Anatomy of a Compounder Part 3: Capital Light Compounders

January 8, 2024

By Isaac Bowman, Investor
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In Part 3 of our Anatomy of a Compounder series, we will talk about companies that can compound cashflows over time without the need for very much, if any, reinvestment.

Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders

Anatomy of a Compounder Part 3: Capital Light Compounders

January 8, 2024

By Isaac Bowman, Investor
download document icon

In Part 3 of our Anatomy of a Compounder series, we will talk about companies that can compound cashflows over time without the need for very much, if any, reinvestment.

Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders

Anatomy of a Compounder Part 3: Capital Light Compounders

January 8, 2024

By Isaac Bowman, Investor

In Part 3 of our Anatomy of a Compounder series, we will talk about companies that can compound cashflows over time without the need for very much, if any, reinvestment.

Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders
Anatomy of a Compounder Part 3: Capital Light Compounders Anatomy of a Compounder Part 3: Capital Light Compounders

Anatomy of a Compounder Part 3: Capital Light Compounders

January 8, 2024

By Isaac Bowman, Investor
download document icon

In Part 3 of our Anatomy of a Compounder series, we will talk about companies that can compound cashflows over time without the need for very much, if any, reinvestment.

In Part 2 of our series, we spoke about our desire for our companies to keep all their cash flow, provided they can continue reinvesting it at a high rate of return. This allows for compounding growth of cash flows over time and is more tax efficient for long-term investors.

However, not all companies will compound solely from reinvesting cash flows. In Part 3 of our Anatomy of a Compounder series, we will talk about companies that can compound cash flows over time without the need for very much, if any, reinvestment. We like to call these companies Capital Light Compounders. Capital light compounders are able to grow their business at the same rate as a reinvestment compounder, but without having to deploy any capital. In other words, they can grow at a high rate of return, while giving money back to shareholders at the same time.

To illustrate what we mean by capital light compounders we are going to use two hypothetical companies, Company A and Company B. These companies share commonalities: each generates $100 in annual cash flow, has a 10-year runway for growth before reaching maturity and is capable of growing at an annual rate of 15%. In short, both are great businesses, but they grow in different ways:

Company A has found a niche industry that is not growing but is ripe for consolidation. It can reinvest all its cash flow through acquisitions at a 15% return on invested capital(ROIC) annually.

Company B has come up with a very creative go-to market engine where other stakeholders fund some of its growth and all new sales staff it hires are immediately profitable, allowing it to grow organically by 15% annually while being a profitable company and without needing significant capital investment.

As seen in the tables above, both companies A and B get to the same mature state of $405 in cash flow in year 10. However, Company B collected an additional $2,030 of cash flow along the way that it could either give back to owners, or allocate to other value creating activities. For this reason, and assuming competitive dynamics don’t change for either Company after the 10-year period, Company B is worth significantly more than Company A.  

It is hard to imagine how companies can manage to grow at 15% without having to significantly reinvest in the business, it seems too good to be true. We think we own some and would like to highlight two below:

Hypoport

Hypoport is a founder-led business based in Berlin, Germany that has developed software used by mortgage brokers. The German banking industry is very fragmented with many participants. Hypoport helps solve this problem for brokers by aggregating mortgage rates from all the different banks that are on its platform. It is essentially a menu that brokers can choose from to provide choice and transparency for their clients.

It was a long and arduous process to build the platform, with the Company founded over 20 years ago.  However, we believe that now the platform is built, it qualifies as a capital light compounder. The platform requires some maintenance, but Hypoport does not need to invest significant capital in its business to grow. Brokers select mortgages from banks listed on Hypoport’s “menu” and Hypoport collects a fee every time this happens. Hypoport has effectively set up an electronic toll road connecting German home buyers to banks.

We not only believe that Hypoport has built a terrific business, but also that it adds value to the German home buying process.

Goosehead Insurance

Goosehead is a personal lines (home and auto) insurance broker based in Westlake, Texas. It has hundreds of corporate employee insurance agents and manages a network of over 1,000 franchised insurance agents who operate under the Goosehead brand. These agents sell insurance policies on behalf of carriers and collect commissions from the insurance carriers whose product they have sold.

Over the last 20 years, Goosehead has developed a very innovative business model where it opens personal lines insurance franchises. Franchise owners pay Goosehead a fee to open a franchise which covers the cost that Goosehead incurs. Franchisees then get access to Goosehead’s training and service departments and technology tools. With these services and tools, Goosehead agents, on average, have superior productivity compared to the average captive or independent agent and can build significant wealth for themselves. For the ongoing value Goosehead provides, it collects royalty fees from its franchisees. It costs Goosehead very little money to open new franchises which then pay royalty fees to Goosehead as long as they remain in operation.

As a result, Goosehead has been able to grow revenue and operating profits over the last 6 years at compounded annual growth rates of 36% and 30%1,respectively, while paying out substantial dividends along the way. Perhaps more importantly, it adds value to everyone in its ecosystem, including carriers, franchise owners and consumers.


The people still matter

We own a concentrated portfolio of businesses that we think can deliver 15% net returns over the longterm2. Critical to this mission is finding businesses that not only can be purchased below their intrinsic value, but also finding businesses that are growing their intrinsic value at 10-15% over time2.We think many investors often underappreciate how long the runway is for some capital light compounders to grow their intrinsic value. The spreadsheets often look tremendous, but we would like to stress that in the real world, despite not requiring much capital, these companies take time to build (20+ years for Hypoport and Goosehead) and are still very difficult to operate successfully. We get comfort that we have not overpaid for these businesses by spending a significant amount of time assessing their real-world competitive advantages and company management’s ability to sustain them over the long-term.


1Based on Langdon’s forecast for 2023. Past performance is not indicative of future returns.

2These projected targets area based on our objectives and current internal analysis for which no assurances are being made as to when and/or if they can be attained.


disclaimer

This article is prepared by Langdon Equity Partners. Content in respect of the Langdon Smaller Companies Fund (ARSN 657 901 614 (the Fund) is issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238 371 (‘PFSL’) as responsible entity of the Fund. PFSL is not licensed to provide financial product advice. It contains general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so.

Past performance is for illustrative purposes only and is not indicative of future performance.

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