MI314: The Art Of Quality Investing w/ Compounding Quality

25:49But it's never too late to get smarter about stock investing from the ground up. At The Investors Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you or for anyone in your life who you might want to share the gift of knowledge with. With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more.

26:28To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. Now that the audience understands the importance of ROIC, let's go over the major ways this can impact a business's returns. A high ROIC is great, But if a business has to return all of its capital to shareholders rather than reinvest in itself, the overall returns will be much lower. Can you go over why this is? Excellent point, Kyle.

27:08Probably everyone knows the following code of Charlie Munger. Over the long term, it's hard for a stock to earn a much better return than a business which underlies its earnings. If the business is 6 % on capital over 40 years and you hold for that 40 years, you're not going to make much different than a 6 % return. even if you buy it at a huge discount. Conversely, if a business is 18 % on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result. So here, Charlie says that in the long term, stock prices tend to follow the return on invested capital.

27:46The higher the return on invested capital, the better your return for an investor. But it's very important to highlight that the above is only true when a company has plenty of reinvestment opportunities. So when a company has a very high return on invested capital, let's say 30%, but they don't have any reinvestment opportunities, this high return on investment capital doesn't have any practical value at all. And let's give you an example to make everything more clear. Let's say that we have two companies, Quality Inc. and Dividend Inc. Both companies generate 100 million in earnings and they need 500 million to operate.

28:24So 500 million is their invested capital. Furthermore, both companies have a return on invested capital of 20%. So basically, Quality Inc. and Dividend Inc. have exactly the same fundamentals, but there's only one difference. Dividend Inc. has no growth opportunities and distributes all earnings as a dividend to shareholders. And as a result, Dividend Inc. will distribute 100 million to shareholders this year and will still make 100 million in 20 years and still have a dividend of 1 million in 20 years. On the other hand, Quality Inc. is active in a secular trend and they are able to reinvest everything in organic growth.

29:04This means Quality Inc. pays no dividend to shareholders and reinvest everything in itself. So I'll just give the audience a few seconds and maybe also a good question for you, Kyle. Can you guess how much profit Quality Inc. would make if they would be able to do this for 20 years? So the correct answer is 3.8 billion. So over 20 years, they would have grown their earnings from 100 million to 3.8 billion. That's a huge difference compared to Dividend Inc, where the earnings are still 100 million in 20 years. So what they can learn from this? Well, a high return on invested capital in combination with plenty of growth opportunities are really the golden egg for investors.

29:44It will result in exponentially growing free cash flow per share. So the trick is to really define those companies. So companies with a high and consistent return on investment capital in combination with plenty of growth opportunities. Excellent description. So a business like Seize Candies is a great example that ticks many of the boxes of a quality investment, but it does have one inability that you just pointed out, which is the inability to reinvest in itself. So do you consider a business high quality if it does not have reinvestment opportunities? The truth is that there are only a handful of quality companies with plenty of reinvestment opportunities.

30:22They are very, very hard to find. So quality stocks are often very capital light, which means that they don't require a lot of capital to grow. And C-scandies is a beautiful example of this. They don't reinvest a lot of their cash flow, but they have done really well over the past few years and decades. One of the beautiful things about C-scandies is that they have a lot of pricing power. So every single year, just after Christmas, sees candies, raises its prices. And Charlie Munger once said the following about this. There are actually businesses that you will find a few times in a lifetime where any manager could raise their return enormously by just raising prices.

31:03And yet they haven't done so. So they have huge untapped pricing power that they are not using. And that's the ultimate no-brainer. So this means that even when a company doesn't have a lot of reinvestment opportunities, you can end up with great investment results. But in general, I'd say that the more reinvestment opportunities a company has, and that in combination with a high return on invested capital, the better. So you've already mentioned the importance of moat in your tenets of quality investments. However, identifying a moat can sometimes be one of the hardest parts of the analytical process.

31:39A business such as Amazon was quietly building Amazon web services in the background underneath competitors' noses for years before they were forced to disclose it. What are the best strategies for investors to use to identify a business's moat when a business is actively trying to keep its advantages a secret? Before we dig into this, I think it's really important to understand that there are five different kinds of moats a company can have. So a company can have a mode based on cost advantages, switching costs, network effects, intangible assets, or efficient scale. So a company can have a mode based on cost advantages.

32:16These companies are able to produce products or services at lower costs than its rivals. Think about companies like IKEA and Walmart, for example. A company can also have a mode based on switching costs. So the costs a consumer pays are the results of switching brands or products. It's also important to highlight here that these costs can be monetary, but also psychological, effort-based and time-based. Think for example, about switching from Apple to Microsoft or the other way around. Customers of Apple are most of the time very loyal to Apple and very sticky. Why? Because it takes time if you want to switch to learn, to work in the Microsoft environment.

32:59and so on. A company can also have a mode based on network effects. This is my favorite kind of mode. And also Morningstar has done some research about this. And they state that modes based on network effects are the most resilient and also perform the best in the long term. And a network effect exists when a value of a product or service grows as its user base expands. So each additional customer increases the value of the product or service exponentially. Think about companies like Facebook, Meta platforms, but also American Express, Amazon, or Alphabet. The company can also have a moat based on intangible assets.

33:37So this includes a competitive advantage due to the strong brands, the patents, the regulatory licenses, and so on. And a great example of this is Coca-Cola. Warren once said, if you gave me 100 billion and take away the soft drink leadership of Coca-Cola in the world, I'll give it back to you. And I say to you, it can be done. So that's a great example of a moat based on intangible assets or a strong brand. And then last but not least, a company can also have a moat based on efficient scale. So in some markets, there is only room for one or a few players. And these kind of markets are called monopolistic or oligopolistic markets.

34:17Great examples here are S &P Global and Moody's or companies like Union Pacific, for example. Personally, as we already briefly touched on, I always use two very simple criteria to quantify the moat. One, you want the gross margin to be larger than 40 % and two, you want to return on invested capital to be larger than 15%. And you also want these gross margins and return on invested capital to be very high and robust as it's an indication that the company has a moat as well as pricing power. So Morningstar, for example, gives the following definition to a company with a wide moat. A wide moat is given to a company that can earn a return on invested capital larger than the weighted average cost of capital or WAC for over 20 years.

35:03And as you know, a company only creates value by reinvesting in organic growth when their return on invested capital is larger than a company's WAC. So personally, for me, I will never invest in a company that is still building a mode. And if you ask me, for example, for Amazon 10 years ago or 20 years ago, it was really difficult to estimate where the company would be today. And as I already said, I don't want to invest in the next big thing. Instead, you want to invest in companies that have already won. So this also means that you'll miss a lot of companies because you will never invest in them, like Amazon, for example.

35:46But for me, that's no problem at all. I wouldn't consider a company that is active in a rapidly changing industry within my circle of competence. So what I'd really try to do is I want to invest in companies that had a moat 10 years ago, have a moat today, and where I think that the company will continue to have a moat in 10 years from now. So these companies are really doing something unique, and it's very hard for rivals to take market share of these kinds of companies. To quote Juan Buffett, it's incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals and actually do better than them in the long term.

36:26So now that we've spoken a bit about what makes a quality business, let's go over management. What are the key management qualities to search for that make a quality business even better? Very good question, Kyle. Via compounding quality, I also run my own portfolio that everyone can follow with full transparency. And the essence there is that the portfolio consists of three buckets. So first and foremost, you have the owner operator stocks. So these companies are still run by their founder. Think about companies like MedPace and Kelly Partners Group, for example. The second bucket are the monopolies and oligopolies.

37:04So where only a few companies dominate the entire industry. These companies, these kind of companies are usually great investments because they are able to operate on attractive conditions due to the lack of competition. Think about companies like Visa and MasterCard or S &P Global and Moody's. And last but not least, there's also a bucket with quality cannibal stocks. So quality stocks that are heavily buying back their own shares. As you know, when outstanding shares decrease, your stake in the company increases. And for example, when a company can buy back 50 % of its outstanding shares. The free cash flow per share doubles, so that can be very interesting.

37:46Examples of quality cannibal stocks are Ulta Beauty and AutoZone, for example. Now, you talked about management, and also for me, 60 to 70 % of the portfolio consists of owner operator stocks. In other words, skin in the game is very important for me. That's also something what surprised me from reading the 5 ,000 page document of Warren Buffett. Warren Buffett talks about the importance of great managers and skin in the game over and over and over again. So he always says, don't invest in companies who are, don't invest in managers who are doing it for the money, but managers who are already financially independent and are just still running the business because they love what they do.

38:31Now, why is skin in the game so important? Well, when a company has skin in the game as an investor, you increase your chances that the incentives of management and shareholders are aligned. It's also just true that companies with skin in the game outperform on average in the long term. So academic studies found that family companies and founder-led companies outperform the S &P 500 3.7 % per year and 3.9 % per year respectively. So to me, to be honest, that's quite funny that a basket with just family companies outperforms the S &P 500 by 3.7 % per year on average. Why? Well, when you look at the data, more than 19%, so 90 % of all professional investors underperform the market.

39:19These people are very smart. They spend more than 60 hours per week on researching stocks. And still, by just selecting a basket of stocks with high insider ownership, you would do better than almost all professionals. And still, by just selecting a basket of stocks with high insider ownership, you would do better than most professionals. Einstein once said that you should make everything as simple as possible, but not simpler. And I think that's also true in investing. So the KISS principle, keep it simple, stupid, is very important. And on the stock markets, there are multiple roads that lead to Rome.

39:56So what you should try to do is you should try to find an investment strategy that suits you and you should stick to it. To give two examples, value investing, when you just would buy the 20 % cheapest stock based on the P-E ratio, you would outperform the S &P 500 by 3 % per year over the past 50 years. And if you just would buy stocks with a wide mode, for example, you would outperform the S &P 500 with 4 % per year since 2000. So I'll repeat it once more because it's really important if you ask me. For quality investors, it's all about the following. One, buy wonderful companies. Two, led by outstanding managers.

40:37And three, you try to buy these companies trading at fair valuation multiples. So preferably you want a company that is still led by its founder or in companies where there is high inside ownership. And when you can find these kind of companies, you look for excellent companies led by a manager with high integrity and a strong track record in value creation. So one thing about looking at the returns of stocks through history is what the data say about market cap size in relation to returns of the business. What size of business should investors be looking at for the best returns on high quality businesses?

41:13Personally, I'm a bottom up stock picker. And by that, I mean that when I think a company looks attractive, I'll buy it regardless of whether it's a micro cap, a small cap, a mid cap, or a large cap. However, one of the key things I took away from working as a professional investor is that no one was looking at small and mid caps. I was involved in the rather small funds with around 200 million in assets under management. And we seldomly invested in companies with a market cap smaller than 500 million. So basically, every worldwide equity fund has companies like Apple, Microsoft, and Amazon in their funds.

41:53And this also means that the market is way more efficient for these large caps. So it's almost impossible to get an informational or analytical advantage by analyzing companies such as Apple. Warren Buffett used to say, well, if you want to be a great investor, go where the competition is weak. And that's exactly in the small and mid-cap space. So also the longer I worked in the industry, the stronger my belief that you can generate high returns in the small and mid-cap space. These companies aren't followed a lot by analysts. Fund managers can buy them due to the low liquidity. And as a result, the market is less efficient in this segment.

42:33So this means if you do your own homework well within space, you can do very well as an investor there. So academic research has also proven that small cap stocks perform better. So in his excellent book, Stocks for the Long Run by Jeremy Seigel, he concludes that between 1926 and 2006, the smallest decile stocks, so the smallest 10%, compounded at a compound annual growth rate of 14 % compared to 10.3 % for the S &P 500. So when you would only invest in small cap stocks and you add an extra criteria, you only invest in small cap stocks with a positive free cash flow, your outperformance would even increase further.

43:19So at compounding quality, our criteria for selecting stocks are very strict. So worldwide, there are 60 ,000 listed stocks, and we identified an investable universe of around 150 names. And this list contains quality stocks led by outstanding managers, but doesn't look at the valuation yet. So out of these 150 companies, probably more than 100 are way too expensive at this point in time. So the companies that remain are often smaller stocks that are not very well known by the general public yet. Think about companies we already talked about like MedPay, OTC Markets, or Kelly Partners Groups. But also companies like Games Workshop, Brown & Brown, or Juju Scientific.

44:02From a commercial perspective, probably way more people would be interested in the subscription of compounding quality when we would invest in the well-known large-cap quality names with less upside potential, at least if you ask me, like S &P Global, Microsoft, Apple, and so on. but to me that doesn't make sense. We really try to invest in companies with the best risk reward characteristics and some wonderful opportunities can be found in the small and mid-cap space. So as Charlie Munger has said, quote, no investment is worth an infinite price. And while Terry Smith has shown that quality businesses can be bought for an optically high price and still deliver stellar returns, I still think Charlie's statement holds true.

44:42Let's discuss how you determine what you should pay for a quality business to use a discounted cash flow, back of the envelope math, or something else the majority of the time. That's exactly true, Kyle. So even when you invest in the best company in the world, you can end up with horrible investment results if you pay too much. Regarding valuation, I think it's important to keep things simple and to use common sense. So for me, using complex formulas to determine the intrinsic value of a company to two decimal spaces doesn't make sense at all. As Keens once said, it's better to be roughly right than precisely wrong.

45:19And this is also true when investing. Personally, I use three things to look at the valuation of a company. So one, I compare the company's free cash flow yields with the average free cash flow yields the past five years. Then I use your earnings growth model. and third, I also use a reverse DCF or reverse discount cash flow model. Let's go through them all very briefly. So the first part, comparing the company's free cash flow yield with the average free cash flow yield of the past five years. This is very straightforward and something you can do in a few minutes. By doing this, you get an indication about whether the company is under or overvalued compared to its own historical average.

46:03Take the US beauty retailer Ulta Beauty for example. Today, Ulta Beauty trades at a free cash flow yield of 5.8 % compared to a five-year average of 3.9%. This already gives you an indication that the company looks cheap from a historical perspective. But you should take this magic with a grain of salt because it doesn't take into account future growth estimates. And that's exactly why I also use an earnings growth model and a reverse DCF. So regarding the earnings growth model, in theory, the yearly return you're going to achieve as an investor is very easy to calculate. So your expected yearly return is equal to the earnings growth plus the shareholder yield plus the multiple expansion or minus the multiple contraction.

46:52Whereas shareholder yield is equal to the dividend yield plus the buyback yield. I'll repeat this once more because it's really important. Your expected yearly return as an investor is equal to the earnings growth plus the shareholder yield plus the multiple expansion minus the multiple contraction, whereas the shareholder yield is the dividend yield plus the buyback yield. Why is this always true? Because in the long term, stock prices always follow the intrinsic value per share growth. Let's give an example to make everything more clear. We'll use Ulta Beauty again, and I make the following assumptions.

47:29Ulta Beauty will grow its earnings with 6 % per year over the next 10 years. The company will in the future have a shareholder yield equal to 3.4%. This is equal to the average shareholder yield over the past five years. And I also think Ulta is too cheap right now. So I think their PE or price earnings ratio will expand from 14.7 to 20 times earnings over the next 10 years. Then we're going to do the calculations, the easy math. Expected return is equal to earnings growth plus shareholder yield plus multiple expansion in this case, because we think all that beauty will become more expensive over the next decade.

48:11So here expected return is equal to 6%, the earnings growth, plus 3.5%, the shareholder yield, plus the change in the PE, which is the ending PE minus the beginning PE divided by the beginning PE. So here that's 20 minus 14.7 divided by 14.7. And if you do these calculations, you see that the expected return is 13.1 % per year for ultra beauty. And the question you need to ask yourself then as an investor is, am I happy with a return of 13.1 % per year? If that's the case, you should consider buying the company. If you are looking for higher upside potential, you should look for other investment opportunities.

48:58And then, last but not least, we also use the reverse DCF or reverse discounted cash flow to value a company. As Charlie Munger once said, if you want to find a solution to a complex problem, you should always revert. And it's better to be roughly right than exactly wrong. Now, what is a reverse DCF? Actually, it's exactly the same as a classical DCF, but now you put the upside potential at 0%. And the next thing you're going to do is you're going to look at what the implied free cash flow per share growth is based on the 0 % upside potential. And after that, you try to determine whether this implied growth is realistic or not.

49:43I'm just covering the basics here because yeah, it's quite difficult to explain a reverse DCF via podcast. Let's take the Ulta Beauty example again here. And what you'll notice when you do a reverse DCF, you'll see that there is an implied free cash flow per share growth of 5.5 % over the next 10 years. So when the company managed to grow its free cash flow per share by 5.5 % per year, shareholders will achieve a yearly return of 10 % per year as we use 10 % as a required return year. To put this number into context, it's very important to highlight that Ulta Beauty is a cannibal stock. So we basically at Compounding quality assume that Ulta Beauty will use 85 % of its free cash flow to buy back shares over the next decade.

50:34This would mean that over the next decade, they could buy back roughly 10 billion worth of shares. And at the current stock price, this would mean that Ulta Beauty could buy back roughly 50 % of its outstanding shares. As a result, the free cash flow per share for shareholders would grow at a bit over 7 % purely based on the share buybacks. This is already more than the 5.5 % implied in the reverse DCF. And this indicates that, at least to us, Ulta Beauty looks under credit today. Let's take a quick break and hear from today's sponsors.

51:48Thank you.

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54:31All right, back to the show. So now that we've discussed what makes a quality investment, let's discuss what makes a quality investor at the individual level. What qualities do you think make up a quality investor? Good question, Kyle. Lawrence Cunningham wrote a book Quality Investing, but he also wrote an excellent other book called Quality Shareholders. And I I think that it's important to highlight here that over time, a company always gets the shareholders it deserves. So to quote Buffett, if they focus their thinking and communications on short-term results or short-term market consequences, they will, in large part, attract shareholders who focus on the same factors.

55:13To me, there are five essential characteristics I believe a good investor has. So one, they always think on the long term. you don't think in corners instead you think in quarter decades. So great investors should take the short-term pain in order to get the long-term gain. This means that you filter out the noise and that you focus on what matters. And the long-term stock prices always tend to follow the intrinsic value per share growth. The second characteristic is that they train themselves to be fearful when others are greedy and to be greedy when others are fearful. It's very easy to say that you'll be greedy when others are fearful and fearful when others are greedy, but in practice, it's a whole different thing.

55:59That's why you should mentally prepare yourself for market downturns and tell yourself that you'll be excited when the market will go down and the other way around. That's exactly why I have some newspaper articles of big stock market questions in my office. So every time I go into my office, I see the articles of the crisis in 1930s, the dot-com bubble, the financial crisis, the crash in 1987, and so on. And I do this to constantly remind myself that over the next five or 10 or 20 years, the stock market will go down with 30, 40, or even 50 % one day, and that you should be ready for this. So just like Warren Buffett says, stocks are like hamburgers.

56:43And when you're going to eat hamburgers every single week for the rest of your life? Yeah, the question you could ask yourself then or Buffett asks to the audience is, would you then prefer lower or higher hamburger prices? Obviously, you would want lower hamburger prices because it will allow you to buy food for cheaper prices. Another very straightforward question. If you are going to buy a car from time to time, would you prefer lower or higher prices for your car? Well, obviously, again, you would want lower car prices. But now another question, if you are going to be a net saver over the next five or 10 years, should you hope for lower or higher stock prices?

57:26And the answer should be that you would want lower stock prices, even when you already have significant investments in the stock market right now. And it's something that's really important to understand. The only reason why it makes sense to wish for higher stock prices is when you're planning to sell your investments in the near future. So now we've talked about using a long-term mindset and to be fearful when others are greedy and to be greedy when others are fearful. The third point is, or the third characteristic of great investor is that they are very patient. So good investing should be like watching paint dry.

58:02As a quality investor, as already mentioned, we don't want to invest in the next big thing. Instead, we want to invest in companies that have already won. So quality stocks are often very, quote unquote, boring companies. Fees and costs harm your investment results. And it's often said that the best investor is a debt investor. So great investors are willing to do nothing at all for very, very long periods of time. Then we arrived at the fourth point and that discipline. So basically all investing is, is laying out some money today to get more money back in the future. Humans are not rational and we suffer from a lot of biases.

58:43And you should really be aware of this and always try to stay as rational and disciplined as you possibly can. That's also why checklists can help you a lot. Charlie Munger once said that no wise pilot, no matter how great is talent and experience, fails to use a checklist. Regarding this topic, I think the book Checklist Monifesto, and I'm probably pronouncing it wrong, but from Atul Gawanda is a great read. And then the last point, you should always keep learning. So great investors keep learning all the time and reading a lot is really an essential skill. You should try to go to bed every single day a bit smarter than when you woke up and you can't help become very successful in whatever subject in life.

59:27So when you spend one hour a day reading books and you read one annual report a day, you'll become a learning machine. So compounding works in investing, but also in health, wealth, and knowledge. So to summarize, I think investors have five characteristics or great investors have five characteristics. They always think on the long term. They are fearful when others are greedy and the other way around. They are extremely patient. They are very disciplined and they always keep learning. So once an investor makes an investment into a quality business, what general developments should they be focusing on in the business to make sure the level of quality is staying intact?

1:00:09In the end, stock prices always tend to follow the evolution of the intrinsic value per share growth. So to me, that's exactly the metric you want to keep preco. In his shareholder letters, quality investor Francois Rochelle states that in the long term, stock prices tend to follow the owner's earnings of a company. And you can easily calculate the owner's earnings yourself as follows. Owner's earnings is equal to EPS growth plus the dividend yields. And when we look at this in practice, so the situation for Francois Rochelle, we see that since 1996, the companies within this portfolio have grown their value by about 2 ,500 % and their stocks have achieved a total return of approximately 2 ,800%.

1:00:58So this indeed shows that in the long term, stock prices follow the owner's earnings of a company. And as a result, each year for every company I own, I'll calculate the owner's earnings. When a company's stock price decreased but the company managed to grow its owner's earnings, you know that the investment case has become more attractive. So in other words, when a stock price declines but the fundamentals remain intact, you should buy more of it. In essence, looking at the evolution of the intrinsic value is the most important thing to me. Another important thing to focus on is whether the company's mode is widening or shrinking.

1:01:38So disruption is the worst enemy for quality investors. And when a company loses its mood, you'll end up with horrible investment results. That's why you should solely invest in companies that fall within your circle of competence. Buffett defines his circle of competence as companies where you can make a reasonable guess about how the company and industry will look like in 10 years from now. In 10 years from now, everyone, for example, will be drinking coffee and chewing gum, but it's way harder to make an educated guess about how everything regarding artificial intelligence will look like, for example.

1:02:13When a company is losing its moat, it's often characterized by two things. Their gross margins are decreasing and two, the return on invested capital is decreasing. So let's move on to some of your biggest inspirations in investing. Who are your biggest inspirations that have helped you become a better investor, either in the investing world or outside of the investing realm? So earlier this year, I went to the NL General meeting of Berkshire Hathaway in Oma. And it goes without saying that Buffett is a big inspiration for me. And I also advise all listeners to attend the AGM next year, because you can talk with the best investors in the world, like Kai Spear, Monish Prabhai, Brian Lawrence, Tom Gaynor, and many more.

1:02:58And in general, I would say that it's very important to learn from different people and investors. So people who inspired me a lot are among others, obviously, Warren Buffett and Charlie Munger, but also Phil Fisher, Joel Greenblatt, Peter Lynch, and Terry Smith, for example. I think, or I would advise everyone to just read everything inside. Read as much as you possibly it can. And also biographies help me a lot to form my investment opinion. Think about the biography of Rockefeller, Tim Cook, Steve Jobs, Elon Musk, Winston Churchill, Theodore Roosevelt, or Einstein. And what's also important is that you read a lot of things that don't match your current beliefs.

1:03:44So whenever Charles Darwin found anything that contradicted his previous belief, he knew that he had to write it down almost immediately because he felt that the human mind was conditioned to reject things you don't believe in. So I think this is a very important thing to understand. In Morgan Housel's book, The Psychology of Money, Morgan Housel states that your personal experiences with money make up maybe 0.00001 % of what happened in the world, but maybe 80 % of how you think the world works. So it's very important to be self-aware, to always keep learning and to learn from opposing views and belief.

1:04:23The best investors are very humble and have an open mindset. In investing, it's way better to have an IQ of 110 and to think it's 90 than to have an IQ of 150 and to think it's 170. In investing, it isn't your IQ that is important, it's your EQ and it's all about rationality and temperament. So a business I believe that we are both invested in is Evolution AB. Can you quickly break this business down for those in the audience not familiar with the name? I'm glad you brought Evolution up, Kyle. So at Compounding Quality, we give every company we analyze a total quality score. And so far, Evolution has the highest quality score, indicating that it might be a very interesting stock.

1:05:09So it's a Swedish company and they are a market leader in creating fully integrated B2B online casino solutions. So the core of their offering are traditional table games like roulette, blackjack and baccarat. Baccarat is typically played in Asia. So it's important to highlight that Evolution isn't a casino operator. They create online casino games and casino operators that use these games pay commission to Evolution on their winnings. To give you an example, when casino operators like Unibet or William Hill use a certain game of Evolution and they make 100 million a year from this, they pay a commission of on average 10 to 12 % to Evolution.

1:05:54Another positive regarding Evolution is that all three founders are still involved within the company. So it's an owner operator stock, it's a company with skin in the game. Two of the three founders still own a bit over 10%. And many people within the board, as well as within key management, own a lot of shares of the company. So in total, insider ownership is about 12%. And we have there two very important people, Martin Carlson, who, by the way, bought 1 million sec worth of evolution yesterday, which is around$9 million. dollars. And Todd Householder, which is the chief product officer, those two people are very important within evolution.

1:06:36And the CPO Householder is often referred to as the Steve Jobs of gambling. So he's a very important person. Now, the online gambling market is in a clear secular trend. So the consensus data this market should grow at a compound annual growth rate of 12 % until 2030. and research of SEB indicates that the company has an implied market share in live casino of roughly 70%. So a clear market leader and their products are far superior compared to their views. What I think is so interesting about the company today is that they have great fundamentals, bright outlook and a very cheap valuation. So the company has had a net cash position every year since 2012.

1:07:23They have a low capital intensity, a high return on invested capital, and a very high profitability. For example, the company's profit margin has averaged 48 % over the past five years. So this means that they translate$48 in earnings every$100 in revenue they generated. And yeah, it's a clear compound, Kyle. Well, for example, since 2012, Evolution has grown its revenue from 30 million euro to almost 1.7 billion, meaning that they doubled their revenue within every two years. And personally, I expect that the company can grow its free cash flow per share by 20 % or roughly 20 % in the years to come.

1:08:09So the company trades with a free cash flow yield of 5.7 % looks really attractive given the healthy fundamentals and the bright outlook. And the reverse DCF we executed indicates that the company should grow its free cash flow by 5.5 % per year over the next decade in order to return 10 % per year to shareholders. And these numbers look very conservative to me because the online gambling market as a rule should already be able to grow by 12 % per year until 2030. And like already said, it's really a compounding machine. So since their IPO in 2015, they compounded at more than 50 % per year. So that's really phenomenal.

1:08:55So the most popular question I get on this business is what is its moat? Can you share your thoughts on what you think is Evolution's moat? I think in short, yes, Evolution Gaming has a sustainable competitive advantage. and that the competitive advantage is based on three main pillars. So one, evolution is a clear market leader in a niche market. Two, it's really hard for casino operators to do it in-house. And last but not least, they have a lot of regulatory expertise. So in the investment case of evolution, it's very important to understand that more regulation is a good thing for evolution.

1:09:36So they are a market leader in a niche market. Evolution is a market leader in the oligopolistic niche markets for B2B online casino solutions. And they have dedicated nearly two decades to the development of live casino games. And over the years, they have managed to create a superior product compared to its peers. And industry experts also say Evolution Gaming's games deliver a high return on investment for casino operators. So it's beneficial for the casino operators and also for Evolution itself, because on its turn, it allows them to charge more than competitors. So they earn a 10 to 12 % commission on the winnings.

1:10:18They can spread their costs across a larger user base because they benefit from economies of scale. And they also have a dedicated lobby. So it's a lobby where only Evolution's games can be played. And then the second part, and that's the most important part for the competitive advantage of Evolution, it's very hard for casino operators to do it in-house. So last year, the largest customer accounted for 14 % of the company's revenue. So last year, Evolution had a revenue of around$1.6 billion. So this means that one customer spent almost$220 million with Evolution Gaming. A question you should ask yourself as an investor is, why wouldn't the casino operator do it himself?

1:11:05Why wouldn't he do it in-house? Well, the answer, it's really hard for casinos to develop everything in-house because there are very high fixed costs, there are risks in hiring skilled employees, and there is also a lack of reputation. So running a studio is very expensive. A small studio costs around$1.5 million per month to run, while a new studio is likely to cost around$30 million. And furthermore, it also takes one year before a company can launch its first selection of core games. So deals with operators usually also take 6 to 12 months, which means that the startup costs lay around$50 million before you can start to generate revenue.

1:11:48And that's why casino operators prefer to stay with evolution instead of doing it themselves. And last but not least, regulatory expertise. So evolution benefits from more regulation. Why? Well, first and foremost, the cost of implementation. Evolution is a market leader and they have more resources compared to their peers. So for them, it's easier to make adaptions to their systems to comply with regulation. and the second part is they have a lot of experience in dealing this. So when something changes in the regulation, they're also able to adjust faster compared to their peers. So as a quality investor, capital allocation is a very important part of the business to track.

1:12:33Now Evolution AB pays a dividend while still having a very high return on invested capital and its last large R &G acquisition seems to contribute very little to the overall business despite having a large price tag. How do you view Evolution AB's capital allocation over the last few years? In every investment case, I give each company a score on 10 based on 15 quality criteria and capital allocation is definitely one of them. For this metric, Evolution Gaming got a score of nine on 10. So the company's return on invested capital and return on equity were equal to 28.1 % and 28.3 % last year. and when you combine this with a gross margin of 69 % and you again get an indication that the company's sustainable competitive advantage as well as pricing power.

1:13:22Another beautiful thing about Evolution is that they are very capital-lite. So the company's maintenance CAPEX on sales was equal to only 4 % last year. This means that the company needs very little capital to grow, which is a reason why the company is also paying a dividend. So since 2017, Evolution's dividend per share increased to 7 euro cents to almost 2 euro per share. And they have a healthy payout ratio. The dividend yield is around 2.3%. And as you know, Kyle, yeah, I think Evolution is undervalued as they traded the free cash flow yield of 5.7%. It's the cheapest valuation they have ever traded at.

1:14:02and as we expect the company to grow each fee cash flow per share by roughly 20 % per year in near futures, you know that the company's PEG ratio or price earnings to growth ratio is lower than one at this point in time. And that's exactly why I think share buybacks would make a lot of sense for Evolution Gaming right now. So the company has a net cash position of a bit more than 800 million euro, which is equal to roughly 4 % of the current market cap. And Evolution Gaming could create a lot of shareholder value by using this money to buy back shares. Compounding Quality, thank you so much for joining me today.

1:14:40Before we say goodbye, where can the audience connect with you? Thank you very much, Kyle. It was really nice talking with you and I hope the audience learned something new. If you want to find me, you can find me on Twitter via Compounding Quality or the handle at QCompounding. And we also write three articles a week on investing, on investment principles and stuff like that via compoundingquality.net. Okay, folks, that's it for today's episode. I hope you enjoyed the show and I'll see you back here very soon. Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by the Investors Podcast Network.

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