How to identify consistent compounders (and 17 stocks that make the cut)

LW: Distilled really simply, with no jargon, what is a consistent compounder?

Michael Wayne: A consistent compounder is essentially a business that's able to deliver consistent or persistent earnings and revenue growth over time in a reliable nature. So these are businesses that are price makers, not price takers, and typically they aren't as exposed, or not exposed at all, to the underlying economic cycles. Certainly, they're not exposed to things beyond management's control, for example, commodity prices.

What do you mean by price makers, not price takers?

If you think about a mining company, for instance, they are forced to take the market price of the underlying commodities, so they're price takers. Conversely, if it's a high-quality business with a dominant market position, typically they're able to set their own prices to a degree without the influence of global financial markets. So if a product is highly sought after or people are dependent upon it, then they're able to, in many ways, set their own price.

If these stocks outperform over the long term, why would people invest in anything else?

Good question. Often I think people attempt to try and pick cycles. For instance, at the moment, we're seeing a big run-up in the gold price and the copper price. So in the short term, if you can time those cycles well, then you can obviously do extremely well from those decisions. 

However, there will be a point where that cycle reaches its peak or its pinnacle and you'll have to rotate out of those businesses or those sectors in order to avoid the downswing. So it's a good question. I think people often try and overcomplicate investing. They try and base their investment decisions on turnaround stories, broad themes or hype stories. Often, quite simply, it's a lot easier to focus on businesses that have demonstrated the capacity to consistently grow earnings over time.

In our view, the total return of a business is determined by earnings growth as well as growth in dividends per share. And ultimately, dividends per share are a function of earnings growth. So from a total return standpoint, the chances of success are higher if you're focused on businesses that can deliver compounded and persistent growth.

What factors besides earnings and dividend growth are important for a stock to compound its earnings consistently?

Well, common factors in defining these quality compounders are things like return on equity or return on invested capital. They're both very important. Businesses that can maintain stability in that return on equity and return on capital, and hopefully, over time, grow those key figures. Margins are another very important metric that we look at. If a company can sustain stable margins or grow those margins over time, that's obviously very important. Earnings quality is also important, and that often just comes through from being able to consistently deliver earnings throughout the cycle. Another thing that is important from our standpoint is having a line of sight on future growth opportunities.

It's one thing to see a company that might have grown well and consistently in recent years, but it's important to figure out whether it will have the capacity to continue to grow into the future, depending on the macro environment or the particular market that it operates in. 

We also look for things like leverage. We think balance sheet strength and a stable balance sheet are important. So having a consistent level of leverage is always a good indicator for us as well.

How about management teams?

Definitely. Management quality is always important, but it's very difficult to get a true grasp on whether management is high quality. The problem as well, once we start getting into larger caps, is that over time the management turnover is quite significant. So investors should question whether the new team, the new management or the C-suite team, is going to be as good as the previous one. Obviously, management is very important, and things like governance and having internal rules around payout ratios, buybacks and capital management decisions that are driven by management are all very important too.

So, would you say that no commodities, resources, or materials companies would be consistent compounders?

That's correct. It's nothing against those companies. It's not like they're doing a bad job. It's merely a symptom of the fact that they operate in industries where it's difficult, if not impossible to be a compounder. The reality is that if you look at the balance sheet of BHP (ASX: BHP), Rio Tinto (ASX: RIO) or Fortescue (ASX: FMG), they are very, very dependent on the underlying commodities that they produce. There'll be some very, very good years, like in the lead up to 2012, 2013, the big China boom - iron ore prices were booming, commodity prices were booming, and then, all of a sudden, the momentum slows. Unfortunately, for those businesses, they were then confronted with low commodity prices. And then the cycle more recently has picked up again. So it's just very difficult for those kinds of businesses.

The same goes for the banks as well. Banks are very much dependent on the economic cycle. At the end of the day, if economic growth is good and unemployment is low, then the banks typically see low default rates or impairments. And vice versa, when things become more challenging, people lose their jobs, struggle to pay back their mortgages, and there are higher insolvencies. 

So those two tend to be pretty cyclical businesses depending on the broader economic cycle. So it's very difficult for businesses that are confronted with cycles to be compounded earners and compounded businesses.

If not the resources companies or the banks, which stocks fit into the category of consistent compounders? 

So, if you look at the balance sheets of businesses in the tech space, for instance, or the healthcare space, these are typically happy hunting grounds for compounders. And again, it goes back to what I was speaking about earlier. They provide a service or a product that people are increasingly dependent on. 

Often, these sectors are shielded against the broader economic cycle, and they're operating a system or delivering a product that isn't easily replicated by competitors. Therefore, they're more price makers as opposed to price takers. So I can give you a few examples of some healthcare companies, and many of the readers, your viewers would be familiar with things like CSL (ASX: CSL), ResMed (ASX: RMD), and Pro Medicus (ASX: PME). These are high-quality compounders in the healthcare space.

In the tech space, you have companies like TechnologyOne (ASX: TNE), which often goes underrated, and is probably one of the businesses that's compounded its earnings most consistently over time.

You have Altium (ASX: ALU), which was recently acquired. They've shown characteristics of a compounder. As well as WiseTech Global (ASX: WTC). And then a couple of others outside of the healthcare or tech sector, like James Hardie (ASX: JHX), which is potentially surprising. That has the characteristics of a compounder. And then companies like REA Group (ASX: REA) is another one that ticks the box in the communications space. 

So there's a good list of businesses there that investors can go away and look at their balance sheets and get proof of the fact that they've been able to deliver reliable, persistent and consistent earnings growth over time.

There are 17 "true" compounders on the ASX (as outlined below). These stocks have market caps higher than $500 million, have a five-year sales CAGR above 5%, and a CAPE 10-year CAGR of more than 5%. These businesses also have a dividend per share CAGR over 10 years of more than 5%, five-year average gross margins above 10% and a five-year average return on equity over 10%. 

That's a decent list, and we hold many of those companies in our managed fund for clients. But one I suppose that is a bit more topical given that it reported last week, and has really been a bit downtrodden in recent years, is ResMed (ASX: RMD). ResMed is a top-five holding in our managed fund. The share price hasn't really changed much over the last four years. 

Nevertheless, during that time, we've seen earnings more than double. So essentially, it's trading on its lowest valuation multiple in over five years, if not a decade, and it delivered a very strong update just last week whereby earnings, revenue, and margins all exceeded expectations. 

The business has continued to deliver good results, but the market has been distracted by weight loss drugs and the impact they might have. But we think that's more of a transitory issue that the market will come to appreciate over time. So ResMed, at the moment, is probably a standout, and that's historically been a very good example of a compounder.

Are any other consistent compounders trading at a discount right now?

CSL (ASX: CSL) is in a similar bracket in that it's trading on a very low multiple relative to its 5-10-year average, and its earnings growth is expected to be quite attractive in the years to come. CSL is a business that you can go back almost 30 years now and effectively it has compounded those earnings pretty consistently year after year over time. So we're seeing a little bit of value in that healthcare space. 

Certainly, share prices haven't fallen away, but they haven't charged ahead. They've been really tracking sideways in many cases, despite the fact that earnings growth and revenue growth have been very strong and are expected to be very strong in the years to come. 

Another one we quite like is TechnologyOne (ASX: TNE). That's a high-quality tech business that's been around for a long time, and it's not overly expensive, particularly relative to some of the other tech names on the ASX.

Are these the kinds of stocks that investors should be trading, or is it better to buy and hold them for the long term?

From our standpoint, we are more "buy and hold" investors. Certainly, if the conditions are right, these are businesses that we see no reason for investors to be buying and selling them. You let the compounding do its job. Over time, the share price should follow the compounded earnings higher.

Obviously, you'll have short-term market gyrations, such as we saw in 2022. You might have elections, or you might have invasions, or war, or all these kinds of things, but that's more short-term noise. Over time, if a business is compounding nicely, then the share price would reflect that. Particularly, if you consider the fact that if multiples are constant, then it makes a lot of sense if earnings and dividends are growing over time, then the share price should mathematically (at least) be higher as well.