The Attraction Of Compounders

|
Includes: MA, PCLN, V
by: Integrator

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 (BRK.A, BRK.B) annual meetings. In that report, Buffett commented that the best kind of business is one where there is the opportunity to reinvest capital at high rates of return over a long period of time. Such a business tends to produce the best long-term 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 runway to deploy capital at high returns is not an easy feat.

The challenge here is being able to accurately assess whether a business's runway for growth may, at some stage, 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 result in a range of competitors moving into a market. This can affect the assessment of exactly how long the business has to derive super-normal rates of return.

In the absence of being able to accurately determine the length of time that's available for business to deploy capital at high rates of return, I contend myself with looking for investment opportunities in businesses that only require a modest amount of capital and yet still generate double-digit rates of growth. I then overlay on this an assessment of 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, the business is able to generate strong growth and profitability from internal growth. That leaves the business independent from a financing perspective and not reliant on debt.

More importantly, this can lead to some fantastic results when combined with an aggressive buyback program. Buffett references See's Candies as one of his investments that required minimal capital to produce exceptionally strong rates of growth. In this case, he took the excess cash that was generated 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 the business in such a manner. However, in some instances, they have something available to them that's almost as good. This is 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 there's a surplus of capital available to aggressively repurchase stock or plough into investments. 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 20-25% 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 the favorable economics for incumbents and allow them to prosper even if a more superior technology or service offering emerges.

The reason this is the case is that participants who are invested in the incumbent solution will typically be loath to move to another solution if other members of the network have not done so. For example, it's a lonely experience moving from a highly populated e-commerce network like Amazon (NASDAQ:AMZN) 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 these network effects are so powerful is that over time, it can effectively allow subpar technologies to remain dominant, irrespective of other technological improvements. In a business that's tech-focused and 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. I've been looking to concentrate my portfolio with these types of businesses. I stacked my Project $1 million portfolio with businesses that include MasterCard (NYSE:MA), Visa (NYSE:V) and Priceline (NASDAQ:PCLN). All are businesses that are able to grow revenue and earnings at double digits and have what I believe to be long runways for growth.

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

The high returns on invested capital and aggressive stock buyback programs have really juiced the stock performances of these businesses. Just how successful has such a strategy been for shareholders? Well, MasterCard, in particular, has rates of return on invested capital in excess of 40%, but has been aggressively buying back stock, reducing its share count by over 15% in the last decade. That has resulted in a 20x appreciation in an investment made 10 years ago.

Next time, I will discuss another type of compounder that I like to hold, which is where large amounts of capital can be deployed at high rates of return.