MI380: Hidden Compounders: The Best Stocks Hiding In Plain Sight w/ Shawn O’Malley

23:27Because acquisitions have such a negative perception in the financial world, these types of companies are often ridden off by mainstream investors. Correspondingly, there's no shortage of literature documenting how mergers and acquisitions have destroyed value for shareholders historically. In part, that's because a premium must be paid typically to acquire a company, leading acquirers to overpay. And also on top of that, those deals usually involve large amounts of debt to finance everything. While this is true, I believe there's precedent for overseeing value-creating serial acquisition. It's just rare.

23:57There are examples though of serial acquirers with exceptional track records in delivering returns for shareholders. The most famous example is, of course, Berkshire Hathaway. Led by Warren Buffett, Berkshire is very much a serial acquirer, and for a long time, you could argue that the company was a hidden compounder before Buffett and Munger gained a cult following. Berkshire is the vehicle for making these acquisitions, as it buys up majority or minority stakes in great businesses and holds them indefinitely until something materially changes about the target company's business model or valuation.

24:28Serial acquirers like Technion and early Berkshire can be undervalued and dismissed, turning them into hidden compounders, not just because of the stigma around conglomerate acquisitions, but also because of the messy system behind how they report earnings. Since 2018, companies like Berkshire have been required by accounting standards to report changes in the market value of their portfolio companies and their own net earnings. Meaning with a 2 % stake in Apple, rather than reporting 2 % of Apple's$100 billion in net income in the last 12 months as its profit, Berkshire would have to adjust its earnings to reflect unrealized gains and losses from swings in Apple's stock price.

25:03As Warren Buffett wrote in 2017 in anticipation of the accounting rule change, quote, the new rule says that the net change in unrealized investment gains and losses and stocks we hold must be included in all net income figures we report for you. That requirement will produce some truly wild and capricious swings in our GAAP bottom line. Berkshire owns$170 billion of marketable stocks, and the value of these holdings can easily swing by$10 billion or more within a quarterly reporting period. Including gyrations of that magnitude in our reported net income will swamp the truly important numbers that describe our operating performance.

25:40For analytical purposes, Berkshire's bottom line will be useless. With Technion, the situation is different because Technion is listed in Sweden and therefore doesn't adhere to the same accounting standards. It also primarily invests in private companies that aren't listed on stock exchanges. But still, the point remains that serial acquirers can be great compounders in their own right, while also being hidden to an extent because valuing a company like Technion or Berkshire is really a valuation of dozens of other companies that they own stakes in, which can get messy quickly. As Chris Mayer explains, as the name suggests, a large part of a serial acquirer's growth comes from acquiring many smaller companies.

26:17Serial acquirers are typically decentralized, with the acquired companies enjoying quite a bit of autonomy. The free cash flow of these daughter companies is funneled to the mothership where it is deployed in new acquisitions, dividends, or whatever. Typically, serial acquirers look to hold companies forever. Looking at Technion, the company has done this to an impressive extent, even though it's just getting started after being founded in 2006. Since going public in 2019, Technion has delivered compounded annual returns of well over 30 % per year on average for shareholders. Like Berkshire and other successful serial acquirers, I think Technion has a hidden moat.

26:54In theory, there's no reason a serial acquirer should have any moat and be able to generate these types of returns over time. As we know, with stock investing, very few people can consistently beat the market averages, and serial acquisition is the same idea on a different scale. Seemingly, anyone could come in and copy the playbook that someone like Warren Buffett has used, and with all that competition, it would become difficult for a company focused on serial acquisition to find enough attractive opportunities for them to compound returns at above average rates. While there is some evidence that after 60 years, Berkshire is brushing up against this problem due to simply how large it has gotten, leaving it with fewer and fewer meaningful acquisition targets, smaller serial acquirers like Technion appear to have a secret sauce that, like Old Dominion, is both powerful and hard to define.

27:40It seems as though Technion is in the process of building its moat, an invisible moat that, also like Old Dominion, may have a lot to do with culture. While serial acquisition seems as simple as just buying and holding companies and then using their earnings to buy more businesses, there's a lot that can go catastrophically wrong with this model. One concentrated bet that blows up is more than enough to derail a serial acquirer. Doing serial acquisition well in a way that is both sustainable and accretive to shareholders requires discipline. I'll read you a list of a few of the things they look for in making an acquisition.

28:15Technion wants to buy companies that operate in niche markets with strong competitive advantages built up over the years. Additionally, they want their target companies to be profitable market leaders with operating margins above 9%. Generally, these will also be companies that can be acquired for between$2 and$10 million, where the initial investment can be recouped within five years with a 15 % annual return. And last but not least, Technion only wants to acquire companies that have good and honest management teams, with the founders or family ideally being still involved in the company. While this formula does give some criteria that shape their capital allocation decisions, it's not as simple as following this formula and finding success, because as I've said, anyone could theoretically do this and compete with them, though that hasn't happened to a meaningful extent, at least not yet.

29:02In part, I think that's because much of what they're doing is so personalized, which has also been a tailwind for Buffett and Munger in their careers from leaning into treating people well and building lasting relationships. That, in its own way, is the moat. Technion is buying family businesses like Berkshire did in its early days with Seize Candy and Nebraska Furniture Market. And when you're selling the business you spent a lifetime building, where your employees are your friends and neighbors, you care a great deal about who you sell it to. Rather than being some soulless private equity firm that's planning on buying the company and getting it, Technion provides an alternative for business owners who are looking to cash out all or part of their stake in the company they built.

29:40But they still probably care a lot about what happens to the company, and that's where the team at Technion thrives. Being Swedish and focusing on acquiring Swedish companies, being honest and trustworthy, and promising to leave their acquired companies intact with a hands-off ownership approach helps build the relationships that enables these deals to happen at all. And as they've acquired companies and sellers have been more than satisfied by how they were treated, that news spreads by word of mouth. And I'm sure that has helped Technion find more founders willing to sell their businesses to the right buyer.

30:10In some academic setting, I would probably be unable to describe this competitive advantage because it's an invisible moat. In theory, it probably shouldn't exist, but I think it does. Trust, relationships, and reputation are not things you can quantify easily, but in the real world, they do exist and can be quite powerful. Technion's financial results and shareholder returns, like Old Dominion, are a testament to it. After having met both Technion's CEO and Chief Acquisitions Officer myself at the Berkshire Shareholder Meeting in 2023, I, like Chris Mayer, am inclined to say that I see the invisible moat in action here.

30:44Their modesty and reverence for Warren Buffett and Charlie Munger, combined with their track record, signals to me that they are very likely spearheading a culture at Technion that is the explanatory factor behind their success beyond how well any single investment has worked out for them. Technion is a hidden compounder not only because it is a small company based in a small European market, but also, as I've mentioned, because it is a serial acquirer where the returns it's compounding are happening behind the scenes at its portfolio of private companies, which do not have the same transparency as the types of publicly traded companies that a large serial acquirer like Berkshire has to invest in.

31:21Nothing about Berkshire is hidden these days. It's probably the most well-studied company on earth. It is arguably still a compounder, but not like what it was in the past. And as I said, it's not hidden. 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. If 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.

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34:57All right, back to the show. For reference, I'll go ahead and just read off a few more companies that are candidates for being what we might call hitting compounders due to their simple, boring businesses, excellent returns, and a lack of easy to define moat. Rollins, ticker ROL, is a pest extermination company with an average annual return on invested capital of 18 % per year in the last five years and a compounded annual growth rate in its stock price of almost 20 % per year over the last two decades. Another candidate for hitting compounder status is Transdime Group, ticker TDG, which operates in the exceedingly boring business of airline components yet has delivered an average annual return on invested capital of 15 % per year for the last 15 years, while compounding its stock at more than 22 % over the last decade.

35:43And one more for a good measure is Sherwin-Williams, a company that simply sells paint. With an average return on invested capital of 28 % in the last 10 years, a simple manufacturer and distributor of paint products has earned returns that rival Google's parent company, Alphabet, which has an ROIC in recent years of 29%. To shareholders in this wonderful company's delight, Sherwin-Williams' stock price has earned compounded returns of 18 % per year in the last decade. So as I've said, some of the most boring businesses you can imagine quite literally compound profits and returns for shareholders at rates you'd expect only from the best-known big tech companies.

36:19To me, this is the epitome of being a hidden compounder. Of course, there are degrees of hiddenness, and whether a company is considered a hidden compounder is definitely subjective. Technion is clearly much more quote-unquote hidden than Sherwin-Williams, which despite being a boring business, is at least a household name across the United States. So again, there's some subjectivity to this, and I really hope that your takeaway is the essence behind the idea of hitting compounders rather than fixating too much on an explicit definition for it. And I'll add as well that there's clearly some companies where it's easier to define their moats than others.

36:53Just because there's room for debate on a company's moat doesn't make it a hitting compounder though. You may decide on a different definition for hitting compounders, but at its core, the idea is to find companies with impressive track records and compounding returns that, for one reason or another, are not appreciated by markets to the full extent they should be. Evidently, I've talked a good deal about so-called boring businesses because I do think these compounders with boring business models are more likely to be overlooked than some company that's doing something really exciting at the forefront of the latest hyped up fad and markets, whether that be gene editing, 3D printing, or more recently, AI.

37:28Relatedly, boring companies in particular are likely to have what Chris Mayer calls invisible moats, where their competitive advantages may not be as clear-cut as a leading tech company that has some network effect or advanced software working in its favor, yet based on their abnormal profits, clearly has some combination of less visible moats collaborating to their benefit. There's nothing wrong with focusing on compounders with flashy moats, It's just a different game to play and one that's more competitive and where the companies probably don't slip to attractive valuations as frequently. Another point worth mentioning here in today's conversation on boring businesses and hitting compounders is a concept known as the Lindy effect.

38:06That is to say, all businesses have a shelf life, eventually all competitive advantages will erode, and economies will grow and contract. But the Lindy effect argues simply that certain things like ideas or books actually get more durable over time. For example, the odds are higher that Shakespeare will still be read in a thousand years from now than the chances are that any of today's bestsellers will be. We can probably learn more from timeless classics because their lasting legacy has meant that they added value to generations of people rather than finding fleeting popularity before fading into obscurity.

38:38I think the same principle holds for companies too. I'd rather bet on a company to survive another decade that has operated profitably for four decades than I would on a hot new company that's only a few years old. The Lindy effect essentially suggests that the longer something has been around and weathered storm after storm, the greater the likelihood is it'll continue to endure. Generally, I think that companies in boring, old-fashioned businesses tend to be the most Lindy. Firms in fast-paced industries are exposed to much greater threats of disruptive innovation, which is why there's so much turnover in market leaders on the cutting edge of technology.

39:12It comes as little surprise then that Warren Buffett, who is the master of finding hidden compounders and great boring businesses to own, avoids rapidly evolving high-tech industries as much as possible. Much of what Buffett has looked for his entire career is implicitly based on this Lindy effect by trying to identify which business models are best positioned to stand the test of time. In that vein, Coke is one of his all-time favorite investments. Since people's thirst for sugary, carbonated, and caffeinated drinks isn't going away anytime soon, same with Geico, which is a leader in car insurance, For many decades, car insurance has been a boring yet profitable business, hardly threatened by disruptive innovations that would fundamentally displace their operations.

39:52The only threat of this nature on the horizon for a company like Geico is if we all switch to self-driving cars, but even that doesn't really seem to be on the horizon anytime soon. Here's Buffett himself on Geico. But Geico is a jewel and it's, it's, uh, it's Revere. because others we feel awfully close to somebody about. But it's an incredible company. It has a culture all of its own. And it's saving its customers probably$4 or$5 billion a year against what they would otherwise be paying based on the average in auto insurance. and added, it will be profitable and underwriting a very high percentage of the year and contributed another$2 billion to flow last year.

40:47It is a terrific company. And like I say, the first four months are dramatically better. Now, there's some seasonal in auto insurance. So the first quarter is usually the best of the four quarters, but it's not a dramatic seasonal side. I think when you read the 10Q and you're taking the word for April, I think Tyco is on a good profit track as well as a good growth track. And the more it grows, the better. I like it. Berkshire Hathaway's investments over time are, in some way, the ultimate compilation of boring businesses that are great but often overlooked compounders. I'll just read you a handful of them in case you aren't familiar.

41:33Berkshire's roster of past and current boring businesses include names like Kraft Foods, Chevron, American Express, Kroger, Duracell Batteries, Clayton Homes, Dairy Queen, Hellsberg Diamonds, B &SF Railroad Company, and dozens more. You'll notice that none of these companies are particularly flashy. Instead, they're intensely practical companies rooted deeply in businesses that are changing very slowly. Grocery stores catering to the middle class, diamond companies, homebuilders, railroads aren't going away anytime soon. By nature, these companies reflect the Lindy effect from both their long track records of success as well as through the simple yet durable industries they operate in.

42:10Boring businesses make up the fabric of our society, providing us with what we need, while almost on purpose, proving forgettable along the way. As the last topic today, to pull the thread a little bit further, I want to share some of my takeaways from a 2016 report from Morgan Stanley on compounders and the value of compounding in an uncertain world. Eight years later, reading the paper in its cautious nature warning about an uncertain world with serious geopolitical risks, it's a reminder to me that rarely do markets ever look quote-unquote normal, and periods of tranquility are fleeting at best.

42:42As uncertain as the world looks today, it looked equally so back then too. The world always feels crazy, and that's just a challenge we face as investors. If the world were safe and predictable, we wouldn't deserve to earn the risk premium and higher returns that stocks offer. The uncertainty is, by definition, what makes stock investing potentially more rewarding than just putting your money in a savings account. Still, the Morgan Stanley paper is interesting because the authors discuss how compounders can offer protection and stability in an otherwise unstable world. The team writes, quote, Our research shows that these compounders, which exhibit characteristics such as strong franchise durability, high cash flow generation, low capital intensity, and minimal financial leverage have generated superior risk-adjusted returns across the economic cycle.

43:29Correspondingly, they recommend that long-term investors, quote, adopt a back-to-basics approach to portfolio management to generate superior returns regardless of what's happening in markets more broadly. Over a 15-year period, they found that the top 25 % of stocks in terms of their returns on invested capital considerably outperformed the rest. So their research isn't focused on hidden compounders per se, but I find it useful to better understand generally what compounders look like. As the authors write, quote, in our experience, relatively few companies have been able to consistently compound shareholder wealth at superior rates of return over the long term.

44:04Instead, we have found that most companies are erratic or inferior creators of long-term wealth. Some of the most durable advantages they found among compounders tended to be intangible assets like customer loyalty, innovation, and brand recognition, which I think plays into this idea of invisible moats, as we've discussed. Intangible assets are, well, intangible, meaning we can't directly observe them per se, but that doesn't make them any less real than tangible assets. In fact, over time, intangible assets have become increasingly important to the modern economy, and you can definitely make a case that some of these more abstract assets and competitive advantages resemble the type of invisible moats that Chris Mayer described when examining Old Dominion freight lines.

44:44As the researchers at Morgan Stanley put it, quote, in contrast, dominant assets that are physical are more easily replicated and often lead to price competition and erosion of a company's returns on capital. So I'm sure you can see how these comments play into what we've discussed in this episode. The advantages that companies like Old Dominion and Technion have are very much intangible. When people think of intangible assets, they typically think of things like patents and software, which you might expect big tech companies to have, then that's certainly true, but even boring businesses can have intangible advantages too, as we've learned today.

45:17Even better is that they found that compounders, especially ones operating in more dull areas of the economy, tended to have less cyclical profits due to the non-discretionary nature of their services. And of course, that makes sense. A company like Murphy's isn't going to see a huge decline in a recession because people are still going to need gas and are going to want cigarettes. The same is true even for a trucking company like Old Dominion, where revenues only fell 2 % in 2020 during the pandemic. Even when the world is seemingly at a standstill, there's still a lot of cargo being shipped around, and Old Dominion clearly has some advantages that position it to fare better in a downturn than others in the trucking business.

45:54And despite that modest downturn, revenues jumped 20 % in 2021. That is just classic hidden compounder behavior. Things are less bad in the bad times and really good in the good times. This line from Morgan Stanley also validates the approach that Technion has taken in finding boring companies that are industry leaders. They write the following, When seeking compounders, we believe that the relative strength of a company within its industry is more important than market capitalization. In terms of industry structure, we typically find that compounders enjoy high relative market share in monopolistic or oligopolistic markets.

46:31These companies generally enjoy high barriers to entry, usually as a result of the intangible assets they possess and their ability to continually innovate. The researchers actually cite their own example of what you might call a boring or a hidden compounder in a Swedish coffee and chocolate company that, through thick and thin, hasn't seen negative sales growth in 23 years, while growing earnings per share fivefold in that period, thanks largely to managing their intangible brand assets so well. Borg and Stanley provide some warnings, too, for investors on the hunt for hidden compounders. They write, quote, When searching for compounders, investors must avoid traps in the form of fading companies or acquisitive companies.

47:09By fading companies, we mean those where patents or licenses are soon to expire, where new technology or a change in fashion or new regulation can disrupt the franchise. Companies that are overly dependent on a single brand or product are more vulnerable to disruption. Adding to that, they suggest that poor or greedy management can similarly derail compounders over time, while acquisitions can be especially damaging. Imagine, for example, a company earning 30 % returns on invested capital that acquires a business earning just 5 % to 10 % returns on capital. While this acquisition would artificially boost profits, it would destroy value for shareholders over time because returns on invested capital are what matter most, and this acquisition would obviously be reducing that average ROIC.

47:51So those are the biggest highlights from the paper, which as always, I'll link to in the show notes in case you'd like to read it for yourself. To wrap things up today, I want to reiterate the old saying that sound investing should be like watching paint dry. Unless you're among the rare breed that finds reading financial statements of practical businesses exciting, which is a great thing, then you really shouldn't find too much about investing exciting beyond thinking about how your returns will compound over time if they're invested in durable, well-run businesses. That is to say, if you're fixated on the hottest, most innovative companies and markets, you're probably going to get burned eventually for a few different reasons, ranging from bursting bubbles to simply not having the technical expertise to determine whether, say, one cutting-edge computer chipmaker has a sustainable advantage over another.

48:35As Wall Street legend George Soros puts it, quote, if investing is entertaining, if you're having fun, you're probably not making money. Good investing is boring. And really, I couldn't have put it any better myself. Good investing takes patience. It involves finding hidden compounders and holding them for long periods of time, letting them simply do their thing, and it requires very little action from you. If you can have just one or two great ideas a year for companies to invest in over a lifetime, you'll do quite well. That's all for today, folks. I hope you enjoyed this conversation on hitting compounders and the best boring businesses hidden in plain sight.

49:12I'll be back again next week with another episode that hopefully makes you a little wiser about investing. I'll see you then. 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 Investor's Podcast Network. Written permission must be granted before syndication or rebroadcasting.