Quality - "Quality is never an accident; it is always the result of intelligent effort" - John Ruskin.
In his 2007 Berkshire Hathaway annual letter, Buffett talks about three types of businesses: ‘The Great; The Good; The Gruesome’. He goes on to explain, how a great business generates great returns on capital and requires no additional capital to grow; the good business generates good returns on capital but requires some capital to grow, whilst the gruesome business generates poor returns on capital and requires large amounts on additional investment each year.
Buffett summarizes it like this: “Think of three types of ‘savings accounts.’ The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”
We believe a quality business is one that has an economic model that generates sustainable, high (>20%) returns on capital. Critically, the cash flow that is returned to the businesses each year as a result of its investment activities, is ‘unencumbered’ or a true surplus over maintenance activities to the owners of the business. As the market values these annual ‘free cash coupons’, not non-cash accounting earnings.
One of the businesses in the quality compounder portfolio – Cochlear Limited (COH) – has generated an average return on equity of 37.5% over the past ten years. What enables Cochlear to earn such high returns on capital it its global market leadership in the very niche and highly complex industry of cochlear implants. Cochlear’s installed base of ~550,000 implants provides a very predictable future revenue stream as patients replace their sound processor (the external component) every five years, which is only compatible with a Cochlear implant. Cochlear’s high returns on capital, niche product offering, high switching costs and attractive industry position have enabled earnings per share to compound at 15.3% over the past 23 years … a remarkable track record which we believe is likely to continue.
Compounder - "Money makes money. And the money that money makes makes more money" - Ben Franklin
Without meaningful growth, a quality business that generates high returns on capital, is unlikely to compound overtime. It is likely to be a good dividend payer (depending on the valuation you pay), but not a compound earnings/share price story. We believe a business that can compound its earnings offers a greater margin of safety than that of a dividend payer over long periods of time.
Businesses can compound their earnings organically (new products, markets or industry share gains), through acquisition, buy backs or a combination of all three. We believe businesses operating in large, growing industries, where management can continually reinvest back into the businesses, offer the most attractive opportunities and thus this is where we spend the majority of our research hours.
In his book, ‘100 Baggers (Stocks that returned 100-to-1 and how to find them)’, Chris Mayer provides a case study on the world’s largest business - Amazon. For IPO investors, Amazon has generated a whopping 1990x or 19,990% return. Over the past 23 years, Amazon sales have compounded at an incredible 49.16% - propelling this earnings growth has been two very strong industry tails winds in e-commerce and cloud computing. Most importantly though, founder Jeff Bezos has not paid out one dollar of dividends and instead has been ploughing Amazon’s unencumbered cash flow back into high returning business activities each year.
We recently added a vertical market software business to the quality compounders portfolio – Objective Corporation (OCL). Objective is a market leader in mission critical, content management solutions for governments. Although OCL doesn’t offer the rapid earnings growth potential of an Amazon, we do however feel that at a much smaller scale, OCL has some very similar elements – those being – a founder leader with material skin in the business, who understands the importance of prudent capital allocation decisions, who is operating in an growing industry where he can continue to allocate growing amounts of free cash flow.
In closing, we will leave you with this quote from the book ‘Quality Investing’ (Cunningham, Eide. Hargreaves), which we hope encapsulates the businesses in the Quality Compounders Portfolio. ‘In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but when combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.’
Thanks for reading,
Quality Compounders Team (Lachie, Sam, Alex & Shaun)