A close look at a foundational element of our investment process.
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A close look at a foundational element of our investment process.
A close look at a foundational element of our investment process.
A close look at a foundational element of our investment process.
Over the course of 2023, we would like to go into more detail about a foundational element of our investment process. This is the official launch of our series on “The Anatomy of a Compounder.” The remainder of the Insight pieces can be found through our website (stay tuned for details), but we felt it was important to begin our journey in our market commentary.
We believe every business we own is, or has the potential to be, a compounder. Over the course of the series, we will give Langdon’s definition of a compounder and provide examples of different types of compounders via companies we currently own. We will also illustrate how companies fail to become compounders and lastly, why smaller companies are a great segment of the market to find compounders.
What is a compounder?
There is no “source of truth” for what defines a compounder. In our opinion, a compounder is a company that can consistently grow its intrinsic value at a high rate for a long period of time. For us at Langdon specifically, a high rate is approximately 15% and a long period of time is ten-plus years. Intrinsic value is in some regards a subjective measure. Thus, we use a combination of InvestedCapital1 and Free Cash Flow2 per Share as our proxies.
Most often, compounders are companies that reinvest their excess free cash flow (FCF) each year back into the business at a high and sustainable rate of return. They have a long runway of opportunity to reinvest this cash flow, and skilled management teams capable of both deploying the capital and operating the business. If returns on invested capital (ROIC)3 hold constant, invested capital and FCF will compound at the prevailing ROIC. A hypothetical example is below:
A second type of compounder are Companies that can grow without the need for capital reinvestment, which is extremely valuable. Imagine growing at 15% annually while also getting a dividend every year? We will explore both types of compounders in more depth in parts 2 and 3 of this series.
Why do we look for compounders?
We are firm believers that over time, a stock will grow at the rate at which the business has grown its intrinsic value. Over the last 96 years, US small caps have returned approximately 12% annually while US large caps have returned approximately 10%4. If we can find companies that can consistently grow their intrinsic value at well above that rate and buy them when we think they are materially undervalued, we think we will be able to outperform the index.
There maybe money to be made through other methods, such as buying mature businesses at low multiples and hoping for the multiple to expand, or trend following, or buying growth at any price. This works for many investors, and we commend them for their performance. However, this leads to higher turnover in portfolios, which is expensive (trading costs and taxes), and creates reinvestment risks for us as investment managers. It is hard to find great ideas, we are very selective. Owning compounders allows us to have a lower turnover portfolio, as management teams we back have intimate knowledge of their own reinvestment opportunities, enabling us to compound with less friction and at lower cost.
What to do when you find a compounder
We think that if we can find a few businesses with durable competitive advantages and long runways for reinvestment, so long as we do not overpay, we can earn high rates of return for our clients. We are very cautious of the price we pay, and we do not underwrite multiple expansion. That is not to say the work stops when we buy. We continue to research our businesses thoroughly and are always testing our hypotheses. However, in an ideal world we merely continue to own and in fact add to the positions over time when price materially dislocates from value.
The relentless pursuit of compounders
Oftentimes, compounders trade at higher multiples, which leads some to believe they are “expensive” and “risky”. Although that may be the case in many situations, we believe successful compounders have proven to be cheap in hindsight due to their ability to continue growing at a high rate for longer than people believe. Humans are not very good at thinking exponentially and it can be scary to model such growth in a spreadsheet. Despite these inherent difficulties, we trust our process to find quality compounders, and are on a relentless pursuit to find companies that will create value for years to come.
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.
While Langdon Equity Partners Limited (‘Langdon’) and PFSL believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Langdon and PFSL disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
FOR AUSTRALIAN CLIENTS:
The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.
Link to the Product Disclosure Statement: here
Link to the Target Market Determination: here
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Important information about each Langdon mutual fund is contained in its prospectus, AIF, fund facts document and in its management report on fund performance. Any potential investor should review these documents prior to making any investment decision relating to such fund. You can view copies of these documents by following the links below:
Link to the Langdon Global Smaller Companies Portfolio Disclosure Documents: here
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