[00:03:05] Kyle Grieve: as a professional investor. So I won’t ask you to divulge anything on that front, but I do find people’s origin stories to be very interesting. What got you interested in investing in the first place? 

[00:03:14] Compounding Quality: First of all, I want to say that I’m incredibly thankful for being a guest on this podcast. I’ve also been a loyal listener myself since the beginning.

[00:03:22] Compounding Quality: And I think that you guys are doing an amazing job. Congratulations with that. I really think that’s trying to help other investors to make more informed investment decisions. That’s exactly what I’m trying to do as well. So I really think that everyone would invest in stocks when everyone would do that, the walls would be a healthier and wealthier place.

[00:03:41] Compounding Quality: So helping other investors trying to become smarter and make better investment decisions is something that makes me jump out of bed every morn. Now. If you ask me about how my investment journey begin to be honest, I’ve always been interested in stocks and I never really liked to spend money and I always saved as much as I possibly could when I was young.

[00:04:03] Compounding Quality: So as a kid, I used to do vacation work like restocking store shelves, sorting candy on the assembly line and things like that. And when I have a lot of respect for the people who do these jobs, I never really liked it. To be honest, I completely detested it, but things changed soon. So when I was 13 years old on a nice summer evening, someone told me about the stock market.

[00:04:25] Compounding Quality: And to me, that was something of the most beautiful things I had ever heard. So you could actually make money without having to work for it, that was astonishing according to me. I remember the conversation as yesterday, as it sparked a light in me, and my passion for investing was born on that summer evening.

[00:04:43] Compounding Quality: So the next day, after my conversation, I set up a brokerage account. I did it via my parents, because you aren’t allowed to own stocks under the age of 18. And after a few days, the account was set up and I transferred the hard earned money to my brokerage account, but there was only one small problem. In which stock should I invest?

[00:05:03] Compounding Quality: I didn’t know anything about stocks, And quote unquote, luckily, the broker I used had a topic list and they recently added a new company to this list. It was a local company active in the production, storage, supply, and transportation of oil and gas. And the people who managed the topic list were so called experts.

[00:05:24] Compounding Quality: They should know what they were doing right. So I blindly followed them and bought with all my money just one stock that I didn’t understand. And after one year, I sold it with a loss of 60%. And that was very painful. But to be honest with you, it’s the best investment I’ve ever made. So my worst investment actually become my best investment ever.

[00:05:45] Compounding Quality: After selling my first investment, which was very painful, I could beat myself up. So how could I be so stupid? And I think that when something like this happens to you, you can do two things. One, You conclude investing isn’t something for you and you give up, or two, you promise yourself to never make the same mistake again and to educate yourself.

[00:06:07] Compounding Quality: And that’s exactly what I did. So from that point in time, I became completely obsessed with the stock market. Starting from age 14, I read all financial newspapers I could find every morning. I read at least one finance book every week and I listened to everything I could possibly find about investing on YouTube to radio and more recently via podcasts.

[00:06:30] Compounding Quality: My ex girlfriend once said to me that I love the stock market and books more than I loved her. And yeah, she was probably right because we broke up a few months later. What can you learn from this? I think that making as many investment mistakes as you can in the beginning is probably the best thing that can happen to you.

[00:06:49] Compounding Quality: So as you know, Kyle, it’s way better to make a mistake with thousand bucks than 100, 000 or even more. Failures are part of life. And I think that if you’ve never failed, you’ve probably never tried anything new. So in that sense, the life of the optimistic investor is beautiful. If you make a good investment decision, you make money.

[00:07:12] Compounding Quality: And if you make a bad decision, you’ll learn something new. As Thomas Edison beautifully said, I have not failed, I’ve just found 10, 000 ways that won’t work. 

[00:07:21] Kyle Grieve: So you’re clearly a big fan of Warren Buffett, but Warren has taken a few twists and turns in his investing journey to end up where he is today.

[00:07:28] Kyle Grieve: What is it specifically about quality investing that attracted you so much to it? 

[00:07:33] Compounding Quality: To be honest, my story about how I got into quality investing is quite funny. I used to work as a professional investor who was involved in managing an equity funds. And before I joined the asset management company, I considered myself as a pure value investor in the sense that I like to buy cheap companies based on traditional metrics, such as the price to earnings ratio, the price to book ratio, and so on.

[00:07:56] Compounding Quality: One thing I didn’t do well before I started working in the industry. Is that I suffered from a lot of biases and more specifically, I suffered from home biases, meaning that almost my entire portfolio was invested in companies located in the country that I lived in. Home biases aren’t a good thing for an investor.

[00:08:16] Compounding Quality: And it also resulted in another problem for me. When I joined the asset management company, I wasn’t allowed to own any companies located in the country I lived in. So why with our equity funds, we could influence the stock prices of these companies. And as a result, when we buy the company on a personal account, before doing it for a fund yeah, you could front run, that’s illegal and something you want to avoid at all costs.

[00:08:40] Compounding Quality: So when I joined the company, I basically needed to liquidate my entire portfolio and rethink my entire investment strategy. And that’s when I started reading books like Quality Investing from Lawrence Cullingham, How to Pick Quality Shares from Phil Oakley, Only the Best Will Do. And the excellent book of Terry Smith, investing for growth.

[00:09:01] Compounding Quality: And for me, it immediately clicked. So I think regarding Warren Buffett, something that’s also very important to understand. is that Warren Buffett is a quality investor and not a value investor. For me, he’s one of the first quality investors ever. It’s true that at the beginning of his career, Buffett focused on cigarette butts.

[00:09:20] Compounding Quality: So really cheaply valued companies based on fundamental criteria. But Buffett actually started focusing on buying wonderful companies at a fair price, rather than fair companies at the wonderful price way sooner than most people think. I Just finished reading everything Warren Buffett has ever said and written.

[00:09:40] Compounding Quality: It’s a 5,000-page document and it’s really good. It’s a free MBA basically. And what he basically said in his 1972 annual letter is that he wants to own companies when true criteria are met. One, the average return on equity over the past 10 years has been larger than 20%. And two, there was no single year.

[00:10:01] Compounding Quality: Over the past decades, where return on equity was lower than 10%, and he said it in 1972, that’s more than 50 years ago. So more than 50 years ago, Warren Buffett already focused on quality criteria, like to return on invested capital and return on equity. 1972 is also the year when Warren Buffett bought C.

[00:10:22] Compounding Quality: S. Kennedy’s, his first quality investment. And since then, Buffett started to focus relentlessly on quality instead of value. I like quality investing so much because it completely makes sense for me to invest in the best companies in the world. And the strategy and the essence is really simple. One, you try to buy wonderful companies, two, led by outstanding managers, and three, you try to buy those wonderful companies led by outstanding managers at a fair valuation multiple.

[00:10:53] Compounding Quality: So quality investing is also the only investment approach where you can use a buy and hold strategy. To quote Buffett, If you bought a wonderful company at a fair price, The best time to sell is almost never. That’s a different approach compared to, for example, value investing. When you invest in a value stock, you buy the stock when it looks cheap on fundamental criteria, and then you sell it when the undervaluation has disappeared.

[00:11:18] Compounding Quality: Once this happens, you sell the stock and try to find another undervalued stock. You do this again and again. So from this point of view, value investors need to trade way more than quality investors do. And as you know, trading costs harm your investment results. In general, I think it’s very important to understand that there are multiple roads that lead to Rome.

[00:11:40] Compounding Quality: So every investor is unique and has his personal preferences. What’s important is that you choose an investment strategy that you feel comfortable with and that managed to perform really well in the past. For me, that’s quality investing. And this strategy resonated with me and managed to perform really well in the past.

[00:11:57] Compounding Quality: To give you two examples, the MSCI World Quality Index outperformed the MSCI World Index by 3. 5 percent per year since 1994. And Morningstar’s Wide Mode Index outperformed the S&P 500 with 4. 2 percent per year since 2000. And as you know, Kyle, when you’re able to slightly outperform the S&P 500, or even with 3 or 4 percent in these examples.

[00:12:21] Compounding Quality: And you do this for years or even decades, you get one hell of a result over time. 

[00:12:27] Kyle Grieve: So you touched a little bit on your definitions of quality there, but I’m going to ask for a little more detail. So quality investing means something different to most people. I know that Terry Smith and Chuck Akre’s simple quality explanations seem to resonate really well with you.

[00:12:40] Kyle Grieve: Could you go over how those two have helped shape your own definition of quality investing? 

[00:12:45] Compounding Quality: Terry Smith and Chuck Akre have been big inspirations for me. Investing for growth is an excellent book and over the years I’ve read everything I could possibly find about Terry Smith and Chuck Yeager. My short definition of quality investing goes as follows.

[00:13:00] Compounding Quality: Quality investing is all about investing in the best companies in the world. We already briefly touched it, but the essence is very simple and it’s based on the philosophy of Terry Smith and Warren Buffett. So it’s one, you buy wonderful companies. Two, led by outstanding managers and three, trading at fair valuation multiples.

[00:13:21] Compounding Quality: So what you try to do is you try to buy wonderful companies at a fair price instead of fair companies at a wonderful price. For me a quality company has six essential characteristics. So one, the competitive advantage or the moats. Two, you want those companies to have skill in the game. 2. You want a low capital intensity.

[00:13:43] Compounding Quality: 4. Great capital allocation skills, 5. High profitability, and last but not least, the secular trend. So if that’s okay for you, Kyle, I’ll briefly go over them all. Let’s start with the competitive advantage, or mode. whAt you want to do as a quality investor is, you don’t want to invest in the next big thing.

[00:14:03] Compounding Quality: Instead, you want to invest in companies that have already won. You want to invest in companies that do something unique, businesses that have pricing power, and are the market leader in their industry. When a company doesn’t have a sustainable competitive advantage or moat, Quality investors will never invest in it.

[00:14:21] Compounding Quality: Warren and Charlie say something similar. If a company doesn’t have a moat, it will never appear on our radar. What’s interesting? I also like to quantify everything because then you can use it in stock screener and so on. How can you quantify the moat or competitive advantage? You want a gross margin larger than 40%?

[00:14:44] Compounding Quality: Return on invested capital larger than 15%. Furthermore, you also want the gross margin and return on invested capital to vary, to be very constant and published. And when this is the case, you know that the company has a sustainable competitive advantage. As well as pricing power. So now we talked about the mode.

[00:15:04] Compounding Quality: The second essential part is skin in the game. Why? You want your incentives as a shareholder to be aligned with the ones of management and academic research has also proven. Companies with skill in the game outperform. If you want to learn more about this topic, I think the founder’s mentality, it’s a book.

[00:15:23] Compounding Quality: The Founder’s Mentality by Chris Suk and James Allen is a very good thread. So how are you trying to quantify the skill in the game parts? You want to invest in companies that are still led by their founder or where insiders, or at least 10% of the comp. So we talked about mode skin in the game.

[00:15:42] Compounding Quality: The third essential part is a low capital intensity. So the less capital a company needs to operate, the better when you would create two buckets. So one bucket with companies with a low capital intensity and all the buckets with companies with a high capital intensity, you’ll see that in the longterm, low capital intensity companies outperform the higher capital intensity companies by a wide margin.

[00:16:07] Compounding Quality: So what you also can see here is we are using different criteria and all these Should in the longterm already do better. And that’s how we try to build or define a quality universe. Now, how can you quantify the capital intensity? You want CAPEX or capital expenditures and sales to be lower than 5 percent and you want CAPEX on operating cash flow to be lower than 25%.

[00:16:33] Compounding Quality: The next crucial part is the capital allocation. Capital allocation is the most important task of management. And it’s all about the decision about what the company will do with the money it earns. So in general, a company has four capital allocation options. One, it can reinvest in a credit growth.

[00:16:53] Compounding Quality: That’s by far the most preferred capital allocation choice, especially when the company is a high return on invested capital. It can also use the cash flow to pay down debts. That’s interesting when the company has a leveraged balance sheet, for example. It can use it for M& A, so mergers and acquisitions.

[00:17:10] Compounding Quality: Roughly two thirds of all acquisitions destroy value, so when you’re looking at a company that does a lot of M& A, I would advise listeners to look at the serial acquirers like Constellation Software, Technion, Watsco, and so on. And then the fourth capital allocation choice a company has is to distribute the money to shareholders via dividends or share buybacks.

[00:17:34] Compounding Quality: Now, how are you going to quantify this? How are you going to quantify the capital allocation? You want to return on invested capital to be higher than 15%. Next part, for a quality investor, you want to invest in companies with a high profitability. The higher the profitability, the better. So you want to invest in companies that translate most revenue into earnings and also in companies that translate most earnings into free cash flow.

[00:18:02] Compounding Quality: Again, When a company translates most earnings into free cash flow, they do way better on the stock markets than companies who don’t. How are you quantifying the profitability? You want the gross margin to be larger than 40 percent and the profit margin to be larger than 10%. So a profit margin of 10 percent means that for each 100 in revenue, the company generates 10 in pure profits.

[00:18:27] Compounding Quality: And then, last but not least, the sixth point, the secular trend. In the long term, stocks tend to follow the evolution of the intrinsic value. And earnings per share growth and free cash flow per share growth is one of the most important pillars for the growth of the intrinsic value. And it’s quite straightforward that when the yen market is growing at attractive rates, That the company, it’s way easier for them to also grow their free cashflow at attractive rates.

[00:18:56] Compounding Quality: Examples of secular trends are obesity, urbanization, digital payments, cybersecurity, and so on. So what I am trying to look for as an investor is I want revenue growth to be larger than 5 percent and earnings growth to be larger than 7%. And I want this to be the case in the past, so you look at the historical growth, but also where you estimate that the company can continue to grow its revenue and earnings by 5 and 7 percent respectively.

[00:19:26] Compounding Quality: To summarize, quality investing for me is all about investing in the best companies in the world, and the best companies in the world possess over 6 characteristics. They have a mode or competitive advantage, they’re a skin in the game, there’s a low capital intensity, great capital allocation skills, a high profitability, and last but not least, a secular trend.

[00:19:49] Kyle Grieve: Excellent. So you mentioned returns on invested capital. So I want to get into that a little bit more detailed. So just so the audience knows, I’m going to be referring to that as ROIC from here on out. But why do you think this metric is so important? And do you see a case for other capital efficiency metrics like return on equity and a return on capital employed?

[00:20:07] Compounding Quality: I’m happy you touched this, Kyle. So for me, return on invested capital is one of the most important metrics as an investor. Why? It tells you, as we already said, it tells you how efficiently management is allocating capital. So capital allocation is by far the most important task of management. And when you combine a great business With a great capital allocator, you get something magical.

[00:20:32] Compounding Quality: It’s really how compounding machines are created over time. Just think about examples like Berkshire Hathaway and Constellation Software, but also of less well known companies like Wattscore and Kelly Partners Group. Regarding capital allocation, I love this quote from Mark Leonard, which is the founder and CEO of Constellation.

[00:20:52] Compounding Quality: Over the long term, stock returns will be determined largely by which capital allocation decisions the CEO makes. Two companies with identical operating results and different approaches to allocating capital. will derive two very different long term outcomes for shareholders. So yes, capital allocation skills of management are very important to me.

[00:21:15] Compounding Quality: To look at capital allocation, I prefer to look at the return on invested capital of a company. And I prefer, as already discussed, to be this number to be larger than 15%. So the next question you can ask yourself is, why would you want to choose the return on invested capital over the return on equity and the return on capital employed?

[00:21:34] Compounding Quality: Let’s first briefly touch on the formulas. So return on invested capital can be calculated by taking the NOPAT or net operating profit after tax and divided by the invested capital. Return on equity can be calculated by taking net income and dividing it by total equity. And return on capital employed can be calculated by taking EBIT and dividing it by capital employed.

[00:21:58] Compounding Quality: Let’s first compare the return on invested capital with the company’s return on equity. You can calculate return on equity by dividing a company’s net income by its total equity. As you see, It only uses the company’s total equity in a denominator, and you don’t look at the company’s debt. This means that a company can increase its return on equity by using less equity and more debt.

[00:22:22] Compounding Quality: In other words, a company can increase its return on equity by using more gearing. which increases the risk for investors. That’s exactly why I prefer Return on Invested Capital over Return on Equity. Return on Equity only looks at the equity part, while Return on Invested Capital takes all invested capital into account.

[00:22:42] Compounding Quality: When we compare a company’s Return on Invested Capital with its Return on Capital Employed, The main difference is that return on invested capital uses the total invested capital as a denominator, while return on capital employed uses the capital employed as a denominator. Invested capital is the amount of capital that is circulating in the business, while capital employed is the total capital the company has.

[00:23:06] Compounding Quality: So invested capital is therefore a subset of capital employed. Capital employed includes every aspect of capital in the entity, such as debts and shareholders capital, while invested capital includes only the active capital in circulation and excludes non active assets, especially those outside the business, such as securities, health, and other companies.

[00:23:28] Compounding Quality: So we like to look at the return on invested capital instead of return on capital employed. Because it’s the active capital and circulation that matters. 

[00:23:36] Kyle Grieve: Now that the audience understands the importance of ROIC, let’s go over the major ways this can impact a business’s returns. A high ROIC is great, but if a business has to return all of its capital to shareholders rather than reinvest in itself, the overall returns will be much lower.

[00:23:52] Kyle Grieve: Can you go over why this is? 

[00:23:54] Compounding Quality: Excellent point, Kyle. Probably everyone knows the following quote of Charlie Munger. Over the long term, it’s hard for a stock to earn a much better return than a business which underlies its earns. If the business is 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return, even if you buy it at a huge discount.

[00:24:17] Compounding Quality: Conversely, if a business is 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result. So here, Charlie says that in the long term, stock prices tend to follow the return on invested capital. The higher the return on invested capital, the better your return for an investor.

[00:24:38] Compounding Quality: But it’s very important to highlight that the above is only true when a company has plenty of reinvestment opportunities. So when a company has a very high return on invested capital, let’s say 30%, but they don’t have any reinvestment opportunities, this high return on invested capital Doesn’t have any practical value at all.

[00:24:57] Compounding Quality: And let’s give you an example to make everything more clear. Let’s say that we have two companies, Quality Inc and Dividend Inc. Both companies generate 100 million in earnings and they need 500 million to operate. So 500 million is their invested capital. Furthermore, both companies have a return on invested capital of 20%.

[00:25:18] Compounding Quality: So basically Quality Inc and Dividend Inc have exactly the same fundamentals, but there’s only one difference. Dividend Inc. has no growth opportunities and distributes all earnings as a dividend to shareholders, and as a result, Dividend Inc. will distribute 100 million to shareholders this year. And will still make 100.

[00:25:38] Compounding Quality: 000. 000 in 20 years and still have a dividend of 100. 000. 000 in 20 years On the other end, Quality Inc. is active in a secular trend and they are able to reinvest everything in organic growth This means Quality Inc. pays no dividend to shareholders and reinvest everything in itself So I’ll just give the audience a few seconds and maybe also a good question for you, Kyle.

[00:26:01] Compounding Quality: Can you guess how much profit Quality Inc would make if they would be able to do this for 20 years? So the correct answer is 3. 8 billion. So over 20 years, they would have grown their earnings from 100 million to 3. 8 billion. That’s a huge difference compared to Dividend Inc, where the earnings are still 100 million in 20 years.

[00:26:22] Compounding Quality: So what they can learn from this? A high return on invested capital in combination with plenty of growth opportunities are really the golden egg for investors. It will result in exponentially growing free cash flow per share. So the trick is to really define those companies, so companies with a high and consistent return on invested capital in combination with plenty of growth opportunities.

[00:26:44] Kyle Grieve: Excellent description. So a business like Seize Candies is a great example that ticks many of the boxes of a quality investment, but it does have one inability that you just pointed out, which is the inability to reinvest in itself. So do you consider a business high quality if it does not have reinvestment opportunities?

[00:27:03] Compounding Quality: The truth is that there are only a handful of quality companies with plenty of reinvestment opportunities. They are very hard to find. So quality stocks are often very capital light, which means that they don’t require a lot of capital to grow. And Seed Candies is a beautiful example of this. They don’t reinvest a lot of their cash flow, but they have done really well over the past few years and decades.

[00:27:27] Compounding Quality: One of the beautiful things about See’s Candies is that they have a lot of pricing power. So every single year, just after Christmas, See’s Candies raises its prices. And Charlie Munger once said the following about this. There are actually businesses that you will find a few times in a lifetime, where any manager could raise their return enormously by just raising prices.

[00:27:49] Compounding Quality: And yet they haven’t done so. So they have huge enterprising power that they are not using and that’s the ultimate no brainer. So this means that even when a company doesn’t have a lot of reinvestment opportunities, you can end up with great investment results. But in general, I’d say that the more reinvestment opportunities a company has, And that in combination with a high return on invested capital, the better.

[00:28:15] Kyle Grieve: So you’ve already mentioned the importance of moat in your tenets of quality investments. However, identifying a moat can sometimes be one of the hardest parts of the analytical process. A business such as Amazon was quietly building Amazon web services in the background underneath competitors noses for years before they were forced to disclose it.

[00:28:33] Kyle Grieve: What are the best strategies for investors to use to identify a business’s moat when a business is actively trying to keep its advantages a secret? 

[00:28:41] Compounding Quality: Before we dig into this, I think it’s really important to understand that there are five different kinds of moats a company can have. So a company can have a mode based on cost advantages, switching costs, network effects, intangible assets, or efficient scale.

[00:28:58] Compounding Quality: So a company can have a mode based on cost advantages. These companies are able to produce products or services at lower costs than its rivals. Think about companies like IKEA and Walmart, for example. A company can also have a mode based on switching costs, so the costs a consumer pays as a result of switching brands or products.

[00:29:21] Compounding Quality: It’s also important to highlight here that these costs can be monetary, but also psychological, effort based, and time based. Think, for example, about switching from Apple to Microsoft or the other way around. Customers of Apple are most of the time very loyal to Apple and very sticky. Why? Because it takes time if you want to switch to, to learn to work in the Microsoft environment and so on.

[00:29:45] Compounding Quality: A company can also have a mode based on network effects. This is my favorite kind of mode. And also Morningstar has done some research about this, and they state that modes based on network effects are the most resilient and also perform the best in the long term. And a network effect exists when a value of a product or service grows as its user base expands.

[00:30:06] Compounding Quality: So each additional customer increases the value of the product or service exponentially. Think about companies like Facebook, Metaplatforms, but also American Express, Amazon, or Alphabet. A company can also have a mode based on intangible assets, so this includes a competitive advantage due to the strong brands, the patterns, the regulatory licenses.

[00:30:28] Compounding Quality: And a great example of this is Coca Cola. Warren once said, if you give me 100 billion and take away the soft drink leadership of Coca Cola in the world, I’ll give it back to you. And I say to you, it can be done. So that’s a great example of a mode based on intangible assets or a strong brand. And then last but not least, a company can also have a mode based on efficient scale.

[00:30:53] Compounding Quality: In some markets, there is only room for one or a few players, and these kind of markets are called monopolistic or oligopolistic markets. Great examples here are S& P Global and Moody’s, or companies like Union Pacific, for example. Personally, as we already briefly touched on, I always use two very simple criteria to quantify the modes.

[00:31:16] Compounding Quality: One, you want the gross margin to be larger than 40 percent and two, you want to return on invested capital to be larger than 15%. And you also want these gross margins and return on invested capital to be very high and robust as it’s an indication that the company has a moat as well as pricing power.

[00:31:34] Compounding Quality: So Morningstar, for example, gives the following definition to a company with a white moat. A white moat is given to a company that can earn a return on invested capital. larger than the weighted average cost of capital or WACC for over 20 years. And as you know, a company only creates value by reinvesting in organic growth when the return on invested capital is larger than the company’s WACC.

[00:31:58] Compounding Quality: So personally, for me, I will never invest in a company that is still building a moat. And if you want, if you ask me, for example, for Amazon 10 years ago or 20 years ago, it was really difficult to estimate where the company would be today. And as I already said, I don’t want to invest in the next big thing.

[00:32:20] Compounding Quality: Instead, you want to invest in companies that have already won. So this means also means that you’ll miss a lot of companies because you will never invest in them like Amazon, for example. But for me, that’s no problem at all. I wouldn’t consider a company that is active in a rapidly changing industry within my circle of competence.

[00:32:40] Compounding Quality: So what I really try to do is I want to invest in companies that had a moat 10 years ago, have a moat today, and where I think that the company will continue to have a moat in 10 years from now. So these companies are really doing something unique and it’s very hard for rivals to take market share of these kind of companies.

[00:33:00] Compounding Quality: To quote Warren Buffett, it’s incredibly arrogant for a company. To believe that it can deliver the same sort of products in its rivals and actually do better than them in the long term. 

[00:33:12] Kyle Grieve: So now that we’ve spoken a bit about what makes a quality business, let’s go over management, what are the key management qualities to search for that make a quality business even better?

[00:33:22] Compounding Quality: Very good question, Kyle. Via Compounding Quality, I also run my own portfolio that everyone can follow with full transparency. And the essence there is that the portfolio consists of three buckets. So first and foremost, you have the owner operator stocks. So these companies are still run by their founder.

[00:33:41] Compounding Quality: Think about companies like Medpace and Kelly Partners Group, for example. The second bucket are the Monopolis and Onigopolis. So where only a few companies dominate the entire industry. These companies, these kind of companies are usually great investments because they are able to operate on attractive conditions due to the lack of competition.

[00:34:02] Compounding Quality: Think about companies like Visa and MasterCard or S& P Global and Moody’s. And last but not least, there is also a bucket with quality cannibal stocks. So quality stocks that are heavily buying back their own shares. As you know, when outstanding shares decrease, your stake in the company increases. And for example, when a company can buy back 50 percent of its outstanding shares, the free cash flow per share doubles.

[00:34:28] Compounding Quality: So that can be very interesting. Examples of quality cannibal stocks. Now, you talked about management and also for me, 60 to 70 percent of the portfolio consists of owner operator stocks. In other words, skin in the game is very important for me. That’s also something what surprised me from reading the 5000 page document of Warren Buffett talks about the importance of great managers and skill in the game over and over again.

[00:34:59] Compounding Quality: So he always says, don’t invest in companies who are, don’t invest in managers who are doing it for the money, but managers who are already financially independent and are just still running the business because they love what they do. Now, why is skill in the game so important? When a company has skin in the game as an investor, you increase your chances that the incentives of management and shareholders are aligned.

[00:35:24] Compounding Quality: It’s also just true that companies with skin in the game outperform on average in the long term. So academic studies found that family companies and father led companies Outperformed 3. 7 percent per year and 3. 9 percent per year, respectively. To me, to be honest, that’s quite funny that a basket with just family companies outperformed by 3.

[00:35:48] Compounding Quality: 7 percent per year on average. Why? When you look at the data, more than 19% So 90 percent of all professional investors underperform the market. These people are very smart, they spend more than 60 hours per week on researching stocks. And still, by just selecting a basket of stocks with high insider ownership, you would do better than almost all professionals.

[00:36:13] Compounding Quality: And still, by just selecting a basket of stocks with high insider ownership, you would do better than most professionals. Einstein once said that you should make everything as simple as possible, but not simpler. And I think that’s also true in investing. So the KISS principle, keep it simple, stupid, is very important.

[00:36:32] Compounding Quality: And on the stock market, there are multiple roads that lead to Rome. So what you should try to do is you should try to find an investment strategy that suits you, and you should stick to it. To give two examples, value investing. When you just would buy the 20 percent cheapest stock based on the PE ratio, you would outperform 500 by 3 percent per year over the past 50 years.

[00:36:56] Compounding Quality: And if you just would buy stocks with a wide mode, for example, you would outperform the S&P 500 with 4 percent per year since 2000. I’ll repeat it once more because it’s really important if you ask me, for quality investors, it’s all about the following. One, buy wonderful companies. Two, led by outstanding managers.

[00:37:16] Compounding Quality: And three, you try to buy these companies at trading at fair valuation multiples. Preferably, you want a company that is still led by its founder. Or in companies where there is high insider ownership and we can’t find these kind of companies. You look for excellent companies led by manager with high integrity and a strong track record in value creation.

[00:37:37] Kyle Grieve: So one thing about looking at returns of stocks through history is what the data say about market cap size in relation to returns of the business. What size of business should investors be looking at for the best returns on high quality businesses? 

[00:37:51] Compounding Quality: Personally, I’m a bottom up stock picker, and by that I mean that when I think a company looks attractive, I’ll buy it regardless of whether it’s a micro cap, a small cap, a mid cap, or a large cap.

[00:38:05] Compounding Quality: However, one of the key things I took away from working as a professional investor is that No one was looking at small and mid caps. I was involved in a rather small fund with around 200 million in assets under management, and we seldomly invested in companies with a market cap smaller than 500 million.

[00:38:24] Compounding Quality: So basically every worldwide equity fund has companies like Apple, Microsoft, and Amazon in their funds. And this also means that the market is way more efficient for these large caps. So it’s almost impossible to get an informational or analytical advantage by analyzing companies such as Apple. Warren Buffett used to say if you want to be a great investor, go where the competition is weak and that’s exactly in the small and mid cap space.

[00:38:53] Compounding Quality: So also the longer I worked in the industry, the stronger my belief that you can generate high returns in the small and mid cap space. These companies aren’t followed a lot by analysts, fund managers can buy them due to the low liquidity. And as a result, the market is less efficient in the segments. So this means if you do your own homework well within space, you can do very well as an investor there.

[00:39:18] Compounding Quality: So academic research has also proven that small cap stocks perform better. So in his excellent book, Stocks for the Long Run by Jeremy Seigel, he concludes that between 1926 and 2006, the smallest decile stocks, so the smallest 10%, compounded at a compound annual growth rate of 14%, Compared to 10. 3 percent for the S&P 500.

[00:39:44] Compounding Quality: So when you would only invest in small cap stocks and you were add an extra criteria, you only invest in small cap stocks with a positive free cashflow. Your odd performance would even increase further. So at Compounding Quality, our criteria for selecting stocks are very strict. So worldwide, there are 60, 000 listed stocks.

[00:40:06] Compounding Quality: And we identified an investable universe of around 150 names. And this list contains quality stocks led by outstanding managers, but doesn’t look at the valuation yet. So out of these 150 companies, probably more than 100 are way too expensive at this point in time. So the companies that remain are often smaller stocks that are not very well known by the general public yet.

[00:40:29] Compounding Quality: Think about companies we already talked about like Medpace, OTC Markets, or Kelly Partners Groups. But also companies like Games Workshop, Brown and Brown, or Juju Scientific. From a commercial perspective, probably way more people would be interested in a subscription of Compounding Quality. When we would invest in the well known large cap quality names with less upside potential, at least if you ask me, like S& P Global, Microsoft, Apple, and so on, but to me, that doesn’t make sense.

[00:40:58] Compounding Quality: We really try to invest in companies with the best risk reward characteristics. And some wonderful opportunities can be found in the small and mid cap space. 

[00:41:07] Kyle Grieve: So as Charlie Munger has said, quote, No investment is worth an infinite price. And while Terry Smith has shown that quality businesses can be bought for an optically high price and still deliver stellar returns, I still think Charlie’s statement holds true.

[00:41:20] Kyle Grieve: Let’s discuss how you determine what you should pay for a quality business. Do you use a discounted cash flow, back of the envelope math, or something else the majority of the time? 

[00:41:29] Compounding Quality: That’s exactly true, Kyle. Even when you invest in the best company in the world, you can end up with horrible investment results if you pay too much.

[00:41:37] Compounding Quality: Regarding valuation, I think it’s important to keep things simple and to use common sense. So for me, using complex formulas to determine the intrinsic value of a company to two decimal spaces doesn’t make sense at all. As Keens once said, it’s better to be roughly right than precisely wrong. And this is also true when investing personally, I use three things to look at the valuation of a company.

[00:42:03] Compounding Quality: So one, I compare the company’s free cashflow yields with the average free cashflow yields the past five years. Then I use an earnings growth model. And third, I also use a reverse DCF or reverse discount cashflow model. Let’s go through them all very briefly. So the first part. Comparing the company’s free cash flow yield with the average free cash flow yield of the past five years.

[00:42:28] Compounding Quality: This is very straightforward and something you can do in a few minutes. By doing this, you get an indication about whether the company is under or overvalued compared to its own historical average. Take the US beauty retailer Ulta Beauty for example, today Ulta Beauty trades at a free cash flow yield of 5.

[00:42:48] Compounding Quality: 8 percent compared to a 5 year average of 3. 9%. This already gives you an indication that the company looks cheap from a historical perspective. But, you should take this magic with a grain of salt, because it doesn’t take into account future growth estimates. And that’s exactly why I also use an earnings growth model and a reverse DCF.

[00:43:10] Compounding Quality: So regarding the earnings growth model, in theory, the yearly return you’re going to achieve as an investor is very easy to calculate. So your expected yearly return is equal to the earnings growth. Plus the shareholder yield plus the multiple expansion or minus the multiple contraction, whereas shareholder yield is equal to the dividend yield plus the buyback yields.

[00:43:34] Compounding Quality: I’ll repeat this once more because it’s really important. Your expected yearly return as an investor is equal to the earnings growth. Plus the shareholder yield, plus the multiple expansion, minus the multiple contraction, whereas the shareholder yield is the dividend yield plus the buyback yield. Why is this always true?

[00:43:53] Compounding Quality: Because in the long term, stock prices always follow the intrinsic value per share growth. Let’s give an example to make everything more clear. We’ll use hold up duty again, and I make the following assumptions. Ulta Beauty will grow its earnings with 6 percent per year over the next 10 years. The company will in the future have a shareholder yield equal to 3.4%. This is equal to the average shareholder yield over the past 5 years. And I also think Ulta is too cheap right now. So I think their PE, or price earnings ratio, will expand from 14.7 to 20 times earnings over the next 10 years. Then we’re going to do the calculations, the easy math. Expected return is equal to earnings growth plus shareholder yield.

[00:44:41] Compounding Quality: Plus multiple expansion in this case, because we think all that beauty will become more expensive over the next decade. So here expected return is equal to 6 percent the earnings growth plus 3.5 percent the shareholder yield plus the change in the PE, which is the ending PE minus the beginning PE divided by the beginning PE.

[00:45:05] Compounding Quality: So here that’s 20 minus 14.7 divided by 14.7. And if you do these calculations, you see that the expected return is 13. 1 percent per year for Ulta Beauty. And the question you need to ask yourself then as an investor is, am I happy with a return of 13.1 percent per year? If that’s the case, you should consider buying the company.

[00:45:29] Compounding Quality: If you are looking for higher upside potential, you should look for other investment opportunities. And then, last but not least, We also use the reverse DCF or reverse discounted cash flow to value a company. As Charlie Munger once said, if you want to find a solution to a complex problem, you should always revert.

[00:45:50] Compounding Quality: And it’s better to be roughly right than exactly wrong. Now what is a reverse DCF? Actually it’s exactly the same as a classical DCF, but now you put the upside potential at 0%. And the next thing you’re going to do is you’re going to look at what the implied free cash flow per share growth is based on the 0 percent upside potential.

[00:46:15] Compounding Quality: And after that, you try to determine whether this implied growth is realistic or not. I’m just covering the basics here because, yeah, it’s quite difficult to explain a reverse DCF via podcast. Let’s take the Ulta Beauty example again here, and what you’ll notice when you do a reverse DCF, you’ll see that there is an implied free cash flow per share growth of 5.

[00:46:38] Compounding Quality: 5 percent over the next 10 years. whEn a company managed to grow its free cash flow per share by 5. 5 percent per year, shareholders will achieve a yearly return of 10 percent per year, as we use 10 percent as a required return year. To put this number into context, It’s very important to highlight that Ulta Beauty is a cannibal stock, so we basically at Compound Equality assume that Ulta Beauty will use 85 percent of its free cash flow to buy back shares over the next decade.

[00:47:11] Compounding Quality: This would mean that over the next decade, they could buy back roughly 10 billion worth of shares, and at the current stock price, this would mean that Ulta Beauty could buy back roughly 50 percent of its outstanding shares. As a result, the free cashflow per share for shareholders would grow at a bit over 7 percent purely based on the share buybacks.

[00:47:33] Compounding Quality: This is already more than the 5. 5 percent implied in the reverse DCF, and this indicates that, yeah, at least to us, Ulta Beauty looks undervalued today. 

[00:47:43] Kyle Grieve: So now that we’ve discussed what makes a quality investment, let’s discuss what makes a quality investor at the individual level. What qualities do you think make up a quality investor?

[00:47:53] Compounding Quality: Good question, Kyle. Lawrence Cunningham wrote the book Quality Investing, but he also wrote an excellent other book called Quality Shareholders. And I think that it’s important to highlight here that over time, a company always gets the shareholders it deserves. So to quote Buffett, if they focus their thinking and communications on short term results or short term market consequences, they will, in large part, attract shareholders who focus on the same factors.

[00:48:23] Compounding Quality: To me, there are five essential characteristics I believe a good investor has. So one. They always think on the long term, you don’t think in quarters, instead you think in quarter decades. So great investors should take the short term pain in order to get the long term gain. This means that you filter out the noise and that you focus on what matters.

[00:48:46] Compounding Quality: And the long term, stock prices always tend to follow the intrinsic value per share growth. The second characteristic is that they train themselves to be fearful when others are greedy. And to be greedy when others are fearful. It’s very easy to say that you’ll be greedy when others are fearful and fearful when others are greedy, but in practice, it’s a whole different thing.

[00:49:09] Compounding Quality: That’s why you should mentally prepare yourself for market downturns and tell yourself that you’ll be excited when the market will go down and the other way around. That’s exactly why I have some newspaper articles of big stock market crashes in my office. So every time I go into my office, I see the articles of the crisis in 1930s, dotcom bubble, the financial crisis, the crash in 1987, and so on.

[00:49:35] Compounding Quality: And I do this to constantly remind myself that over the next five or 10 or 20 years, The stock market will go down with 30, 40, or even 50 percent one day, and that you should be ready for this. So just like Warren Buffett says, stocks are like hamburgers. And when you’re going to eat hamburgers every single week for the rest of your life, yeah, the question you could ask yourself then, or Buffett asks to the audience is.

[00:50:02] Compounding Quality: Would you then prefer lower or higher hamburger prices? Obviously you would want lower hamburger prices because it will allow you to buy food for cheaper prices. Another very straight forward question. If you are going to buy a car from time to time, would you prefer lower or higher prices for your car?

[00:50:22] Compounding Quality: Obviously, again, you would want lower car prices. But now another question, if you are going to be a net saver over the next five or 10 years, should you hope for lower or higher stock prices? And the answer should be that you would want lower stock prices, even when you already have significant investments in the stock market right now.

[00:50:43] Compounding Quality: And it’s something that’s really important to understand. The only reason why it makes sense to wish for higher stock prices is when you’re planning to sell your investments in the near future. So now we’ve talked about using a long term mindset and to be fearful when others are greedy and to be greedy when others are fearful.

[00:51:02] Compounding Quality: The third point is, or the third characteristic of a great investor is that they are very patient. So good investing should be like watching paint dry. As a quality investor, As already mentioned, we don’t want to invest in the next big thing. Instead, we want to invest in companies that have already won.

[00:51:21] Compounding Quality: So quality stocks are often very quote unquote boring companies. Fees and costs harm your investment results and it’s often said that the best investor is a debt investor. So great investors are willing to do nothing at all. For very long periods of time. Then we arrive at the four points and that discipline.

[00:51:41] Compounding Quality: So basically all investing is laying out some money today. To get more money back in the future, humans are not rational and we suffer from a lot of biases, and you should really be aware of this and always try to stay as rational and disciplined as you possibly can. That’s also why checklists can help you a lot.

[00:52:00] Compounding Quality: Charlie Munger once said that no wise pilot, no matter how great his talent and experience, fails to use a checklist. Regarding this topic, I think the book Checklist Manifesto. And I’m probably pronouncing it wrong, but from Atul Gawanda is a great read. And then the last point, you should always keep learning.

[00:52:20] Compounding Quality: So great investors keep learning all the time and reading a lot is really an essential skill. You should try to go to bed every single day, a bit smarter than when you woke up and you can’t help become very successful in whatever subject in life. So when you spend one hour a day reading books, and you read one annual report a day, you’ll become a learning machine.

[00:52:44] Compounding Quality: So compounding works in investing, but also in health, wealth, and knowledge. So to summarize, I think investors have five characteristics, or great investors have five characteristics. They always think on the long term. They are fearful when others are greedy, and the other way around. They are extremely patient.

[00:53:03] Compounding Quality: They are very disciplined and they always keep learning. 

[00:53:07] Kyle Grieve: So once an investor makes an investment into a quality business, what general developments should they be focusing on in the business to make sure the level of quality is staying intact? 

[00:53:18] Compounding Quality: In the end, stock prices always tend to follow the evolution of the intrinsic value per share growth.

[00:53:24] Compounding Quality: So to me, That’s exactly the metric you want to keep track of. In the shareholder letters, quality investor François Rochon states that in the long term, stock prices tend to follow the owner’s earnings of a company. And you can easily calculate the owner’s earnings yourself as follows. Owner’s earnings is equal to EPS growth plus the dividend yields.

[00:53:47] Compounding Quality: And when we look at this in practice, so the situation from, for François Rochon. We see that since 1996, the companies within his portfolio have grown their value by about 2, 500 percent and their stocks have achieved a total return of approximately 2, 800%. So this indeed shows that the long term stock prices follow the owner’s earnings of a company.

[00:54:13] Compounding Quality: And as a result, each year, for every company I own, I’ll calculate the owner’s earnings. When a company’s stock price decreased, but the company managed to grow its owner’s earnings, you know that the investment case has become more attractive. So in other words, when a stock price declines, but the fundamentals remain intact, You should buy more of it.

[00:54:35] Compounding Quality: In essence, looking at the evolution of the intrinsic value is the most important thing to me. Another important thing to focus on is whether the company’s mode is widening or shrinking. So disruption is the worst enemy for quality investors. And when a company loses its modes. You’ll end up with horrible investment results.

[00:54:55] Compounding Quality: That’s why you should solely invest in companies that fall within your circle of competence. Buffett defines his circle of competence as companies where you can make a reasonable guess about how the company and industry will look like in 10 years from now. In 10 years from now, everyone, for example, will be drinking coffee and chewing gum, but it’s way harder to make an educated guess about how everything regarding artificial intelligence will look like, for example.

[00:55:22] Compounding Quality: When a company is losing its moat, it’s often characterized by two things. Their gross margins are decreasing, and two, their return on invested capital is decreasing. 

[00:55:33] Kyle Grieve: So let’s move on to some of your biggest inspirations in investing. Who are your biggest inspirations that have helped you become a better investor, either in the investing world or outside of the investing realm?

[00:55:43] Compounding Quality: So earlier this year, I went to the general meeting of Berkshire Hathaway in Omaha, and it goes without saying that Buffett is a big inspiration for me. And I also advise all listeners to attend the AGM next year, because you can talk with the best investors in the world, like Guy Speer, Manish Prabhai, Brian Lawrence, Tom Gayner, and many more.

[00:56:06] Compounding Quality: And in general, I would say that it’s very important to learn from different people and investors. So people who inspired me a lot are among others, obviously, Warren Buffett and Charlie Munger, but also Phil Fisher, Joel Greenblatt, Peter Lynch, and Terry Smith, for example. I think, or I would advise everyone to just read everything inside.

[00:56:30] Compounding Quality: Read as much as you possibly can, and also biographies help me a lot. Think about the biography of Rockefeller, Tim Cook, Steve Jobs, Elon Musk, Winston Churchill, Theodore Roosevelt, or Einstein. And what’s also important is that you read a lot of things that don’t match your current beliefs. So whenever Charles Darwin found anything that contradicted his previous belief, He knew that he had to write it down almost immediately because he felt that the human mind was conditioned to reject things you don’t believe in.

[00:57:05] Compounding Quality: So I think this is a very important thing to understand. In Morgan Haisel’s book, The Psychology of Money, Morgan Haisel states that your personal experiences with money make up maybe 00001 percent of what happens in the world, but maybe 80 percent of how you think the world works. So it’s very important to be self aware.

[00:57:27] Compounding Quality: To always keep learning and to learn from opposing views and beliefs. The best investors are very humble and have an open mindset. In investing, it’s way better to have an IQ of 110 and to think it’s 90, than to have an IQ of 150 and to think it’s 170. In investing, it isn’t your IQ that is important, it’s your EQ.

[00:57:50] Compounding Quality: And it’s all about rationality and temperament. 

[00:57:53] Kyle Grieve: So a business I believe that we are both invested in is Evolution AB. Can you quickly break this business down for those in the audience not familiar with the name? 

[00:58:02] Compounding Quality: I’m glad you brought Evolution up, Kyle. So at Compounding Quality, we give every company we analyze a total quality score.

[00:58:11] Compounding Quality: And so far, Evolution has the highest quality score, indicating that it might be a very interesting stock. So it’s a Swedish company and they are a market leader in creating fully integrated B2B online casino solutions. So the core of their offering are traditional table games like Roulette, Blackjack, and Baccarat.

[00:58:32] Compounding Quality: Baccarat is typically played in Asia. So it’s important to highlight that Evolution isn’t a casino operator. They create online casino games, and casino operators that use these games pay a commission to Evolution on their winnings. To give you an example, when Unibet or William Hill use a certain game of Evolution, and they make 100 million a year from this, They pay a commission of on average 10 to 12 percent to Evolution.

[00:59:02] Compounding Quality: Another positive regarding Evolution is that all three founders are still involved within the company. So it’s an owner operator stock, it’s a company with skin in the game. Two of the three founders still own a bit over 10 percent and many people within the board as well as within key management own a lot of shares of the company.

[00:59:22] Compounding Quality: So in total insider ownership is about 12%, and we have there two very important people. Martin Carlson, who by the way, bought 1 million sec worth of evolution yesterday, which is around $9 million. And thought householder, which is a Chief Product officer, those two people are very important within evolution.

[00:59:45] Compounding Quality: And the CPO householder is often referred to as the Steve Jobs of gambling. He is a very important person. Now, the online gambling market is in a clear secular trance, so the consensus states that this market should grow at a compound annual growth rate of 12 percent until 2030, and research of SEB indicates that the company has an implied market share in live casino of roughly 70%.

[01:00:13] Compounding Quality: So a clear market leader and their products are far superior compared to their peers. What I think is so interesting about the company today is that they have great fundamentals, bright outlook, and a very cheap valuation. So the company has had a net cash position every year since 2012. They have a low capital intensity, a high return on invested capital and a very high profitability.

[01:00:38] Compounding Quality: For example, the company’s profit margin has averaged 48 percent over the past five years. So this means that they translate 48 in earnings every 100 in revenue they generated. yEah, it’s a clear compound the cow, for example, since 2012 evolution has grown its revenue from 30 million euro to a bit or almost 1.

[01:01:03] Compounding Quality: 7 billion, meaning that they doubled the revenue within every two years. And personally, I expect that the company can grow its fee cashflow per share by 20 percent or roughly 20 percent in years to come. So the company trades at a fee cashflow yield of 5. 7%. looks really attractive given the healthy fundamentals and the bright outlook.

[01:01:26] Compounding Quality: And the reverse DCF we executed indicates that the company should grow its free cash flow by 5. 5 percent per year over the next decade in order to return 10 percent per year to shareholders. And these numbers look very conservative to me because the online gambling market as a whole should already be able to grow by 12 percent per year until 2030.

[01:01:51] Compounding Quality: Like already said, it’s really a compounding machine. So since their IPO in 2015, they compounded on more than 50 percent per year. So that’s really phenomenal. 

[01:02:02] Kyle Grieve: So the most popular question I get on this business is what is its moat? Can you share your thoughts on what you think is Evolution’s moat? 

[01:02:10] Compounding Quality: I think in short, yes, Evolution Gaming has a sustainable competitive advantage.

[01:02:16] Compounding Quality: Another competitive advantage is based on three main pillars. So one, evolution is a clear market leader in a niche market. Two, it’s really hard for casino operators to do it in house. And last but not least, they have a lot of regulatory expertise. So in the investment case of evolution, it’s very important to understand that more regulation is a good thing for evolution.

[01:02:42] Compounding Quality: They are a market leader in a niche market. Evolution is a market leader in the oligopolistic niche markets for B2B online casino solutions. And they have dedicated nearly two decades to the development of live casino games. And over the years, they have managed to create a superior product compared to its peers.

[01:03:03] Compounding Quality: And industry experts also say Evolution Gaming’s games deliver a high return on investment for casino operators. So it’s beneficial for the casino operators and also for evolution itself. Because on its turn, it allows them to charge more than competitors. So they earn a 10 to 12 percent commission on the winnings.

[01:03:24] Compounding Quality: They can spread their costs across a larger user base because they benefit from economies of scale. And they also have a dedicated lobby. So it’s a lobby where only Evolution’s games can be played. And then the second part, and that’s the most important part for the competitive advantage of Evolution.

[01:03:41] Compounding Quality: It’s very hard for casino operators to do it in house. laSt year, the largest customer accounted for 14 percent of the company’s revenue. Last year, Evolution had a revenue of around 1. 6 billion dollars. This means that one customer spent almost 220 million dollars with Evolution Gaming. A question you should ask yourself as an investor is, Why wouldn’t the casino operator do it himself?

[01:04:09] Compounding Quality: Why wouldn’t he do it in house? The answer, it’s really hard for casinos to develop everything in house because there are very high fixed costs, there are risks in hiring skilled employees, and there is also a lack of reputation. So running a studio is very expensive. A small studio costs around 1. 5 million dollars per month to run, while a new studio is likely to cost around 30 million.

[01:04:36] Compounding Quality: And furthermore, it also takes one year before a company can launch its first selection of core games. So deals with operators usually also take six to 12 months, which means that the startup costs lay around 50 million before you can start to generate revenue. And that’s why casino operators prefer to stay with Evolution instead of doing it themselves.

[01:04:58] Compounding Quality: And last but not least, regulatory expertise. So Evolution benefits from more regulation. Why? First and foremost, the cost of implementation. Evolution is a market leader. And they have more resources compared to their peers. So for them, it’s easier to make adaptions to their systems to comply with regulation.

[01:05:21] Compounding Quality: And the second part is they have a lot of experience in dealing with this. So when something changes in the regulation. They are also able to adjust faster compared to their peers. 

[01:05:32] Kyle Grieve: So as a quality investor, capital allocation is a very important part of the business to track. Now, EvolutionAB pays a dividend while still having a very high return on invested capital, and its last large RNG acquisition seems to contribute very little to the overall business, despite having a large price tag.

[01:05:48] Kyle Grieve: How do you view EvolutionAB’s capital allocation over the last few years? 

[01:05:53] Compounding Quality: In every investment case, I give each company score on 10 based on 15 quality criteria, And capital allocation is definitely one of them. For this metric, Evolution Gaming got a score of 9 on 10. So the company’s return on invested capital and return on equity were equal to 28.1 percent and 28.3 percent last year. And when you combine this with a gross margin of 69%, And you again get an indication that the company’s sustainable competitive advantage as well as pricing power. Another beautiful thing about Evolution is that they are very capital light. So the company’s maintenance capex on sales was equal to only 4 percent last year.

[01:06:35] Compounding Quality: This means that the company needs very little capital to grow, which is a reason why the company is also paying a dividend. Since 2017, Evolution’s dividend per share increased to 7 euro cents to almost 2 euro per share. And they have a healthy payout ratio, the dividend yield is around 2.3%. And as you know, Kyle, yeah, I think Evolution is undervalued, as they traded a free cash flow yield of 5.7%. It is the cheapest valuation they have ever traded at. And as we expect the company to grow its fee cashflow per share by roughly 20 percent per year in the near future, you know that the company’s PEG ratio, or price earnings to growth ratio, is lower than 1 at this point in time. And that’s exactly why I think share buybacks would make a lot of sense for Evolution Gaming right now.

[01:07:25] Compounding Quality: So the company has a net cash position of a bit more than 800 million euro, which is equal to roughly 4 percent of the current market cap, and Evolution Gaming could create a lot of shareholder value by using this money to buy back shares. 

[01:07:41] Kyle Grieve: Compounding Quality, thank you so much for joining me today.

[01:07:43] Kyle Grieve: Before we say goodbye, where can the audience connect with you? 

[01:07:46] Compounding Quality: Thank you very much, Kyle. It was really nice talking with you and I hope the audience learned something new. If you want to find me, you can find me on Twitter via Compounding Quality or the handle @QCompounding and we also write three articles a week on investing.

[01:08:04] Compounding Quality: On investment principles and stuff like that via compoundingquality.net. 

[01:08:10] Kyle Grieve: Okay folks, that’s it for today’s episode. I hope you enjoyed the show and I’ll see you back here very soon. 

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