How To Pick Stocks With Compounding Power

How To Pick Stocks With Compounding Power
Paul Allison, CFA

9 months ago10 mins

  • Compounding is the idea that when you increase a sum of money by a fixed percentage every year, it leads to an ever-increasing annual gain. So, if you can find firms that have the building blocks for producing sustainable profit growth, you’ve got a compounder candidate.

  • Focus on unearthing companies that have produced after-tax profit growth around 8% over a long period of time by delivering a sustainable ROIC of 20%. Those levels are just attractive enough without implying an elevated sustainability risk, and that should leave you with a big enough investment universe.

  • Then, sit back and watch compounding work its magic.

Compounding is the idea that when you increase a sum of money by a fixed percentage every year, it leads to an ever-increasing annual gain. So, if you can find firms that have the building blocks for producing sustainable profit growth, you’ve got a compounder candidate.

Focus on unearthing companies that have produced after-tax profit growth around 8% over a long period of time by delivering a sustainable ROIC of 20%. Those levels are just attractive enough without implying an elevated sustainability risk, and that should leave you with a big enough investment universe.

Then, sit back and watch compounding work its magic.

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Albert Einstein called compounding the eighth wonder of the world, and Warren Buffett attributes much of his vast personal fortune to its magic. In investing, if you have time on your side, buying and holding compounders can turn even small sums of money into big ones. So let’s take a closer look at how it actually works, and how you can recognize the company traits necessary to deliver impressive compounded shareholder returns.

1. What’s compounding?

It’s a simple mathematical idea: if you start with a small pile of money and grow it by a fixed percentage, then over time the incremental growth – the actual amount stacked on top of your pile – gets bigger. Leave it alone for long enough, and your pot of money will be bigger than you might think. This chart shows two investors starting out. Investor one gets going at age 25, sets aside $5,000 a year for ten years, and then stops. Investor two starts ten years later – at 35 – and sets aside the same $5,000 a year, but for 30 years. Both investors earn an annual return of 8% per year – roughly in line with the long-term level of equity returns.

Compound returns of two young investors.
Compound returns of two young investors.

Investor one put away a lot less money – $50,000 compared to investor two’s $150,000 – but that 10-year head start and the power of compounding meant that she had a bigger account balance at age 65. But the thing is: not all companies compound, so it’s important to seek out the ones that do.

2. How do you find companies that compound?

An easy way to think about firms that produce compounded returns is as individual savers. But, whereas individual savers put aside a certain sum a year and invest in, say, the US stock market, firms put a certain amount aside to invest it in their own business, by buying new equipment or opening new stores. If those investments earn a tidy profit, then as firms continue to invest in themselves, the amount of profit they generate compounds higher over the years. And because share prices trace profit growth over time, your return as an investor should compound too. Here’s a formula that captures all that.

Return on invested capital (ROIC) x reinvestment rate = profit growth

Meet Finimize Inc., not the world-class investment platform, but a slightly less world-class, but good-all-the-same widget-maker.

Finimize Inc.: a hypothetical widget-maker that generates a 20% return on invested capital and reinvests 40% of its profit to generate 8% profit growth.
Finimize Inc.: a hypothetical widget-maker that generates a 20% return on invested capital and reinvests 40% of its profit to generate 8% profit growth.

Finimize Inc. makes widgets, it earns a 20% ROIC, reinvests 40% of its profit back into the business, and consequently enjoys an 8% growth rate. Remember the magic formula: ROIC (20%) x reinvestment rate (40%) = profit growth (8%). Let’s go through each part of that equation in turn:

ROIC: 20%. Finimize Inc. starts out with $10 million and spends it all on ten widget-making machines at $1 million a pop. Each of those machines generates $1 million in sales but costs $750,000 to run, so they generate $250,000 in profit each – $2.5 million total profit for the company. Now that’s an after-tax profit of $2 million, assuming a 20% tax rate. So our much-loved widget-maker started with $10 million and in year one generated $2 million in profit: that’s a 20% return on that originally invested capital, or a 20% ROIC.

Reinvestment rate: 40%. Now, Finimize Inc. could reinvest all that $2 million and buy two more machines (at $1 million each), and some hyper-growth companies do, of course, invest all their profit (and often more on top) back into their businesses. But you’re looking for compounders, not growth stocks. One important difference between out-and-out growth stocks and compounders is sustainability. See, had Finimize Inc. reinvested 100% of its profit and been able to sustain a 20% ROIC, then its growth would be 20% (100% x 20% = 20%). The thing is, 20% growth is rarely sustainable over a multi-decade period, and it’s that sustainability factor that sets compounders apart. A compounder that grows at 8% for 30 years will make you more money than a growth stock that puts up 20% growth for a few years and then slows to, say, 4%.

Back to the example: Finimize Inc. reinvests 40% of its after-tax profit to buy new machines. That’d be $800,000, or 0.8 machines (I guess for the purposes of our hypothetical widget-maker, we’ll just assume fractional machines are a thing). Finimize Inc. is now the owner of 10.8 machines, which would churn out $200,000 in after-tax profit each, or $2.16 million in total. Notice that $2.16 million is 8% more than our original $2 million and so the formula holds: ROIC (20%) x reinvestment rate (40%) = profit growth (8%).

Now take another look at the table in the chart. If Finimize Inc. just kept reinvesting 40% of its profit in new machines, and the firm continued to generate 20% ROIC on that reinvested cash, its profit would keep growing at 8% a year. But this is where the power of compounding kicks in. After year seven, Finimize Inc. would be generating enough annual profit to buy 1.27 more machines, which would increase the firm's profit by $254,000 a year, which is 60% more than that year one profit increase of $160,000.

And that’s after just seven years. If nothing else changed and the firm just kept churning out 20% ROIC and reinvesting 40% of its profit then after 25 years it’d own 65 machines and be spitting out nearly $14 million profit a year, a 600% increase on year one. If Finimize Inc. was a real public company, and you owned its shares, you’d expect to see a 600% gain on your investment, then. Not too shabby.

How do you turn this into real-world stock picks?

I’ll start with growth and work backward. In my example, Finimize Inc. grew profit consistently at 8%. That’s a deliberate choice. See, looking for firms that grow any faster than that and you’re foraying into the world of growth stocks, which throws up the issue of sustainability risk again. So the lower the growth bar you set yourself – while still sticking to the realms of attractive, of course – the better your odds of actually finding compounders. Now, you’re bound to get a decent percentage of your stock picks wrong, and you’ll pick ones that do better (and worse) than 8%. But hopefully, over time, things’ll average out just fine. But if you seek only those hyper-growers, you’re almost certain to be disappointed – sometimes massively.

That’s why attractive but sustainable growth makes so much sense – and in my mind, 8% growth is just about ideal.

To see for yourself, go back in time and look at firms that have produced around 8% growth in profit. Remember this is profit and not earnings per share, so you’ll want to pull out the annual earnings-before-interest and tax (EBIT) and deduct a sensible tax rate (we used 20% for Finimize Inc., and I’d suggest using the same in your real-world analysis), and go back five or ten years and crunch the numbers. You can get EBIT numbers from almost any free investment tool, but personally, I use Koyfin. Firms post their annual filings on their investor relations websites too, and you’ll find EBIT in the income statement.

But you’ll also want to dissect the building blocks of that 8% profit growth. I suggest focusing on ROIC because ultimately if you get comfortable that a firm’s able to deliver sustainable ROIC, and it has a track record of 8% profit growth, then the reinvestment part is taken care of – the formula wouldn’t work otherwise.

The key here is to apply the same sustainability principle that we used for growth. If you look for only those firms that have been producing very high ROIC, you’ll run into the same sustainability risk. What’s more, a high ROIC bar whittles down your options pretty quickly, leaving you with too few options to build a properly diversified portfolio. My threshold is around 20%, and that opens up plenty of opportunities to invest in companies in different industries. Here’s the other formula you’ll need:

ROIC = after-tax profit / invested capital

Think of ROIC as the profit a firm makes on the amount of cash it invests in itself. On the one hand, plenty of firms can be super profitable, but if they have to spend every spare penny they make to maintain those profit levels, there won’t be a lot left over for shareholders. On the other hand, firms could try to get by without investing in themselves very much, but that’s likely to come at the expense of a good product or a strong brand that could command a high margin. ROIC, then is the sweet spot between the two, and a healthy ROIC shows a firm is striking the right balance.

Now, in the formula, the top half is easy enough; we saw it earlier: you just take EBIT from the income statement and subtract a tax rate (20% is a good one to use). Calculating invested capital, though, can be a bit tricky. The best way to do this is to go through a firm's balance sheet and add together all assets involved in its operations. Generally, that’s fixed assets – sometimes called property plant and equipment (or PPE) – along with intangible assets like goodwill (which is an accumulated amount related to past acquisitions) and something called net working capital (think of that as the day-to-day stuff needed to run a firm, like inventory).

To calculate net working capital for ROIC purposes, take current assets and subtract non-interest-paying current liabilities. Current assets are totaled on the balance sheet, current liabilities are too but, you’re looking for those that wouldn’t require any interest payments – the big two are accounts payable (this is just what the firm owes its suppliers in the near term) and accrued expenses (any type of prepaid expense).

If you add fixed assets and goodwill to current assets, and then subtract those non-interest-paying current liabilities, you get invested capital. All that’s left is to divide after-tax profit by that invested capital and you have ROIC. Check out the chart below, which pulls the relevant figures from Procter & Gamble’s income statement and balance sheet, and shows the firm enjoys a compounder-like 23% ROIC.

Procter & Gamble’s ROIC calculations for fiscal year 2022. Source: Koyfin.
Procter & Gamble’s ROIC calculations for fiscal year 2022. Source: Koyfin.

Now you can find all of this by scanning a firm’s balance sheet, which will be filed on its investor relations web page. Or again, free investment tools like Koyfin have all the financial statements in one place. A word of warning though: there are actually a number of ways to calculate ROIC and if you google it you’ll find a host of different methodologies. You can even Google ROIC for a firm and you’ll probably get some number. Just be careful and give it the common sense test. Be suspicious of very high ROIC – say, 40% or above. Some firms do generate very impressive ROIC (tech firms with high margins and low invested capital, for example), but they’re rare. The key is sustainability again. Plenty of firms produce high ROIC for one year, or even a few years, but then see it plummet.

Once you’ve unearthed those firms that’ve produced sustainable growth of 8% or so by delivering a consistently high ROIC of around 20%, then you can have a decent degree of confidence that you’ve found a compounder. Now all you need to do is build a diversified portfolio of them, and hold on for the long term. With luck, compounding will take over and make the magic happen for your portfolio.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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