Investors often talk about compounding and when they do - donuts and snowballs are often used as illustrations.
🍩 The ring of a donut resembles the compounding cycle of retaining profits from the previous year to reinvest for the following year.
❄️ And if animations are to be trusted, a ball of snow rolling down a hill can start small, but gradually becomes larger and larger, just like the compounding's snowball effect.
In this post, I’ll explore how different Returns on Capital (ROC) and growth rates can impact the compounding process and explain why even small adjustments can create a huge difference in your returns over time.
1. High ROC + Low Growth Rate: Flatline Snowballs
While investors in compounders often emphasise the importance of consistently high returns on capital, they often neglect to mention that it's possible for a company to have a high ROC, but also a low or even negative growth rate. Take a look at the below example. Even though ROC is 50% each year, a high payout (suggesting a lack of reinvestment opportunities) results in returns drop minus 50% each year. Compounding needs reinvestment to fuel growth.
Examples of Flatline Snowballs are consumer staples. While they often have high returns on capital, they often lack reinvestment opportunities and are instead forced to payout large dividends.
2. Low ROC + High Growth Rate: Bloated Snowballs
Now, let's switch these around and consider when there's a low ROC and high growth. Note in the below example the higher amount of invested capital required to generate the returns. Even though there's a high growth rate, each year new capital has to be issued to generate these returns, which either increases your leverage or dilutes your shareholders - both are suboptimal!
Examples of Bloated Snowballs are capital intensive sectors, with high infrastructure costs - hence the debt, but also reliable and consistent demand that allow them to grow - such as the utilities, telecoms and real estate.
3. High ROC + High Growth Rate: The Snowball Effect In Action
The previous examples demonstrate that you need both a high return on capital and a high growth rate. When both ROC and growth rate are high, the snowball really picks up speed. Each year’s reinvested capital creates higher returns, creating a cycle that compounds faster and faster.
4. Increasing ROC + High Growth Rate: Supercharged Snowballs
This final class of compounders are capital-light compounders, or Supercharged Snowballs. They can grow without reinvesting. This means they can maintain a high growth rate and also a high payout ratio. Consequently each year they typically see their ROC go up, as the spread between their return and their invested capital widens.
So what examples are there of Supercharged Snowballs?
The below is a list of companies that meet this definition. Over the last 10 years they have consistently grown their free cash flow (see columns C and D). Rather than retaining these profits to reinvest, they have distributed them to their shareholders out as dividends and buybacks, hence the high capital return ratio over the last 10 years (see column E). This has allowed them to reach a high return on capital that has grown over the last 10 years (see columns F, G and H). And often as a consequence of this supercharged effect, they have seen their share count significantly go down (see column I).
$Manhattan Associates(MANH)$ $Apple(AAPL)$ $Novo-Nordisk A/S(NVO)$ $Fortinet(FTNT)$ $Fair Isaac(FICO)$ $Automatic Data Processing Inc(ADP)$ $MasterCard(MA)$ $MasterCard(MA)$ $Mettler-Toledo(MTD)$ $IDEXX Laboratories(IDXX)$ $Fastenal(FAST)$ $O'Reilly(ORLY)$ $Applied Materials(AMAT)$ $Adobe(ADBE)$ $Lowe's(LOW)$ $Cadence Design(CDNS)$ $Lam Research(LRCX)$ $MSCI Inc(MSCI)$ $KLA-Tencor(KLAC)$ $Dollarama, Inc.(DLMAF)$ $Visa(V)$ $NVR Inc(NVR)$
Bringing it all together
So in summary, it's not enough for quality investors to consider the return on capital alone or the growth rate alone. They have to be considered together.
High payouts can mean a lack of reinvestment opportunities and growth opportunities. And high issuances of new capital can dilute shareholders and leverage the balance sheet.
Investors need to consider the ROC, growth rate, growth opportunities, payout ratio and leverage together to get the big picture.
Understanding these dynamics is key to identifying opportunities that can deliver strong compounding returns over the long term.
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