Commentary: The quest for the ‘Holy Compounder'

The adage of vying to hit singles and doubles instead of home runs remains relevant to a "boring," quality-focused investment approach. Though speculative investments have the potential for extraordinary returns, many more result in permanent capital impairment.

However, we'd argue there's a difference between home runs derived from speculative investments, and those derived from companies that can continually compound over many years. The outsized leadership of high-quality compounders such as Apple Inc., Microsoft Corp., Amazon.com Inc., and Alphabet Inc. over the past decade suggest that a limited number of home runs can indeed have a profound impact at large.

It is perhaps no surprise that most of the companies mentioned above are technology focused. Given their asset-light nature and the growth of the markets in which they operate (and often create), technology companies can be terrific compounding investments, in part explaining the often-associated sky-high valuations reflecting this potential.

However, the prospect of rising interest rates has caused a rerating in many technology companies over the past few months.

Here's a framework we use for trying to narrow the probabilities in analyzing fast-growing technology companies in an effort to improve our odds of identifying compounders.

The first step is to evaluate a company's TAM, or total addressable market. There are legitimate criticisms of TAM as it is an unknowable and unauditable number. However, it also encourages us to think about the sustainability of a company's long-term growth.

In evaluating whether companies have the potential for a large TAM and a sustainable growth rate, we ask ourselves:

1. What is the company's current market share vs. its incremental market share? An early signal that Shopify Inc. had the potential to be a compounder was that even when it had a mere 1% market share, 90% of merchants establishing their online presence were choosing Shopify.
   
2. How scalable is the business? Put differently, if the company's revenues grew tenfold, what might that mean for its cost base and organizational complexity? Payments platform Adyen offers a unified payments solution to help companies integrate different payment schemes across geographies. Given Adyen's singular platform integrated across geographies, they have the ability to scale efficiently; i.e,. at higher incremental margins vs. their geographically siloed competitors.
   
3. What is the elasticity of demand? In its infancy, nearly everybody underestimated Uber Technologies Inc.'s TAM because the starting point was the existing taxi market. But Uber's value proposition created a demand-side response given the much improved customer experience. Companies with real options have the potential for more sustainable growth.
   
4. Relatedly, is the company creating genuine value? Microsoft is a wonderful business due to the dominance of its Office Suite and how embedded it is in its customers' processes. But Microsoft is doing much more than this: it is making IT departments more efficient, allowing their customers to focus on their core businesses. Genuine value propositions create greater TAM.

For compounders, growth alone isn't enough. Their growth needs to be wealth creating — the businesses need to earn high economic returns on the capital they employ.

The second part of the framework, therefore, is aimed at evaluating whether a company is growing profitably, and whether it is indeed generating true economic returns. Consider the time series of Shopify's reported returns-on-equity below. A cursory interpretation of the chart would suggest that a radical transformation took place in Shopify's business in the past two years. But was this really the case?

There are a record number of companies today that "lose money" on an accounting basis. Many of these companies genuinely are! But others simply demonstrate the growing irrelevance of accounting profits for some businesses. It is estimated that roughly two-thirds of selling, general and administrative expenses spending in technology companies is actual investment — outlays today with an expected payoff over many years in the future. These are treated as expenses on the income statement. But to understand whether a company is wealth creating, we need to recast spending and capital expenditure.

We frame this by asking: If the business stopped growing tomorrow, what would its profile look like? The following tables contrast Shopify with a more traditional business — energy producer Suncor Energy. Notice that in reclassifying a portion of Shopify's expenses as investments, with operating expense defined as the cost to maintain the current business, Shopify's profitability — along with its free cash flow multiple — looks a lot more attractive.

(Note that these adjustments go both ways — much of Suncor's reported investments in capex should instead be classified as expenditures — outlays needed to maintain the current levels of production.)

The work needed to make these adjustments requires an understanding of how a company is directing its cash flows. For example, Amazon disclosed that it has roughly 10,000 employees working on Alexa. These employees' wages are treated as expenses on an accounting basis, but Alexa is ultimately a bet on the future — an investment. By using a rough developer cost estimate of $200,000 per employee, we've reclassified this $2 billion of Amazon's expenses as investments.

The final stage in the framework is to evaluate whether a company can defend its TAM as it grows profitably. This is the most important part of the framework as high profitability and high growth likely invite competition. Companies need to have sustainable competitive advantages to roll up the compounding curve over time.

There are many frameworks for evaluating competitive advantages (think: Porter's five forces), but here are a few additional ways we consider a company's ability to maintain competitive advantages specific to technology companies:

1. Cost of ownership vs. inertia. We mentioned payments company Adyen earlier. Adyen's technically superior, all-in-one solution delivers payments technology to its customers at a lower cost of ownership, meaning that Adyen's platform reduces the number of payment providers and acquirers that need to be integrated by the merchant's IT team. A typical Adyen client saves $5 million per year vs. competing payments options due to error reduction alone.
   
2. Learning flywheel vs. sticky customers. A common competitive advantage exhibited by many strong technology business models is that once a product has been embedded into a customer's workflows, it becomes painful to switch providers given the integrations with other systems, the training required and the incremental cost-benefit analysis. But this can be a double-edged sword. SAP SE and Oracle Corp. are great examples of businesses with sticky customers, but where market leadership has led to increasing levels of technical debt — the costs and long-term consequences of underinvesting in technology. By contrast, companies like Google constantly learn from the market share they command and the data they aggregate, thereby continually improving the value-proposition to their customers.
   
3. Platforms vs. tools. Generally speaking, platforms tend to be more defensible than individual applications as, once adopted, they are more difficult to displace — think: the value of iOS or Android vs. any individual applications.
   
4. Culture. Given the importance of being able to attract talent, be flexible and innovate, corporate cultures can make a big difference over time.

In the end, much like the Holy Grail, the quest to identify "Holy Compounders" is an elusive goal. But given the potential these companies have to generate value over long periods of time, this three-step evaluation framework provides guideposts for separating expensive, speculative investments from those with the ingredients of genuine compounders.

Justin Anderson is an equity analyst at Mawer Investment Management Ltd., Calgary, Alberta. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.