Capital Compounders Can Boost Your Stock Portfolio’s Returns

Robin Speziale’s newest list of 15 Canada-listed capital compounders has generated an average compound annual return of 23%

Robin Speziale | July 16, 2018 | SmallCapPower: Since age 18, I have had an insatiable drive to find and invest in a concentrated group of stocks that can continually beat the market in the long-run (i.e., greater than the S&P/TSX’s long-term 9.8% compound annual return). I showcased my research on these 25 market-beating Canadian stocks, which are still publicly traded on the TSX, to reveal the key attributes that they all have in common:

– Mostly small-mid caps ($100M – $10B) in the non-cyclical Technology, Consumer, and Diversified Industries space – large addressable markets / long growth runways;
– Free cash-flow generative, high return on capital businesses (with a durable moat);
– Run by exceptional operators, and shareholder-oriented managers who;
– Effectively deploy capital in (re)investment opportunities to grow the business (i.e., re-invest in the business, acquire/integrate smaller companies, and buy back shares over time), continually delivering high rates of return for their shareholders

Read: My 70 Rules for Stock Investing – Part One

Read: My 70 Rules for Stock Investing – Part Two

I said: “I like to think that there’s a strong correlation in the long run between a company’s Return on Capital (i.e., ROIC) and its share price performance… the average ROIC of these 25 Capital Compounder stocks is 16% (5 Year Average)… and the average compound annual return [since trading inception on the TSX] is 26%”. Looking back, this may have not been the best comparison; matching the 25 Capital Compounders’ past 5 years average ROIC with past 15+ years (average) share price performance, but it was important to make the abstract connection. Later in this issue, I’ll show the shorter 2017-2018 period share price performance (1 Year) vs. ROIC (5 Year Average) and discuss whether there was in fact a correlation.

It’s now been over one year since my talk on these 25 Capital Compounders, and so I wanted to gauge their stock performance over that period, reflecting on both my process, and justification for picking this particular group of stocks. The results were satisfactory. In aggregate, the 25 Capital Compounders (see Table 1 below) achieved a +15.8% return from April 19, 2017 to June 29, 2018, easily beating the S&P/TSX (+4.7%) and ranking closely alongside the S&P 500 (17.2%), and DJIA (19.9%). Further, it was encouraging to see that for YTD 2018 (i.e., Jan – June), this basket of 25 Capital Compounders was up +5.7%, ahead of all three comparison indexes; S&P/TSX (+0.4%), S&P 500 (+1.7%), and DJIA (-1.8%). The performance comparison summary can be found below in Table 2.

Table 1: Original 25 Capital Compounders 

Table 2: Performance Summary (“CC” vs. Comparison Indexes)

*CC = 25 Capital Compounders

The top three performers over that 2017 – 2018 period were Pollard Banknote (+104.8%), Constellation Software (+62.2%), and Photon Control (+56.7%), and the top 10 (out of 25) stocks delivered an average 43.5% return. Interestingly, the top three performers YTD 2018 were the same 3 stocks from the 2017 – 2018 period, demonstrating that performance trends can prevail. “The trend is your friend,”as they say. Note: If I remove the worst performer from the group (CRH Medical), the 2017-2018 average return is 19.2%. But if I remove the best performer (Pollard Banknote), it’s 12.1%. And that I observed about 80% of these stocks seem to be in a multi-year consolidation phase. Thus, I wouldn’t hesitate to personally buy more at these share price levels, as there’s a near-term opportunity to break out of their bases (but that’s not certain).

Indeed, one year later, there was a correlation between these 25 Capital Compounder stocks’ Return on Capital (i.e., 16% ROIC; 5 Year Average) and their share price performance (+15.8%). While this correlation won’t always be achieved in the short term and can be due to a mix of other factors, ‘High ROIC = High Share Price Performance’ should theoretically play out in the long run. But nothing is certain! Companies come and go, and markets can surprise us.

This is why it’s so important to always be on the quest for new Capital Compounders. As a DIY investor, one needs to continually keep their portfolio fresh with small-to-mid cap growth stocks. I’m not saying to sell long-held stocks at ‘the top’, because as we know, high can go higher, which is the desired outcome. Rather, I’m suggesting that one supplements his/her portfolio (which might now include large-caps) with new ideas. Obviously, based on the law of large numbers, a company cannot compound at the same high rate forever. For example, Brookfield Asset Management, which is now a large $40+ billion-dollar company can’t as easily/quickly double many more times over at this point in its life. Plant new seeds, and water the growing trees (i.e., winners).

To this end, I’ve posted below the Next 15 Canadian Capital Compounders for your consideration, which I’ll supplement and track along with my original 25 Capital Compounders. The majority of these 15 companies (see Table 3 below) are Small-Cap ($100M – $2B) and Mid-Cap ($2B – $10B) in size, sharing the same attributes as discussed above (i.e., high ROIC, exceptional managers, ample investment opportunities/ returns, etc.). On a trailing twelve-month (TTM) basis, these 15 companies in aggregate have achieved a 17.2% Return on Capital (ROIC), and over the last 5 years, 15.9% Average ROIC. Their average compound annual return (since inception on the TSX) is 23.3%, with an average public life of 14 years. Interestingly, 5 (out of 15) companies below have achieved a compound annual return that is greater than or equal to 30% since their inception, with Kinaxis (+61%), Spin Master (+47%), and FirstService (+43%) ranking the highest.

The ‘newest’ companies (out of 15), with only 3-5 years of public trading on the TSX, are Spin Master (TOY), Fairfax India (FIH.U), Sleep Country (ZZZ), First Service (FSV), Kinaxis (KXS), and BRP (DOO). Some companies, like Transcontinental (TCL.B), have a much longer tenure on the stock market, but are transforming their business models for future growth, and so one might expect higher compound returns from this point onward. In Transcontinental’s case, transforming their business from traditional newspapers/printing to shipping/packaging for the e-commerce age. Others are larger companies (e.g. Magna) that are diversifying into new investment opportunities (AI, electric vehicles, etc.) to drive their next growth phase. However, the majority of companies below fit into the small-mid-cap space, with large addressable markets, and long runways to grow.

Table 3: Next 15 Capital Compounders

*TTM = Trailing Twelve Months

I’ll track these 40 Capital Compounders (25 + 15) for the foreseeable future. And I’ll always be on the lookout for more (email me your suggestions!). As Peter Lynch said: “The person that turns over the most rocks wins the game.” Overall, if I achieve a 15% compound annual return in my portfolio over the long run, then I’m a happy guy. Striving for anything over 15% and I’m taking on too much risk and that can blow up my portfolio. Achieving anything below 15%, and I’d rather just hold an Index ETF. 15% is the sweet spot and means that I can double my money every 5 years, based on the Rule of 72.

Before I conclude this issue, it’s important to note that I am not overly concerned with Price-to-Earnings multiples (P/E) in the long run as I’m a Growth-at-a-Reasonable-Price (GARP) investor. This means that I’ll invest in a company trading at 30 P/E if its EPS growth rate is 30% or greater, for example. I say this because most so called ‘value investors’ would just balk at that 30 P/E and move on. Please look into “PEG.” If I avoided companies with 30+ P/E over the past 13 years, I wouldn’t have created much wealth at all in my portfolio. I’d just be sitting on my thumbs, “waiting for a pullback” and investing in the likes of Torstar, and Corus Entertainment, both being classic “value stocks” that teach one a very valuable lesson: cheap stocks can get cheaper.

Also, notice that I don’t invest at all in Pharma, Oil & Gas, or Mining. I call those industries “Capital Destroyers,” as all are cyclical, ebbing and flowing through the years, with little cash-flow predictability, and hardly any sustainable wealth creation to be seen. Instead I focus on and allocate capital to these three non-cyclical areas: Technology, Consumer, and Diversified (e.g. Media).

Further, I use Return on Capital (ROIC) rather than Return on Equity (ROE) to ultimately base my investment decisions, as the latter metric can be inflated (i.e. look great!!) due to extensive debt leverage. I don’t like debt. And I especially don’t like companies that grow-by-excessive-leverage. We saw what happened to Valeant. I much prefer companies that are self-funded through their own free cash flow, combined with strong, well capitalized balance sheets, so that those companies are capable of funding growth, and avoid crashing in economic downturns. This very important ROIC metric must be consistently high (which is why I use a minimum 5-year average), above a company’s cost of capital, and preferably rising throughout the years, combined with growing revenues, book value per share, earnings per share, and free cash flow per share.

But perhaps most importantly, companies that I invest in need to have sustainable competitive advantages, whether that be through the industries in which they operate, their operating models, distribution network, niche and/or new products and services, regulatory advantages, patents, technology, and brand/goodwill, etc. Durable competitive advantage allows these companies to compound shareholder wealth for a longer period of time, warding off competition for as long as possible.

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