The Attraction Of Compounders (Part 2)

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Includes: ACNXF, BABA, CMG, MELI, ULTA
by: Integrator

I previously discussed my interest in compounding machines. Today, I will expand on this theme a little further.

Last time, I discussed my interest in compounding machines that were able to compound earnings with minimal capital. The other type of compounder or business that is highly valuable 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 of equity.

The challenge that arises with reinvestment businesses is the certainty of reinvestment at high rates of return. However, there are a few examples that I can think of where 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 rollout will largely extend on an expanded rollout, provided there is 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 of some instances where reinvestment of capital at high rates of return will generally add long-term value to a franchise.

Chipotle (NYSE:CMG) and Ulta Group (NASDAQ:ULTA) provide very good illustrations of this. Chipotle was able to steadily expand its fast casual restaurant concept nationally at double-digit rates of return on capital, maintaining largely similar economics with each new rollout.

Ulta, another favorite of mine, was similarly able to expand its revenue and store presence with strong returns on incremental capital. The company has expanded its store presence at a rate of return on capital in excess of 20%.

Similarly, R&D that's invested back into a platform business to add new features generally strengthens the value of the platform and will typically also provide a healthy payoff.

Such platform R&D that adds additional features to the platform helps in retaining existing customers or increasing the competitive barriers that need to be overcome by others in attempting to overthrow an incumbent solution. The challenge is to identify where this reinvestment is adding value to an existing solution and the lock that a business has on its customers 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 business growth and tend to be in areas that are rapidly changing. As such, this long-term deployment of investment of capital tends to almost be essential to be assured of 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 Alibaba (NYSE:BABA), MercadoLibre (NASDAQ:MELI), Aconex (OTC:ACNXF) and WiseTech. Alibaba and MercadoLibre are both investing capital to provide related platform offerings to strengthen the value delivered to consumers.

In MercadoLibre's case, this includes bolstering payment capabilities as well as a solid shipping offering. For Aconex and WiseTech, the reinvestment of capital is largely being done to further strengthen the existing lock on the customer and solidify network effects. Deployment of capital into R&D will ultimately be done at high rates of return, as an expanded feature set helps to minimize customer churn, while network effects are strengthened.

It's my belief that 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 being aggressive repurchasers of company stock such that low-double digit rates of growth can be transformed into mid- or high-double digit rates.

Reinvestors who have the 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.