Stockholm (HedgeNordic) – So-called compounder stocks usually describe growing high-quality companies that can compound earnings and shareholder value on a consistent basis by reinvesting capital at attractive rates of return. Because these companies compound capital superbly well, compounder stocks tend to rank among the best-performing stocks in the long-term. As Indian-American investor Mohnish Pabrai says, “the compounding machine stocks are the Holy Grail of investment.” Why isn’t everyone then focusing solely on finding and investing in compounder stocks? One possible answer is that these high-quality compounders tend to have some of the most expensive valuations in the market, thereby scaring off many investors.
Copenhagen-based MW Compounders, founded by Johannes Møller and Dan Wejse in early 2020, focuses on finding more attractively valued quality compounders by giving up some quality in return for a more attractive valuation. “When describing our investment style compared to other strategies, we have one parameter called the quality of the company. We try to be at the top third of the quality universe,” explains Møller. “We are not an outright quality strategy with only top quality companies, because we also have valuation as a parameter.”
“We always start out by trying to find the best quality companies, the great compounders, but the valuation needs to fit as well.”
“We always start out by trying to find the best quality companies, the great compounders, but the valuation needs to fit as well,” elaborates Møller. “That is why we are not at the top end of quality, because the highest quality companies often have a hefty valuation attached to them.” Even so, valuation always comes as the last item in the duo’s analysis process. “We look at the compounding characteristics of a company first,” confirms Dan Wejse. “We do not buy anything just because it looks cheap. If a company is too expensive but we like the business, we put it on the watchlist.”
“The highest quality companies often have a hefty valuation attached to them.”
MW’s Three-Rule Selection Process
Instead of following a long checklist of characteristics to find long-term compounders, partner-owned MW Compounders looks for three parameters in a company. “First of all, we look for businesses enjoying organic growth,” starts Møller. “The growth rate does not necessarily have to be 20 percent or even 10 percent, but the business needs to grow. If you want to invest with a company for 10 or 20 years, the company must continually evolve and grow instead of staying still or dying out slowly,” he continues. “There are very few examples of companies that beat the market over the long term without growing revenue.”
“We look for businesses enjoying organic growth. If you want to invest with a company for 10 or 20 years, the company must continually evolve and grow instead of staying still or dying out slowly.”
The second parameter Møller and Wejse are looking for is an attractive return on invested capital (ROIC). “If the return on invested capital is too low, then the company needs to invest a lot to grow the business,” explains Møller. “As an investor, the choice is either between getting growth achieved by reinvesting internally-generated cash flows or getting the cash flows,” he elaborates. “If you have a company generating high returns on invested capital, it can both grow and generate cash for shareholders.”
“If the return on invested capital is too low, then the company needs to invest a lot to grow the business.”
However, the measure of return on invested capital only shows the rates of return a business has earned on previously invested capital. High returns on invested capital are not of much use if the business cannot keep reinvesting at those high rates going forward. However, evidence shows that market-beating returns on capital are far more persistent than investors seem to think. “Investors can make two mistakes. One of them is assuming that a high ROIC will last forever, which is not what academia is supporting,” says Wejse. “Alternatively, the second one is saying that high returns are entirely competed away in the long term.”
“We try to balance those two views,” explains Wejse. “We assume that a portion of the returns is competed away for all companies, even the best companies.” The process of selecting the companies that can maintain high returns on invested capital requires judgment and experience. “We bring more than 15 years of experience on both the sell-side and buy-side to identify which companies can generate a high return on capital going forward,” says Wejse. “If we find a business with deteriorating returns on invested capital transitioning towards a cost of capital business, we will look away and try to find something else,” he continues. “We focus on companies that have shown to generate an excess return in its history, that is the starting point.”
“Lastly, there needs to be a good capital allocation.”
“Lastly, there needs to be a good capital allocation,” Møller lists the third parameter of their selection process. “After the company is done with its normal daily business and having done the necessary investments for its business activites, we analyze what they do with the cash that remains,” he continues. “Companies can either pay out the cash flows as dividends or do share buybacks, they can make acquisitions or they can leave the money on the balance sheet.” The duo, however, seeks to avoid companies with too much idle cash on their balance sheets that is not creating value. “It is fine with us for companies to have conservative balance sheets, but we do not like companies piling up too much cash. We also avoid companies that make a lot of expensive acquisitions that tend to destroy a lot of value.”
Apart from the three parameters, the team at MW Compounders does not have a “checklist of characteristics that we look for in a company,” according to Møller. “If we had a long checklist saying that a company needs to have a dominant position, the return on capital needs to be higher than 40 percent, management needs to be there for 20 years, there needs to be insider buying, we would just end up looking at very few companies,” he explains. “These checklists are perfectly fine, but we try to take a little more holistic view when analyzing companies.”
Valuation and Portfolio Turnover
For its portfolio of 20 to 30 names, “we buy compounder companies at attractive valuations,” says Wejse. “After we identify companies with the three parameters, only then we start looking at the valuation,” he emphasizes. Although the duo only buys “companies that we could theoretically own for ten years or more, the investment horizon can be shorter due to this valuation overlay,” explains Møller. “We tend to focus quite a lot on valuation.”
“We buy compounder companies at attractive valuations. After we identify companies with the three parameters, only then we start looking at the valuation.”
“Within our portfolio so far, we have had some investments that returned several times over the original investment in just a year, and some that lost 20 or 30 percent,” says Wejse. “Even though we like some companies very much, we may sell companies that are too expensive,” he continues. “With the valuation overlay, it is difficult to say how long we will keep a company in the portfolio. It depends on the market.”