MI349: The Quality Quest: Building Wealth, One Quality Investment At A Time w/ Compounding Quality

26:41And you talked about it quite a bit in your book. So I'm interested in knowing if you can briefly describe both what pricing power is and also how you factor pricing power when evaluating a business. So in general, I would say, well, I absolutely love companies with pricing power. So what is pricing power? Pricing power is basically the ability to raise prices annually without losing customers. And that's very attractive. Why? Well, pricing power is only possible when a company does something unique. So for example, when you have company A and company B, and they have identically the same products, and company A increases prices and company B doesn't.

27:23Well, in that case, I think it's quite straightforward that everyone will go to company B. So you can only increase your prices when you do something unique, or when your customers are very sticky. So for example, for myself, I have an iPad, I have an iPhone, and I have a MacBook. Well, last time or last week, my MacBook crashed. Well, you need to look for a new laptop. Which one are you going to buy? Well, I bought a new MacBook. Why? Because it's way easier. Your phone, your iPad and so on is immediately synced. The backup is there. So you buy the new MacBook and you're good to go. So that's something customer loyalty can also cause pricing power, by the way.

28:05The most interesting part maybe is that pricing power is a source of growth. And it's a source of growth that doesn't need many investments, right? When you need a new factory and so on, well, you need a lot of topics, a lot of capital expenditures. But where you just can increase your prices every year, well, you increase your prices every year by 3%, 4%, for example. Well, in that case, your revenue increases by 3%, 4 % and your bottom line increases even more, hopefully, due to operating leverage. So that's something really attractive. Take, for example, well, most well-known example may be Seas Candies.

28:40So Buffett or Berkshire bought it in 1972. And since 1972, Seas Candies has increased its prices every single year. So they have increased their prices for more than 50 years straight. And it taught Buffett, well, the power of pricing power, the power of great companies. And when he wouldn't have bought Seas Candies, well, he probably wouldn't have bought great companies like Moody's, Apple, Coca-Cola, and so on later on. So in general, I would say pricing power is really attractive. The most preferred companies are still companies with plenty of reinvestment opportunities, but they are very rare in general.

29:20What maybe to add here? Well, what are some examples of companies with pricing power? Think about the graduating agencies like as it be Global and Moody's, well, they increase their prices every year by 3 % to 4%. You have in the luxury space companies, once again, like Patek Philippe, Rolex, LVMH, and so on. And what's also interesting to see is when you look at the current portfolio of Warren Buffett, you will see that almost all those companies are active oligopoly or in the monopoly. And most companies within an oligopoly or monopoly also have pricing power. So when you look at the current portfolio of Buffett, but also all the positions he has held in the past, well, the majority of them has pricing power.

30:07And if even Warren Buffett thinks it's attractive, well, I think we should definitely keep an eye on it too. So you made a really good point about action bias, which is our tendency to take action often without good reason. This is one of the most prevalent biases that I've observed in the market and one of the most harmful to investors' potential returns. You and I both spend a lot of time studying great long-term investors with incredible track records, as well as market psychology and history of markets. We both probably have come to the same conclusion that doing nothing is indeed where a lot of money is made.

30:43But for other investors listening to this show who maybe aren't obsessed about it like we are, how can they best educate themselves to understand the power of doing nothing and the downside of being too active? Well, you know the saying that the best investor is a debt investor, right? And that's actually, or fortunately, that's true. So each year, for example, you have a study of JP Morgan, and they look at the performance of different asset classes. And over the past 20 years, you see that the S &P 500 returned 9.5 % per year, while the average investor only had a return of 3.6 % per year. So that's really bad, right?

31:22That's really not good, especially because those people, those investors, they have been invested in the stock market. They have taken the risks of being invested in the stock market, but they didn't get the reward for that. So that's something to be really cautious of. Risk reward is very important in the investment field. I think it was Paul Samuelson who said, well, good investing is very boring. Good investing is like watching paint dry. And if you want excitement, well, go to Las Vegas, go to the casinos. And in that case, you're sure that you will lose all your money, right? I would say the most important thing here is to really get out the noise.

32:03Don't focus on the quarterly results and focus on decades instead. And I think the best example of this, and I'm a huge fan, is Francois Rochaud. You also know them. Well, last week, he published his latest annual shareholder letter. And each year, he compares the stock price or the performance of his fund with the owner's earnings of the businesses. And the owner's earnings are simply calculated by doing EPS or adding EPS for the dividend yield. And what you see is that since 1996, well, his portfolio returns 2 ,887 % and the owner's earnings were equal to 2 ,859%. So in the very long term, well, stock prices follow the owner's earnings almost exactly.

32:50And the key reasoning here is that in the short term, so in one year, and in some cases, even two years or three years, well, stock prices might differ from the owner's earnings, but in the long term, they always follow each other. If stock prices decline and the owner's earnings increase, well, you know that the company became more attractively valued. It might be an opportunity to add more to your position, right? So the essence here is, well, think, always focus on what matters in the big picture. Last summer, I quit my job. I worked in the industry. And basically what we did, and especially during results season is, well, you have those reports from JP Morgan, Maureen Stanley, Goldman Sachs, and so on.

33:33So what you did during results season is you were reading all those quarterly reports. And Company X, well, the EBS was$2.20 and the consensus was$2.20-21. So that's not good. And the stock price declines 4 % and so on. But in the end, I think that's just noise. And today I'm working full-time on compounding quality. I don't read those quarterly reports from the broker or from the research houses anymore. And I think it's actually a good thing. Just reading the 10K, just reading the transcripts of the earnings calls, that's more than enough. And it helps you to focus on the big picture and don't get distracted when a certain company report two cents below consensus or something like that.

34:18I think that's indeed true and also know it or see it with some friends. Well, some people, indeed, they want excitement, but excitement is not a good thing on the stock market. So if you know from yourself that you really want some excitement, well, I would advise you to do it only with a very small fraction of your portfolio because the essence of investing is really trying to do a bit above average for very long periods of time. And you can do that by investing in very boring, great companies. So I want to discuss another bias that you discussed in your book, which was the neglect of probability.

34:55So this is the tendency to consider the magnitude of an event, but not its probability. So I'm interested in knowing how do you think investors can combat this bias to ensure that they aren't neglecting probabilities in their investing process? So I think in general, investing, especially looking for the next big thing, it sounds really exciting, right? So for example, well, when you invested in Amazon at the IPO in 1997, well, when you did that for 10 ,000, today you would have more than 15 million. And I guess that sounds really appealing. Everyone wants to have a company like that in their portfolio.

35:32And you see a lot of articles also in the media, well, will this company be the next Amazon and so on and so on? But what nobody could have imagined, I guess, for example, for Amazon is that when they were at the IPO, it was just a loss-making online bookstore, right? Nobody could have predicted that they would have evolved to one of the largest e-commerce company in the world. To add to that, well, when you look at Amazon since 1997, there have been multiple times that the stock declined by 50%. And even one time, the stock declined by more than 90%. For me personally, when I'm honest to myself, well, when I would have bought Amazon in 1997, I definitely or probably wouldn't have kept the company until today because there is so much uncertainty.

36:21Also, the last decade, the stock increased so much. So you really needed to have a strong stomach to be still invested in Amazon today when you already bought it at the IPO. And I think that people who bought it at the IPO, well, only a fraction of them will still own the shares or still own all the shares. So and still, many people try to find the next Amazon ride. But chances you'll find one are less than 0.00001%. When your investment philosophy, when your investment strategy consists of trying to find the next Amazon, well, it's very, very, very likely that will be a disappointment. And I think that the best way to avoid things like that and the best way to avoid black spam events is to really invest in very boring companies and don't seek excitement.

37:14So invest in companies that have already won, companies with a very strong track record. And everyone knows the code from Warren Buffett. Well, rule number one, don't lose money. And rule number two, never forget rule number one. That's exactly true. So we all know that when your investment loses 40 % in value, well, you need to make almost 70 % to recover from that. So that's something you want to avoid at all costs. So moving on to the financing aspect of quality investing. So you made some really, really good points about how if a quality investment wants to fundraise, some of them are going to have a lot of tangible assets.

37:54Some of them are going to have a lot of intangible assets. And depending on their mix of those things, one company might be able to secure a higher degree of funding than another. So for people who don't understand the difference between tangible and tangible, do you mind just actually briefly covering what those are? And then as well, just briefly discuss why you think or where you think quality investors should give preference to between one or the other, or if they should give a preference at all? Tangible assets are physical assets. So they have a measurable value. You can touch them. Think about real estate, factories, inventory, and so on.

38:32And on the other side, you have intangible assets. So intangible assets are non-physical assets. Can touch them. Think about IP, so intellectual property, brand recognition, patents, copyrights, and so on. What is a good example of a company that has a lot of intangible assets? Well, think about Coca-Cola, for example, right? Buffett said, well, if you gave me 100 billion and said, take away the market leadership of Coca-Cola, I would give it back to you. And I'd say to you, well, it can be done. So they have a lot of very strong intangible assets. The brand name of Coca-Cola is very strong. Same goes for Constellation Software, for example.

39:12Well, their reputation is so good, their culture is so good that when you are in the VMS field, so the vertical market software, and you need to or you want to sell your business, well, Constellation software, everyone knows that within the segment, and it's the place to go. So what is the difference here is the thing that when you look at classical companies and industries, tangible assets were really important. Think about the 1970s, for example, right? You have those classical industries, factories producing goods and so on. While nowadays, well, intangible assets are very important. The fact that intangible assets are becoming more and more important, well, this has advantages, but it also has disadvantages.

39:56What is, for example, the disadvantage of tangible assets? Well, tangible assets can be copied, right? Let's go back to the example of the factory in the 1970s. Well, when you have enough capital, you can just copy or rebuild another factory and do exactly the same. That's an advantage of intangibles because some intangibles are very hard to copy, right? Think about, once again, about the example of Coca-Cola or when other companies like Alphabet, Apple, and so on are doing. So in that case, increased intangible is an advantage, but it's also a disadvantage or a risk. Why? Because, well, intangible assets have no recoverable value.

40:40When you go into bankruptcy and you have a factory, well, and you have some inventory, you can still sell the factory, you can sell the inventories and so on. But when And most of your assets are intangible assets and you're going to bankruptcy. Well, IP, well, it can become worthless in that case, right? So the consensus here or the key takeaway, I guess, is that I think that's no problem at all that intangible assets are becoming more important, especially for quality companies, especially for software companies. But it's really important that you look at the strength of those intangible assets.

41:16So for example, for Coca-Cola, well, the strength of their brand is very strong, but another company where there's way more uncertainty, well, in that case, when there isn't a proven track record and it's only intangible assets, that's something to be a bit more worried about, I guess. So take me through your process here for evaluating management. So in your book, you discuss things like compensation, incentives, and insider ownership. So I'm just looking, what specific numbers are you generally looking for in these metrics that help you determine whether you like a company's management or not?

41:52It was Charlie Munger who said, well, show me the incentive and I'll show you the outcome. Right. And he also said, well, I've always thought that the incentives are very important and I've always underestimated them. And I completely agree with them. So management is very important. And that's also why company quality, for example. Well, 60 to 70 % of the portfolio is invested in companies with skin in the game. So skin in the game is really important to me. Why? Well, you want the incentives of management to be aligned with the ones of you as a shareholder. And it has been proven that these kind of companies also perform better on the stock market.

42:33When you, for example, take the Credit Suisse Family Tauberts study, well, they conclude family businesses outperform by 3.7 % per year on average. And then you also have another study from the Harvard Business Review, who basically conclude that founder-led businesses are performed by 3.9 % per year on average. So preferably, I really want to invest in companies that are still led by their founder. And when the founder still has significant insider ownership, like MetBase, we already briefly touched upon, or Kelly Partners Group. And when this isn't the case, well, I prefer the companies, the family businesses or companies with a high insider ownership.

43:12Well, think about Evolution AB, Brown and Brown. And so that's also what I do. And it's available on the website. Well, I made an investable universe with 100 quality stocks. But 100 quality stocks where all the companies within the list are quality and they have skill in the game. And the main reasoning there is that I guess when you just would, for example, create a equal way to the ETF of those 100 names that you tend to do quite well on average in the long term, hopefully, or that's the goal already better than the S &P. And maybe I will add a little story here to make everything more clear.

43:50Well, I guess we will meet each other at the AGM of Berkshire in Omaha this year, Kyle. Well, last year, I also went and I live in Belgium. So when I went back, I needed to take my flights and it was from Omaha to Chicago, then from Chicago to London and then London Brussels. I was traveling alone and Chicago is a really large airport and I was feeling a bit lost there and I didn't know where to go because you need to take the metro to go to another departure aisle and so on. When we took off in Omaha, I heard someone behind me say that I was also going to London. So I saw him in the airport in Chicago, I asked him, well, You also need to go to London, if I'm not mistaken.

44:35Well, do you know where we need to go? Which metro we need to take? Well, okay. We went together. He was really kind. And obviously, we started to talk. And first thing you ask is, because everyone in Omaha that weekend is there for the Berkshire AGM. Well, what brought you or what brings you to Omaha, to the Berkshire AGM? And his answer was, well, I come there every year. I've come or I've went for several years now. And that's because I really love the philosophy of Warren Buffett and Berkshire Hathaway. And I want to have the same philosophy or we have the same philosophy within our businesses.

45:11As an investor, that's what starts to get you interested, right? So we started to talk even more. Then I asked him, which company do you work for? And he told me, well, I work for Judges Scientific. And Judges Scientific is 100 beggar in the UK. And they are basically, they can be seen a bit as a mini Danair. So they are active in scientific instruments and they acquire other companies within this niche with a decentralized business model. So really intrigued, really interested. Obviously, a one-on-one beggar. I've known it because it's a zero-acquire, excellent business and so on. So next question I ask him is, which role do you play at the company?

45:51And it was actually David Cicero. So he's the founder and CEO of Judges Scientific. And it was really friendly. And it was quite surprised that I knew the company because it isn't that large. So we talked about the business for one hour, two hours. Obviously, there are two things clear. You have skin in the game because David is still running the business. And second part, well, it's an excellent business. It's a 100 bracket. So I had two main questions for him. First one, well, I think if I recall correctly, I think David is 71 years old right now. Well, what will happen with the business after you decide to retire?

46:31Well, and his answer was very clear. Well, we have been working just like Berkshire on the company culture for very long periods of time. So after I retire, well, the culture will remain intact. And then the second question I had for him is since 2004, Judges has been a 100 bagger. Over time, everyone or every company suffers from the large numbers. So when you look at the next 20 years, what do you think the business will do or be able to do over the next two days? He needed to laugh. He didn't want to answer the question immediately and we moved the conversation to something else. But then after 30 minutes, he came back to me and he said, well, I think that churches can still 20x its intrinsic value over the next 20 years.

47:18So that's something you love to see, right? And those are the stories of excellent owner operators in great businesses that we are looking for. And maybe the side note here, I really think that Judges is an amazing business. It's a company I would love to own, a company I would love to be associated with. But today I don't owe them or I don't owe them yet because I think the valuation is a bit too high. But those are exactly the companies where you're looking for as a quality investor. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message.

47:54If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle. Just go into your podcast app and type in We Study Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more. My colleagues Stig Brodersen, Clay Fink, Kyle Greve, Preston Pysh, and William Green each host their own We Study Billionaires episodes and bring their own unique perspectives.

48:31A whole new world of insights awaits you. Just go ahead and type in We Study Billionaires into your podcast app and see what you've been missing out on. Seriously, go ahead. I promise you'll like what you find. Bonus points if you show your support for our work by clicking follow. If something piques your interest, just start listening. No hard feelings. I'll be waiting for you back here. Just like everybody else, there was a time when I was a beginner investor, and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on.

49:01But 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.

49:40To 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. Not to be cliche, but building a market-beating portfolio really doesn't have to be a mystery, at least with the right tools. If you've listened to our podcast for a while, then you know we spend a lot of time learning from savvy investors. So why not use the same tools we do? With TIP Finance, you can. Screening for great companies, calculating intrinsic value, keeping up with legendary investors' portfolios, and more are all not just possible, but easy to do.

50:27TIP Finance was created by investors for investors. It's quite literally the tools we wanted to use ourselves when researching investments in a simple to use interface. You can get started by creating an account for free. Who knows, maybe TIP Finance will help you find your next 100 to 1 investment. Between the screener and Legend Investment Portfolios to reference, I've gotten a ton of ideas from TIP Finance. What are you waiting for? Take the next step in your investment journey today with the right tools at your fingertips. Grab your device and type into your browser, theinvestorspodcast.com slash tip-finance to get started.

51:05That's theinvestorspodcast.com slash tip-finance. All right, back to the show. Moats are obviously a massive part of quality investing. Without a moat, a business simply can't protect its profits from being withered away by competitors. But I think moats have different strengths at various times in a business's life cycle. So when you're analyzing a business, how are you analyzing the strength of each moat and whether or not it's getting stronger or weaker? A business like Amazon, they have scale economies, they got network effects. So are you looking at each specific moat? And yeah, just love to know more about how you're analyzing their moats on an individual basis?

51:53Yeah. So for quality investors, it all starts with the moat rights. So we will never invest in a company that doesn't have a moat, or at least where you think that they don't have a moat. So moat is very important. And how are you going to quantify this? Or how do I do it? Well, I want the gross margin to be larger than 40%. This is also an indication of pricing power. and you want to return the invested capital to be larger than 15%. So in general, there are five mode sources. So the first one is for the cost advantage. So being able to produce something cheaper than someone else. Think about IKEA, right?

52:29This is a mode source I really, or I prefer the least because it's the weakest one basically. And studies have also proven that when you look at all the mode sources, well, a mode source based on cost advantages, they don't outperform as much. as the other mode sources. You have one based on intangible assets. Think about Coca-Cola example. Switching costs. Well, think about the MacBook example I gave you. I'll just buy the MacBook again because it's easier and you know the platform and everything synced. Four mode sources, economies of scale. So when you produce something more that you benefit more from it, right?

53:07So they can produce it cheaper and so on. And then last but not least, well, network effects. This is the best mode source, the strongest mode source. And it means that the more people use a certain product or service, well, the more valuable it becomes. So probably everyone, for example, today will have already used a service of a meta platform. So Facebook, Messenger, WhatsApp, or Instagram, that's a very strong mode source. And what I think is really important to understand here is that a mode is never constant. So in other words, a company's mode is widening or shrinking every single day. And how can you look at this?

53:50How can you see that a mode is widening or shrinking? Well, when a company, and that's exactly what you want to see, when a company's gross margin, as well as return on invested capital is increasing over the years, Well, it's a very good indication that the company's mode is widening and the other way around. And for quality investors, but maybe more broader for every investor in general, disruption is really your worst enemy. So when you invest in a quality stock and the market recognizes quality, so the valuation is often a bit more expensive and the mode disappears, you will end up with very bad results.

54:29It's a two-edged sword. So the valuation comes down and maybe the growth, your doubts, the company would report. Well, it stagnates or even declines. So that's something really bad. Now, how can you protect yourself against disruption as an investor? Well, a company should always keep innovating. So in the book, The Art of Quality Investing, we also gave two examples. Well, Netflix and Kodak. I think everyone knows both companies. while Kodak had really a strong mold 25 years ago. It was even mentioned the Kodak moments with a perfect picture moment, right? But they didn't innovate. They didn't keep reinvesting in themselves and they completely missed the boat of that digitalization of photography.

55:15So today, Kodak is only a fraction of itself and compare that with Netflix, for example. Well, Netflix in the early days when it was founded was just an email service for physical DVDs, right? So you could order a DVD at your house. And they evolved and they kept innovating and kept investing in R &D. And today it's the largest subscription revenue streaming platform in the world. So innovation is really crucial. And disruption is always your worst enemy. And you have other examples like Amazon we touched upon. So the evolution from an online bookstore to the largest e-commerce player in the world.

55:51Same for Microsoft. So Microsoft today trades at quite rich valuation levels. And in 2011, they only traded at around 11 times PE. What was the reason? Well, the consensus was that the growth phase from Microsoft was over. So all from the laptops from Microsoft and so on, they couldn't grow anymore from that. Well, but then the cloud came right. And it's the most important growth builder for Microsoft right now. And as a matter of due to that, well, the valuation levels of Microsoft tripled again from 2011 compared to these levels. So the cloud obviously is really important. So longevity here is also crucial, I guess.

56:37So the longer a company already has a mode, the better. And the longer the track record of the company and the longer the track record of management of continuously innovating, keep reinventing of itself, the better because that's really important for investors and as a company. So you wrote about your preferred capital efficiency metric in your book, which was returns on invested capital. And I share your sentiment that it's also my favorite metric to determine how efficient a business is at managing its invested capital. But I'm interested in knowing, can you compare and contrast returns on invested capital to returns on assets and return on equity and also tell the audience why you think return on invested capital is such a powerful metric and has advantages over those two others that I mentioned?

57:23It's a very good question, a very important one to understand though. So when you compare return on assets, return on equity and return on invested capital, I completely agree with you. Return on invested capital is by far the most preferred metric. Let's shortly explain why. So first of all, when you look at return on assets, this is a metric I really don't like to use. Why? Well, return on assets is calculated by dividing the net income by total assets of the company. Actually, this is a wrong formula. So it's a mismatch. Why? Well, in the numerator, you use net income, right? And net income is something that is for the shareholders.

58:03It's the money for the shareholders, basically. But in the denominator, you use total assets. And total assets, well, they can be linked to the shareholders as well as the debt holders. So they're comparing something that's only for the shareholders in the numerator to something that is for the shareholders and debt holders in the denominator. And that's something that is just mathematically not correct. And to add to this, well, when you look at the total assets, in total assets, there are also certain things that aren't needed to run the business. Think about excess cash and goodwill. So in general, well, some people still use the metric, but I would advise everyone to not use that return on assets metric.

58:46Return on assets is a no-go for me. Now, return on equity, already more interesting, I guess. Return on equity can be calculated by doing the net income and dividing it by the equity. But it can be a good metric because you look at what's attributable to the shareholders, right? But it's very important to understand here that companies can lower their equity parts by buying back shares or by levering their balance sheet. So as a matter of fact, they can increase their return on equity by taking more risk by leveraging their balance sheet. Also, the share buyback part, well, in extreme situations, you can even have a negative equity and as a result, a negative return on equity because the company bought back shares so heavily.

59:31Think about Starbucks, for example, while they have a negative equity due to the heavy share buybacks. As a matter of fact, it can actually be a good thing, right? So return on equity, you can use it, but please be cautious with it. Don't use return on assets if you ask me. Most preferred metric is definitely the return on invested capital. In the book, we talk about it. Well, make the distinction between two kinds of return on invested capital, traditional variants and the operational return on invested capital. Well, the traditional return on invested capital is calculated by taking the Nolbot, net operating profit tax, and dividing it by the invested capital.

1:00:12And you want this to be larger than 15%. And when this is the case, it's a great indication of the fact that the company has a moat and is great in capital allocation. And then you have also the operational return on invested capital. And this one is maybe a bit less well-known, but it's really an interesting one. And it's a really important one, especially when you want to calculate the reinvestment rate of a company. Now, what's the formula for the operational return invested capital? It's once again, no but divided by invested capital. But within the invested capital box, you exclude the goodwill and all the excess cash.

1:00:51And this is really interesting to calculate the reinvestment needs of a company. So when you want to calculate your investment needs, well, you take the growth rate of a company and divide it by the operational return on invested capital. So to give you an example, well, when a company wants to grow by 10 % this year, and they have a return on invested capital or an operational return on invested capital of 50%, well, you take the growth rate of 10 % and divide it by the operational return on invested capital of 20%, and 10 % divided by 20 % is 50%. So in this case, you see that the company needs to reinvest 50 % to grow at 10 % per year.

1:01:36And it's also an interesting example here. The higher the operational return invested capital, the less they need to reinvest. Let's take an extreme situation. Company wants the same 10 % growth per year, but their return invested capital is 100 % right now, 10 % divided by 100%. In that case, the company only needs to reinvest 10 % in order to grow 10%. And they can use the remaining 90 % of their free cash flow to distribute to shareholders, get dividends, share buybacks, and so on. And this also shows, for example, why compounding machines or quality stocks that can reinvest all their free cash flow in the business are so rare.

1:02:18Just because their return invested capital is often really high, and they just don't needs a lot of capital in order to grow at attractive rates. So one of the points that you made in your book that really resonated with me was how if you have a high enough return on invested capital benchmark, you don't really have to worry about the weighted average cost of capital. Can you just briefly discuss what the weighted average cost of capital is and the relationship it has with return on invested capital? Yes. So it's the important thing to know here that growth only creates value when the return Returnal invested capital is larger than the weighted average cost of capital, right?

1:02:56And it also means that when a company with a very low return invested capital, you invest in the business, well, they actually destroy shareholder value. So they would be better off to just distribute the shareholders via dividends and share buybacks that the shareholders can invest in other more attractive opportunities. So take, for example, Airbus and Boeing. Well, those companies are very capital intensive. They have a low return invested capital. So it's really hard. It's very hard for them to create shareholder value. And compare this with a company like Visa, with a company like MasterCard.

1:03:33Well, Visa has a return invested capital with over 20%. MasterCard will almost 40%. Well, we can all agree, or I hope that we can all agree, that the rated average cost of capital will never exceed 20%, right? So basically the weight, the average cost of capital, it's just at which rates you need to return in order to break even on a certain investment. And as a matter of fact, for me, for my side, to keep it simple, I always just use a proxy of my required return as a proxy for the weight, average cost of capital, which is 10 to 12%. But when you're, to come back to the Visa and MasterCard example, well, MasterCard has a return invested capital of 40%, you can basically just say that they can do any growth investment and it will always create value for them.

1:04:26And that's what's so attractive. Companies with a high return invested capital and plenty of reinvestment opportunities, well, those are actually real compounding machines. So to take the formula, again, reinvestment rate is growth rate divided by return invested capital. While if Mastercard wants to grow by 10 % per year, they only need to reinvest 25 % of their fee cash flow to do that. And they can use the remaining 75 % to do share buybacks, dividends, and so on. And that's actually what they do. And when you can find, as a quality investor, a great business with a higher return on invested capital, but plenty of free investment opportunities.

1:05:10Well, that's actually really interesting. That's the golden egg for investors. And so far, I only know two main companies, I guess, that can do that, that can reinvest almost all their free cash flow in organic croats. And those are Copart and Dino Polska. you. So speaking of Dino Polska, I want to finish this conversation off by discussing the business as I know it's a newer position for you. This is a stock that my colleague Clay and I discussed in a lot of detail on the Investors Podcast, episode 587 for anyone who wants to learn more about it. And full disclosure, I own shares in Dino Polska.

1:05:44So once this podcast episode is released, I won't be buying or selling any shares within 14 days. But I want to get an overview of the business. Just simply put, why do you own it? Short answer, well, I think that Dino Polska has a quality stock, right? What I think is really attractive is that they can reinvest everything back in the business in organic growth. That's very rare. And that's exactly how compounding machines are created. So I think that Dino still has plenty of room for growth to add. Now, what is Dino Polska? Dino Polska is basically a Polish company. And it's a Polish grocery company active in the rural areas of Poland.

1:06:22So they are focusing on standardized store designs and they have fresh products. They have their own meat supplier. They have their own distribution centers and so on. So the company, if you ask me, definitely has a moat. Why? Well, they are the number one store in Poland when you talk about price, convenience and selection. And what also provides them with a competitive advantage is that they own almost all their own stores. And nobody else does that. when you look at the math, when you look at the numbers? Well, buying your own stores and buying the land, creating the stores and so on, it only gives you a competitive advantage when your investment horizon is larger than nine years.

1:07:04And that's also the case for Dina Polska. And it shows management focused relentlessly on the long term. The founder, Thomas Wiennacki, well, he's still involved within the company. He still owns more than 50 % of the business. And it's really well known for being a penny pincher. So looking for the cheapest garbage bins to spare or to save a few dollars every year in every store. Well, that's what it's known for. So it reminds me a bit about Mark Leonard. So being very secretive, focusing relentlessly on the business. And that's exactly what you want to see. So I guess it's a quality business.

1:07:46The fundamentals look really great. And the most effective thing for me is that they can still reinvest almost everything in organic growth at a high return on investment capital. Yeah, I agree with your sentiment. So one thing that's been interesting about Dino Polska just over the last year is that it's been an incredibly volatile stock to own. So for short-term investors, probably not a good fit, but for long-term investors like yourself and myself, and probably a lot of listeners of this podcast, it's really good because it just gives you opportunities to decrease your cost basis. So I'm interested in just knowing a little bit more about what you think specifically about evaluation of Dino Polska.

1:08:22Can you kind of discuss what kind of growth you're expecting in the near future? Yeah, sure. I think the future still looks bright for the company. So Dino basically started in the west of Poland and they're gradually expanding to the east. And when you look at the numbers, I think that Dino can actually almost double its store cards from today's levels. So this means that the number of stores are expected to grow from around 2 ,400 a day to 5 ,300 in a few years from now. And what is interesting that during the latest earnings call, and let's be honest with each other, the latest numbers weren't that good.

1:08:59So numbers were a bit below estimates. There was some margin impression and so on. The reason there is that there was more competition and obviously you have some inflation. But what was really interesting in the latest earnings call is that they said, okay, growth will accelerate again in 2024 and margins will also go up in the long term. And when you compare 2025 to 2024, growth will accelerate once again. So over the next two years, well, I think that the results the company will publish should be quite good. And they also said that after they matured in Poland, well, they will expand to neighboring countries like Czech Republic and so on.

1:09:40And what is really important in this investment case, in the investment case of Dino Polska, I guess, is that in practice, the fundamentals are way better than how they look like on paper. So when you look at Dino Polska today, well, they have 2 ,400 stores, but you know or you see that 40%, 4 ,0 % of these stores are still less than three years old. And why is that so interesting? Well, because these stores haven't reached their full profitability yet. And when you look at the fundamentals, when Dino Polska opens a new store after one year, it's still loss making. After two years, well, the free cash flow margin is usually on average equal to 2%.

1:10:24And then after three years, well, it goes to the normal or long-term profitability of 8%, which is actually not bad for a retailer, by the way. So this means that all these stores, their margins, and it's 40 % of their stores, are still lower than what they will be in three years from now. So right now, Dino Bolsk is still investing heavily in future growth. But once one day, the growth will mature and the growth will stagnate. Well, they need to reinvest less in aguarded growth. So their growth capics will go down, their free cash flow will go up. And the margins of the business will go up because all stores will reach their full profitability over time.

1:11:06I think what's also interesting, and it's the last thing I will add, is the valuation looks quite attractive. So when I run my own earnings growth model, well, the expected return is 11.7 % per year. So in other words, I'll expect that shareholders will get 11.7 % per year. I return in my model. And when you look at the reverse DCF, you see that currently the market expects Dino to grow its free cash flow by 7 % per year over the next few years. This in comparison with the guidance of management, in comparison with the guidance or the consensus of analysts, well, over the next two years, they think that free cash will grow by 25%.

1:11:50So the market thinks Dino will grow to free cash flow by 7%. The consensus state that will grow by 25%. So there's a mismatch here. And it's why I think that Dino Bolska is true. that's one, the quality business and two, to achieve today, which is why I'm very happy to be a shareholder today. So Compounding Quality, I want to thank you so much for joining me today. But before we say goodbye, I want to hand it off to you. Where can the audience connect with you and learn more about you and your services? Yeah, sure. So obviously the book, The Art of Quality Investing has just been published. It would be lovely to get some feedback on the book and to learn from each other.

1:12:31And for the rest, yeah, people can also find me via Twitter, obviously, CompoundEquality, or via the website, CompoundEquality.net. Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.