3 Little Compounding Machines

Published in Investing Strategy on 10 March 2010

Here's one way to identify tomorrow's growth stocks today.

In 1972, Wal-Mart was a tiny retailer with just 51 stores (today, it has over 8,000). It had plenty of room to grow, and over the next five years, Wal-Mart began to show signs that it was going to be a major player:

Year19711972197319741975
Number of stores516478104125
Return on equity27%18%20%17%24%

Source: Wal-Mart annual reports

Not only was Wal-Mart expanding rapidly across the US, it was also generating solid returns to investors year after year. Over the next 34 years, Wal-Mart sustained superior business performance and generated 22.7% annualised returns for investors -- turning a $1,000 investment into over $1 million today.

That simple, huh?

Because of its tiny size, Wal-Mart may have seemed like a risky investment back then, but the example illustrates the profit potential in finding high-quality small businesses and giving them time to flourish. Because whilst small shares can be volatile, quality shares -- regardless of size -- are rewarding long-term propositions if bought at the right price and held for the long-run.

This philosophy has worked for US-based fund manager, Chuck Akre. Although his newest fund (Akre Focus) only launched in September, Akre's been in the business 40 years and during his 13-year tenure at his previous fund, he generated 12.6% annualised returns and never trailed the S&P 500 in any rolling five-year period. That is, in a word, impressive. And it's proof enough that Akre is a guy worth listening to.

What's his strategy?

I'm based in Northern Virginia so we're lucky to have Akre as a relatively close neighbour and he's been a long time friend of the Fool. When I spoke with him last month, Akre said he looks for "little compounding machines" -- businesses that generate consistently high return on equity (15% or more), with solid management teams and opportunities to reinvest extra cash to boost returns.

Wal-Mart was clearly generating those high returns back in 1976 thanks to its competitive advantages (low prices and efficient inventory management) and wide market opportunity. Firms that can do that can consistently reward shareholders through the miracle of compounding.

What do I mean by compounding? Let's say Company A has £1,000 in equity, which it can use to invest in projects earning 15% returns. At the end of year one, that £1,000 equity turns into £1,150. 

Not bad, but if that rate can continue year after year, consider the effects on growth:

Year23456
Return on Equity15%15%15%15%15%
Equity£1,322£1,521£1,749£2,011£2,313

By contrast, Company B, which generates just a 5% return on equity over the same period would have turned £1,000 into only £1,340 at the end of year six -- almost exactly where Company A left off in year two. By year six, Company A is nearly twice as far ahead of Company B and is creating much more shareholder value (assuming similar cost of equity for both companies).

There's always a catch

Of course, identifying these little compounding machines is rather difficult. For one, they're typically smaller firms with plenty of lucrative projects still available. Second, any business generating such high returns will inevitably invite competition, thus putting pressure on future margins.

So what are investors like us to do?

In a recent shareholder letter (pdf file), Akre gave some advice for the small investor: "So, you ask, 'What do we do now?' Or perhaps, 'How should we be thinking about our investments?' The individual investor has a great advantage, in that he is able to think 'long term.' … We also believe that the only thing to focus on is the fundamentals of the individual assets (stocks, bonds etc.)."

So let's focus on some fundamentals. Taking a page from Akre, I screened for companies with:

  • Market caps between £200 million and £1.5 billion

  • Return on equity greater than 15% in each of the past three years

  • Long-term debt-to-equity below 35%

  • Price to earnings ratio under 20

Here are three of my results:

CompanyMarket Cap3-Year
Average
ROE
LT Debt-
to Equity
Price to
Earnings
(trailing)
Carillion (LSE: CLLN)£1.3bn16.6%24%8.8
Rotork (LSE: ROR)£1.2bn41.9%0%17.5
Spirax-Sarco (LSE: SPX)£1.0bn20.7%14%18.4

Source: Capital IQ as of 10 March

Of course, these are just starting points for further research and are not formal recommendations.

All three of these shares pay dividends, but in most cases, "little compounding machines" will retain nearly all of their earnings -- rather than pay them out as dividends -- so they can reinvest more in high-rate projects. That's not always the case, though: Wal-Mart began paying dividends in 1974 and did just fine.

Final thoughts

As individual investors, our two greatest advantages over large institutional traders are our ability to be patient and finding overlooked small companies compounding at above-average growth rates. By making better use of the unique advantages we have, we stand a much better chance of achieving long-term investing success.

More from Todd Wenning:

US Fool analyst Todd Wenning is a shareholder of Akre Focus, but does not own shares of any company mentioned. You can follow him on Twitter.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

KJH118 11 Mar 2010 , 5:49pm

Why did you leave out Halma?
Market cap £956m, ROE 19.5%, debt/equity 21%, P/E 18%.
And a 30 year record of annual dividend increases of 5% or more.
And a 25 year record of return on sales 15% or more.

beastofbodmin 11 Mar 2010 , 8:01pm

What tools do you use to screen?

How much do they cost to use?

XMFPhila100 16 Mar 2010 , 1:27pm

Apologies for my slow response...

@ peterduncan,

I don't believe Halma showed up on my screen, but if it did, I just didn't select it for inclusion in the article. If I recall, there were about 40 results.

@ bestofbodmin,

The data provider we have here at Fool US is CapitalIQ, but it's prohibitively expensive for individual use. This free tool from msn will help get you started (http://uk.moneycentral.msn.com/investor/finder/custstoc.asp)

Foolish best,

Todd Wenning
US Fool analyst

beastofbodmin 18 Apr 2010 , 8:40am

Hi Todd,

I'm just into my first week of a free trail of Zack's tools.

I found

http://uk.moneycentral.msn.com/investor/finder/custstoc.asp

to be rather basic. I find the google screener to be best of the free online bunch.

Best,
BoB

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