Discover more from Compounding Quality
Next week, Compounding Quality will launch its Portfolio.
Our goal is to outperform the S&P 500 with more than 3% per year.
In today’s article we’ll go through the reasons why the Portfolio should outperform.
You can apply this framework to your own portfolio as well.
For every investor, the reason why your Portfolio should outperform the S&P 500 should be obvious.
Try explaining your investment plan to a 11-year-old and why you think your portfolio will do better than a stock market index.
If even a child can see the rationale behind your strategy, you’re on the right track.
For Compounding Quality’s Portfolio, you’ll notice two things:
The fundamentals for the companies we own are way better
The companies aren’t valued more expensively than the S&P500
Healthier balance sheet
You want to invest in companies which are in good financial shape.
We look at two metrics:
Interest Coverage: shows how well a company can pay the interest due on its outstanding debt
Criteria: Interest Coverage > 5
Net Debt / Free Cash Flow: shows you how many years it would take if a company uses all its Free Cash Flow to pay off its debt
Criteria: Net Debt / FCF < 3
When we compare the balance sheet fundamentals of the Portfolio with the S&P 500, you get the following:
As you can see, companies within the Portfolio are in better financial shape compared to the S&P500.
“Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.” - Warren Buffett
Lower capital intensity
The less capital a company needs to operate, the better.
Two metrics are taken into account:
CAPEX/Sales: the percentage of sales a company uses in Capital Expenditures
Criteria: CAPEX / Sales < 5%
CAPEX/Operating Cash Flow: the percentage of Operating Cash Flow a company uses in Capital Expenditures
Criteria: CAPEX / Operating CF < 25%
Companies within the Portfolio require way less capital to operate compared to companies within the index.
“Asset-light industries are attractive since they require less capital to be deployed to generate sales growth. The finest examples are franchise operations, such as Domino’s Pizza, where growth is funded by franchisees rather than by the company.” - Lawrence Cunningham
Capital allocation is the most important task of management.
Return On Equity (ROE): measures how many dollars are generated for each dollar of shareholder’s equity
Criteria: ROE > 15%
Return On Invested Capital (ROIC): shows the percentage return that a company earns on its invested capital
Criteria: ROIC > 15%
Based on these data, the companies within the Portfolio are way better in capital allocation.
The higher the profitability, the better.
The best companies translate most revenue into earnings and free cash flow.
Gross margin: shows the percentage of revenue that is left over after direct costs are subtracted
Criteria: Gross Margin > 40%
Profit Margin: shows how much revenue is translated into earnings
Criteria: Profit Margin > 10%
FCF / Net Income: the percentage of Net Income that is translated into Free Cash Flow
Criteria: FCF / Net Income > 80%
As you can see in the table above, the companies within the Portfolio are very profitable.
Combine this with plenty of reinvestment opportunities and great capital allocation metrics and you get a Compounding Machine.
“The higher the profitability, the better. When a company has a high and robust gross margin, it’s a great indication that the company has pricing power as well as a sustainable competitive advantage.” - Compounding Quality
Historical growth and outlook
You want to invest in companies which are active in a clear secular trend.
Companies need to grow at attractive rates in order to create shareholder value.
Revenue Growth: at which rate did the revenue of the company grow in the past?
Criteria: revenue growth > 5%
EPS Growth: at which rate did the company manage to grow its Earnings Per Share in the past?
Criteria: EPS growth > 7%
The companies within the Portfolio managed to grow at very attractive rates in the past.
The outlook for the Portfolio also looks brighter compared to the index.
“When you invest in companies active in a strongly growing end market, you have the wind in the sails as an investor.” – Compounding Quality
You try to buy wonderful companies at a fair price.
We’ll look at two metrics to compare the valuation of the Portfolio with the S&P500:
P/E Ratio: divides the stock price of a company by its earnings
PEG Ratio: divides the P/E Ratio of a company by its expected EPS growth for the next 5 years
As you can see in the table above, the Portfolio is valued slightly more expensive compared to the S&P500 when taking into account current earnings, but significantly cheaper when we take into account future growth.
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” - Warren Buffett
In the end, it’s all about creating shareholder value.
When a great manager is leading the company and the company has performed really well in the past, it’s a great indication that the company will continue to do so in the future.
That’s why we like to look at the historical value creation (stock price appreciation).
We want to invest in companies that managed to compound with at least 12% per year since their IPO.
As you can see, the average company within the Portfolio returned more than 26% per year to shareholders since their IPO. These numbers are phenomenal.
“We don’t want to invest in the Next Big Thing. We want to invest in companies that have already won.” - Terry Smith
When you create an equal-weighted portfolio of all companies Compounding Quality will buy and compare these results with the S&P 500 since 2006, you get the following:
Since 2006, the results look as follows:
CAGR Compounding Quality: 26.2%*
CAGR S&P500: 7.9%
This means that when you would invest $10,000 in both, the value of your investment would be equal to:
Compounding Quality: $1,017,000
S&P 500: $41,000
* While the backtest shows that the Portfolio returned 26.2% per year since 2006, it isn’t realistic at all to expect a return of more than 20% in the long term. The goal of the portfolio is to outperform the S&P500 with 3% per year. Compounding Quality should be able to achieve this as we’ll invest in fundamentally better companies compared to the index.
The Premium Service will launch this Sunday.
This week, we’ve already launched the Compounding Quality Community.
It’s a group chat where I’ll post daily, but where you can also talk with other Partners.
I am sure that over the next few weeks and months great friendships will be formed via the Community.
If you become a Partner before the end of this week, you’re getting $300 worth of investing tools for free (3-months access to Koyfin Pro):
About the author
Compounding Quality has a true passion for investing and helping other investors. He aims to invest in the best companies in the world as it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Compounding Quality used to work as a Professional Investor but left his job to help investors like you. The main reason for this? He was sick of the short-term mindset of Wall Street and wanted to genuinely do the right thing.
All readers of Compounding Quality are treated as PARTNERS. We ride our investment journeys together.
“We have an attitude of partnership. Charlie Munger and I think of our shareholders as owner-operators.” – Warren Buffett