One of my favourite podcast episodes is from the Focus Compounding where Geoff Gannon and Andrew Kuhn talk about compounders.
I’ve probably listened to it maybe more than a dozen times now and I would have to admit that there is a lot to unpack. It’s just over half-an-hour long but there’s a lot of concepts (specifically heuristics) when looking out for our favourite investing characteristics: compounders!
“FICO doesn’t need to have capital in the business … it grew its sales by like 3% or so but it actually shrank its assets, which is very powerful. That’s an amazing sign of a business.”8:21, Geoff Gannon
“It’s the relationship between the amount of new growth that they have, the incremental growth while you own the business, and incremental capital put into the business of shareholder money. So it’s the money that they retain from you, that would be from earnings, but instead is retained in the business, versus their sales growth …”9:02, Geoff Gannon
“The only way it can retain it and create value relative to what you can get generally in the market, is if it earns a greater than 8% return on what it retains. Which means, that that’s 1 divided by 0.08, that is 12.5. So if you think this company can grow EPS by 1 cent this year, you want to make sure that it does not retain more than 12.5 cents of your earnings. If it does, you have a problem. And in fact, there’s no value created that say grows 7% a year, while retaining all your earnings to do that.”11:16, Geoff Gannon
“But the other part of the calculation that is important and that people should think about is, that they think that a high return on equity is good, in all cases. But a high return on equity is going to be benefit you as a shareholder only to the extent that they are retaining earnings in the future or to the extent that they’re growing. Now, I would say growth without any retained earnings is the best of all. … You can have your cake and eat it too.15.21, Geoff Gannon
“… combination of sales growth, dividends and buybacks will cause an increase on a per-share basis … so that say they are growing at 6% a year, but if they buyback 3% of their shares a year and they pay a 3% dividend you’ve suddenly gone to a 12% return … and compounded that makes a huge difference.”16:00, Geoff Gannon
“So growth is not valuable unless you have a high enough return on equity, but the return on equity isn’t valuable unless you have growth.”16:31, Geoff Gannon
“What matters is a combination of adequate growth and adequate return on equity. And you see it over and over again which companies are successful. It’s like a Phil Fisher companies, or Peter Lynch invest in these, which are often things that grow at 15% year after year. The only way they can do that is if they have returns on equity that are in double digits, that’s how they grow at those rates all the time. They are self-financing most of it. That’s how you create value.17:12, Geoff Gannon