[00:02:45] Intro: Celebrating 10 years, you are listening to Millennial Investing by The Investor’s Podcast Network. Since 2014, we have been value investors go to source for studying legendary investors, understanding timeless books, and breaking down great businesses. Now, for your host, Shawn O’Malley.

[00:03:13] Shawn O’Malley: Today, we’ll be talking about hidden compounders and finding the best companies that are hiding in plain sight. There is nothing sexy about the companies I’ll discuss today, but as an investor that really shouldn’t matter to you. Sometimes the most plain and simple businesses are the most profitable.

[00:03:28] Shawn O’Malley: The great investor Peter Lynch is probably the most famous for talking about investing in boring businesses. His book went up on wall street discusses at length how individual investors can get an advantage in markets by investing in companies they know well through personal experience. As well as businesses that are uninteresting.

[00:03:43] Shawn O’Malley: He writes, quote, a company that does boring things is almost as good as a company that has a boring name and both together is terrific. Peter Lynch is best known for running the Fidelity Magellan Fund, where he racked up one of the most impressive careers in Wall Street history. In just 13 years, Lynch takes a bottoms up approach to investing, aiming to thoroughly understand a company, its prospects, its competitive environment, and whether the stock can be purchased at a price.

[00:04:07] Shawn O’Malley: Rather than having some formula or screen that enables him to quickly pick stocks, he chooses to instead investigate them one by one to assess what story can be told about their future. You can probably imagine the types of things he looks for, like earnings growth and low price to earnings ratios, but what’s interesting to me and relevant to this episode on Hint Compounders is that he specifically makes a point of emphasizing his interest in companies that are particularly unappetizing.

[00:04:30] Shawn O’Malley: That is, companies that operate in a boring field, or even do something that is disagreeable or depressing. This could be anything from a company that operates funeral homes to one that does waste disposal. On the flip side, he finds hot stocks and exciting industries unattractive since they’re likely to garner a disproportionate amount of attention from Wall Street.

[00:04:48] Shawn O’Malley: So to reiterate, what I find interesting is not only trying to find companies that are compounders, which are essentially stocks you can buy and hold for several decades with such profitable businesses and attractive growth opportunities that they can single handedly and reliably generate market beating returns.

[00:05:03] Shawn O’Malley: But also companies like this that are hidden in plain sight. They’re secret compounders as Mohnish Pabrai calls them. On our We Study Billionaires podcast back in May 2020, Mohnish told listeners that one of his biggest career mistakes has been not appreciating the power of compounders. Let’s listen.

[00:05:20] Mohnish Pabrai: For most of my investing career, I always focused on finding 50 cent dollar bills. And basically the idea was invest at 50 cents, sell at 90 cents. Hopefully the transition from 50 to 90 happens in two or three years. And that’s a great and that’s written return. Well, there are two, three problems with that. Number one is taxes because you end up with a significant tax bill. And the second is that you have to continue to be right.

[00:05:48] Mohnish Pabrai: So if I invest in a company for three years and I doubled my money, I now have to find a second investment for three years. And I have to keep finding these two, three year bets and I have to always keep being right. And so it’s not that easy to continuously be right like that.

[00:06:07] Shawn O’Malley: Fast forwarding a bit, Mohnish goes on to add the following. Let’s listen again.

[00:06:12] Mohnish Pabrai: There are three kinds of businesses. Businesses that are cheap. But not necessarily great compounders. They are just cheap on current earnings and what they’ll make in the future. But who knows where they are 10 years from now. Then the second is that there are compounders which are well known and Visa, MasterCard, Coke, and Amex, and so on, and Costco, and they’ve got huge runways ahead of them. Those businesses, which are known compounders. Probably rightfully traded high multiples. Then there’s the third class of businesses, which I would say are the hidden compounders. So the hidden compounders is where I have put all my efforts now. Okay. Because that’s the Holy grail for me may not be for the investors.

[00:07:02] Shawn O’Malley: I couldn’t put it any better. The Holy grail of investing is finding compounders that most people don’t even realize are compounders. I really love this framework because it is simple but also true. In my years of studying stocks, I have continuously been surprised that there are so many wonderful companies to be found out there that are not only great compounders, but also largely hidden.

[00:07:22] Shawn O’Malley: In part, these compounders may be hidden because their moats aren’t easily recognizable. Pretty easy to explain why Meta has moats. The company has billions of users across Facebook, Instagram, and WhatsApp, and that reinforces network effects that keep people engaged with those platforms since those are the apps everyone else is using.

[00:07:39] Shawn O’Malley: And that success helps the company attract the best engineers and programmers, and all those advantages compound in the company’s favor. But what are we to make of companies that, based on their track record, clearly have some competitive advantage, though it’s not easy to define what that is. It’s a question that Chris Mayer of Woodlock House Capital explored in his 2020 blog post called Invisible Motes.

[00:07:59] Shawn O’Malley: An economic moat refers to, in the words of Morningstar, how likely a company is to keep competitors at bay for an extended period. A successful moat allows high returns on capital to persist. One of my favorite parts about researching companies is trying to determine what moat there is, if any, and debating that with friends.

[00:08:18] Shawn O’Malley: Old Dominion Freight Lines, one of Mayors portfolio companies, is rife for controversy on that front. As I’ve alluded to, this is a company with no discernible moat, at least not one that is easy to sum up in 30 seconds or less. For context, Old Dominion is the third largest trucking company in the US that specializes in being what’s known as a less than truckload carrier.

[00:08:39] Shawn O’Malley: These are essentially companies that combine multiple smaller shipments from different customers into a single truck, as opposed to loading a truck with inventories from only one customer. Because they carry cargo for multiple customers at the same time, the logistics for less than truckload carriers, or LTL as they’re known, can be much more complicated.

[00:08:56] Shawn O’Malley: Though for those looking to ship cargo, LTL can be a great option because they only pay for their portion of truck space and don’t pay for any empty trailer space. Supporting its LTL carrier business, Old Dominion has around 235 service centers and 9, 200 trailers, and it has earned a reputation for being one of most disciplined and efficient trucking companies in the industry.

[00:09:17] Shawn O’Malley: It’s profitability and returns on capital are head and shoulders above its peers. Through 2019, including dividends, shareholders earned more than 30 percent per year over 3 year and 10 year time periods, and in the past 5 years, the stock has continued that impressive streak by growing over 257%, which translates to a compound annual growth rate of 29 percent per year.

[00:09:38] Shawn O’Malley: In short, the company has been a wonderful compounder, yet it competes in an industry that is seemingly commoditized. Truck space is truck space, and it’s not immediately clear why a trucking company should have competitive advantages that extend across decades. If it were solely due to organization and efficiency, those are surely factors that could fade away over time or be copied by competitors, but that hasn’t happened.

[00:10:03] Shawn O’Malley: As Matthew Young of Morningstar puts it, quote, In our view, even the best operators, like Old Dominion, struggle to carve out a sustainable, competitive edge via the key economic moat sources. Cost advantage, intangible assets, switching costs, and network effect. Young continues by arguing that economies of scale and trucking have largely proved insufficient as a competitive advantage given that the trucking behemoth YRC Worldwide was pushed to the brink of bankruptcy during the 2009 recession.

[00:10:30] Shawn O’Malley: So, despite Old Dominion’s track record of high and rising returns on invested capital, with correspondingly high returns for shareholders, there’s not a simple story to be told about why this is happening. Working in Old Dominion’s favor is that its drivers aren’t unionized, as compared with IRC, which certainly helps, and Old Dominion has relatively little debt, too.

[00:10:49] Shawn O’Malley: Still, as Chris Mayer writes, quote, I admit Old Dominion doesn’t seem to have a traditional moat that fits in one of those buckets. Instead, it seems to have pieces of the different buckets. Somehow the whole adds up to a strong competitor versus just looking at the parts. Old Dominion does own about 1. 5 billion dollars’ worth of service centers, which isn’t easy to replicate and run efficiently, even if you had 1.5 billion dollars lying around. But there isn’t much keeping competitors from entering the market, at least for full truckload shipping. All that’s needed are a truck and a trailer, insurance and licensing, and a driver. With those parts in place, a truck driving startup simply needs to win a shipping contract to begin earning revenues.

[00:11:29] Shawn O’Malley: However, the challenge that new startups and many existing trucking companies face is that there is very high turnover for truck drivers because the job is so demanding and may require driving across the country in a few days with little rest. Another advantage for LTL carriers is that while rail isn’t an option for short deliveries, it is an option for longer deliveries.

[00:11:47] Shawn O’Malley: So not only do full truckload carriers have to deal with higher driver turnover, but they’re also competing more directly with railways, which tend to be cheaper. So there are some less obvious advantages supporting a company like Old Dominion that operates as a less than truckload carrier. And LTL carriers need to win many contracts to operate profitably since they’re carrying loads for a handful of customers at any one time.

[00:12:08] Shawn O’Malley: And importantly, They need to have consolidation centers that can load and unload cargoes mid route. As a result, the LTL market tends to be much more consolidated than the full load trucking market with the top 10 LTL carriers holding about 55 percent of the market share. On top of that, Mayer points out that Old Dominion has an ownership culture that gives it advantages as well.

[00:12:28] Shawn O’Malley: The Congdon family has continuously run the company since Old Dominion’s founding in 1934, retaining a board and management presence over the company while also holding a combined 13 percent ownership stake. More impressive is that Old Dominion’s employees not only are loyal to the company but want to invest in it too.

[00:12:44] Shawn O’Malley: Over 20 percent of Old Dominion’s employees 401k assets are invested in Old Dominion stock and with an employee turnover rate of just 10 percent it’s about as low as it gets in the trucking business. An ownership culture where the company is heavily owned by both its founding family and employees, plus the efficiency and discipline it has shown in the LTL carrier business, truly makes for some kind of moat, right?

[00:13:06] Shawn O’Malley: A company doesn’t compound at 30 percent per year for 15 years without any kind of moats protecting it. As Chris Merritt puts it, Old Dominion has something of an invisible moat. The company is a hidden compounder not only because its business model is unglamorous, but also because many who have looked into the company can’t understand what competitive advantage it has that’ll support the business going forward, so they just assume that competition will erode its above average returns in the future.

[00:13:32] Shawn O’Malley: As we’ve mentioned, Old Dominion seems to benefit from a range of factors that, in total, form a moat, while each part, in its own, is arguably not a full moat. To me, the fact that there’s so much room for debate about Old Dominion’s competitive positioning is exactly what makes it a hitting compounder. If everyone agreed that Old Dominion was a dominant player in its market and competition was unlikely to change that, then the stock would be bid up so much that it would be harder for new investors in the company to earn market beating returns.

[00:13:59] Shawn O’Malley: Yet the uncertainty around Old Dominion’s moats, in addition to the company itself not being particularly exciting to the average investor, I think contributes to the fact that the stock has been able to compound reliably at such incredible rates. Obviously, what underlies that too is the invisible moat supporting the company’s high returns on capital.

[00:14:16] Shawn O’Malley: In an interview with Guy Spear, who runs the Aqua Marine Fund, Mohnish Pabrai suggests that another great way to find hidden moats is to look for younger companies that haven’t operated long enough for their advantages to be appreciated by the market. He uses the example of having discovered Chipotle when it had just a few restaurant locations open.

[00:14:33] Shawn O’Malley: If you had stumbled upon one of these early Chipotle locations, you might have come away thinking that not only was the food tasty, affordable, and reasonably healthy, but that the company had the chance to revolutionize the fast casual dining industry. As he puts it, you likely would have had a sense that this business could appeal to a large number of people.

[00:14:51] Shawn O’Malley: In contrast to having a fully formed but hidden moat like Old Dominion, this is more akin to a moat that is in construction. Chipotle was in the process of building its moat, and anyone who recognized that would have been rewarded generously. To be perfectly candid with you, I hesitate to share these examples because I do think they make everything sound much easier than it is.

[00:15:11] Shawn O’Malley: There have been a ton of fast casual chains that you might have had similar convictions in that flopped while Chipotle didn’t. Whenever looking at case studies on compounders, we have to be mindful of survivorship bias. For every company that has found multi decade success in compounding returns for shareholders at market beating rates, There are probably dozens of companies that went out of business, underperformed, or simply delivered average results.

[00:15:33] Shawn O’Malley: As with everything in life, there’s an element of randomness to it all that, as stock investors, I think we have to be honest with ourselves about. If you found Chipotle early on, it was probably due to luck. Either having a location open near you, having someone recommend it to you, or whether you came across some article on the company, there was a huge element of randomness involved.

[00:15:52] Shawn O’Malley: There’s even luck on Chipotle’s side too, where you could imagine a number of things could have gone wrong early on that sidetracked the company’s success. Being lucky, though, doesn’t make you a good investor. That said, to be a bit cliche, what does distinguish great investors is not letting those sorts of opportunities pass them by.

[00:16:09] Shawn O’Malley: To me, it’s about always keeping your eyes open to investment opportunities that might be sitting right in front of you. Whether that’s where you’re eating lunch or thinking about the company that delivers things for you by truck, there are great compounders hidden all around us. I want to keep going here to show some more examples of what you might call hidden compounders.

[00:16:27] Shawn O’Malley: Murphy USA is a gas station company that operates convenience stores across 1800 locations, mainly in the southwestern, southeastern, and midwestern regions of the United States. Despite that very basic business model, Murphy’s has averaged an excellent return on invested capital of 18 percent per year for the last five years, while its stock has grown at a compound annual growth rate of 25 percent per year over the past decade.

[00:16:49] Shawn O’Malley: If you’ve ever driven through the regions it operates in, you’d see the company’s locations labeled as either just Murphy or QuickCheck. Interestingly, the company aims to differentiate itself by maintaining a strategic proximity to Walmart with many of its locations and by selling gasoline at relatively discounted prices.

[00:17:05] Shawn O’Malley: Murphy’s. Murphy’s. The company does have a formal relationship with Walmart, too, where Walmart Plus customers get special discounts at Murphy’s, but on top of that, Murphy’s is clearly trying to appeal to the types of price sensitive shoppers who frequent Walmart. As a result, their margins on gas are very thin, but they make up for that with higher sales volumes and with sales of retail products, particularly tobacco products.

[00:17:27] Shawn O’Malley: Murphy’s is essentially an industry leader in per store cigarette sales among gas stations driven primarily by its proximity to Walmart as well as its rewards programs on tobacco products. With Murphy’s, there’s probably five or six factors at work in their favor, and I’ve already mentioned a few, but like Old Dominion, there’s no obvious single wide moat to point to.

[00:17:48] Shawn O’Malley: The company’s advantages aren’t neatly categorized, yet its track record speaks for itself and implies some form of durable modes. I haven’t done enough research on Murphy specifically to argue strongly that it’s a hitting compounder, but I think it’s at least a strong contender. It operates in an unglamorous business model that most people take for granted in their daily lives.

[00:18:06] Shawn O’Malley: It lacks the type of obvious moat that some of the best known compounders possess. And still, it is both incredibly profitable and run in a way that has created a tremendous amount of wealth for shareholders. That last point may seem obvious, where profitable companies earn strong returns for shareholders, but you’d be surprised at how many companies operate profitably but find a way to destroy value for investors.

[00:18:26] Shawn O’Malley: From paying dividends when that cash would be better reinvested, to making frivolous and expensive acquisitions of other companies and issuing so much stock to employees and executives that, despite total profits increasing, profits per share remain flat or even decline. As crazy as it may sound, there are profitable companies that are terrible investments.

[00:18:45] Shawn O’Malley: And my point here is to say that a potential hidden compounder like Murphy’s has both a strong financial track record in terms of profits earned from its operating business And a strong track record of ensuring shareholders reap the benefits of that operating success. Another example of a hidden compounder I’ll spend a little more time on is a company my colleagues on our We Study Billionaires podcast have talked about in past episodes, Teqnion.

[00:19:08] Shawn O’Malley: I’ll link to the full discussion in the show notes, but Teqnion is what’s known as a serial acquirer. So rather than operating a hidden compounder themselves, they manage a holding company that buys up stakes in these sorts of companies. In other words, they find the hidden compounders for you, and in doing so, become a hidden compounder themselves.

[00:19:26] Shawn O’Malley: Thanks. Teqnion operates in a very narrow niche, targeting small Swedish B2B industrial companies. Here’s Teqnion’s director of M&A, Daniel Zhang, to paint some more color around their business.

[00:19:37] Daniel Zhang: We like to say, in order to finish first, uh, you must first finish. Uh, so we’re saying that we never want net debt to be too high.

[00:19:47] Daniel Zhang: And in our case, we say, let’s not make it go over 2. 5. And as you’ve seen, we’ve been much more conservative than that. Secondly, uh, when the stability is fine, we focus on profitability, which means that we want to assure that all of our companies are actually creating value. And that is not enough. We want them to create value, but also to capture enough of that value so that they are relevant and can reinvest money for themselves and for us to deploy to acquire new companies.

[00:20:21] Shawn O’Malley: Suffice to say, investing in companies that invest in boring yet profitable businesses can also be quite rewarding. Serial acquirers like Teqnion are hitting compounders in their own way. Because acquisitions have such a negative perception in the financial world, these types of companies are often ridden off by mainstream investors.

[00:20:38] Shawn O’Malley: Correspondingly, there’s no shortage of literature documenting how mergers and acquisitions have destroyed value for shareholders historically. In part, that’s because a premium must be paid typically to acquire a company, leading acquirers to overpay, and also on top of that, those deals usually involve large amounts of debt to finance everything.

[00:20:56] Shawn O’Malley: While this is true, I believe there’s precedent for overseeing value creating serial acquisition. It’s just rare. There are examples though of serial acquirers with exceptional track records in delivering returns to shareholders. The most famous example is, of course, Berkshire Hathaway. Led by Warren Buffett, Berkshire is very much a serial acquirer, and for a long time, you could argue that the company was a hidden compounder before Buffett and Munger gained a cult following.

[00:21:20] Shawn O’Malley: Berkshire is the vehicle for making these acquisitions, as it buys up majority or minority stakes in great businesses and holds them indefinitely until something materially changes about the target company’s business model or valuation. Serial acquirers like Teqnion and Early Berkshire can be undervalued and dismissed, turning them into hidden compounders, not just because of the stigma around conglomerate acquisitions, but also because of the messy system behind how they report earnings.

[00:21:46] Shawn O’Malley: Since 2018, companies like Berkshire have been required by accounting standards to report changes in the market value of their portfolio companies and their own net earnings. Meaning with a 2 percent stake in Apple, rather than reporting 2 percent of Apple’s 100 billion in net income in the last 12 months as its profit, Berkshire would have to adjust its earnings to reflect unrealized gains and losses from swings in Apple’s stock price.

[00:22:08] Shawn O’Malley: As Warren Buffett wrote in 2017 in anticipation of the accounting rule change, quote, The new rule says that the net change in unrealized investment gains and losses in stocks we hold must be included in all net income figures we report for you. That requirement will produce some truly wild and capricious swings in our GAAP bottom line.

[00:22:28] Shawn O’Malley: Berkshire owns 170 billion of marketable stocks, and the value of these holdings can easily swing by 10 billion or more within a quarterly reporting period. For Including gyrations of that magnitude in our reported net income will swap the truly important numbers that describe our operating performance.

[00:22:45] Shawn O’Malley: For analytical purposes, Berkshire’s bottom line will be useless with Teqnion. The situation is different because Teqnion is listed in Sweden and therefore it doesn’t adhere to the same accounting standards. It also primarily invests in private companies that aren’t listed on stock exchanges. But still, the point remains that serial acquirers can be great compounders in their own right, while also being hidden, to an extent, because valuing a company like Teqnion or Berkshire is really a valuation of dozens of other companies that they own stakes in, which can get messy quickly.

[00:23:14] Shawn O’Malley: As Chris Mayer explains, as the name suggests, a large part of a serial acquirer’s growth comes from acquiring many smaller companies. Serial acquirers are typically decentralized, with the acquired companies enjoying quite a bit of autonomy. The free cash flow of these daughter companies is funneled to the mothership where it is deployed, in new acquisitions, dividends, or whatever.

[00:23:34] Shawn O’Malley: Typically, serial acquirers look to hold companies forever. Looking at Teqnion, the company has done this to an impressive extent, even though it’s just getting started after being founded in 2006. Since going public in 2019, Teqnion has delivered compounded annual returns of well over 30 percent per year on average for shareholders.

[00:23:53] Shawn O’Malley: Like Berkshire and other successful serial acquirers, I think Teqnion has a hidden moat. In theory, there’s no reason a serial acquirer should have any moat and be able to generate these types of returns over time. As we know, with stock investing, very few people can consistently beat the market averages and serial acquisition is the same idea on a different scale.

[00:24:14] Shawn O’Malley: Seemingly, anyone could come in and copy the playbook that someone like Warren Buffett has used, and with all that competition, it would become difficult for a company focused on serial acquisition to find enough attractive opportunities for them to compound returns at above average rates. While there is some evidence that, after 60 years, Berkshire is brushing up against this problem due to simply how large it has gotten, leaving it with fewer and fewer meaningful acquisition targets, Smaller serial acquirers like Teqnion appear to have a secret sauce that, like Old Dominion, is both powerful and hard to define.

[00:24:45] Shawn O’Malley: It seems as though Teqnion is in the process of building its moat, an invisible moat that, also like Old Dominion, may have a lot to do with culture. While serial acquisition seems as simple as just buying and holding companies and then using their earnings to buy more businesses, There’s a lot that can go catastrophically wrong with this model.

[00:25:04] Shawn O’Malley: One concentrated bet that blows up is more than enough to derail a serial acquirer. Doing serial acquisition well, in a way that is both sustainable and accretive to shareholders, requires discipline. I’ll read you a list of a few of the things they look for in making an acquisition. Teqnion wants to buy companies that operate in niche markets with strong competitive advantages built up over the years.

[00:25:26] Shawn O’Malley: Additionally, they want their target companies to be profitable market leaders with operating margins above 9%. Generally, these will also be companies that can be acquired for between 2 and 10 million dollars. Where the initial investment can be recouped within 5 years with a 15 percent annual return.

[00:25:42] Shawn O’Malley: And last but not least, Teqnion only wants to acquire companies that have good and honest management teams, with the founders or family ideally being still involved in the company. While this formula does give some criteria that shape their capital allocation decisions, it’s not as simple as following this formula and finding success, because as I’ve said, anyone could theoretically do this and compete with them, though that hasn’t happened to a meaningful extent, at least not yet.

[00:26:07] Shawn O’Malley: In part, I think that’s because much of what they’re doing is so personalized, which has also been a tailwind for Buffett and Munger in their careers from leaning into treating people well and building lasting relationships. That, in its own way, is the moat. Teqnion is buying family businesses like Berkshire did in its early days with See’s Candy and Nebraska Furniture Market.

[00:26:26] Shawn O’Malley: And when you’re selling the business you spent a lifetime building, where your employees are your friends and neighbors, you care a great deal about who you sell it to. Rather than being some soulless private equity firm that’s planning on buying the company and gutting it, Teqnion provides an alternative for business owners who are looking to cash out all or part of their stake in the company they built.

[00:26:45] Shawn O’Malley: But they still probably care a lot about what happens to the company, and that’s where the team at Teqnion thrives. Being Swedish and focusing on acquiring Swedish companies, being honest and trustworthy, and promising to leave their acquired companies intact with a hands off ownership approach, helps build the relationships that enables these deals to happen at all.

[00:27:03] Shawn O’Malley: And as they’ve acquired companies and sellers have been more than satisfied by how they were treated, That news spreads by word of mouth, and I’m sure that has helped Teqnion find more founders willing to sell their businesses to the right buyer. In some academic setting, I would probably be unable to describe this competitive advantage, because it’s an invisible moat.

[00:27:22] Shawn O’Malley: In theory, it probably shouldn’t exist, but I think it does. Trust, relationships, and reputation are not things you can quantify easily, but in the real world, they do exist and can be quite powerful. Teqnion’s financial results and shareholder returns, like Old Dominion, are a testament to it. After having met both Teqnion’s CEO and Chief Acquisitions Officer myself at the Berkshire shareholder meeting in 2023, I, like Chris Mayer, am inclined to say that I see the invisible moat in action here.

[00:27:49] Shawn O’Malley: Their modesty and reverence for Warren Buffett and Charlie Munger, combined with their track record, signals to me that they are very likely spearheading a culture at Teqnion that is the explanatory factor behind their success beyond how well any single investment has worked out for them. Teqnion is a hidden compounder not only because it is a small company based in a small European market but also, as I’ve mentioned, because it is a serial acquirer where the returns it’s compounding are happening behind the scenes at its portfolio of private companies which do not have the same transparency as the types of publicly traded companies that a large serial acquirer like Berkshire has to invest in.

[00:28:26] Shawn O’Malley: Nothing about Berkshire is hidden these days. It’s probably the most well studied company on earth. It is arguably still a compounder, but not like what it was in the past, and as I said, it’s not hidden. For reference, I’ll go ahead and just read off a few more companies that are candidates for being what we might call hidden compounders due to their simple, boring businesses, excellent returns, and a lack of easy to define moat.

[00:28:49] Shawn O’Malley: Rollins, ticker ROL, is a pest extermination company with an average annual return on invested capital of 18 percent per year in the last 5 years and a compounded annual growth rate and its stock price of almost 20 percent per year over the last 2 decades. Another candidate for a hidden compounder status is TransDigm Group, ticker TDG, which operates in the exceedingly boring business of airline components yet has delivered an average annual return on invested capital of 15 percent per year for the last 15 years.

[00:29:17] Shawn O’Malley: While compounding its stock at more than 22 percent over the last decade. And one more for a good measure is Sherwin Williams, a company that simply sells paint. With an average return on invested capital of 28 percent in the last 10 years, a simple manufacturer and distributor of paint products has earned returns that rival Google’s parent company Alphabet, which has an ROIC in recent years of 29%.

[00:29:39] Shawn O’Malley: To shareholders and this wonderful company’s delight, Sherwin Williams stock prices earned compounded returns of 18 percent per year in the last decade. So, as I’ve said, some of the most boring businesses you can imagine quite literally compound profits and returns for shareholders at rates you’d expect only from the best known big tech companies.

[00:29:58] Shawn O’Malley: To me, this is the epitome of being a hidden compounder. Of course, there are degrees of hiddenness, and whether a company is considered a hidden compounder is definitely subjective. Teqnion is clearly much more quote unquote hidden than Sherwin Williams, which despite being a boring business, is at least a household name across the United States.

[00:30:16] Shawn O’Malley: So again, there’s some subjectivity to this, and I really hope that your takeaway is the essence behind the idea of hidden compounders, rather than fixating too much on an explicit definition for it. And I’ll add as well that there’s clearly some companies where it’s easier to define their moats than others.

[00:30:32] Shawn O’Malley: Just because there’s room for debate on a company’s moat doesn’t make it a hitting compounder though. You may decide on a different definition for hitting compounders, but at its core, the idea is to find companies with impressive track records and compounding returns that, for one reason or another, are not appreciated by markets to the full extent they should be.

[00:30:49] Shawn O’Malley: Evidently, I’ve talked a good deal about so called boring businesses, because I do think these compounders with boring business models are more likely to be overlooked than some company that’s doing something really exciting at the forefront of the latest hyped up fad in markets, whether that be gene editing, 3D printing, or more recently, AI.

[00:31:06] Shawn O’Malley: Relatedly, boring companies in particular are likely to have what Chris Mayer calls invisible moats, Where their competitive advantages may not be as clear cut as a leading tech company that has some network effect or advanced software working in its favor, yet based on their abnormal profits, clearly has some combination of less visible motes collaborating to their benefit.

[00:31:26] Shawn O’Malley: There’s nothing wrong with focusing on compounders with flashy motes, It’s just a different game to play and one that’s more competitive and where the companies probably don’t slip to attractive valuations as frequently. Another point worth mentioning here in today’s conversation on boring businesses and hitting compounders is a concept known as the Lindy effect.

[00:31:44] Shawn O’Malley: That is to say, all businesses have a shelf life, eventually all competitive advantages will erode, and economies will grow and contract. But the Lindy effect argues simply that certain things like ideas or books actually get more durable over time. And For example, the odds are higher that Shakespeare will still be read in a thousand years from now than the chances are that any of today’s bestsellers will be.

[00:32:06] Shawn O’Malley: We can probably learn more from timeless classics because their lasting legacy has meant that they added value to generations of people rather than finding fleeting popularity before fading into obscurity. I think the same principle holds for companies too, I’d rather bet on a company to survive another decade that has operated profitably for four decades than I would on a hot new company that’s only a few years old.

[00:32:27] Shawn O’Malley: The Lindy effect essentially suggests that the longer something has been around and weathered storm after storm, the greater the likelihood is it’ll continue to endure. Generally, I think that companies in boring, old fashioned businesses tend to be the most Lindy. Firms in fast paced industries are exposed to much greater threats of disruptive innovation, which is why there’s so much turnover in market leaders on the cutting edge of technology.

[00:32:50] Shawn O’Malley: It comes as little surprise then that Warren Buffett, who is the master of finding hidden compounders and great boring businesses to own, avoids rapidly evolving high tech industries as much as possible. Much of what Buffett has looked for his entire career is implicitly based on this Lindy effect by trying to identify which business models are best positioned to stand the test of time.

[00:33:11] Shawn O’Malley: In that vein, Coke is one of his all-time favorite investments, since people’s thirst for sugary, carbonated, and caffeinated drinks isn’t going away anytime soon. Same with Geico, which is a leader in car insurance. For many decades, car insurance has been a boring yet profitable business, hardly threatened by disruptive innovations that would fundamentally displace their operations.

[00:33:31] Shawn O’Malley: The only threat of this nature on the horizon for a company like Geico is if we all switch to self-driving cars, but even that doesn’t really seem to be on the horizon anytime soon. Here’s Buffett himself on Geico.

[00:33:43] Warren Buffett: But Geico is a jewel, and it’s, it’s uh, you know, it’s really our, we’ve got stuff, others we feel awfully close to somebody about, but, but it’s an incredible company, it has a culture, all of it’s all in it.

[00:34:02] Warren Buffett: Did saving its customers probably four or $5 billion a year against which they would other, uh, against what they would otherwise be paying based on the average in auto insurance and add it, it will be profitable on underwriting a very high percentage a year. It contributed that other $2 billion to flow last year.

[00:34:26] Warren Buffett: It is a terrific company and like I say, for four months ours. Grammatically better. Now, there’s some seasonal in auto insurance. So the first quarter is usually the best of the four quarters, but it’s not a dramatic seasonal sign. I think when you read the 10Q and you can take my word for April, I think, uh, I think Tyco is on a good profit track as well as a good growth track. And the more it grows, the better I like it.

[00:34:58] Shawn O’Malley: Berkshire Hathaway’s investments over time are, in some way, the ultimate compilation of boring businesses that are great but often overlooked compounders. I’ll just read you a handful of them in case you aren’t familiar. Berkshire’s roster of past and current boring businesses include names like Kraft Foods, Chevron, American Express, Kroger, Duracell Batteries, Clayton Holmes, Dairy Queen, Helzberg Diamonds, BNSF Railroad Company, and dozens more.

[00:35:25] Shawn O’Malley: You’ll notice that none of these companies are particularly flashy. Instead, they’re intensely practical companies rooted deeply in businesses that are changing very slowly. Grocery stores catering to the middle class, diamond companies, home builders, and railroads aren’t going away anytime soon. By nature, these companies reflect the Lindy effect from both their long track records of success, as well as through the simple yet durable industries they operate in.

[00:35:48] Shawn O’Malley: Boring businesses make up the fabric of our society, providing us with what we need, while almost on purpose, proving forgettable along the way. As the last topic today, to pull the thread a little bit further, I want to share some of my takeaways from a 2016 report from Morgan Stanley on compounders and the value of compounding in an uncertain world.

[00:36:07] Shawn O’Malley: 8 years later, reading the paper in its cautious nature warning about an uncertain world with serious geopolitical risks, it’s a reminder to me that rarely do markets ever look quote unquote normal, and periods of tranquility are fleeting at best. As uncertain as the world looks today, it looked equally so back then, too.

[00:36:25] Shawn O’Malley: The world always feels crazy, and that’s just a challenge we face as investors. If the world were safe and predictable, we wouldn’t deserve to earn the risk premium and higher returns that stocks offer. The uncertainty is, by definition, what makes stock investing potentially more rewarding than just putting your money in a savings account.

[00:36:43] Shawn O’Malley: Still, the Morgan Stanley paper is interesting, because the authors discuss how compounders can offer protection and stability in an otherwise unstable world. The team writes, quote, Our research shows that these compounders, which exhibit characteristics such as strong franchise durability, high cash flow generation, low capital intensity, and minimal financial leverage, have generated superior risk adjusted returns across the economic cycle.

[00:37:07] Shawn O’Malley: Correspondingly, they recommend that long term investors, quote, Adopt a back to basics approach to portfolio management to generate superior returns regardless of what’s happening in markets more broadly. Over a 15 year period, they found that the top 25 percent of stocks, in terms of their returns on invested capital, considerably outperformed the rest.

[00:37:26] Shawn O’Malley: So, their research isn’t focused on hidden compounders per se, but I find it useful to better understand generally what compounders look like. As the authors write, quote, In our experience, relatively few companies have been able to consistently compound shareholder wealth at superior rates of return over the long term.

[00:37:43] Shawn O’Malley: Instead, we have found that most companies are erratic or inferior creators of long term wealth. Some of the most durable advantages they found among compounders tended to be intangible assets, like customer loyalty, innovation, and brand recognition, which I think plays into this idea of invisible moats, as we’ve discussed.

[00:38:00] Shawn O’Malley: Intangible assets are, well, intangible, meaning we can’t directly observe them per se, but that doesn’t make them any less real than tangible assets. In fact, over time, intangible assets have become increasingly important to the modern economy, and you can definitely make a case that some of these more abstract assets and competitive advantages resemble the type of invisible moats that Chris Mayer described when examining Old Dominion Freight Lines.

[00:38:22] Shawn O’Malley: As the researchers at Morgan Stanley put it, quote, In contrast, dominant assets that are physical are more easily replicated and often lead to price competition and erosion of a company’s returns on capital. So I’m sure you can see how these comments play into what we’ve discussed in this episode. The advantages that companies like Old Dominion and Teqnion have are very much intangible.

[00:38:43] Shawn O’Malley: When people think of intangible assets, they typically think of things like patents and software, which you might expect big tech companies to have. And that’s certainly true, but even boring businesses can have intangible advantages too, as we’ve learned today. Even better is that they found that compounders, especially ones operating in more dull areas of the economy, tended to have less cyclical profits due to the non-discretionary nature of their services.

[00:39:06] Shawn O’Malley: And of course, that makes sense. A company like Murphy’s isn’t going to see a huge decline in a recession because people are still going to need gas and are going to want cigarettes. The same is true even for a trucking company like Old Dominion where revenues only fell 2 percent in 2020 during the pandemic.

[00:39:21] Shawn O’Malley: Even when the world is seemingly at a standstill, there’s still a lot of cargo being shipped around and Old Dominion clearly has some advantages that position it to fare better in a downturn than others in the trucking business. And despite that modest downturn, revenues jumped 20 percent in 2021. That is just classic hidden compounder behavior.

[00:39:41] Shawn O’Malley: Things are less bad in the bad times and really good in the good times. This line from Morgan Stanley also validates the approach that Teqnion has taken in finding boring companies that are industry leaders. They write the following. When seeking compounders, we believe that the relative strength of a company within its industry is more important than market capitalization.

[00:40:01] Shawn O’Malley: In terms of industry structure, we typically find that compounders enjoy high relative market share in monopolistic or oligopolistic markets. These companies generally enjoy high barriers to entry, usually as a result of the intangible assets they possess and their ability to continually innovate. The researchers actually cite their own example of what you might call a boring or hidden compounder in a Swedish coffee and chocolate company that, through thick and thin, hasn’t seen negative sales growth in 23 years while growing earnings per share fivefold in that period, thanks largely to managing their intangible brand assets so well.

[00:40:35] Shawn O’Malley: Morgan Stanley provides some warnings to for investors on the hunt for hitting compounders. They write quote When searching for compounders, investors must avoid traps in the form of fading companies or acquisitive companies. By fading companies, we mean those where patents or licenses are soon to expire, where new technology or a change in fashion or new regulation can disrupt the franchise, companies that are overly dependent on a single brand or product are more vulnerable to disruption.

[00:41:02] Shawn O’Malley: Adding to that, they suggest that poor or gritty management can similarly derail compounders over time, while acquisitions can be especially damaging. Imagine, for example, a company earning 30 percent returns on invested capital that acquires a business earning just five to 10 percent returns on capital.

[00:41:17] Shawn O’Malley: While this acquisition would artificially boost profits, it would destroy value for shareholders over time because returns on invested capital are what matter most. And this acquisition would obviously be reducing that average ROIC. So those are the biggest highlights from the paper, which as always, I’ll link to in the show notes in case you’d like to read it for yourself.

[00:41:36] Shawn O’Malley: To wrap things up today, I want to reiterate the old saying that sound investing should be like watching paint dry. Unless you’re among the rare breed that finds reading financial statements of practical businesses exciting, which is a great thing, then you really shouldn’t find too much about it investing exciting beyond thinking about how your returns will compound over time if they’re invested in durable, well run businesses.

[00:41:57] Shawn O’Malley: That is to say, if you’re fixated on the hottest, most innovative companies and markets, you’re probably going to get burned eventually for a few different reasons, ranging from bursting bubbles to simply not having the technical expertise to determine whether, say, one cutting edge computer chip maker has a sustainable advantage over another.

[00:42:14] Shawn O’Malley: As Wall Street legend George Soros puts it, quote, if investing is entertaining, if you’re having fun, you’re probably not making money. Good investing is boring and really I couldn’t have put it any better myself good investing takes patience It involves finding hidden compounders and holding them for long periods of time Letting them simply do their thing and it requires very little action from you If you can have just one or two great ideas a year for companies to invest in over a lifetime, you’ll do quite well That’s all for today folks I hope you enjoyed this conversation on hitting compounders and the best boring businesses hidden in plain sight You I’ll be back again next week with another episode that hopefully makes you a little wiser about investing. I’ll see you then.

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