Three ways to identify capital compounders

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There are thousands of publicly listed companies globally, yet only a small percentage generate long-term wealth for shareholders. In a study that analyzed the performance of 64,000 global stocks over a 30-year period, from January, 1990, to December, 2020, researchers discovered that only 2.4 per cent of stocks accounted for all net wealth creation of US$75.7-trillion. During this time frame, most stocks underperformed the returns of a U.S. one-month Treasury bill.
That’s a sobering thought for advisors and investors. How can we tilt the odds in our favour? One way is to seek out companies that are long-term compounders of value. The definition of a compounder is a company that delivers sustainable growth over long periods of time. These are the kinds of quality companies that investors should seek to acquire at a fair price and let grow. If compounders are the holy grail of investing, what kind of attributes should investors look for?
It’s important to distinguish between younger or emerging companies with unproven track records and established compounders that have successfully navigated various market and economic cycles. To identify established compounders, investors should focus on three key attributes: quality of the business, management team and total addressable market.
Quality of the business
A quality business should have a proven track record of profitability during various market cycles. Having a wide moat that provides both defensive attributes against competitors and pricing power is one way for a business to maintain a sustainable competitive advantage.
Another way to achieve that competitive advantage is to provide a sought-after good or service that makes demand “sticky.” One qualitative approach is to find out what customers and competitors say about the company and its offerings. Taking the “scuttlebutt” approach to understanding the company’s reputation and the quality of its goods or services can provide insight on the durability of the company’s free cash flow.
On the quantitative side, the investor should dig into the company’s financial reports, focusing on resilient revenue, high profit margins and high returns on invested capital. Is the company able to allocate its free cash flow to grow at an above-average rate? If so, it’s likely to be a good compounder of value.
Management team
Skilled managers are key to growing value for shareholders over the long term. For example, managers at Berkshire Hathaway Inc.’s BRK-A-N more than 67 operating subsidiaries are given great autonomy in decision-making. They’re simply required to provide regular financial statements and send over to Berkshire the excess cash not needed to grow their individual businesses. To deduce the quality of a company’s management team, investors should look at its track record. Senior management should be motivated and aligned with the company’s goal of sustainable, long-term value creation through a suitable compensation and incentive structure.
Total addressable market (TAM)
A company can have a great product or service and a skilled management team but be in a mature industry or one with many competitors. Companies in slower-growing sectors with smaller total addressable markets will benefit less from reinvesting their profits than those in rapidly expanding industries.
One Canadian company that’s a good example of a quality compounder is Kinaxis Inc. KXS-T, which provides cloud-based subscription software that enables customers to manage supply chains.
The company checks all the boxes mentioned above. Since its initial public offering in June, 2014, at $13, the share price has increased to around $160. The total addressable market is expanding, it has a strong underlying business and a proven management team.
It’s often said, “Compound interest is the eighth wonder of the world.” Investors in companies that are established compounders would concur with the sentiment.
Sharon Wang is senior equity analyst at PenderFund Capital Management Ltd. in Vancouver.
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