch for the fascinating medical technology company, Intuitive Surgical. Finally, at the end of the show, we field a question from the audience about how the market can possibly be attempting new highs, even though we’re seeing all-time unemployment numbers and a devastated workforce. So, without further delay, let’s get started.

Intro  00:38
You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Stig Brodersen  01:02
Welcome to The Investor’s Podcast. I’m your host, Stig Brodersen. As always, I’m accompanied by my co-host, Preston Pysh. Today’s main topic is investing through COVID-19. And in the second part of the interview, Arif is also pitching a stock for us Intuitive Surgical, which I think you will find very interesting. 

Arif, welcome to our show!

Arif Karim  01:25
Hey, thanks, Stig, and thank you for having me. I appreciate having a chance to chat with you.

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Stig Brodersen  01:30
I can’t help but kick this episode off by talking about all the volatility that we have experienced, especially since February, but it has been an almost unprecedented time, just looking back. It seems like it’s been decades, but it’s only been a few months. 

I have to ask how it’s been for you and your team to manage a billion dollars, then see the size of that portfolio just plunge, and only to see the market having the largest 50-day trading rally ever. 

Now, we’re close to an all-time high. Can you talk through some of the emotions that you’ve gone through over the past few months? 

Arif Karim  02:08
It definitely has been an unprecedented time to have a pandemic. It’s the first in our careers to live through. It has been really interesting and dramatic. This pandemic obviously started in China, and one of the things that perked up my interest was when I saw, after Lunar New Year, the second-largest economy in the world basically shut itself down. That was an amazing thing to see. While very few are concerned about it here, that got me interested and Twitter is an amazing platform for that. 

I started following frontline workers in China. In-text, they could say anything. Reports were coming out of Taiwan and Hong Kong about people hearing things out of China. An epidemiologist started tweeting about things going on there, and virologists were interested. 

I was trying to find the people who would understand more about what’s going on in China, on the ground, and try to get data from them. I just kind of follow what happens there, the dramatic steps the society and the government took, and then follow that into Italy as well. I kind of saw how the spread there happened.

So, long story short, we were following what was going on. The market here took about a month to react after China shut itself down. Going into it, we were, to some degree, prepared. We had thought about how our portfolio was positioned, what kinds of implications we would have under certain scenarios, so although we are long-only and don’t generally take macro bets, we can make tactical changes in the portfolio to make it as resilient as possible to whatever may come. 

While we generally position the portfolio that way for all seasons, of course, when you speak information about an impending storm, you try to mitigate damage from the storm by best-positioning your portfolio for that storm.

Having said that, in general, as we think about investing, we’re humble about the fact that the world is complicated. A lot of surprises happen on a fairly regular basis, right? Each surprise might be new or a black swan or new in our lifetime, but the collection of surprises happens, so we’re always prepared, emotionally, for ourselves. 

We prepare clients, as well, that there are surprises that are to the upside, the good things, and there are surprises to the downside. We have to kind of take them as they come, all the while remembering that our portfolio has to be positioned in a way that survives and thrives post any sort of crisis. 

And so, the drawdown was large. It was fast as it was dramatic. It’s not easy to see, but at the same time, we entered it in a way where we’re very confident about the positioning of companies that we own in the portfolio.

Preston Pysh  04:48
Arif, talk to us a little bit more about this. You’re not shorting the market. The timing is very tricky. How did you specifically change your portfolio after COVID-19 hit? 

Arif Karim  04:59
Our perspective is that, over the long arc of time, the market has returned something on the order of 9% a year. That’s with big up years and big down years. That’s to be expected. So, to the extent that you can have a long-term focus on the value being created by the companies that you own and their resiliency, that’s really important, right?

Warren Buffett talks about never losing money, never losing money. From a permanent loss of capital perspective, that’s a perspective that we take. We only want to own companies where we have a strong sense of their resilience and competitive advantage so that, going through episodes like this, we have a very strong conviction of their ability to survive and thrive afterward.

Having said that, in front of any crisis, and we were, to some degree, fortunate that we read the tea leaves right and saw what looked like potentially a big tsunami heading our way, we did the things that any normal investor would do. We thought about our companies, how their balance sheets were structured, what kind of financing they would be needing in the next three to five years. They have access to the markets. What would their revenues do?

One of the companies that we own in our portfolio is Booking.com, which we think is a great and very resilient business. But obviously, it was going to be in the heart of this pandemic, and the travel industry just got clobbered. And so, one of the stress test scenarios that we ran with Booking.com was how much of a revenue decline would they have to see for them to start losing money. 

We concluded that it would have to be somewhere on the order of 70%. They would be able to survive, they’re resilient enough, and they will survive. Out of this, hotels would be even more dependent on Booking.com to help them gain customers again, so their competitive edge would be strengthened.

In addition, you have to look at other things, such as the probability that a company would be able to access the financial markets. A big part of this is that there’ll be a big shock to the system, potentially, and that’s what ended up happening with shutdowns of global economies. 

In that shock, you’ve got a liquidity crisis right at the heart of it, which is that they have bills to pay. And either they have a balance sheet or they would need to access capital in order to make it through the trough of that, going into the pandemic.

Finally, at some point, we’ll be coming out of it, right? So, we sort of thought about all those factors that have the resilience to the income statement of cash flows, liquidity of the balance sheet, the ability to raise money, etc. 

One of the things that we came out of this analysis was that larger companies would be at a relative advantage over smaller companies in terms of access to capital and resilience, and so we pruned, within our portfolio, companies that we have lower conviction in and added companies that we had higher conviction in going into this. That really helped us, emotionally, be resilient.

Stig Brodersen  07:44
Arif, as investors we are always on the lookout for secular trends whenever we consider our current portfolio and also stocks that we have on our watch list. There are some secular trends that we’ve known for a long time. One example could be the shift to e-commerce and retail, and could also be the shift towards renewables in the Indian industry. 

Also, they are to a large extent, priced into the market. Which secular trends have you seen coming out of COVID-19, if we can even say they’re coming out of COVID-19? Most investors are looking for secular trends to find undiscovered value, but you have a different approach. Could you please elaborate on that?

Arif Karim  08:26
I have a little bit of a different view from the way most people view how to make money via secular trends. I’ll give an example. I think the notion of undiscovered or underappreciated secular trends, while very romantic, I don’t think is necessary. I would skip betting on things that other people haven’t seen. I’ll give an example of that.

E-commerce right now, obviously, has accelerated in the US quite dramatically since the pandemic has hit and we’ve had the lockdowns. The e-commerce trend has been around for about 20-30 years now. In the last recession, e-commerce was maybe in the low to mid-single digits in penetrating retail here in the US. 

Amazon, of course, was one of the leaders in that. Amazon is still one of the leaders. It may even now be a stronger leader today. You could have said 10 years ago, “Oh, e-commerce is a known trend, it should be discounted,” yet Amazon has way outperformed market returns. 

That goes to say that, although, there are trends that are in place that are appreciated by seemingly everybody, it doesn’t necessarily mean that you can’t keep making money on that trend in a way that outperforms the market. I don’t think the market necessarily fully discounts things that are well-known. And so, there are ways to basically capitalize on those existing trends.

Another example I’ll give you is the trend of cash to digital payments. MasterCard and Visa have been around for about 50 years, probably, right? My colleague, Sean, was on your show a while ago, and he talked about MasterCard. That’s been a phenomenal stock although the premise of the company has been around and in place for so long, so I don’t think you necessarily need to bet on undiscovered trends or new trends. 

Of course, you have to understand what the secular trends are because they will be winds at your back or headwinds ahead of you, and you’d prefer a tailwind rather than a headwind.

Having said that, I think the most important part of investment analysis, from our perspective, is being a business analyst and understanding if those companies that are competitively advantaged, in the way that they’re trying to capitalize on secular trends, are creating value for their customers. 

Are they creating value for their stakeholders in a way that competitors potentially may not be able to, so that they can create outsized returns from an ROI perspective and eventually be able to grow through duration? 

So, to the extent that the secular trend is within a very large market, call it payments, from cash to digital, you can have decades and decades of outsized returns in that kind of a market, provided that the companies that you’re betting on have the ability to create a differentiated, competitively-advantaged business in that market.

Preston Pysh  11:09
Prior to this pandemic, I think very few investors had this kind of situation built into their model. I know I personally did not have a pandemic built into any models that I ever considered. Moving forward, how do you treat this in your model? We might have a second wave or something else completely. Tell us some of your thoughts on this.

Arif Karim  11:29
I think that’s why people get paid an equity risk premium. But, having said that, having worked 10 years going into the great financial crisis 10 years ago, one thing that we learned coming out of it was that people have what’s known as recency bias. We focus on those things that we personally experienced.

For the last 10 years, everyone’s been worried about another financial crisis. The financial systems have been made more resilient and central banks have become much more aggressive in the way that they’ll act. It’s interesting. We saw, in this crisis, the Fed stepped in very, very aggressively before anything had happened. 

Nothing had happened yet, and they were already…well, that’s not entirely true because the credit markets were starting to freeze up and they saw that happening. But the pace at which they acted, and the magnitude that they acted, was unprecedented. In a way, I think that’s what’s behind the massive recovery that we saw both in the credit markets and the equity markets.

Bernanke had to develop these unprecedented tools that came out of his study of the Great Depression, but he also had to convince politicians that they would be okay with the central bank taking these very large unprecedented steps. He set up the framework for dealing with this sort of crisis. Some of you were lucky, having gone through the financial recession 10 years ago, which now seems like a preview to this much bigger type of crisis that we’re going through, this bigger shock that we’re seeing. 

All J-PAL had to do was basically reboot that playbook that Bernanke had, and then just turn up the volume till 11, right? He threw in not just the kitchen sink, but the whole kitchen and the bathroom at it. That, to some degree has, I think, supported financial markets at this time around.

I think, going forward, we definitely are worried about a second wave. Most epidemiologists expect this as a given. We’re no experts, but we’re following the experts. It’s hard to predict exactly how things will react. One thing that seems clear is that human nature being what it is, the initial wave was a shock to societies, and every society has reacted differently, right? 

China has reacted differently to the US or Germany or New Zealand. Everyone reacted differently at various levels of success in containing the pandemic. And so, the second waves are likely to look very different in different societies, different countries.

Having said that, you have to be prepared for the worst. What’s being said by the experts is that until there is an effective durable vaccine available and deployed all around the world, we’re going to be facing a new normal or next normal living with this virus. That could very well be 2-4 years, we hope, and not longer than that, in which we’re sort of dealing with this. 

But, having said that, we are strong believers. I think history proves this, that humans are resilient and adaptable. So, what takes us as a shock and a surprise, this tragedy that we’re facing, we generally figure out ways to deal with them. We figure out ways to overcome them. We figure out ways to outmaneuver the challenges that are presented to us.

Stig Brodersen  14:44
Arif, one of the reasons why we really wanted to speak with you here today is that you are a hot micro guy. Like the rest of the world, we’re also micro guys looking at individual stocks. We have to factor in all the crazy macro-environment that’s also happening around us.

After having to speak to different macro guys who look at equities as an asset class more than specific stock picks, it would be interesting to have the complete opposite here, someone who really focuses on the individual companies, but typically doesn’t look at stocks as just one broad asset a class. 

I know I’m making it very simplistic, and I think you and Preston and I are all on that spectrum between macro and micro, but knowing where you’re coming from, I’m very curious to hear your thoughts about the trillions of dollars in stimulus packages that we’ve seen. We also have the Fed announcing repurchase of both investment-grade and high-yield corporate bonds here recently. How can our community, as value investors, best navigate the stock market?

Arif Karim  15:50
That’s an interesting question. It’s obviously one that all investors have had to deal with in trying to understand the macro landscape for the past 10 years, at the very least. Like you mentioned, we’re much more micro-oriented than macro-oriented. 

We spend 95% or more of our time looking at companies that understand the dynamics and such, but you have to understand the macro context in which you live in. That feeds into some of your overall assumptions about the way the world looks today.

Having said that, I’ll give you a little anecdote. I, just like many, many investors in the world, was really perplexed by the $10 to $12 trillion negative-yielding sovereign debt back in 2015 or 2016. I have an economics background and remember one of the key tenets of economic theory, as I had learned over 20 years ago. I hope things have changed since then. 

But one of the key tenets was that capital is scarce and that’s a fundamental driver of how entities, people, actors, or companies decide how to *inaudible* capital. You have scarce capital, so you put it to work at the most productive uses of that capital. In exchange, there’s a cost to that capital, which you can call an interest rate or an equity premium or whatever you want to call it.

I think the challenge in today’s world and going forward, where basically capital is abundant, is the cost of capital is free. As investors, we’re not going to get a free lunch anymore of getting some yield without taking any risks. Our job, and I think this plays to our *inaudible*, is to find those companies that are competitively advantaged with management’s teams and cultures that revolve around creating value for customers, stakeholders, and the world. That, in the end, will end up paying us as shareholders a portion of that value and hopefully an outsized portion rather than the risk that we’re taking.

One thing that’s become clear is that we no longer live in a scarce-capital world. Starting in maybe 2013-2015, sometime then, I began to shift the way I thought about the role of capital in the sense that when you have 0%, 1%, -1% yielding capital, what that tells you is that there’s plenty of capital around. What there’s not enough is a productive use of that capital. What does that mean? That means, to make your capital productive, you have to find talent who is able to take that capital and create productive uses out of it.

It’s interesting that we, as investors, sometimes are inculcated with these tenets about what’s true about the world and there’s no rule about it. It’s just that this is what we just believe. Our forefathers believed it and they kind of passed it on to us, right?

But one of the tenets is that “Oh if I have money that I’ve saved up, I should be able to put in the bank or buy a treasury bond or a bond and get a positive return without taking a risk. There’s a risk-free rate.” Well, who says your capital should earn anything without taking any risk?

If you remove that tenet, then it becomes really clear how you should be navigating the world ahead, which is that the central banks have basically taken the risk-free rate down to zero across the world or most large sections of the world. I think what that ends up doing is creating opportunities for us, as well as challenges for us, as investment practitioners, to find either directly-productive use of capital ourselves where you can earn a yield that’s a good risk/reward or find the talents to do that. 

And so, we want to find talented management teams running companies where they can earn outsized returns, which, from our perspective, is return-invested capital, and can reinvest cash flows coming out of their business in new opportunities that offer outside investor capital.

Preston Pysh  19:47
Arif, let’s go ahead and transition to the second part of the show. I’m really excited to go through this pick because I think the technology that this company has is really quite amazing. The name of the pick is Intuitive Surgical (ISRG). Talk to us a little bit about their business.

Arif Karim  20:04
It’s a really interesting business. It’s a little bit of a sci-fi business if you think about it. Intuitive Surgical makes robotic surgical systems that surgeons used to perform minimally invasive surgery. Some of your audience may have seen the robots cameo on some popular TV drama shows like Grey’s Anatomy. E.R. might be too old for it.

But basically, what you’ll see are robotic scaffolding hovering over patients with four large arms. These are remotely controlled by a surgeon from a separate stand-alone console. What it enables the surgeon to do brings both new capabilities, but also improves patient care from the sense that it allows surgeons to treat patients without having to cut their abdomen open. It allows you to perform certain procedures in a minimally invasive way. It minimizes how much of the body is open to the air, which reduces both blood loss as well as infection complications.

It’s really innovative from the perspective of both improving the surgeons’ ability to perform certain procedures. Their start came from prostatectomies for prostate cancer, which is the removal of the prostate, and hysterectomy, which is the removal of the uterus for uterine cancer, but since then, they’ve gone on to many more procedures, which is why the stock has done so well. Their procedure account has grown dramatically from a couple hundred thousand procedures back in 2012 or so to about 1.2 million procedures globally done today.

Stig Brodersen  21:47
Arif, you’ve been following Intuitive Surgical since 2012. Except for TV shows, how did the company come on your radar and why did you decide to start building a position?

Arif Karim  22:02
I have all sorts of friends, and many of my friends are engineers, actually. A lot of my engineering friends are also interested in investing, so we’ll talk shop a little. I learned from them about technological stuff, and they learn from me about financial markets and investing stuff. 

One of my engineer friends at Google mentioned the company to me and said, “Hey, have you seen this company?” This was back in 2012. “Intuitive Surgical. It’s this really cool company that makes these surgical robots.” Of course, you would expect an engineer at Google to be very impressed by a surgical robot, right? I’d heard of the name, but had never really looked at it or knew what they did, so I took a look, and I was intrigued.

From my perspective, as I looked at the company, this mental image came into mind, which is that of the bionic surgeon. This machine takes a human surgeon and makes them bionic.

Just like most value investors probably at the time, I looked at its financial metrics and was like, “Oh, this looks expensive.” 80% of the procedures were in urology, so prostatectomies, and gynecology, mainly hysterectomy, so it seemed limited at the time. But one thing that I have learned over my career is that, oftentimes, if you look at the curve of technological adoption, there’s a learning curve and application curve involved. 

And so, I followed it because I was interested, but what I also saw was that, with their fourth generation machine, called the da Vinci Xi, they were talking about doing a lot more than just prostatectomies and urological and gynecological procedures.

The two key metrics that got me were, firstly, as I studied it more, I realized that you paid $1 million to $2 million to turn a regular surgeon into a bionic surgeon, which is incredible, and that the capabilities that could potentially bring were incredible. This was both in the way they did their job to be a better surgeon, but also in creating new ways to perform their surgeries on patients that humans cannot perform. You need to be inside the body and have sort of a reverse-angled wrist to do some of these things.

The second was really interesting to me, as well, as a financial guy. We’re all familiar with the model of the razor blade. The Gillette razors are a classic model for this. When I was in high school, at around 17-18 years old, I got a free Gillette razor in the mail with one blade. I started using it and remarked, “Huh, I like this thing.” 

Gillette made no money from there. They lost money on that razor they sent me, but then, I went and bought these expensive razor blades. That became an annuity that they make. That model is one that the financial markets really like a lot where you pay a small investment upfront at a low or negative margin, then get this high margin consumable that your customers will pay for a long period.

With Intuitive Surgical, when I analyzed their financial statements, I came up with a guesstimate that they were making something like 60-70% gross margins on the robot, on the razor, which to me was really interesting because you have hospitals paying $1-2 million upfront to become captive customers of Intuitive Surgical, and then paying them something like an 80-90% gross margin on the instruments that are the consumables on these robots. 

From a procedure perspective, there’s the robot which typically lasts something like 5-7 years that they’re paying $1-2 million for, and then they’re buying these instruments that can be replaced after every so many surgery that roughly runs around $1800 to $1900 per procedure. That model was really interesting to me. The fact that they collected such a high margin on their robots was really interesting. There was also no competition in soft tissue surgery. They were the only game in town.

Finally, what caused me to pull the trigger into seeking a position was a competitive analysis that there’s a moat there, from my perspective. It was an early market, but it was a large market that they could go after. They were doing a low, single-digit percent of surgeries around the world. That’s something like 300 million surgeries. 

Not all of them apply to something as complicated as the da Vinci XI robot, but some proportion of that is. Maybe it’s 20% or 30%, but they were doing a very, very low percentage of that addressable market.

Over time, I was confident with the new machine. Management talked about improvements and that there were new procedures that they were going to try to ascertain for the machine to address. That would layer on growth curves for them via those new procedures. They have that geographic expansion, as well. 

At the time, something like 75% or so their procedures were the US. But the US, as we know, is only 4% of the global population. It has a much bigger percentage than that in healthcare consumption, but still, there’s a large developed market out there that also could use this machine.

I’ll just add one last thing that really impressed me at the company. When I talked to the company, I asked them how they decided what procedures to go about targeting for new instrument development. So, you have this robot and it’s got four arms. One of which is a 3D HD video camera that allows a surgeon to see what’s going on. The other three arms have instruments that you use to actually do the procedure. That varies depending on what procedure type you’re doing.

I asked the company how they allocate the resources to creating the instruments necessary for certain specific procedures that they see as being viable for the robot that doctors will adopt. I said, “How do you target that? How do you decide?”

They answered, “Honestly, we have some ideas about what the machine can do and our salespeople go and talk to doctors about that. We maybe will introduce an instrument to enable a certain type of surgery, but more often than not, we get doctors coming back to us and telling us, ‘Hey, I took your machine and I tried this procedure. I think it’d be great for this.’ And then we test the market, talk to other doctors in similar fields, and ask them what they think.”

They get this percolation of demand that comes up organically from their user base. Their doctors are saying, “Look, I use it for this thing, but this other thing is also applicable. I’m really excited to use this machine for this other procedure. Will you develop the right instruments so I can do that?” That impressed me. There’s this inherent latent demand among surgeons for certain new procedures for the company to develop because they’re excited to use this machine on patients for that.

Preston Pysh  28:25
This is a fascinating market. They’re doing around a million surgeries a year, and there’s a potential for 300 million surgeries globally if Intuitive Surgical could capture that international market. So, talk to us about the company’s competitive advantage, and what it takes to create intellectual property in this space.

 Arif Karim  28:44
It’s really interesting. As a patient and a doctor, you’re not going to let the first new device that comes along into a patient’s body or your own body. There are safety factors that are involved. I mentioned that when I first looked at it, there wasn’t much in the way of competition, but there’s competition on the horizon. 

To your point, there’s a large market and some of the larger medical device makers like Johnson & Johnson and Medtronic have taken notice. So, I’ll go a little into the history and kind of tie that into your question about competition.

Intuitive Surgical started out as this group at Stanford Research Institute (SRI) that was working with the military in developing a remote telepresence surgical device that could be used on the battlefield to help wounded soldiers. That didn’t go very far although there was some money invested in that. I guess that it’s probably because the communication bandwidth wasn’t quite there yet. We weren’t there, technically. And so, that project basically spun out into what became Intuitive Surgical.

Initially, it was about leveraging the technology they built in a way that would address surgery, and they found that several versions of the device until finally– I think it was in 2000 or 2002, they hit on a product-market fit in the form of prostate removal and then uterus removal.

It was kind of a niche market. Medical device makers who had a very high-profit margin and laparoscopic rudimentary manual tools weren’t going to invest a whole lot of money in this fancy robotic machine for some niche markets. 

What happened was, over time, Intuitive Surgical got better and better, developed new capabilities, know-how, earned trust amongst surgeons that were performing surgeries, worked their way to basically racking up a safety record over hundreds of thousands of procedures, and trained thousands of surgeons on using their machine.

In 2014, they came out with the da Vinci XI machine. Word of that machine leaked out before it was introduced or around the time it was introduced. That’s when Johnson & Johnson and Medtronic, who make laparoscopic tools for general surgery, started to get worried. They realized a potential threat this robotic surgery created for their own very profitable businesses, and that’s when they decided to invest money in developing their own machines.

Long story short, I don’t know if you’ve heard the story, but this is really intriguing to me. The story shared by Jeff Bezos last year when he was at the economic club of New York mentioned that they hadn’t talked about Amazon Web Services (AWS), which is their cloud computing initiative, for many, many, many years. 

For something like seven years, they didn’t have a single competitor. They didn’t talk about it because they saw how lucrative it was, how fast it was growing. They didn’t want competitors to know. Over that seven-year period, they had all this time to keep developing more and more capabilities for AWS.

Similarly, with Intuitive Surgical, for basically two decades, they had no competition. No one was working on this. They had a two-decade headstart on know-how and capabilities, reputation, relationships, and the record of successfully-performed surgeries using their robots, and 50,000 trained doctors with experience using their robot, which creates a really strong moat around the company and robotic minimally-invasive surgery.

What you’ve seen as a result is that Medtronic and J&J have both had initiatives, before the XI introduction, but started sometime during the development of the XI when they heard about it, because it targeted general surgery, not just these niche procedures, not two procedures, it was all surgery basically. And so, they saw the threat, and they’ve been developing their own robots since then.

J&J had an initiative so they had their robot. Then they created a JV with Google, actually Google’s healthcare division called Verb. That was going to incorporate a bunch of machine-learning and AI and data analytics into it. A few months ago, J&J basically bought out that JV and they’re delayed by I want to say 1-2 years on introducing that machine. From my perspective, that doesn’t look like it went all that well, that JV with Google. There’s no word on when to expect that device.

So, I think Intuitive Surgical with the XI, that’s been out since 2014, as they’ve been selling it, holds the majority of the machines out there in the field today. That’s their 4th generation device, and it’s going to be competing with a 1st generation device from Medtronic, and J&J. In fact, I would speculate that by the time Medtronic and J&J are out with their first-generation device, Intuitive Surgical will already have their fifth-generation device out in the market at that point.

So today, they have something like 5,600 to 5,800 robots out there in the field, globally. They’ve been growing their base by about 10-12% a year. It’s a very mission-driven company, and because they’re focused on this one area, I think they’re likely to continue exceeding their competitors’ efforts in the area. So, they’ve got a moat already, and I think that moat gets wider, especially in light of COVID and the things that are going on now.

Stig Brodersen  33:53
Let’s talk about that. How do you expect COVID-19, if ever, will impact Intuitive Surgical Business both short-term and long-term?

Arif Karim  34:03
Short term, it’s negative. Their first quarterback in April was the time China was recovering from its COVID-19 actions having shut down the economy. Hospitals also had reduced the number of surgeries that they were performed because they wanted beds available for COVID patients throughout countries.

Although the epidemic was contained within China, for the most part in the Hubei province, which is about 60 million people or so, they were worried about widespread COVID infections and what that would mean for the healthcare system. Any elective surgery was postponed. By elective, it’s not plastic surgery where I want to look good, but more like surgery that’s needed to be done, but doesn’t have to be done today. It can wait a couple of weeks, a couple of months, that sort of timeframe. Half of all of the Intuitive Surgical procedures are cancer treatment surgeries, so they need to be done, but the timing can shift. 

So, in China, they saw a 90% reduction in their surgeries in February. But by the time they had their conference call in April, that reduction was down to 20% reduction from a 90% reduction and recovering.

However, the rest of the world obviously got hit in mid-to-late February to March and April, so they didn’t really give guidance for the quarter because nobody knows, but at the time, they talked about their surgical procedures being down 65% in the US, and down 60% globally, at the time of their conference call.

I expect their Q2 to be a terrible quarter from a procedural perspective and a revenue perspective. Q3 may see some partial recovery, but it’s not going to be a terrible quarter, as well, most likely.

What happens though, is that these procedures that have been delayed in anticipation of COVID cases are going to come back because most of them are things like cancer treatments or hernia treatments or other procedures that have to get done. They can be delayed, but they have to get done. 

And so, there’s this big backlog that’s been forming, and that’s going to have to come back to the extent that the gating factor really will be the care teams, the doctors and the nurses and surgical teams that are available to perform these surgeries. Not only is there a backlog, but then there’s the ongoing organic growth of the needed procedures.

Therefore, I think in the post-COVID era, most procedures will recover most likely, and then you’re going to have this big backlog to cover over the next three to five years. The demand for Intuitive Surgical will have to be made up. Hopefully, we haven’t lost too many people along the way waiting to get treatment, but never getting to that point where they need treatment. 

Larger companies typically have all sorts of capital allocation priorities including dividends, buybacks, earnings per share they’re going to print for the quarter. That sort of stuff just doesn’t play a role for Intuitive Surgical. It’s a very singularly-focused company on the core value of its customers. I think that ends up in a time like this, where you may see Medtronic and J&J pull back their investments across divisions. 

We’ve seen nothing like that in Intuitive Surgical, where they’re continuing to focus on extending their capabilities. So, coming out of this period, I expect Intuitive Surgical’s competitive vantage difference relative to competitors to be even wider than it already is.

Stig Brodersen  37:34
Studying the different generations of Da Vinci robots, I mean, you can’t help but be impressed by the capabilities. I would encourage everyone to go to YouTube and check out some of those videos because it is really sci-fi, as you refer to it. It looks like something that almost shouldn’t happen in 2020.

Our audience is deeply-rooted in the investment philosophy of Warren Buffett, and Buffett always makes it very clear that you don’t want to invest in a company that has to reinvent itself. Buffett is often using the example of See’s Candies because chocolate doesn’t have to be reinvented and technologies are not going to change how we consume chocolate. How do you think about Intuitive Surgical’s need to reinvent itself and the sustainability of the business? 

Arif Karim  38:23
That’s a really good question. I think there’s a couple of points in there to unpack. Buffett is great at packaging these pithy little sayings that have so much wisdom embedded in them. I think it was Einstein who may be said to simplify things as much as possible without oversimplifying it. He said it much more eloquently than I did, but I think that’s a very simple message, and it’s an important one, but it is a little overly simplistic, and I’ll explain why.

 In the chocolate business, right, See’s Candies, you’re right. The consumption of chocolate hasn’t changed a whole lot. There’s a lot of wisdom in thinking about the sustainability of a business and its competitive advantages. We do this all the time. There’s a lot of wisdom in trying to understand how much cash flows are thrown out by a business. 

Of course, the more capital intensive it is, the less cash flow comes out for the shareholders. That very much is a core part of how we value capital-intensive businesses. So, we’re interested in the free cash flows, and, of course, capital-intensity plays a big part in it.

What I’ll say is that when you have any business where it has to reinvent itself, it probably is not a great business. But the businesses that we find very attractive within the technology realm are those where the core value proposition is not being reinvented. 

What’s happening is you’re extending that core value proposition, you’re extending the scope of it, you’re expanding the growth runway for it, you’re increasing the value you’re creating for customers so you can take a portion of that back right in the form of the value that you keep for employees and shareholders. In a way, that’s fair.

I’ll give you a couple of examples. With Intuitive Surgical, what they’re doing today is no different than what they did in 2000. The core value proposition is no different. What they’ve done via their investments is they have extended the number of procedures that can do so the scope to which they can address. 

They have extended the capabilities of the surgeon, creating value for the care team. They’ve extended what a surgeon can do. All that is value created and Intuitive Surgical gets to keep a piece of that, which is what we see reflected in their revenues and profit margins.

Similarly, if you look at Google, for example, their core business is still Search, which is what they started with back in the late 90s to 2000. I started using Google for search, and that’s predominantly what I use it for today. That hasn’t changed. The investments they’ve made haven’t reinvented Search so much as extended its capabilities and the scope from the perspective of oh, now they have YouTube, so now Search applies to video. 

They bought double-click and incorporated display ads into their business, which leverages their AdWords platform towards another part of the business. Also, AI, machine-learning, improves upon all those businesses they have. So, the investments they’ve made have extended the capabilities of that core value proposition and the core technology.

The final example I’ll give, which I think is very interesting as I think it’s a controversial name. but at the same time, I think it is very instructive in addressing this question about having to reinvest in your business. It’s Netflix. We have owned Netflix since 2016 or so. One of the first things I did when I came to the ensemble in 2015 was to look at the media industry and try to understand whether it was an investable space for us.

The key question there was: How does the internet change the way media is delivered, consumed, and the value created out of it? It was on the verge of being investable because we didn’t know, or not many people knew, how the internet would affect the media industry. In the process of trying to understand it, what became really clear to me was that Netflix had the right strategy, which is media.

Delivering media went from being something tied to a pipe like a cable company or telephone company wiring from their central office to your home and then delivering media to you, to this virtual network that the internet brought to customers. 

In other words, whereas most media companies were dependent on this wire bringing their service to your home via distribution company, they end up being regionally scaled. What the internet did was disintermediated the connectivity of the customer from the actual wire that connected us. In some places, it became wireless with 4G internet.

What that made me realize was that Netflix was going to supersede the existing media companies unless they change their strategies from being a regional scale model to a global scale model. All that meant that they had to invest heavily in content to apply their service, leverage their service around the world to billions of customers –all with different viewing habits, different languages, etc. 

What that entails, in order to capture that market, is investing capital to get to scale so that you are applying to the global market. Once you’re there, it becomes really hard to compete with you for the traditional media companies because that scale has scaled dynamics. 

For example, the media companies produce but are also acquiring talent to produce a show. More than any other media company, Netflix can pay more than anybody else, and yet, on a per-subscriber basis, it costs it the least to deliver to that subscriber. That’s the kind of scale economics that Netflix has today because it invested in its scale. Its content catalog attracted a subscriber base that’s now growing 20% plus per year at a huge scale. They’re closing on 200 million subscribers, globally.

Tying that concept back to the Warren Buffett concept that you mentioned, which is you don’t want to be invested in companies that have to reinvent themselves. You don’t want to be in companies that use large amounts of capital. I would say that there’s a nuance to that, which is that See’s candy, maybe has $200 million a year in revenue saved or maybe a billion. But they fail to capture the premium chocolate market.

Buffett often says that if you’re going to bring your sweetheart a box of chocolates, you’re not going to care about the price. Well, he’s right. But guess what? My sweetheart, my wife is not going to be like, “Oh, honey, you brought me a See’s Candy Box for my birthday. It’s awesome!” She’d be like, “It should have been Godiva.” Something else. Something higher end, right? Some European chocolate. The fact that See’s was unable to capture that premium market to go up there because it didn’t invest enough, I think that’s a flop. 

The chocolate market has become a much bigger market than it used to be. Hershey’s bars, at $1 a bar, are no longer sufficient. Right? You have all these $6 and $3 candy bars that See’s could have been on top of, but they didn’t reinvest and reinvent themselves from a branding and marketing equality perspective to address that much larger, much more profitable market.

And so, the companies that we invest in, we want management teams to be actively thinking about, first of all, their competitive moats. Secondly, thinking about return on invested capital. How do they maximize that in a way that’s also fair to their stakeholders, employees, and customers? 

And then, thirdly, we want them to be able to reinvest excess cash flows in broader, preferably global scale, opportunities. And so, our best favorite ideas are MasterCard, Booking, Netflix, Google. All of these are global-scale companies. They address the global market, which has a huge and long runway for growth, which is an inherent part of valuation and value creation total. 

Preston Pysh  45:48
So, Arif, the company, the revenues are growing like crazy. The cap ex is reasonable. They don’t dilute their shares outstanding. It’s generating a lot of cash flows with minimal debt. The addressable market is massive. As you know, it all comes down to the price. Right now, the price is at $560 a share. Talk to us about how you’re valuing this. 

Arif Karim  46:09
One is that we don’t slap a PE or price-to-sales multiple to come up with our targets. We do a bottoms-up valuation analysis based on what we believe to be a good, free cash flow scenario. That balance is kind of the tail end of the risk. It could be an upside to how the company performs. There could be a downside over the long term. But from our perspective, it’s in this probabilistic range of about 700.

There are not many companies that can durably sustain something along the lines of 80% return on capital, and that’s hard to do in a competitive market, but what we’ve seen with Intuitive Surgical is that because of their focus and their two-decade lead in this market, it’s going to be hard for competitors, even large ones, to be able to take market share from them. 

Now, having said that, there will be incremental market share that will go to competitors, but the market, we think, is going to be growing fast enough for the next couple of decades that there will be space for competitors and Intuitive Surgical to have great growth.

I’ll just say one last thing, which is that if you look at about the million or so procedures in 2019 relative to the entire surgical space and where the opportunities for robotic surgery are, it’s very clear to us that the penetration of the available market is something in the range of mid-single digits for Intuitive Surgical. So, there’s a long way to go for this market.

And finally, I’ll just add that our intrinsic value is based on the long term. We all know that we’re living in an unprecedented time, one that we haven’t seen in a century, and so, there’s very likely to be volatility along the way in the short term and the medium term. Intrinsic Surgical basically withdrew its guidance after reporting Q1. 

We talked about how, in the Q1 trend, they didn’t look very good for the near term because of the healthcare systems in many different countries being overwhelmed by COVID. So, from our perspective, it’s going to be probably another year or so that we have this lack of visibility because the world is dealing with COVID until some sort of a vaccine is here and deployed across billions of people. It could be longer, right? 

But if you have a long-term time horizon, and you’re able to take advantage of the volatility that we’re likely to see in the sort of call it 1, 2, 3, 4 quarters, you can be set up for great prospective returns on a company as high quality as this.

Stig Brodersen  48:33
Fantastic. Arif, thank you so much for coming on our show and talking about investing through COVID-19 and bringing so many different case studies, not just from Intuitive Surgical, but so many other case studies in terms of how you think about stock investing. Where can the audience learn more about you and Ensemble Capital? 

Arif Karim  48:52
We’ve got our website, ensemblecapital.com. There’s a bio of me there, but also ways to reach me and my colleagues in research and wealth advisory there, as well. We’re also very active on social media. We post blogs where we’re talking about ideas, both high-level ideas as well as company-specific ideas. It’s a way for us to communicate with clients and also just peers and interested folks that are interested in talking to us, so that blog site is intrinsicinvesting.com. 

And then finally, we’re on Twitter. Our handle is @IntrinsicInv, and we’re very active there. So, there are all various ways to reach us and learn more about what we’re doing. Please, we welcome feedback and sharing of ideas and everyone whom we interact with, and we continue to learn and grow. 

Stig, I also want to say thank you for having me on your podcast. I’m a big fan of your podcast. You guys do some great interviews, great guests, and I’m really honored to be invited to chat with you and Preston about what you guys are doing here.

Stig Brodersen  49:47
Thank you so much for your kind words. I hope we can invite you back on the show another time Arif.

Arif Karim  49:53
I would love that.

Stig Brodersen  49:54
All right guys. So for this segment of the show, we will play a question from the audience and this question comes from Theodore.

Theodore  50:00
Hi, Preston and Stig. This is Theodore from Philadelphia, Pennsylvania. As you’ve already discussed, the market has rebounded for the past month and a half to two months from its low of late March, early April. The market has left me a bit confused. I don’t know how to make sense of the unemployment that increases every week, while the stock market goes up. 

I’ve heard you mentioned that the stock market doesn’t necessarily reflect the sentiments of the actual economy, and, in my opinion, that’s never been truer than today. Period. But I’m very curious if you can really spend a bit of time to give us your opinion as to what you think is going on with this market that, in my opinion, is schizophrenic.

Stig Brodersen  51:00
You are surely not alone Theodore. I think we’re all looking at the stock market and the economy, and are wondering what’s going on right now.

Now, the first thing to understand is that the stock market is not the economy. It rhymes, but it’s not the same thing. Let’s first talk about what the economy is. The economy is the sum of all goods and services that Americans, in aggregate, produce. Before COVID-19, the economy was around $22 trillion annually in the US. 

And so, everything else equal, when you have high unemployment, it won’t be good for the economy for the simple reason that unemployed people don’t produce as many goods and services as employed people do.

Everything else equal, you’re absolutely right when you don’t understand why the stock market should be going up when the economy’s going down. But let’s talk about what the stock market is. The stock market is the value investors put on the earnings of listed US businesses. That’s also why the Shiller PE that we talked about a bunch of times here on the show is such a problem metric because it measures what price all investors put on the inflation-adjusted earnings over the past 10 years. 

Implicitly, this number is also the opportunity cost of all the assets and the growth potential of US equities. If the Shiller PE is high, it means that other asset classes are less attractive. It could also mean that the growth potential for US equities is high or it could downright mean that the stock market is overvalued, and typically it is a combination of the three.

But going back to the original question, it’s a really important standard that the US stock market is not the same as the US economy. Let me give you an example. Apple has more workers abroad than in the US. Apple also has more revenue internationally than in the US. 

However, Apple is still considered US stock. But, in theory, even if the US went into a slump with declining revenue and declining margins for Apple as a result of that, the market would still rationally value the Apple stock higher if the international business more than offsets that. That would, in turn, result in the US stock market being priced higher. While I just used Apple as a generic example, I hope that it really showed why the economy and the stock market are not the same things.

There are also many other reasons why the stock market has just recently raised the 2020 loss. One reason is that the economy is generally backward-looking, whereas the stock market is forward-looking. So, when you hear the latest unemployment numbers and GDP numbers, it’s something that has already happened. The stock market is trying to press in what’s going to happen and what’s going to happen to the discounted cash flows of the remaining of the lifetimes of US equities. 

Now, the stock market does get an indication of what’s happening at the present, but in nature, it’s forward-looking. You also have the Fed manipulating the market big time. Whenever you have enormous buyer bonds in the market that splits more than $2.6 trillion, it presses down the yields of bonds, which makes stocks in comparison more attractive as the cost of holding bonds changes. That forces the stock market to go up.

Now, giving credit where credit is due, Preston mentioned this already when the market was tanking back in March. This was when everyone was talking about the 1929 stock market dropping 85% from its all-time high. Preston talked about how dependent the stock market is on the printing of the Fed. 

Given that, he wouldn’t be surprised if the stock market hit all-time highs. I think it was a really interesting call that he made back in March. If I can even add to that based on my point earlier, it’s the expectation of the future more than what has happened already. It can be very local about printing as much as required. 

We know, from earlier crises in 2008, but also other crises, that the Fed can talk the market up and down just as effectively as actually printing money and buying securities, and that is what you see playing out right now.

Preston Pysh  55:23
Theodore, I think my comment might sound more cynical. What I think a lot of people are misunderstanding about the markets today is they’re assuming that they’re free and open. I think that’s a bad assumption. I think that what you have played out right now is just an unprecedented amount of manipulation happening in the market. 

That’s, first of all, why it doesn’t feel normal or feel right that you’re seeing the things that you’re seeing. I don’t know what the real unemployment number is, but let’s just say the number is between 15% and 20%. How can you have that kind of numbers and the stock market is making runs at all-time highs? The only way that I can personally come up with how that’s possible is that there is an intervention. There is manipulation happening in the market.

Let me just give you an example. The Fed balance sheet, before all of this, went down in the February-March timeframe, was hovering close to $4 trillion. Today, it is now at $7 trillion. They printed that much money, they almost effectively doubled the size of the Fed balance sheet in a matter of three months. 

Think of it like, and I know shares are not a fixed supply, but they’re much more of a fixed supply than some other things that are going on right now, so I think if you want to say it’s similar to gold again, you can try to make that argument. 

It’s not as far as the supply base and how much you can actually increase the supply of the shares outstanding if you were looking at the market as a whole, but let’s just say that that’s somewhat pegged or fixed. 

What I think you’re finding is that a lot of people in the market are looking at equities more as a form of sound money than they are looking at the earnings or the actual performance of the underlying security. 

And so, when you’re looking at something that has somewhat of a fixed peg to it, the equity, the number of shares outstanding, and you’re comparing that to the money supply that went from $4 trillion to $7 trillion in a matter of three months, people do not want to be sitting there on the sidelines holding fiat cash when you literally had a tsunami flood of fiat that was added into the system.

Now, in my personal opinion, what this is all coming down to, globally, is the dollar. You have so much dollar-denominated debt all around the world and what’s happening is the Fed steps in and they print more and more and more and they add this into the system. What’s not happening is the money is not making itself down into the general population. Where that money is going is straight into the market capitalization of securities, primarily in the bonds. 

And so, that’s why your bond yields just keep getting pushed lower and lower and lower all around the world. All these countries that have dollar-denominated debt, they need that servicing. They need more liquidity added into the system in order to keep the solvency of all these securities in check.

The problem is that as the Fed keeps adding more and more liquidity into the system, it’s going to servicing that and it’s going into bidding the market capitalization of those, opposed to trickling down into the economy where people need this money. If you check out the velocity of money, that’s why the chart has been going down for year after year.

So, how do you look at this as an investor I think is where you’re really getting at it. As an investor, I think that if you’re heavily relying on valuation metrics, which is Stig’s and my bread and butter, you might find yourself in a tricky situation because so much of what’s happening in these big violent moves are based on dollar liquidity in the system, and in it drying up and then them replenishing it, and then it drying up and then them replenishing it.

When you’re doing these Buffett-style valuations, you’re making an underlying assumption that you’re dealing with sound money, and you’re dealing with a real cost of capital and economic calculation that’s occurring in the economy. My argument is today, you’re not seeing that because all these interest rates are pegged to nothing percent, and if they’re pegged to nothing percent, you don’t have a cost of capital and you can’t do the economic calculation for the valuation of things. 

So, this is where I think at least having more of a momentum style of investing in your approach can help significantly because it really takes a lot of the valuation piece out of it and it’s just looking at the pure statistics of the price action, saying, hey, historically, this volatility is uncharacteristic, therefore, it’s going up. Or this move, based on the price action, is uncharacteristic to the downside, therefore, I need to sell it.

And so, the calls that our TIP Finance has been making for the S&P 500, for the NASDAQ, have been exemplary because it’s heavily relying on just the price action. It’s looking at statistical volatility is basically giving you a thumbs up or a thumbs down, whether it’s within a trend or out of trend. 

So, I think that moving forward, that’s going to be a really powerful tool for people because so much of what’s happening, how can you come up with a valuation when interest rates are at zero percent because every central bank in the world is manipulating their economy in order to have enough liquidity to service all this dollar-denominated debt and all these issues that we’re now seeing playing out real-time.

I think that as we move forward, I think you’re going to see more violent whiplash, like we have seen since the start of 2020. If we saw another leg down as deep as what we saw before and maybe even deeper, that would not surprise me in the least bit. If we made all-time highs, that would not surprise me in the least bit. I know that doesn’t sound like that helps anybody, but I guess what I’m really getting at is your expectation moving forward should be that we are going to experience extreme volatility. 

The reason why I think you’re going to continue to see extreme volatility is that we’re in a major, major currency crisis. As you have so much credit in the system, it contracts and expands as they’re adding more. The contraction is happening because of all the issues that you have on the balance sheets for all these companies in the impairment that you’re having on balance sheets.

Also in the derivatives market, as you get into the supply and demand adjustments that are happening based on the expectation of the demand for oil, now all of a sudden, COVID-19 is going away or people are saying it’s going away, so then all those derivatives get repriced. Well, guess what all those derivatives are denominated in? They’re denominated in dollars. So, there’s this surge for dollars as all this supply and demand contraction and expansion is occurring.

All those things are making this an extremely difficult time to navigate, so I would tell you to focus a lot on a momentum strategy. If you can back it up with valuation metrics, I think that that’s probably going to be the best approach moving forward.

So Theodore, for asking such a fantastic question, I’m excited to be able to give you a 1-year subscription to our TIP Finance Tool where it has the Momentum Tool in there that will assist you with some of these things. I’m excited for you to be able to dive into that and use it firsthand.

If anybody else out there wants to get a question played on the show, go to asktheinvestors.com. It’s really easy. Just click a button to record your question, and if it gets played on the show, you get a free subscription to our TIP Finance Tool.

Stig Brodersen  1:03:38
All right, guys. Preston and I hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro 1:03:46
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