Issue #47: Lessons From My Favourite Compounders

This week I was at the Enduring Ventures shareholder summit in Miami. I want to thank both Sieva and Xavier (give them both a follow!) for putting on a great event. And also for inviting me to do a fireside chat on my favourite compounders and lessons we can learn from them.

I figured I’d share my discussion notes here with my mailing list. These are talking point notes, not fully fleshed out sentences, so forgive me if some of the nuance is missed. I’ve also included links to further readings and deep dives for each of the companies as well. The companies I covered were Mainstreet Equity, Pool Corp, Copart, Transdigm, Constellation Software, Terravest Industries and Thomson Newspapers.

Disclaimer: I may hold a position in any of the above companies, none of this should be construed as investment advice. Do your own due diligence and consult with your financial advisor.

Let’s dive in.

What are “compounders”?

Companies that have reinvested earnings at a high rate over a long period of time. Though arbitrary, I will say “high rate” means 15%+ and “long period of time” means 15+ years.

It sounds simple enough, but these companies are rare and it is a difficult feat (which is why they are worth studying).

Why study publicly traded businesses?

Though I spend the majority of my time these days looking at privately held businesses, I do spend a chunk of time studying (and investing in) publicly traded companies as well. I believe everyone should study pubcos for 3 main reasons:

1. Some of the best companies of all time are publicly listed. This makes sense, at a certain point for many companies an IPO is inevitable as insiders want liquidity (amongst other benefits). So by studying some of the best companies in the world, you are standing on the shoulders of giants.
2. The scoreboard is visible and accurate. The performance of these companies is out in the open, you can calculate the ROI and returns of shareholders very easily. Not only is it difficult to obtain private company data, it’s not always accurate as well (valuations can become subjective, and investor IRRs can be easily manipulated)
3. Lot’s of equity research available on publicly traded businesses. There is an army of very intelligent analysts putting their research out there on their favour stock picks. You can greatly benefit from studying their work, and learning from their analysis can make you very efficient in your own analysis. There is nowhere near as much research and analysis out there on private companies for obvious reasons.

So let’s jump into my favourite compounders now.

Mainstreet Equity

• Returns: 53x since 1999 IPO

• What they do:
  • Residential real estate investor: buy, reno, rent, refinance, repeat… BRRRR (before it was cool)
  • Focus exclusively on mid-sized apartment buildings in Western Canada
  • Incredible capital allocation results in the face of a volatile macro environment (operate in O&G markets)

• Why I like the biz & key lessons:
  • Unusually focused in a narrow (and contrarian) niche which gives them a huge edge
  • Lack of fees can lead to some extraordinary compound returns (how many syndicators/REPE delivered 53x to equity investors?)
  • Unlike other REITs, Mainstreet keeps a tight fist around equity, big CEO alignment here (high insider ownership at ~50%)

• Further reading: I wrote about the biz over a year ago, check out my writeup on Mainstreet Equity here​

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Pool Corp

• Returns: 373x since 1995 IPO
• What they do:
  • Largest distributor (middleman) of pool supplies and equipment
  • Source from over 2k suppliers and sell to over 120k customers (retailers/contractors)
  • Reoccurring revenue from parts required for maintenance/repairs (most of revenue), beneficiary of a large install base (~10m pools in North America)
• Why I like the biz & key lessons:
  • I love distributor businesses because of the network effects which can create an enduring moat, especially when there is fragmentation of suppliers/customers (Pool Corp has a high degree of fragmentation)
  • Reoccurring non-discretionary revenue (NEED to maintain your pool) and scale advantages with buying + pricing power leads to phenomenal results
  • Has done an incredible job reinvesting its capital both organically (opening new sales/distribution centres) and inorganically (acquiring them)
• Further reading: Young Hamilton did a fantastic writeup on Pool Corp​

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Copart

• Returns: 247x since 1994 IPO
• What they do:
  • Rolled up and operate a network of junkyards and sell salvaged cars and car parts
  • Source wrecked cars from insurance companies, salvage them on one of the yards and then sell them
  • Largest online salvaged car auction
• Why I like the biz & key lessons:
  • Supply-constrained roll-ups are insanely accretive – that’s what led to their physical moat, network of junkyards in a world where new junkyards are basically illegal. The industry went from a fragmented mom/pops to a duopoly. Amateur value investors focus on demand, veteran value investors focus on supply – Copart is a great example of why
  • Never stop innovating (take lessons from other industries).That’s what led to their digital moat – launched online auction site during dotcom boom, led to huge network effects moat
  • 2 important capital allocation decisions that made their biz what it is today: 1) buy the land instead of leasing 2) consign the inventory from insurecos instead of buying
• Further reading: I wrote about why Copart is one of the greatest rollups of all time. Young Hamilton wrote a great piece on the biz too. Also recommend the book Junk to Gold.

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Transdigm

• Returns: 31x since 2006 IPO, not including special divs (1750x return since 1993 inception)
• What they do:
  • Sell niche airplane parts and components
  • Growth by acquiring manufacturers (over 65 since inception) and implementing their value add playbook
  • Successful PE-backed small biz to bigco story, $50m to $42bn market cap
• Why I like the biz & key lessons:
  • Cost control framework – profits-first approach led to incredible discipline around EBITDA growth. This is a manufacturing biz with nearly 50% EBITDA margins
  • Pricing power – small share of wallet, little/no competition due to regulatory barriers, critical non-discretionary components that wear out (need to be replaced regularly). Aggressive annual price increases. Does wonders for profitability
  • In every supply chain (even ones that appear crappy like airplanes), there is always a player capturing a lot of the value
• Further reading: I wrote about some of the major lessons from Transdigm here. As well, highly recommend checking out this podcast which interviews the CEO, Nick Howley. The book Lessons From The Titans has a great chapter on the biz as well.

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Constellation Software

• Returns: 145x since 2006 IPO (not including any dividends or spinoffs)
• What they do:
  • Serial acquirer of vertical market software (over 600+ acquisitions)
  • Mission-critical applications with high switching costs to vertical markets (many non-growth end markets like government, utilities, etc.)
• Why I like the biz & key lessons:
  • Decentralization: they’ve turned the M&A process (something considered to be highly complex/subjective) into widget-making. Most unique “capital allocation organization” of all time as lower-ranking employees make capital allocation decisions, not all tightly controlled at HQ like most of it’s peers
  • Smaller assets are the most profitable, little competition means cheap entry price (their avg deal is $5-10m revenue).
  • Game selection: vertical software is a great biz model. Pricing power – share of wallet, non-discretionary, high switching costs, critical service, low on-going capex, collection of See’s Candies.
  • Great employee incentives and alignment (their bonus must be spent on stock purchases)
• Further reading: The 10th Man wrote an incredible deep dive on Constellation Software.

Terravest Industries

• Returns: 14x since 2012 (doesn’t include divs, 2012 was really the rebirth of biz)
• What they do:
  • Serial acquirer of small niche manufacturing business in the steel industry (fuel/propane/HVAC containers and tanks, processing equipment)
  • It was a busted income trust, purchased by Canadian billionaire George Armoryan in 2012 and he eventually installed Dustin Haw to run the biz
  • Completed 14+ acquisitions since then all with incredible track record
• Why I like the biz & key lessons:
  • Operation playbook post acquisition to drive down costs, especially around steel procurement (reminds me a bit of TDG) – incentivizing BU managers accordingly. Small head office.
  • Price discipline (deals are small, and therefore cheap relative to cash flow) 3-5x EBITDA.
  • Tight-fisted around equity, growth financed (so far) cash flow + debt. Concentrated insider ownership, so good alignment
  • Unlike the others on this list, Terravest is still relatively early in their compounding journey, but have a long enough track record to prove to be an attractive biz
• Further reading: Fairway Research did a great writeup on Terravest Industries. Guy Gottfried did a great job pitching the biz in 2019 at this investing class.

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Thomson Newspapers

• Returns: no clear data but at one point, Roy Thomson was the wealthiest man in the world and his heirs/family today are the wealthiest family in Canada.
• What they do:
  • Rolled up niche/small local newspaper businesses from 1950s to the 1980s (~170 acquired)
  • At the time, great economics, pricing power, and proved to be great assets, lauded as a the great compounder of the time, shrewdly deployed capital into profitable assets
  • In the end, industry was eventually disrupted by cable TV, ROIC dropped, and rollup busted
• Why I like the biz & key lessons:
  • Strategy very similar to CSU (in fact Leonard had said Thomson was his inspiration and business hero) – small niche acquirer, profitable capital allocation.
  • BUT nothing grows to the moon, eventually ROIC will drop, and profitable reinvestment opportunities disappear as you get larger.
  • Not to mention, threat of disruption is always at your doorstep. All business models have an expiry date, be careful of extrapolating growth and paying up a premium for it.
  • Pricing power isn’t forever, and sometimes organic “growth” via price increases alone could be a red herring
  • This is a fascinating case study, as the biz was once lauded as a model “compounder”, so its good to see what the end state looks like and the signals to lookout for to know when a compounder is nearing it
• Further reading: Exploring Content did a fantastic 2-part writeup on Thomson Newspapers, highly recommend reading both Part 1 and Part 2. I enjoyed this case study so much that I will probably do a full feature on Thomson Newspapers in a future issue.

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Commonalities across compounders

• Inorganic growth (hard to reinvest into organic growth over a long time)
• Traditional industries (none are really considered innovative or high tech, demand has stabilized and unit economics, profitability are well known)
• Skilled capital allocator at helm and or sensible capital allocation policies (discipline around IRR/hurdle rates for capital deployment)
• These organizations focus more on supply (and capturing it) instead of demand (and chasing it)

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What’s your favourite compounder? Any key lessons I missed for these companies? I’d love your thoughts, please let me know!