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The attraction of compounders

Updated: Feb 24, 2021

My obsession with compounders

Businesses that can compound their income through ongoing reinvestment into their business are a rare breed. I explore why I like these businesses so much.

I wanted to reflect on some material which I saw recently that was published in one of Berkshire Hathaway's annual meetings. In that report Buffet commented that the best kind of business is one in which the opportunities to reinvest capital at high returns over a long period of time would arguably produce the best investment results.

While that seems a fairly easy concept to understand, the challenge of being able to accurately identify a business that truly has such a long time runway to deploy capital, at high returns is not an easy feat.

The challenge here is compounded by being able to accurately assess whether a businesses runway for growth will be impacted by competitive pressures. The nature of the free-market economy and capitalist motivations is typically such that opportunities to derive unusually high rates of return on investment typically see a swarm of competitors coming in.

In the absence of being able to accurately determine the length of time that's available for a business to deploy capital at high rates of return, I content myself with looking for investment opportunities in businesses that can deploy a modest amount of capital at high returns on invested capital and yet generate impressive double-digit rates of growth in revenue and operating income. I then assess whether these businesses have suitable tailwinds that can actually support these double-digit rates of growth on revenue and operating income.

The attraction of being able to achieve strong rates of growth with minimal deployment of capital is fairly obvious. It largely means that with very modest effort, a business is able to generate strong growth and profitability from the results of internal growth that leaves the business independent from a financing perspective and not reliant on debt but more importantly this can lead to some fantastic results when combined with an aggressive buyback program.

Buffet references See's candy as one of his investments that required minimal capital to produce exceptionally strong rates of growth. In this example Buffet took the excess cash that was generated surplus to See's requirements and reinvested that into other parts of the Berkshire Empire.

Of course, average investors typically don't have the ability to control cash flows of a business in such a manner. However in some instances they have something available to them that's almost as good in the form of corporate buybacks.

When you have a corporation that's able to have double-digit rates of growth on revenue and profit with minimal capital, that typically means that there's a surplus of capital available to aggressively repurchase stock.

This stock repurchase program in combination with aggressive growth rates can really juice earnings-per-share over a long period of time and produce fantastic rates of return for the investor. For example, a 15% increase in earnings per share on a fixed capital base can all of a sudden become a 20 to 25% improvement in annual earnings-per-share with a steadily reducing share count.

However to get confidence in such an assessment it's imperative that the investment case be supported by long-term growth drivers or tailwinds that reinforce this case. I also like to see the evidence of network effects being present in these types of businesses. Network effects actually provide some level of long-term cushioning of favorable economics for incumbents and allow them to prosper even if a more superior technology or service offering emerges.

The reason that this is the case is that participants who are invested in the incumbent solution will typically be loathed to move to another solution if other members of the network have not done so. For example it's a lonely experience moving from highly populated e-commerce network like Amazon to a newer alternative network where there are significantly fewer merchants and significantly fewer members providing detailed product reviews on items available for purchase.

The other reason that these network effects are so powerful is that over time it can effectively allow subpar technologies to remain dominant where the rate of disruption tends to be meaningfully high. That's a huge advantage to have.

I've been aggressively accumulating these businesses where I can find them at an attractive price and really moving to concentrate my portfolio such that these types of businesses dominates far as portfolio allocation.

Additionally many of these businesses require relatively little capital for incremental growth. MasterCard and Visa in particular require less than 10% of their operating cash flow to be redeployed in the business for growth. They have minimal working capital needs which means that the majority of operating cash flow is available to be returned back to shareholders in the form of either dividends or stock repurchases.

The other type of compounder business is one where capital can be aggressively redeployed at high rates of return to steadily expand and widen the business franchise. Now while I prefer those businesses that don't require much capital to produce fairly high long-term rates of business growth, I do also very much like these businesses that have opportunities for reinvestment at high rates also. The challenge that arises with reinvestment businesses is the certainty of reinvestment at high rates of return.

However there are a few examples where I think one can be relatively confident that an investment will produce high rates of return. The first instance is where you have a format that's been successfully deployed regionally which you're expanding nationally or into international markets. In general, the economics that are evident in the limited regional rollout will largely extend on a more national rollout basis providing you the accounting for variations in demographics, economic trends and other cultural variations. Taking a retail chain and expanding that regionally and nationally is a good example where reinvestment of capital at high rates of return will generally have enduring long-term value to a franchise.

Additionally R&D that's invested back into a platform business to add new features and generally strengthen the value of the platform will typically also provide a healthy payoff in either retaining existing customers or increasing the competitive barriers that need to be overcome in trying to overthrow an incumbent solution. The challenge is to identify where this reinvestment is adding value to an existing solution versus a need to innovate just to remain competitive.

Again being focused on a network effect that provides a protective shield around these businesses will allow for long-term rates of return on capital to be maximized and the business value of the franchise to be enhanced with incremental deployment of capital. My experience with these types of businesses and investments is that they are very early on in their long-term growth and evolution for these industries tend to be in areas that are rapidly changing such that this long-term deployment or investment of capital tends to almost be essential to maintaining their existing dominant positions.

The businesses that I've identified in my own portfolio as being ones that have the opportunity to compound capital at high rates of growth include businesses like Mercadolibre and Sea . The reinvestment of capital in these businesses is largely being done to further strengthen the existing lock on the customer, solidify network effects and better monetize customers in other ways. Deployment of capital into R&D will ultimately be done at high rates of return as customer attrition is minimized and network effects of strengthened.

Compounding machines can deliver long-term wealth to investors who are able to correctly identify these businesses. Those businesses that are capital light and still able to generate rates of revenue and operating income growth in the low double digits are able to magnify that wealth effect by doing aggressive repurchases of company stock such that low double-digit rates of growth can be transformed into into mid or high double digit rates of growth.

Re investors, who have opportunity to deploy capital at high rates of return are able to significantly expand their franchise over time, and strengthen any network effects that they may already have. While I tend to prefer the capital light businesses as presenting a lower risk profile, both can be highly beneficial for long term returns.

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