Compounding Quality: The Patient Investor’s Guide To Stock Market Success

17th May '23 by Megan Boxall

34 comments 5349 reads

A few weeks ago, my 14-year-old brother who has just started studying for his GCSE maths exams asked me to help with with a question on compound interest. As a passionate advocate for the importance of teaching investment concepts in schools, I was delighted. Compounding is one of the most valuable lessons a novice investor can learn and (for those with a quality-first mindset) is a sure fire way of instilling enthusiasm for the power of the markets.

Compounding is often taught in the context of personal finance: investor A spends the profits from his investments every year while investor B reinvests them, after 20 years investor B has 50% more money in his portfolio. That sort of thing.

But how about in the context of business reinvestment? The principles of compounding are the same: earnings are reinvested to generate additional earnings over time. But how do businesses do that? And why are some so much better at it than others?

The answer lies in a company’s ability to squeeze profits from its operations. Highly profitable businesses have a greater capacity to reinvest in expanding their business. As the chart below shows, that reinvestment initially leads to a gradual increase in profits, but over time this accelerates.

When it comes to compounding, it is important to remember that lines can bend.

All of this matters because the first investment strategy we have chosen to focus in our series is Quality Compounding, which works because the reliable and enduring profitability of some businesses means they can reinvest to stimulate accelerating profitable growth.

It’s an investment strategy employed by some of the world’s most revered investors. Warren Buffett, for example, who’s “favourite holding period is forever” and Terry Smith who seeks to buy great companies, not overpay and then “do nothing.”

But employing this strategy is not easy. To build a robust quality portfolio not only requires a good understanding of the concept of compounding, but also depends on patience, diligence and discipline. This article aims to:

Help you assess whether your mindset and timeframe are suited to the “compounding quality” investment style
Demonstrate why quality compounders are the ideal stocks for patient, diligent investors
Show you how to identify compounding quality companies
Demonstrate ways to implement this strategy
Illustrate the pitfalls that investors seeking quality compounders should…

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timarr

17th May '23

Interesting point about Relx (which I am a massive fan of) and AI

Good article Megan. I suspect that, l ike a lot of subscribers here, I'm attracted to the concept of quality compounding, but my execution is less than optimal ...

On the AI thing everyone is focusing on the threat, but it's a two-way street. The AI models need data to train them and the organisations that own the data will likely be winners. Relx (LON:REL) are a probable beneficiary - Pearson (LON:PSON) and London Stock Exchange (LON:LSEG) also, although in all cases that has to be caveated with the concern that managements need to be sufficiently capable to address the issues and I'm not convinced that's true with all of the aforementioned.

As BnB points out, the UK is not liberally supplied with quality compounders, but that's at least partly because our companies tend to get sold before they get big. I suspect that the UK isn't a big enough market to sustain companies through the growth stage, but it's probably also something to do with the woeful capital allocation policies of UK institutions. Katie Potts of Herald Investment Trust (LON:HRI) is excellent on these kinds of issues.

However, to add a few companies that haven't been mentioned so far - Renishaw (LON:RSW), Admiral (LON:ADM), Croda International (LON:CRDA) and possibly CVS (LON:CVSG). In the latter case, at least, that may be as much to do with the secular trend to humanise pets, but even Terry Smith thinks it's a good sector to look at, and who am I to argue?

Generally, though, the problem isn't identifying quality companies, it's buying them at the right price. Rob Arnott did some research that shows we're very good at identifying quality companies but habitually overpay, such that we end up underperforming the market. But, of course, the last eighteen months have been one extended buying opportunity - as Shelby Cullom Davis said:

"You make most of your money in a bear market, you just don’t realise it at the time"

BnB

We're very good at identifying quality companies but habitually overpay, such that we end up underperforming the market

Does it matter over a timeframe of decades whether we buy at a FCF of 2.75x instead of 3.25x if the latter simply isn’t on offer in the year we invest? A year’s good numbers and the gap is made up. And underperforming the market isn’t a problem to me if you still overperform on a risk-adjusted basis, which is what these quality compounders offer - uninterrupted operating performance improvements and a good night’s sleep.

Does it matter over a timeframe of decades whether we buy at a FCF of 2.75x instead of 3.25x if the latter simply isn’t on offer in the year we invest?

It does rather depends on how long you plan to live ... :-)

Chrisgsy

18th May '23

Megan

Thank you for a great article. It is always good to remind oneself of certain investing principles, as inevitably on a day to day basis it is too easy to deviate. Personally I feel that compounding and quality are some of the most important factors to be reminded.

One additional observation I would make is that some companies have excellent quality metrics, yet they are not necessarily good compounding opportunities. For example, fund managers are generally of low capital intensity/high ROCE, but they may not have great re-investment of profit opportunities. This often leads to profits being distributed. In my view this is why numerous UK fund management businesses have high dividend yields accompanying high ROCE. They are still potentially attractive investments, but not necessarily compounders.

Rusty2

Megan, welcome back, I thought you had left.

Ashtead (LON:AHT) is worth mentioning, this is the sort stock we are talking about, up over 300x in the last 20 years, is there a better performing stock? It does not qualify at the moment.

The Top Quality screen, has gone up 140% but the Top QM screen is up 289%, since inception. Adding momentum does increase performance. I tend to look at the top QM and VM shares on a regular basis. Last 15 months they have not performed that well, below the market.

Mark Carter

One way that I've been looking at lately ...

On the front page of Stocko, you can see the indices for FTSE100, 250, and AIM. Click on one of them, and sort by descending quality. Look for ROCE above 13% (avg 5 yr) and at least 5% CAGR divs. The good news is that it's all on the page. Then check ones that pass. Look for

Revenue growth > 5% avg over 5 years
Operating profit likewise
Net profit < net debt/5
low average share issues (< 2%, say)
increasing FCF/share over that period.

Also check the preceding 5 years before that (using the "Print" button). If all checks out, then it looks pretty good.

Here's some examples that I own:

3i (LON:III) (FT100)
IG group (LON:IGG) (FT250)
Renew Holdings (LON:RNWH) (AIM)

I think that one thing that can help here is to look at dividend cover. High dividend covers suggests that the company has lots of re-investment opportunities, whilst low one suggests that their opportunities are limited.

A good example of the latter is WD40. Apparently it's a very small company. I think that competitors have tried to enter the market, but withdrawn not long thereafter, as there is just no growth to be had. WD40 has a great ROCE, but limited re-investment opportunities. I think the same is for See's Candy, too.

You guys will be interested in an interview with Anthony Deden on the topic

He takes a little while to get into it, but it's an interesting watch.

Another semi-interesting one:

09:20 If you had invested equal amounts in the original S&P500, as founded in 1957, then you would have actually outperformed the S&P500 itself.

13:50 Lexington Corporate Leaders Trust, started 1935 in the US. It was founded before the investment act of 1940, so they weren't allowed to make any changes since that date. Amazingly, the fund has outperformed the S&P500 over the last 15 years (snapshot taken 11 months ago), and even on a 5-, 3- and 1-year basis.

19th May '23

How about Burberry (LON:BRBY)?

I rest my case!

I don't understand.

Worth looking at the price action after this week's report (also worth reading to identify the frailties) and compare to LVMH, Richemont, Hermes et al share moves after their recent TUs.

Chipspa

martinck1 I am also a big fan and holder of fundsmith. I believe he totally sold out of SAGE in early 21, however Nick Train is a holder (as am I) although he has said he is on a 'wait and see if they can do this' period with them. Sage do seem to be performing recently, growing their ARR and particularly their cloud business. So fingers crossed with them.

I own a lot of the shares discussed here, but additionally I like Computacenter (LON:CCC) which I think qualifies as quality.

Decent ROCE, CROCI, free cashflow generation and growth, high inside ownership, low Capex requirements, low valuation (using Fcf yield). Its also a key player in a growing market, so overall a thumbs up from me.

Sanjiv Shah

Great article Megan i have been exploring similar ideas too. I write about them at https://sanj2f3.substack.com/p...

MichaelFBS

Thank you for this fantastic article this is good timing as I have just read John Huber's blog (https://basehitinvesting.subst...) on "Sources of Enduring Business Success", having a long term horizon and compounding.

He also references Nick Sleep (whose letters I am currently working my way through https://igyfoundation.org.uk/w...) he paraphrases:

"is how the average holding time period for many of the stocks he owned was around 50 days, whereas he planned to hold these stocks for more than 250 weeks (5 years). I think his key observation is important: The marginal buyer who is holding a stock for 2 months is not placing much emphasis on that company’s competitive advantage because that advantage won’t matter much at all over the next few months;"

Finally from Warren Buffett's BPL letter from 1963:

"....Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to about $20,000. If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment."

"In an amusing story, Buffett figures the $24 paid to the Indians for the island of Manhattan was worth about $12.5 billion in 1965, working out to about a 6.12% compounded gain. But he was making a point: To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6½% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6½%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion."

As quoted from Warren Buffett's ground rules which I am finding very interesting.

Regards

Michael

I would add Games Workshop (LON:GAW) Bioventix (LON:BVXP)

simoan

20th May '23

I was going to make this same point. It’s a very important one IMO. You can’t simply equate a high ROCE to indicate a company is a compounder. It could just be the company needs very little capital to operate. That’s certainly the case with Bioventix (LON:BVXP) which is not a compounder in my book - any company that pays out cash in special dividends on occasion is definitely not a compounder.

All the best, Si

I’m sorry but one minute you’re talking about compounding over decades and the next it’s just relative share price movements over a week. Which is it to be? The latter is irrelevant IMHO.

I’m sorry but one minute you’re talking about compounding over decades and the next it’s just relative share price movements over a week. Which is it to be? The latter is irrelevant IMHO.

I disagree. It’s about the update that prompted the movements. Apologies if I didn’t make that sufficiently clear. The disappointing TU from Burberry (LON:BRBY) is a sign of its lower quality relative to the European big guns. The associated price movements are simply a graphical illustration of its capacity to disappoint. How is that not relevant to my assertion, made prior to the TU, that it is not of the same calibre? Bear in mind that most luxury retailers, bar Kering, another serial disappointer, have been delivering positive surprises this quarter - and not because they were previously under-followed or unadmired.

If you disagree, feel free to make the case for Burberry’s right to be mentioned in the same breath.

Lawrence Judd

31st May '23

Hi all,

We're excited that Megan has agreed to run a webinar on quality investing. It's next Tuesday at 6 p.m. UK time. Find out more and sign up here.

As ever, we'll send the replay direct to anyone who registers, regardless of whether you join us live.

Looking forward to seeing as many of you as possible next Tuesday!

Jonner

17th Jun '23

And how each affects market cap, ie overall valuation. - would be good.

Compounding Quality: The patient investor’s guide to stock market success

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Megan Boxall

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