How to find the world's most consistent compounders (and 10 that make the cut)

One of the things we look for in all the businesses that we invest in is what's called earnings durability. What we're really thinking about is how big a company's total addressable market is. For example, retail sales shifting online or e-commerce becoming more prevalent globally. The total addressable market is realistically how much of the total retail sales around the world could be online in the future.

Investors should ask themselves, 'What is the big picture opportunity?' and then, 'How much share could this company take within that opportunity?' We want to make sure that they are the key enabler or one of the key enablers of that big structural change and therefore can grow their earnings in a sustainable way over the long term. 

We want companies' top-line revenue figures to grow at a rate that is at least double GDP, or at least outgrowing their market or industry. If they're growing their sales faster than their market, then they effectively have some degree of competitive advantage or pricing power.

We also like companies that are growing their earnings - so EPS, EBITDA or operating profits - faster than their revenues. This means a company is expanding its margins over time and becoming more profitable.

Management is also really important for growth compounders. We always look for companies with a controlling shareholder or a founder still involved in the business. Founders think much more long-term about the opportunity set in front of them. If you think about some of the world's most famous founders over the last 10 to 30 years, people like Steve Jobs or Jeff Bezos - these founders thought about where their business would be in 20 years' time.

In comparison, the investment community might be focused on the next quarter, the next six months or the next 12 months. So a controlling shareholder aligned with the shareholder base can create durable growth and margin expansion over a long period of time.

The last thing that we always like to look for, and it's a little bit hard to judge as it's more subjective, is really great customer perception of the product. For example, when customers really love a product it can grow virally, meaning that the company never really has to “sell” the product.. To gauge this, we look at download data, customer reviews, trending data and we also watch a lot of YouTube videos about products to understand what the customers actually like about the company. 

Let's compare that company to banks, for example. A bank's earnings aren't driven by that structural change from physical to digital cash. Yes, they benefit from that structural change, but a bank's earnings are more impacted by external macro factors like central bank moves, inflation, and unemployment. That makes it difficult to get that compounding nature of earnings over a long period of time.

So, where a company is more vulnerable to the macro, and where it's not backed by one of these big structural changes in the world, is where you are unlikely to see that great compounding element over the long term.

Resources companies, cyclicals and some parts of the energy market are also more macro-exposed, so they typically wouldn’t fit into how we think about a consistent compounder. 

I think an obvious one is Amazon (NASDAQ: AMZN). So, if you think about the two markets that Amazon exists in and think about the total addressable market opportunity, retail sales are still roughly 70-80% offline. E-commerce is only about 25% of total retail sales. And in our view that is going to lift higher over time. So that provides the structural underpinning for Amazon's e-commerce business.

In digital payments, MasterCard (NYSE: MA) and Visa (NASDAQ: V) are classic examples of compounders. Everyone is familiar with these businesses, but digital payments today still only make up roughly 70% of total payments in the world. There are many emerging markets that are yet to digitise their payment systems.

In innovative healthcare, we've been invested for several years in the GLP-1 opportunity. This both improves outcomes for the patient and removes costs from healthcare systems. GLP-1s address the obesity problem, which on a global basis affects approximately 1 billion people, of which only a small percentage are treated with pharmaceutical drugs. The companies that provide these drugs, like Novo Nordisk (CPH: NOVO-B) and Eli Lilly And Co (NYSE: LLY), are set to grow their earnings as a result of this large opportunity over a long period of time. That growth is durable because it's a big addressable market with little penetration today. 

We believe TSMC provides a good opportunity right now given the multiple ’we have to pay today. TSMC has a broad end-market exposure across areas such as high-end semiconductors, autos, industrials and consumers.

TSMC is not growing its earnings as fast as other semiconductor companies such as NVIDIA, but we believe the valuation is attractive. It’s priced at just above the S&P 500 multiple on a 12-month forward basis, and it’s the leader in an oligopoly with competitors Intel and Samsung. So the valuation, in addition to that competitive positioning in a market that is accelerating, means it could have the potential to be a compounder over the long term. 

As investors, we keep across earnings reports, which are important as we believe earnings growth drives share prices. Anytime a company updates its earnings profile, that can be an important catalyst for an investment case to play out. However, over the long term, in our experience, and consistent with our investment philosophy, great compounding businesses are held and not traded.

For example, Amazon has been able to grow its Prime Membership base over almost 20 years or its AWS product since 2006. During that time, we've had lots of different macro-related impacts on the market - we've had the GFC, a European crisis, the COVID pandemic, we've had different political leadership in power around the world, but over that period, you didn't really need to worry too much if you were a long-term investor.

All of these different events impacted the stock on a short-term basis. But really, to be a successful Amazon investor, you just needed to work out that retail sales would shift online in the future and that workloads would shift to the cloud as well. Those two big structural changes outweighed all the macro factors, allowing Amazon to be the great compounder it has proven to be.