We have defined compounders in Part 1 as companies who are able to grow intrinsic value per share at a superior rate for over a decade. Subsequently, we’ve introduced two types of value-creating companies: reinvestment compounders in Part 2 and capital light compounders in Part 3.  

Labeling companies as ‘Compounders’ based on their historical financial performance is tempting but risky. It can lead to complacency and ignores an important investing axiom: over a long enough horizon, every compounder eventually stops being one. ‍

It starts with understanding what makes a company unique

We do not take unusually great or improving economics for granted and spend considerable time understanding the underlying reasons why a company is unique. These qualitative attributes are put to the test and validated with numbers and bottom-up financial analysis. This allows us to identify changes in the business environment that could deteriorate or impair a company’s value-creation abilities. In fact, discussions around what could “kill” a company are part of the first step of Langdon’s 6-stage diligence process. Getting to these insights often requires a deeper understanding than Porter’s 5 forces.¹ Below are some examples of how great businesses can stop being compounders.

Harder to sell as a business continues to expand: fading unit economics

It’s common for vertical software companies in the earlier stages of their growth journeys to require few sales resources to grow revenues as they focus on core customers who absolutely need their solutions. An example is SmartCraft, a Norway based USD~$40m revenues company offering software solutions to small contractor firms (electricians, plumbers, carpenters, etc.) in the Nordics and the UK. SmartCraft has sales cycles of ~1 month and turns ~50% of their leads – many of which are inbound - into paid customers. This is unusually efficient, and part of the reason why SmartCraft can grow at 15-20% organically with a 40% EBITDA margin.²

SmartCraft benefits from selling affordable solutions to customers who are using pen and paper and Excel to operate their small businesses. If they were to reach a ceiling within their core markets and decided to go after larger companies, it might require investing more in internal resources. It might also require them to compete with more incumbent solutions on tenders, elongate sales cycles and necessitate investment in lower margin implementation resources. As a result, it would have been a mistake to extrapolate their 15-20% organic growth and 40% margins into the future if going upmarket was a necessary condition or part of their strategy.

‍Success built on a changing ‘infrastructure’

Many business models are built around and benefit from regulatory or market constraints, such as typical lengths of mortgage financing, construction zoning rules, invoicing norms, government-mandated monopolies to transport critical goods, consumer online shopping habits, etc. These can be great, but also represent a version of the ‘stroke of the pen risk’ outside of a company’s control.

An example is Hypoport’s Credit Platform business and its main product, Europace. Europace provides mortgage advisors in Germany with a real-time menu of interest rates and lending options from thousands of banks. Europace charges standard customers 0.01% per year of amortization. The German banking industry is extremely fragmented between savings, cooperative, and private banks. This wide variety of options can be intimidating to homebuyers in Germany, who typically commit to a fixed rate for 10 years. Europace, therefore, appears to provide tremendous value given the number of financial institutions and the decade-long commitment buyers make. This value proposition could be at risk if German banks started to aggressively consolidate, and earnings could be impaired if the length of financing decreased substantially.  

It is important to recognize when a company provides a solution to a problem created by a market structure. Part of our job in underwriting an investment in a company is to identify and understand how changes in structure could impact the company's ability to compound intrinsic value over the long term.

Starting a new life away from home

Many of the companies that we meet and study benefit from exceptional economics in their domestic markets, where they have had the chance to establish a reputation, customer relationships, and a strong employee base for decades.

An example that comes to mind is a European distributor of fluid circulation accessories that we visited. This business has a tremendous track record of value creation spanning close to 60 years. The next phase of growth for this company will require them to step outside their home market, where they benefit from a long tail of businesses they have consolidated at low entry multiples, and transportation efficiencies given their strategic location close to a major highway network, airports, and large logistical centers. These conditions will be hard to replicate as the company continues to grow internationally, and it is likely that future returns on capital deployed could be much lower than they have enjoyed for decades.‍

‍The Empire Builder’s New Clothes

Compounders inherently generate increasing amounts of cash, which leaves management teams with the crucial responsibility of allocating this capital to the best alternatives. When companies decide to do large transactions and multiply their size overnight, it could alter their ability to continue growing intrinsic value per share at superior rates.

A press release announcing ‘strategic’ or ‘platform’ acquisitions that will transform a company’s footprint is often a politically correct way to justify overpaying for an asset. Many executives are motivated to build corporate empires, either by their variable compensation KPIs or for personal reasons. Beyond the lower returns on capital, larger transactions require management’s scarce time and attention during the integration process.

Deploying increasingly large amounts of capital into acquisitions is one of the surest ways of destroying shareholder value. Just like in Christian Andersen’s tale of ‘The Emperor’s New Clothes,’ corporate empire builders often find themselves in possession of a lot less than they originally believed once a platform acquisition is closed. It almost always looks better on the spreadsheet.‍

‍People, people, people

This is to small cap investing what ‘location, location, location’ is to real estate. In the world of smaller companies, individuals and teams drive outcomes to a larger and more direct degree than would be possible in bigger enterprises with defined processes and bureaucracy around decision-making. We spend time understanding who the key people are throughout the organization, what drives them, but also get a sense of bench strength in the event of key people leaving the company.

In a more intangible way, changes in culture within an organization can be an amazing leading indicator of cash flow compounding deterioration. This is where having met with key people in their own facilities, in different contexts, and importantly, over several years becomes extremely valuable to us as investors. It allows us to get a sense of levels of excitement, frustration, and office set ups as indicators of changing hierarchy and information flowing to the c-suite, among other factors that can’t be observed sitting behind our desks.

Price will always matter

Great businesses with sound fundamentals and strong management teams are highly sought after in the investment community. This means that ‘obvious compounders’ tend to be relatively more expensive, which ultimately compromises future returns for the marginal investor.

Valuation is one of our least favorite reasons for parting ways with a great business, but we recognize that any asset can turn into a terrible investment if we overpay for it. We require every portfolio holding to have a risk-reward of at least 2:1 and pay close attention to the downside risk of permanent loss of capital. We also do not allow for any multiple expansion in our underwriting. Said differently, a company’s cash flow per share growth has to exceed our hurdle rate.  We do not rely on the stock market to earn a return but will take advantage of it to redeploy capital in a more attractive opportunity.

Rare by definition

According to a study on 64,000 companies from 1990-2020 across 43 countries, only 2.4% of listed equities accounted for all the performance above short-term treasuries.³ Our investment process at Langdon is structured to maximize our odds of owning these wealth-creating businesses while also recognizing that most companies are not ‘forever compounders’.

The companies in our Global and Canadian Smaller Companies strategies are unusual in many respects. Not only do they tend to be located outside major cities and are seldom recognized even by investing aficionados, but they also hold unique business characteristics that enable them to grow intrinsic value per share at uncommon rates. We spend over half of our time monitoring existing holdings, constantly testing our hypotheses and making sure the cash flow compounding abilities are not impaired. Our goal is to own a portfolio of high-conviction, durable businesses with an ability to defy this fade for longer than the market prices in.

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