Compounding is one of the bedrock concepts of investing – “the ability to generate earnings from previous earnings”1. For us, “Compounders” are those companies that can internally compound their intrinsic value at a mid-teens annualized pace or better for an extended period of time, for example a company growing its business at a mid-teens pace will typically double its intrinsic value every five years.
These high quality companies usually have demonstrable track records of building wealth, generating high returns on invested capital as well as having strong internal reinvestment opportunities, and are run by management teams with unusually strong capital allocation abilities. This is a relatively rare combination.
Compounders are seldom available at classically cheap valuations, but account for the vast majority of the stock market’s long term returns. We aim to buy Compounders at sensible prices and then remain patient as the stock performance roughly tracks the wealth creation of the underlying business over time – “buy low and let grow”. We would sell if we felt valuations were becoming stretched or if we anticipated the compounding process was falling below our minimum threshold pace.
(Also see Close the Discount)