Compounders: The Key to Long-Term Investment Success
Exploring the characteristics and real-world examples of compounding machines
What if I could identify the few businesses capable of compounding wealth over decades? For value investors, the compounders are the holy grail.
“The first rule of compounding is to never interrupt it unnecessarily.”
— Charlie Munger, former vice chairman of Berkshire Hathaway and Warren Buffett’s lifelong business partner
As a value investor, I’m drawn to businesses that exhibit strong fundamentals, led by talented managers, selling at reasonable prices. There’s a subset of companies that demand attention for their remarkable ability to compound value over time: the compounders. These businesses, when identified early and held for the long-term, offer a path to wealth creation that rivals any other investment, yet remain deeply rooted in the principles of value investing.
What is a Compounder?
A compounder is a business that consistently grows its free cash flow, and intrinsic value at a rate that significantly outpaces the broader market over the long-term. These businesses reinvest their profits at high rates of return, fueling a virtuous cycle of compounding. The power of finding and holding compounders cannot be overstated: identifying a compounder early and having the discipline to hold it through market fluctuations can be transformative for a patient investor’s portfolio.
Characteristics of a Compounder
What makes some businesses successful compounders? Several traits stand out:
High Return on Invested Capital (ROIC)1: Compounders typically boast high ROIC over a long period of time, which reflects their ability to efficiently allocate capital and reinvest at high rates of return.
Underlying profitability: While reported earnings (net income) may fluctuate, compounders often show strong operating income generation, maintaining a solid financial foundation to reinvest profits.
Predictable and recurring revenue model: Businesses with predictable and consistently growing revenues and businesses with growing recurring revenues, such as subscription models, provide a stable base for compounding growth.
Ample reinvestment opportunities: The ability to reinvest profits into growth opportunities at similarly high rates of return is key to compounding. Without this, profits simply pile up as cash or are distributed back to shareholders by means of dividends or buybacks, losing the magic of compounding. Operating in an industry with a large Total Addressable Market (TAM) reinforces reinvestment opportunities for growing companies.
Widening competitive advantages (moats): Compounders often have widening moats, whether through brand, network effects, or technological superiority, that protect their market position and allow for sustained growth.
Adaptive culture and leadership: Strong company culture, often driven by CEOs who embody values like humility and adaptability, is critical for overcoming the inevitable challenges that come with growth. Many great compounders are led by founders who remain actively involved or CEOs that have a substantial part of their net worth tied to the business performance ensuring the company stays aligned with its long-term vision.
Not every compounder will exhibit all these traits in equal measure, but the presence of a combination of these factors is indicative of a potential compounder.
Now that we’ve established the traits of successful compounders, let’s explore some real-world examples that embody these principles.
Real-World Examples: Connecting Different Types of Compounders to Investor Profiles
Visa (V 0.00%↑) and Mastercard (MA 0.00%↑): Payment processing networks Visa and Mastercard are prime examples of compounding machines operating in a duopoly. With minimal capital expenditures and the ability to scale globally, these businesses generate enormous cash flows, which they reinvest into growth opportunities, share buybacks, and dividends. Their duopoly market position and global scalability offer a compelling case for investors who prioritize security and consistency in their portfolios.
Over the last decade, these compounding machines have maintained their ROIC at an average of 27.64% and 91.43%, respectively, compounding free cash flow per share at rates of 14.83% and 17.05%, achieved through a combination of total free cash flow growth and share buybacks. They have also increased dividends at a Compounded Annual Growth Rate (CAGR)2 of 15.44% and 17.08%. This compounding growth is ultimately reflected in share price appreciation, with CAGR of 18.49% and 21.87%, respectively, extraordinary for large and established companies, all while maintaining relatively predictable business models.
Amazon (AMZN 0.00%↑): Amazon might seem unconventional for a traditional value investor, but for those willing to embrace technology-driven business models, it represents a powerful compounder. With its relentless focus on reinvesting profits into high-growth areas, Amazon is ideal for investors seeking long-term capital appreciation in innovative industries. The long-term vision of Jeff Bezos, and now Andy Jassy, has allowed Amazon to focus relentlessly on customer satisfaction and reinvest profits into new areas such as cloud computing, automated logistics, and becoming an advertising platform.
The company reinvests its earnings at high rates of return (with a 10-year average of 10.87%, currently at 18.26%), resulting in exponential growth that has been reflected in share price appreciation, achieving a CAGR of 26.78% over the past 10 years.
If you’re interested to learn more about tech-driven and innovative business models, I’ve discussed these topics in a previous article.
Berkshire Hathaway (BRK.A / BRK.B): Berkshire Hathaway is the quintessential compounder for investors who value conservative, long-term growth. With its focus on acquiring high-quality businesses that generate substantial cash flows, Berkshire provides a diversified and steady growth vehicle. It appeals to those seeking a business with a disciplined approach to capital allocation and a track record of compounding intrinsic value over decades.
Buffett’s focus on businesses with durable competitive advantages enables steady compounding over time, reinforcing its alignment with value investing principles. The company achieved a CAGR of 19.8% between 1965 and 2023 compared to 10.2% of the S&P 500 index.
Constellation Software (CSU.TO): Constellation Software is a prime example of a well-managed serial acquirer, appealing to investors who appreciate businesses with a disciplined and strategic acquisition approach. By targeting niche software companies with stable cash flows and reinvesting in further acquisitions, Constellation offers a growth path for those who see value in a diversified and scalable business model driven by technology.
The compounding effect has been remarkable, with Constellation producing consistent double-digit returns year after year by carefully managing its capital and focusing on long-term growth. Over the last decade, the company has averaged a 43.04% return on invested capital, compounded free cash flow per share at 20.88%, and achieved a CAGR of 31.96% in share price appreciation.
Building Wealth with Compounders: Lessons from Investment Legends
When viewed through the lens of value investing, compounders offer immense value not through traditional metrics like a low Price to Earnings (P/E)3 ratio, but through their ability to internally generate and compound value at high rates of return without relying on external financing. This is where the time horizon becomes crucial. Munger famously said:
“If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
A company compounding its returns at 18% annually will naturally see its stock price reflect that over time, even if initial valuations seem high compared to the market average. Munger highlighted patience as the essential ingredient when investing, especially in compounders:
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.”
In his 1992 shareholder letter, Buffett succinctly defined the key quality that distinguishes the best businesses:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
I like to believe that when Buffett wrote this in early 1993, he was referring to compounders. The true value of such businesses lies in the quality and durability of their compounding engine.
In his 2022 shareholder letter, Buffett attributed much of his success managing Berkshire Hathaway from 1965 to 2022 to a dozen key investment decisions, all of which involved investing in companies that compounded value over decades:
“In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. […] Our satisfactory results have been the product of about a dozen truly good decisions - that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”
Buffett elaborates in the letter on how this long-term perspective has yielded enormous benefits, both in terms of capital appreciation and dividends. Notable examples include Berkshire’s early and substantial investments in Coca-Cola and American Express, two stalwarts that continue to be cornerstones of its publicly listed portfolio. He also uses a metaphor to convey his belief that exceptional investment performance results from a few outstanding investments held for an extended period:
“The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders.”
Mohnish Pabrai, a self-described ardent disciple of Buffett and a respected value investor, has attempted to distill the list of key investment decisions to which Buffett referred. He has presented this list on several occasions, most recently during an investors presentation at a mutual fund that he manages, Pabrai Wagons Fund:
All key investment decisions but one (hiring Ajit Jain), according to Pabrai, involved investing in compounders that have compounded value over a long time.
In 2023, Pabrai shared his insights on Buffett’s 2022 shareholder letter during a presentation at the University of Nebraska in Omaha. I highly recommend watching at least the first seven minutes of this recording, as it provides a particularly valuable perspective.
Revisiting Benjamin Graham’s Views on Growth Companies
Benjamin Graham, the father of value investing and mentor to Buffett, recognized the appeal of growth stocks and cautioned investors against buying them at inflated prices:
“The term ‘growth stock’ is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future. […] Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.”
While he might not have used the term compounders, he did discuss growth companies, defining them as businesses that have shown significant past growth and are expected to continue this trajectory. This definition doesn’t fully align with the modern understanding of compounders; however, many of today’s compounders have undoubtedly performed well recently and appear likely to sustain their growth moving forward.
If you’re interested, you can read more about the modern relevance of his teachings from The Intelligent Investor in a previous article I’ve written.
Graham cautioned that investing in growth companies comes with unique risks, particularly the danger of overpaying for future growth expectations. In The Intelligent Investor, he wrote:
“There are two catches to this simple idea [the idea of investing in growth companies]. The first is that common stocks with good records and apparently good prospects sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward.”
Graham’s view on growth stocks can be summarized as follows:
Valuation concerns: Growth companies often come with high valuations, meaning their future success is already priced in, limiting upside potential.
Sustainability of growth: Genuine growth companies are rare, and it is challenging for most to sustain rapid expansion over the long-term.
Analyst judgment: Forecasting a company’s long-term prospects is inherently uncertain, leading to a high probability of misjudgments and false positives.
Graham’s caution was rooted in the context of his time: the economic environment he operated in offered fewer growth opportunities, and the odds of correctly identifying a growth company were low. Today’s economic landscape is constantly evolving, with scalable business models that didn’t exist in the previous century. This environment allows level-headed investors to reassess the odds and implications of investing in growth companies, particularly in compounders.
While Graham’s caution remains valid, today’s innovative business models offer a broader field for discerning investors to apply his wisdom.
Assessing Today’s Compounders with Graham’s Framework
Let’s evaluate today’s market landscape through the lens of Graham’s view on growth stocks:
Is growth priced in? Often. During periods of market euphoria and greed, quality companies are not immune to overvaluation. This is especially true for companies with strong growth prospects, as investors sometimes overlook the importance of price or, worse, buy into them at any valuation, as seen during the dot-com bubble. Hyped growth stocks may trade at elevated prices. Conversely, there are times when market participants collectively fail to recognize the potential ahead for certain businesses, particularly following disappointing short-term developments at a company or when companies discover new ways to expand beyond their initial markets, creating unexpected growth avenues.
How prevalent are growth companies today? The landscape has shifted significantly since Graham’s era. Over the past decades there has been a tremendous wave of disruption across industries, with innovative companies emerging and growing at an unprecedented rate. This suggests that growth companies are more common today, increasing the likelihood of finding genuine compounders.
Is growth predictable? Yes. Predictability has improved with the rise of business models featuring recurring revenues, such as subscription services and Software-as-a-Service (SaaS). Additionally, many sectors now exhibit a winner-takes-all dynamic, where dominant players consolidate their positions over time, strengthening their competitive moats and increasing the predictability of their growth.
Constructing an Investment Portfolio with Compounders
In building my portfolio, I apply the principles of value investing to identify compounders with the potential for long-term growth. The goal is not just to find businesses that exhibit high growth potential but to acquire them at reasonable prices, ensuring that I avoid overpaying while benefiting from their compounding effects. To achieve this, I focus on several key steps:
Research and analysis: Before adding a company to my portfolio, I conduct thorough research into its business model, financial health, and competitive position. I prioritize businesses that consistently generate high Return on Invested Capital (ROIC) and show a disciplined approach to reinvestment, as these are critical indicators of a company’s ability to compound value over time.
Evaluating management and corporate culture: Great compounders are often led by visionary CEOs with a long-term mindset. I look for leaders who have a proven track record of capital allocation, exhibit humility, and remain adaptable. An owner-operator mentality, where management has substantial skin in the game, is also a significant factor in my decision-making.
Focusing on industries with large TAMs: Companies operating in industries with large or expanding Total Addressable Markets (TAMs) provide the best opportunities for reinvestment and growth. I seek businesses with scalable models and innovative approaches that allow them to capture and expand market share effectively over time.
Valuation discipline: Even when identifying promising compounders, I remain disciplined about valuation. Paying a fair price relative to intrinsic value is acceptable for wonderful companies. By buying at reasonable prices, I not only maximize my potential returns but also protect my portfolio from downside risk if growth expectations fall short.
Monitoring and reassessing: Investing in compounders requires patience, but it also involves active monitoring. I regularly reassess each position, ensuring that the company continues to meet my investment criteria and that its competitive advantage remains intact or, better, widens over time.
By staying true to these principles, I aim to build a portfolio that captures the value of compounding machines while adhering to the fundamentals of value investing. This approach should provide a path to sustainable, long-term wealth creation, aligning with the wisdom imparted by investment legends.
Conclusion: Navigating the World of Compounders
Investing in compounders requires a long-term horizon and discipline. Unlike traditional value plays, which often yield gains within a few years when the market corrects a mispricing, compounders take time to bear fruit. The market may not always recognize the value of compounding, especially in the short-term, and patience becomes the most crucial attribute for investors. Compounders reward those who can look beyond market fluctuations and focus on the underlying business’ ability to grow and compound value over time.
The challenge for level-headed investors is to identify businesses that can generate high returns on capital, have ample opportunities for reinvestment, and exhibit the discipline to reinvest effectively. While these businesses may not appear cheap when viewed through traditional valuation metrics, their true value lies in their potential for exponential growth over the long-term.
As Graham highlighted, the risks of overvaluation and the unpredictability of growth are real concerns. However, today’s dynamic economic environment presents more opportunities for scalable business models than ever before. By critically evaluating these opportunities and staying true to the principles of value investing, I can navigate the evolving landscape and position myself for long-term success.
For those with the discipline to hold through market noise, compounders represent a powerful force for wealth creation. They prove that value investing isn’t just about finding undervalued stocks; it’s also about identifying exceptional businesses with the potential to grow intrinsically over many years. Buffett’s wisdom rings true:
“The weeds wither away in significance as the flowers bloom.”
In other words, it takes just a few outstanding investments to achieve exceptional results. By recognizing and investing in these real-world compounding machines, investors can capture the outsized returns that accompany businesses capable of sustained, long-term growth.
Return on Invested Capital (ROIC) is a measures a company’s efficiency at allocating the capital under its control to generate profitable returns. It is calculated by dividing the company’s net operating profit after taxes (NOPAT) by its invested capital, which typically includes equity (book value) and total debt (current and long-term) used for operations, excluding cash and cash equivalents. ROIC provides insight into how well a company is using its capital to generate profits and is often used as a key indicator of a company’s ability to create shareholder value.
Compounded Annual Growth Rate (CAGR) represents the mean annual growth rate of an investment over a specified period, assuming the profits are reinvested at the end of each period. It is calculated using the formula:
where n is the number of years. CAGR provides a smoothed rate of return, useful for comparing the growth rates of different investments.
Price to Earnings (P/E) ratio is a valuation metric that measures a company’s current share price relative to its per-share earnings. It indicates how much investors are willing to pay for each dollar of earnings, providing insight into whether a stock is overvalued or undervalued relative to its earnings performance.