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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP772: How Great Compounders Turn Time Into a Superpower w/ Kyle Grieve
01:04:24
Kyle discusses what makes elite compounders so valuable and why they can generate exceptional returns even when purchased at high valuations.
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- [00:01]
Podcast Announcer
You're listening to tip.
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Kyle Grieve
What do the world's greatest long term compounders have in common? You know, the rare businesses capable of delivering 20 plus percent returns for decades and turning early investments into life changing wealth. And more importantly, how exactly do they keep it? In today's episode, we're going to unpack this puzzle by breaking it into its essential elements, capital efficiency, reinvestment rates and the underappreciated role of time. You'll discover why so many iconic winners are serial acquirers of tiny niche businesses and how dominant market share, durable competitive advantages and smart capital allocation allow them to trade at premiums while still crushing the market's return. We'll dive into nine just remarkable case studies from, you know, manufacturers that quietly boost margins through elite working capital discipline to a vertical market software giant that really just cracked the code on perfect management incentives to companies with cultures that are just so strong that they can continue to compound through multiple CEO transitions. This episode is for long term investors seeking durable, low maintenance winners and for business owners looking to build cultures that attract talent, expand margins and create lasting competitive advantages. Let's jump right in.
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Podcast Announcer
Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve.
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Kyle Grieve
Welcome to the Investors Podcast. I'm your host Kyle Grieve and today we're going to talk about a really, really interesting book that I've been going through and studying very, very closely and really, really enjoying because it really plays on my love of businesses that are compounders. So as an investor, we have to analyze what we're going to pay for a business. So why is it that some companies seem to generate exceptional returns even when they're priced at sky high multiples? So Nvidia is a business that probably comes to mind for pretty much anyone when discussing this exact problem. You could have bought this business in January of 2017 for 43 times earnings, which is just a sky high multiple. But if you bought it at that price, do you know what your return would have ended up being? 63% per annum. So traditional value investing advises buying stocks at a low price and then waiting for the market to recognize your view and then finally selling when price and value converge. But a business like Nvidia is a case study in the flaw in that strategy, and that is that an excellent business that can reinvest in itself at high rates of return is simply worth paying up for now. In the book the Compounders From Small Acquisitions to Giant Shareholder Returns by Aud Bjorn, Dibvad, Kettle Nyland and Adnan Hadi Fendik. Sorry if I butchered the names there. The authors outline their framework for evaluating businesses that they end up covering. All of these businesses were massive, massive winners. And they also tend to trade at pretty premium multiples to the market's multiple. We'll be diving into these business in a lot more detail shortly. But to understand why you can pay 43 times earnings for Nvidia and still make 64% per annum, you must understand one very straightforward concept. Shareholder value is created when a company earns a return on capital that exceeds its cost of capital. That is all you really need to know to purchase a business that can generate value for shareholders. The problem is that most businesses just struggle to do this. The forces of capitalism erode returns on capital as more fighters enter into the ring. Generally speaking, over a multi year time period, the cost of capital is exactly where returns of capital are drawn to like a moth to a flame. Only businesses with competitive advantages can stave off competition long enough to generate value. So if we acknowledge that most businesses just can't do this, why should we expect a company that can do this to trade at the exact same multiple as a majority that can't? And the answer is that we shouldn't expect it. A default cost of capital is something like 9.5%, which also happens to be the approximate return of the S&P 500. So if you can find a business that has returns on invested capital in excess of that 9.5%, then you're looking at a company that can create a lot of shareholder value simply by reinvesting its cash back into itself. For serial acquirers, that means buying more businesses. For Nvidia, it means investing in developing better hardware. Let's take two companies, Nvidia and IBM. IBM. Everyone's going to know Big Blue. It's a blue chip company at this point in its growth profile. If you look at its returns on capital, it's actually lower than its cost of capital. This means that growing the business will actually destroy shareholder value. That's why the company just doesn't reinvest profits and instead it pays them all back to shareholders as dividends and in buybacks. That's smart capital allocation. So as a result of the business's inability to create shareholder value from growth, the shares deserve to be traded at about nine times earnings to earn a return that's equal to the cost of its capital. But what about Nvidia, which can reinvest its profits at high levels? According to fiscal AI, Nvidia has an average ROIC of about 90% since 2017. To earn its cost of capital, assuming a growth rate of only 8%, you can pay 60 times earnings. That's nearly seven times more for Nvidia than for IBM. Now, it's essential to understand that assumptions have to be met for this to happen. And there's two. So the first one is that the business must maintain its ROIC in the future, and the second is that the growth rate must be maintained into the future. If you can make those assumptions, then you can understand why a business is worth significantly more than another one. The other problem that investors face is the problem of time. Most investors assume that a business will have its ROIC eroded over time by competitors. This is why in most discounted cash flow models, you're going to see a gradual decrease in the growth rate of cash flows, followed by a perpetual growth rate that is generally in line with inflation, which is, you know, 2 to 3%. However, outstanding businesses such as Nvidia completely buck that trend. Ten years ago, Nvidia had a ROIC of around 38%, and today it's 100%. Now, in the compounders, the authors write, what truly matters in investing in companies that are not only strong today, but are positioned to become even stronger over the next 10 to 15 years. In such cases, traditional valuation models can appear almost irrelevant. Instead, the focus should shift towards identifying businesses with durable competitive advantages, sustainable reinvestment potential, and the capacity to strengthen their market position over time. Another issue highlighted in the compounders is something called hyperbolic discounting. So in traditional finance, we use a method called exponential discounting, in which the discount factor remains constant. Due to this type of discounting, future cash flows are not valued as highly as those that are closer to the present. But as I've learned over many years, what traditional finance model tells us is often very different from reality. In fact, if we follow a phenomenon known as hyperbolic discounting, valuations decline rapidly for near term periods, quenching our thirst for instant gratification. After the present, the declines fall much more slowly compared to exponential discounting. So what exactly does this mean for a business that can compound? It means that it's human nature to use hyperbolic discounting. In hyperbolic discounting, the present value of cash flows far into the future is significantly higher than what is used in exponential discounting. For a business that can compound at high rates for a more extended period hyperbolic discounting values these businesses higher than the exponential model would suggest. The book suggests that this is a possible reason that businesses with strong long term growth prospects and the ability to sustain a high return on invested capital tend to trade at a premium, the authors write. It's likely that the market, whether consciously or not, prices these businesses using a discounting approach that more closely resembles hyperbolic rather than exponential discounting. Relying solely on exponential discounting to value long term compounders could lead to significant undervaluations of their true worth. Now let's get into the primary reason why the nine businesses that were outlined in the compounders have outperformed all indexes and grown 10k into $6.6 million over 35 years. An outstanding 20% KEGR while there are many, many ways a company can generate value over decades, there are really just two keys that the book goes over. The first one is high performing, decentralized cultures. After all, without a culture of excellence, mediocrity is just tolerated and high performing companies have a way of filtering out mediocrity. And the second is a durable reinvestment engine. Without high returns on invested capital and a place to invest excess capital, it's impossible to get the compound engine running. These two attributes are precisely what I look for in every company that I invest in, and in about 90% of the cases, it's precisely what I want to find. And while it sounds easy to look for, it's quite hard to find in reality. It's not always easy to determine a company's authentic culture. If you meet a CEO, chances are that he's going to be coming off on his best behavior, become seen as a very, very nice and skilled businessman. But it's not really until you maybe you hear stories from others that he's maybe a tyrant, rude, or he's unkind to his employees, or unkind to a waitress. And you may just not hear these stories until it's too late. When it comes to durability, all investors obviously want that. It's the key here to compounding. If a business has a return on invested capital of 50% this year and then zero the next year, it's pretty challenging to determine what a normalized number is going to be. I know that I want the certainty that a business can maintain or preferably even increase its return on invested capital over time, because that means it's a compounding engine. But as experience has taught me, I'm regularly wrong about that assumption. I spent a significant of my maintenance due diligence trying to determine whether a business can simply maintain its existing growth one way or if competitors are starting to chip away at it. Now, the compounders says that every company profiled in the book drove growth by turning time into a superpower. And they did this because they were able to generate large amounts of cash which could then be reinvested into the business at high rates of return. This virtuous cycle is what creates these incredible businesses that offer incredible shareholder returns. Now, there are three subcategories of compounding that you must understand while analyzing a business. The first one is a business's reinvestment rate. The reinvestment rate is a sum of organic capex and acquisitions divided by operating cash flow. If a company makes $100 million in operating cash flow, then invests 10 million in organic capex and $90 million in acquisitions, then it has a 100% reinvestment rate. And I get downright giddy when I see a business with a reinvestment rate like this. But you don't only want a high reinvestment rate. For a compounder to actually compound, you need that high ROIC that I mentioned earlier. For those unfamiliar with roic, it's net operating profits after tax divided by invested capital. So businesses require capital obviously to invest in themselves to generate more net operating profits after tax or no pap. It could be seen like having an option between two vending machines. So the first machine you put a dollar in and you get two cans of pop. The second one you put a dollar in and you only get one can of pop. Which soda machine are you going to prefer? Obviously you're going to want the one that gives you the highest output per dollar spent. And it's the exact same with business. You want a company that can deploy its capital at a high and sustainable rate of return. The final part of this equation is simply just time. The longer time a company can maintain a high reinvestment rate with a high roic, the better it is for the company and for shareholders. Let's imagine that we have two companies and briefly examine what they can do with their reinvestment rates and ROIC over a five year period. So company A has a 100% reinvestment rate and a 20% ROIC. If it starts with $100 million of no PAT in year zero, in the first year it's going to have 120 million. The following year is going to be about 144 million. By year five, it will be approximately $250 million. Now, company B is different they also have a 100 reinvestment rate, just to keep the numbers simple here, but they have a roic of only 10%. So similar to company A, they have 100 million in year zero. By year five, they have about 160 million of no pap. So the longer durations you go out, the bigger the difference, obviously. 160 million versus 250 million. If these two companies compound at the same ROIC with the same reinvest rate for 20 years, company A has 3800 in OPAP versus only 670 for company B. This is why time is the friend of the compounder. And this is why investors may struggle to value these businesses. Because it can just be challenging to forecast whether a company will continue to have a substantial capital efficiency number five years from now, let alone, you know, 10 or 20 years from now. So now that we understand the importance of reinvestment rate, ROIC and time, let's examine some of the standard character traits shared by the nine companies in this book. The first one relates to reinvestment, which we've already discussed in quite a lot of detail today. However, many of these companies can reinvest in two different ways, allowing them to reinvest even more capital at high rates of return. So these two approaches are through organic growth, where you invest in the business that you already have to drive further growth. Then there is a programmatic acquisition angle where the parent company can allocate capital to new businesses that are already generating cash and can be added to the portfolio. So another benefit for public companies involved in programmatic acquisitions is just the price that they pay. So with nearly all the businesses that are discussed in the book, a serial acquire arbitrage is attached to each acquisition that they make. A company such as, you know, Constellation Software trades on average over the last nine years at an EV to EBITDA about 28 times. However, they typically acquire a business at a multiple of around 5 times EV to EBITDA. So once Constellation acquires a company, it's automatically revalued at this higher level. Serial acquirers can do this because private markets offer a ton of inefficiencies compared to public markets. For instance, public companies have, you know, complete transparency in their financials and offer much better liquidity compared to a private company. This is part of the reason that there are so many of these attractive businesses in the private markets. Other advantages include things such as key personnel who can effectively run the business, limited numbers of customers and suppliers, and just lower sales thresholds, which creates less competition for deals. So I mentioned earlier that one of the fascinating aspects of compounding is to the role of time. If you double your money every five years, then doubling from 10 million to 20 million is obviously great. However, if you double 1 billion, you reach 2 billion. And the jump there is obviously a massive difference between the two, even though the time to double between them is the exact same. So if you're looking for a compounder, you need a business with resilience to get to that larger number at some point into the future. Now, there are two great ways to build resilience in business. The first is to protect your downside. Successful siriquires do this by having multiple revenue streams with different customers and suppliers. This added diversification can help protect and shield these businesses when certain subsidiaries are going through more challenging times. And this is not a matter of if, but when certain companies will be tied to very specific industries. And when those industries are at the bottom of the cycle, you're going to see deeply decreased top and bottom lines. And second is sustainability. This is a function of the business model and capital allocation. You want a business that can produce some sort of organic growth, even if it's in the low single digits. Then you want a business that can grow through value added acquisitions. You'd also prefer a business that can maybe optimize a business after it's acquired. This may involve centralizing certain backend functions such as, you know, accounting or erp. Or it might mean getting really hands on, removing parts of the business that aren't as attractive to make the overall business even better. Now here's what the book mentions on these two aspects of resilience. To reach the critical compounding phase, a business must survive and thrive during its early stages. Which is why having a strong foundation, the sprawling roots of a tree, is so essential. This means offering a diverse range of products to a wide variety of customers across multiple end markets. Achieving exponential growth, what some call reaching the second half of the chessboard, requires more than just aiming for the highest returns it demands avoiding catastrophic losses at all costs. By steering clear of single exposure risks and prioritizing long term resilience, firms position themselves to thrive in the fullness of time. Another area of emphasis for the compounders featured in this book is a focus on small niche industries and products. I love this concept because it's often what I look for in my micro cap bets. Why are small niche businesses so interesting to certain investors? Plenty of reasons. So niche businesses often fly under the radar of deep pocketed private equity, which are usually more interested in pursuing larger and growing markets. The book provides a great example of the Lyftco subsidiary called Brock, so it dominates the market of autonomously run demolition robots. The market size is only $300 million, so not that big and it's not growing that much, but they own approximately 70% of it. Niche markets also have their own benefits. When a business dominates a small market, it has significantly more pricing power when there's very little competition. There are very few alternatives to shop for when looking to replace a niche product or service, and some businesses have subsidiaries that are direct to consumer, while others focus purely on business to business or B2B sales. Many companies will have mission critical products or services that their customers cannot function without. A business like Heico, for instance, has a high degree of customer lock in with its customers in the aviation industry, which gives it pricing power and high level of customer retention. Many of the businesses featured in this book are highly focused on products that can be considered consumables by their customers. This means they have a very steady and predictable sales cycle and since the products are usually smaller in basket size, they get paid quicker and therefore don't need to worry too much about having cash tied up for excessive working capital needs. Next is decentralization. A business like Constellation Software cannot rely on one person to make the nearly 1200 deals that they've made throughout their lifetime. As enterprises scale up, they must pass off responsibility to other people. A business like Constellation has been an absolute master at this. Too much bureaucracy is a death sentence for aging companies. You get tied up doing too much talking and not enough doing. This is why many companies opt for decentralization. They get the right incentives, they get the right systems in place, then they just allow their people to execute which they are incentivized to do. And then speaking to culture, you know, cultures that really foster leadership and entrepreneurship are just so important. If you're looking at a business that cultivates these two things, then you may be looking at a great long term compounder. Leaders often retire and may eventually need to leave a company if that business is forced to hand it over to someone maybe outside who doesn't understand the culture that can obviously spell a disaster. But let's suppose you do have a small army of these great leaders and entrepreneurs who are very well versed in the company's culture. In that case, the transition period can offer a new perspective while maintaining a culture which tends to be a win win situation. The same companies that have established long term cultures prepare really really well for events such as the CEO's retirement. The book has an excellent table showing the tenure of former and current CEOs and the companies that were outlined, and it's quite powerful. So you can see that on average, the CEO of the nine businesses that were discussed have an average tenure inside of the company of about 21 years and an average tenure of 13 years as CEO. When you have CEOs that are willing to stay on that long, you can assume that they're taking a longer term view of the business and can strategize accordingly. Another area of the book that I'm glad was addressed was why Sweden just has so many successful serial acquirers. So I posed this question to Chris Mayer back when I was hosting the Millennial investing podcast on Mi310, which I'll link to in the show Notes. Let's take a quick break and hear from today's sponsors.
- [20:00]
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- [23:19]
Kyle Grieve
All right, back to the show. Chris gave a really interesting breakdown of his own research from speaking with people in Sweden and had two primary reasons why he thought Sweden had been this kind of hotbed of serial acquirers. And the first is his trust. So Swedes tend to have more trust in their culture, so a business model that utilizes decentralization makes a lot more sense. And the second was just Bergman and Bevy, which is a company that we're going to be going over a lot today. So this is a business that achieved considerable success by spinning off multiple companies that were also highly successful. So Chris believed that there's probably a lot of this kind of Silicon Valley aspect to Sweden in that people in Sweden could see this very clear success from Bergman and Bevin and then just simply tried to clone them. So the book's authors have achieved pretty considerable success investing specifically in the Nordics, and they provide their own reasoning for that. So the first was at Sweden had simply embraced innovation and globalization because they didn't have constraints on this. They were able to take a lot of advantage of the opportunities that were provided to, you know, innovate and create products that were viable at a great price. They also have a history of expanding globally through acquisition, which dates back to the mid 20th century. So riding on what Chris mentioned to me regarding trust the book states that Sweden ranks high on international indices for ease of doing business, global innovation, perception of corruption and human development. This high trust environment provides a solid foundation. And since trust is so high, so is transparency, which allows for large amounts of public information to be readily and easily accessible by the public. Now there are really two pioneers of decentralized philosophy in Sweden that are worth mentioning here. So they're Hans Verthen, the former CEO and chairman of Electrolux, and Jan Valander, the former CEO of Handelsbanken. So Verithan was integral to the evolution of Electrolux's culture. He created a culture that avoided bureaucracy and centralization, that limits quality growth in countries all over the world. He also empowered lower level employees with decision making, as they were the ones closest to the customer and therefore had unique insights into what the customer exactly wanted. So Verthan was also highly frugal. One of his first moves of CEO was to move the HQ from their luxurious spot in Stockholm's business district to a much more modest and lower priced location on the outskirts. He also eliminated unnecessary staff budgets and forecasts and minimized internal meetings. And in Electrolux's cases, all these initiatives worked absolute wonders as sales and earnings grew 80 times while he headed the company, achieving a remarkable KEGR of 20% over 25 years. Now, Jan Volander was also someone who simply loved centralization. However, it was a concept that he had to really work hard to push through as he initially encountered quite a bit of pushback on it. So here's Volander's philosophy. Decentralization is a management philosophy that can release the full potential of people in any corporation because it is in accordance with human nature, not against it. People are the only sustainable competitive advantage. So Volander shares many similarities with Verathan. He just did it in the context of a bank. So he eliminated annual plans and budgets as well as fixed performance contracts, which he felt stifled innovation. He gave power and responsibility to branch employees, allowing them to make their own decisions. Now while this decision was highly scrutinized at the outset, it ended up paying off very well long term. As Handels Bonken credit risk decreased, he also rewrote the functions of the headquarters. Instead of being the centralized hub of decision making, it became a center of service for frontline employees who are already accentuating the customer first approach. As a result, he was able to increase efficiency with HQ staff count decreasing by 33%. And because the business's service was just so good, they no longer had to rely so heavily on marketing, reducing their marketing staff from 40 to only one person. He also developed this culture of healthy competition between the branches. So he organized incentives based around profitability and capital efficiency to increase the odds of success over time. And the system clearly worked very, very well. So reading this makes me think that TIP is actually run in many similar ways. You know, Stig gives hosts a very long leash to get creative and encourage it to a very high degree. He also expects us to take responsibility for any mistakes, which keeps me on my toes and helps me strive to be the best podcast host that I can possibly be. But by the same token, if you come up with a great idea and execute on it well, you're also very well rewarded with the incentivization structure that he creates. It's a culture really unlike anything that I've ever been a part of before, but it really works well for me. I can understand why it wouldn't work for everyone. I was just speaking with my vehicle insurance representative who I know well, and he was actually just asking me quickly about my job. He actually said that he had an employee who was working remotely due to the COVID 19 pandemic. He observed that this one worker's production absolutely plummeted when she was working at home, but she was absolutely incredible when in the office. So he mentioned that she had this dog and she just catered to its every whim when she was at home. So when you know, her dog was at home barking, she'd go and address it, among other things, which significantly impacted her productivity. And I think this just demonstrates that you need the right people to make a decentralized structure effective, and that might be why you haven't seen it embrace at the same level in North America as you've seen in Sweden and other Nordic countries. Now let's dive into the first business that's mentioned in the book, which is Lyftco, which I've analyzed in some detail many years ago, but never ended up taking a position in, unfortunately. So. Lyftco currently has about 257 companies, operates in 37 countries, and is divided into three primary segments, dental, Demolition and tools and system solutions. Part of what has made Lyftco so successful over the years is in its leadership. Its CEOs include Frederik Carlssen and Per Valdemarsen. Under both of these great managers, the business has compounded earnings at 14% and per share, free cash flow at 21% per annum since 2006. Another interesting name deeply entwined with Lyfco is Carl Bennett, who owns about 50.2% of the company's shares and 69% of the voting rights. So he was the one who handpicked Carlson as the first CEO of LyftCo. He was taught business during his tenure with Electrolux and he gradually worked out to become the CEO of his own division inside of Electrolux. Bennett and a partner eventually purchased this business called Gatinge, a former struggling part of Electrolux's medical division. Bennett helped turn Gating around simply by raising prices, a strategy that the business had not tried in nearly a decade's time. So LyftGo was eventually spun out from GTing. The business struggled for a time and Carlson had to make some kind of long term decisions that he knew would not be well received by public investors. So As a result, LyftCo was just taken private. So one initiative that Carlson did while the business was private was to sell off the non performing assets inside of the business. So this ended up shrinking the business by 40%. So you can see how a public equity holder probably wouldn't be very happy with that. But over the next few years he was able to actually four times LyftGo's operating profit margins from 2 to 8%. And today they're at 16 and a half percent. So the book covers several areas that have contributed to LyftGO's success today. The first is discipline and capital returns, which are essential for a successful serial acquirer. If you're just not disciplined with what you're paying for an acquisition, the system just falls apart. Therefore, it's no surprise that Lyftco pays no more than 8 times EBITDA for acquisitions. But buying a business is only the beginning. The principal value add for a company like Lyftco is the ability of management involved in the acquisition to boost the business's growth organically. So inside LyftCo, the person heading the acquisition is also incentivized to organically improve the company's profitability, which helps them achieve or not achieve their incentive. So they do this by increasing specialization, which allows them to raise prices, which helps them unlock their bonus. Speaking of incentives, they're most effective when they align the interests of management and shareholders. But Lyftco took this a step further by also aligning the seller of the business with these two key groups. They achieve this by allowing sellers to retain a portion of their ownership in the business. Lyftco tested this out and found that they had much better performance post acquisition when the seller retained an ownership stake. The second point is on decentralization. Bennett learned from Hans Verthen and passed it on to current CEO Per Valdemarsen. LyftGo has a very lean staff. The CEO just doesn't even have an assistant. Many of the decisions for individual businesses are made at that individual or group level, which reduces the decision making authority for the CEO and upper management. This enables Lyftgo to eliminate everyday corporate wide expenses, including, you know, business development strategy, HR and finance. These are all pushed down to the individual company level. So regarding hr, CEO Per Valdemarsen has said hiring an HR person looks good for about two years, but five years down the road we have to risk having five employees. So the last advantage is being able to find talent within the company. Group managers who manage multiple companies simultaneously are all brought up from within the company. And because all group managers were also CEOs of operating companies, they really understand the nuances of running them properly and they're expected to perform. And when you perform, you're very well compensated. The current CEO Per Voldemarsen is an excellent example of this. So he actually rose through the ranks while Frederick Carlson was in charge and gradually worked his way up to the very top. And as a testament to the amount of trust that Carlson had in Lyftgo and the culture that he helped build, he actually bought Lyftco shares on the day that it was announced that he would be removed as LyftGo CEO. The next business I would like to discuss is another notable Swedish acquirer called Indu Trade. So Indu Trade has five business segments which all have attractive tailwinds. They are industrial and engineering, infrastructure and construction, life sciences, process, energy and water, technology and system solutions. The company has grown its cash flow at a 14% KEGR since its IPO in 2005. And during that same time period, the total shareholder return has compound at 22%. So the business was formed from a group of three firms that merged to form a company called AB Nilsdoc. The CEO of one of these three companies was this gentleman named Gunnar Tinberg. And he was a significant fan of growing by acquiring other businesses that were also operated by highly talented entrepreneurs. Another strong suit of Indu Trade that was passed on from Tinberg was in its relationships with its customers and suppliers. So because they focus on maintaining these relationships and making sure that they were strong and healthy, many additional benefits emerged. For instance, in one meeting with a purchasing agent from Atlas Copco, Tinberg asked their representative who their best supplier was. And they named this business called Collie Group. A business that Indutrade still owns. So tinberg retired in 2004 and was succeeded by Johnny Alverson. A year later, they went public. So much of their culture was based on very similar traits that I've discussed today. You know, frugality, decentralization and meritocracy. One initiative that Alverson undertook in the business was to shift from technical trading companies to a more manufacturing oriented companies with proprietary technology. He brought the sales mix from companies with a proprietary product from mid single digits all the way up to 50% while scaling their acquisitions from 60 to 200. Another advantage that Alverson observed was in adding businesses that were outside of the highly competitive Nordic companies. So he started looking at companies in the uk, Germany, Austria and Switzerland, where the competition for acquiring businesses that he was looking at just wasn't as high. Alverson stayed in the business for about 13 years and compounded EBITDA at 14% during that time while compounding total shareholder returns at about 24% now. Once he retired, their next CEO was a gentleman named Bo Anvik. And he picked up exactly where Alverson left off in terms of evolving the business. So Anvik was a great blend of Tinberg and Alverson in terms of understanding technical trade, manufacturing and international growth. He helped continue to improve international expansion, governance and empowering from within indutrade. Another key to Indotrade, which is a concept that I really like, is in their products. So primarily this was because many of their products accounted for a small percentage of the total cost of, you know, the machine or system that they were involved in. These were kind of consumables, you know, valves, transmissions, fasteners, pipes, pumps and filters. A serial acquirer needs to ensure that their subsidiaries continue to grow cash while maintaining this kind of decentralized structure. Now this can be kind of challenging, but one way to achieve it is by creating the right incentive program instead of going in and making massive changes to a business from the top. If you have the right person in charge of the company with the proper incentive, you could just trust that person to write the ship for you. That's what indutrade does so well. Not only does INDU trade require profits to grow, but they should also only grow when generating an attractive return on invested capital. This creates a situation where businesses just can't grow by simply decreasing margins or having poor working capital management or by giving significant discounts to customers. So one argument I get against zero acquires is often why would a company sell to them rather than to private equity? And the argument is that private equity will likely be the highest bidder. And while that's probably valid in the majority of cases, there's more than one reason that someone is going to sell other than just money. For instance, the owner of a business might want to continue improving their business, but maybe just require some capital and know how from others to help them do that. Indutrade is a company that can offer this without making significant scale changes that would likely result in things such as layoffs or rapid shifts in a company's culture. Another initiative that I respect that Indutrade does is this three year post performance review. This keeps management's eyes on the future rather than worrying about just, you know, the following year or the current year. If your business possesses this type of incentive program, you're creating a business that's optimized for a multi year time period rather than, you know, just making sure things are performing well in the very, very short term. Now the next business we're going to go over here reminds me of where Constellation Software is probably going to end up in the next 10 years, which is a successful mothership with multiple spin offs running similar playbooks to that mothership. So we're going to be going over Constellation more later on this episode, but for now let me introduce you to Bergman and Bevin, which is one of the pioneers of serial acquirers. So Bergman and Bevin, which I'm just going to refer to for the rest of the episode as BnB, is an owner and developer of niche products for the construction and industrial industries. So two defining characteristics mark bnb. The first is a dedication to decentralization and the second a firm that's committed to self finance growth through profit goals. What I found most interesting about bnb, having not spent, you know, any time really researching them before reading about them in the book, was there emphasis on point two, especially regarding working capital. So working capital is an area that I've been spending more and more time really, really trying to understand in a deeper fashion in 2025. Now, the catalyst for understanding working capital came from my deep dive at adoption of using owner's earnings as kind of this uniform metric that I use for basically all of my businesses. This allowed me to identify which companies were growing this metric at a healthy clip as well as having a healthy owner's earnings margin. The more I tracked owner's earnings, which I'll simply define here as operating cash flow minus maintenance capex, the more I started to emphasize the importance of working capital. Working capital can be a significant source or a major drain on a company's operating cash flow. So let's use an example of Joe Safety, which is a subsidiary of bnb. So this business is a leading supplier of workplace safety signage, information signs and safety markings. They would clearly need to have inventory, right, to sell to their customers to make money. Now, to buy inventory, you have to hold cash. And once you sell that inventory to your customers, they don't always pay right away. It may take, you know, 30, 60, 90 days or even longer to pay, which will be reflected in the company's accounts receivable. When you haven't collected that payment, you're tying up cash. Now, I have no insights into Joe Safety's actual balance sheet, so this is purely hypothetical. So bear with me here. So let's say they had millions of SDK and inventory and accounts receivable. That's obviously a significant drain on their cash flow. However, we then introduce another beautiful aspect of the balance sheet, which is accounts payable. Now, if Joe Safety has to buy pieces of their signs from their supplier, they also have cash that can stay in their accounts for extended periods of time, which they can then use to finance their customers. So let's say their suppliers offer them 120 days to pay. In this case, the seller is essentially financing Joe safety's business for 120 days for free. This allows them to generate more cash versus if they needed to pay suppliers on just, you know, a monthly basis. So when I saw that BNB had a metric that they called profit to working capital, I was quite intrigued. So they use this number as a ratio and they want it to stay over 45%. So this means that if profits are, you know, 10 millions E K, then the working capital needs to be below 22.22 million SDK. Or another way to think of it is that for every dollar of working capital, you must produce at least 45 cents of profits. An interesting event that happened to BNB was an experiment with centralization. And as you might have guessed, given how much we've spoken about decentralization, this experiment did not end very well. So the year was 2001, and BNB had just spun off two segments of the business, creating ad tech and logicrons as well as the original BNB business. Instead of relying on the business model of decentralization, which had served them so well for decades, they decided to flirt with centralization. They changed their name to B and B Tools, and they decided that they could obtain synergies by integrating product companies with wholesalers and reseller entities that they've Already purchased. Now this kind of reminds me of the efficient market hypothesis. You know, it looks clean and understandable on paper, but it fails to be usable by anyone really. In reality, BNB Tools that created detailed presentations that revealed that profits could scale. And for the first six years it actually worked. They were able to increase operating profits fivefold over that time. But then comes in 2009 and profits slipped by more than 50% in the one year during the lead up to 2009, they'd also been aggressively buying acquisitions and piling up debt that was now. Threatened by that lack of profits, BNB Tools decided to appoint all Lilius to help right the ship. And he did right the ship, focusing on one thing, decentralization. Once they began focusing once again on pushing decision making as close to the customers as possible, the business started to improve. BNB Tools during this centralization process DE emphasized the profit to working capital KPI. But Lilius reemphasized it, which made for much better decision making. They then spun out the reseller business as momentum group. Now, when I was reviewing this profits to working capital ratio, I wondered what the significance of this 45% number was that they chose. And the reasoning behind it is that a business can be considered self financed if they can achieve that lofty metric. So here's what the book says. By achieving a profit to working capital over 45%, the business can generate necessary cash to cover taxes, interest and dividends and make required investments inside of the existing business through capital expenditures, working capital and financing acquisitions. The goal of self financed means that growth, whether organic or through acquisitions, will not dilute current shareholders through equity raises or rely on heavy debt financing. The 45% can be further broken down to three categories. So the first 15% was allocated to cover taxes. The second 15% is reserved for dividend payments, which will be distributed to the parent company. And the remaining 15% is internally invested for future growth and maintenance. So there's six levers that can be pulled by a business to boost the ratio. The first three involve raising profits. You can do things such as increase your sales volume, you can raise prices, and you can reduce costs. Let's take a quick break and hear from today's sponsors.
- [43:48]
Amazon Ads and Vanta Sponsor
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- [47:18]
Kyle Grieve
All right, back to the show. The second three involve working capital management. You can reduce inventory, you can speed up customer payments, or you can extend supplier payment terms. Another vital part of BNB is their internal benchmark system, known as the focus model. This integrates the 45% profits to working capital KPI and applies it across all operating companies within the group. Each group and the companies inside are then ranked according to that KPI. The focus model has three levels to it. The first level is for businesses that require a lot of work. This is a profit to working capital below 25%. Increasing revenue is not the right solution for this segment. They need to focus on improving working capital management and profit margins. The second level is a profit to working capital of 25 to 45%. This strategy isn't too dissimilar from level one, but once you hit the higher end of the range, then you can start making growth investments to improve that top line. Now, the pinnacle is obviously when you get to a profit to working capital of about 45% or higher. If you have done this work to get to this point, then you can focus on profitable growth via acquisitions as well as organic growth initiatives. So what's most interesting is how Bergman and Bevin uses this metric to improve its business. Once you know your level, you can focus on aspects such as product performance, analyzing specific markets and customers, using them as a tool for assessing potential acquisitions, and even negotiating better supplier terms. And while some businesses claim to do all of these things, many companies fall short because their employees are not appropriately incentivized. BNB does a great job of incentivizing employees to progress to a higher level actively. As the book says, the overarching goal is for all employees to quickly see measurable impacts on financial performance. An example of this might be a salesperson who is incentivized to do good things that would reward themselves, the business and shareholders all simultaneously. This might be things such as raising prices, avoiding discounting, asking customers for quicker payment, or extending payment terms with suppliers. Now, I could go on and on about BNB because the business is really excellent and has spawned numerous spinoffs. But I'm going to transition here and speak about two of the spinoffs that were covered in this book, which are Logicrons and ad Tech. So Logicrons is interesting because it's a case study that a turnaround can really turn around. But we'll get back to that shortly. So Logicrons was spun out a BNB in 2001 and has actually been a hundred bagger ever since then, while compounding free cash flow at 16% and owning a 19 return on invested capital. So what do they do? Today it's operating five divisions. Electrify Control, Tech, SEC Niche Products and International. Similar to bnb, each of the companies in each division has a leading position inside of its niche market. Since logacrans is a generalist in their acquisition criteria, they can be very flexible and stay adaptable. Now remember how I mentioned that BNB experimented with centralization here for a time? So Jorgen White, the CEO then shifted similar to Logicrons, focusing more on niche products and businesses. So to right the ship for Logicrons, they realized that their customer concentration was too high using their specifically this distribution business model. Jorgen Vai, the CEO then shifted similar to Logicrons, focusing more on niche product businesses. So one interesting initiative led by Jorgen VI was the addition of these new divisions. So they didn't always have these five divisions that I mentioned. They actually started with three. So in 2012 they added this niche products division which really took off for them. Now the book names a business inside of this division called Asept International which makes ketchup dispensers. Now this business couldn't really be labeled and put under the original divisions, so they just created a new one and obviously had a lot of success. This niche product category was a major strategic victory which allowed Logicrons to consolidate a number of higher margin businesses that just raised the bar for the entire company. They also ended up cloning one of BNB's most prominent traits in terms of incentives. They also used the 45% profit to working capital KPI. A few other incentives that have worked well for this business are 15 annual earnings growth rate over an entire economic cycle. And they achieve this in a particular way. So they do this via about one third organic growth while allowing the remaining profits to just come from value added acquisitions. They aim for about 8 to 12 acquisitions per annum and they aim also for a 25% return on equity. Now these are just excellent KPIs that really keep the business running well and adding shareholder value over the long term. Now let's turn our attention to another BNB spinoff here, Adtech, and see what differentiates Adtech from BNB and Logicrons. So similar to BNB and Logicrons, Adtech has been a cash generating machine since it was spun out in 2001. Since then it's compounded free cash Flow per share at about 19, while delivering total shareholder returns of a massive 26%. Ad tech seems more similar to Logicrons though than BNB, but differentiates itself in its divisions, which are automation, electrification, energy, industry solutions and process technology. As his name implied, the focus of the business is more on technology. So this business learned a lesson that I have spent a lot of time focusing on, and that's that serial acquirers that do not prioritize performance through economic cycles tend to have a pretty tough time thriving over the long term. So I own two micro caps here, acquirers that specialize in trust manufacturing and industrials. They both were somewhat of a market darling immediately post Covid when money was cheap and inflation was rampant. Now these two things acted as tailwinds for the business. While it's nice to have a business that can take advantage of these types of economic environments, the critical thing to remember is that these environments are not normalized. Ad tech went through a few periods, as all businesses do, that also weren't normalized. And they learned some vital lessons from it. Now, the first period was immediately after it IPO'd, so it actually IPOed a week before 9 11. Horrible timing. @ that time, Adtek was exposed to telecommunications, a sector which had been absolutely ravaged by the dot com bubble bursting. And Then also by 911 at CK earned about 34% of its revenue from telecommunications and automotive. And the business suffered as a result of this high reliance. So the business focused on improving profitability, increasing margins from 3.6% to 6.7% three years after the IPO. Then they began expanding their income streams, investing into a medical business that was eventually spun into Ad Life. Then in 2008, another headwind was offered up in the form of the great financial crisis. Specific segments of the business had massive drops in earnings and some reported drops of 30% in orders. So the company shifted focus to even more decentralization, removing its centralized M and A function and separating its business into these four units, which could be more independently run. And during the shift, profits were actually plummeting. So they plummeted about 42% in 2009. But on the plus side, cash from operations only decreased 5%, showing that the businesses that were inside of Ad Tech were able to make the best situation possible from some of the tweaks that they were working on inside of working capital. Since ad tech relies more on tech, there are particular upsides and downsides to that business model. The apparent upside is that technology obviously tends to have a lot of torque when it's in favor. This allows for the possibility of pretty high organic growth in individual businesses. And when a product is in high demand, it also offers great pricing power. But the downside is that technology obviously can become obsolete. If you went out to buy a horse carriage business that was utilizing some technology the year before the car was manufactured for public use, you probably didn't end up doing very well on that acquisition. So you have to really balance what you buy with both of these things in mind. And while this is challenging for most businesses, adtech has demonstrated that it's entirely possible. I think adtech is an excellent example of a great company. While I don't think they ever had bad management, the business also has gone through three different CEOs since 2001. Here was the performance of the company in terms of sales and shareholder value. So the first one was Roger Berkfist From 2001, 2008, he keggered sales at 8% and shareholder value at 19. The second was Johan Xio. From 2008 to 2018, he compounded sales at 6.6% and shareholder value at 21%. And the current CEO is a gentleman named Nicholas Stenberg, whose compound revenue at 15 and shareholder value at 32%. So the business has incrementally increased its value for shareholder as it ages. Like, you know, a fine wine, it's very impressive. Now, the key to this business, like most others, is in its culture. As long as the culture of the company stays intact and is run by someone who fully embraces and can incrementally improve that culture, then chances are that shareholders are in excellent hands. Next, we move to a business that many of our listeners are going to be very, very familiar with, and that's Constellation Software. Constellation Software was engineered by its founder, who recently actually stepped down as CEO. That's Mark Leonard. So Mark figured out early that VMS businesses were fascinating because they generated a lot of cash. But the downside to them was that that money couldn't really be reinvested. So he brainstormed ways to just reinvest the cash and came to the conclusion that you should just buy more of them with the cash that each of them generated. This created the flywheel effect that we see today. Generate cash that just reinvests that cash into more cash flow machines. It's the same strategy of basically every business in this book, which should tell you something very critical. Constellation has compounded operating profit at 33% annually since its 2006 IPO, while maintaining its returns on capital employed by over 30%. Both of those resulted in the business being a 200 bagger. And that takes into account constellations recent over 30% drawdown. So what are the ingredients for a business to succeed like Constellation Software has done? It's not too dissimilar from the businesses that we've already discovered, but Constellation puts its own spin on things. So the first here is the vertical market software VMS industry. While most people find these businesses boring due to their lack of growth, that's where the true advantage lies. Since Leonard realized he could gobble these up with very little competition on bids, he knew that he had an investment Runway that could last for a very very long time. The attractive part about VMS businesses are that the ones that Constellation looks for are usually the number one or two in a given market. They make up a low percentage of their customers revenue. They have deep integrations into their customers workflow and operations. And they are critical to the functioning of their customer's business model and back end systems. So as a result of all this, customers just tend to stick around demonstrating the switching costs of the VMS business model. Additionally, since many of these businesses have these very very deep integrations, they're much less likely to switch to a competitor if prices are raised. If you have a company that is dependent on software for the last decade, it's going to be timely and energy sucking to switch to a new software provider. You can also annoy your employees who are forced to train on new software that they just don't know how to use, which can even cause increased employee turnover. As Constellation scaled, Leonard realized that a decentralized model was necessary for its continued success. Which is why I'll see Constellation broken down into smaller units that make up the whole corporation. The group under corporate level are known as operating groups. Each group is separated by the verticals inside of it. Then you have individual businesses inside of each of these verticals. For instance, the Jonas operating group encompasses the following verticals. Hospitality clubs and resorts, Spa and fitness, Construction, payment and moving and storage. The individual verticals are then further divided into business units or individual companies. Each of these groups and business units is incentivized to continue to create cash flow that goes straight to the parent company. Constellation has in my opinion, the best incentive program that I've ever seen in terms of alignment. So the incentive program has a variable incentive that's the key to the whole thing. So 75% of employees compensation goes into purchasing CSU shares on the open market. The shares are then held in escrow for three to five years. The variable incentive is based on achieving a ROIC of above 5%. This helps the business's capital allocators focus on optimizing for returns on invested capital and not just on returns. So let's say that you're a vertical inside of the Jonas Group. Let's say in construction. Maybe you have a few million dollars to invest. You have two options. You can invest in your current businesses to increase organic growth or you could acquire a new business. This decision will be guided by your incentive ROIC ROIC. If you achieve a ROIC of 28% investing into one of your business units or have the option of a ROIC investing into a new business, you're probably going to opt for the higher ROIC option to optimize your incentive. In reality, CSU adds a bulk of its value adding new companies as long term organic growth has averaged only about 2% now one of my favorite Mark Leonard stories, which highlights just how good of a CEO he is, is when he decided to reduce his salary to zero and waive completely any bonuses. This made him purely into a shareholder of consolation Software. In his 2015 annual letter, he wrote this year, I'll take no salary, no incentive compensation and I am no longer charging any expense to the company. This is not something you see every day, but shows a leader who is laser focused on creating shareholder value. It also shows a leader who did not think of the business as his own personal Piggy Bank. Many CEOs are drawn to the job because of the perks of working there. Leonard's perk was that he got to lead a business that he created and believed in and continued to compound it to new heights. Now the final three businesses discussed in this book are Heico, Ametek and Judges Scientific. I'm going to summarize a few key lessons from these three businesses. So Heico is a business which focuses on supplying critical parts to the aerospace industry, has some superb lessons from it. The first one is that a multi generational family run business can succeed at a very high level. Of course, this only works for specific companies where the next generation is actually interested in becoming involved with the family business, which is probably not the norm for most families in North America. Another area that stuck out to me with Heico was its kind of courage to really just take on large and powerful competitors in the OEMs, original equipment manufacturers. So OEMs tend to have a stranglehold on spare parts. They can cause a lot of pain to their customers who may decide to go elsewhere if they wish on Top of this, when you're talking about parts that are highly regulated and scrutinized, it's just not easy to get a foot in the door and compete with them. But the Mendelsohn family has been doing it for three and a half decades, incredibly successfully. Another key to Heico's success as an acquirer is in retaining talent. While they buy enough of the company to be a majority owner, they know how powerful it is to have the seller involved in the business, so they often allow the seller to keep some skin in the game to keep them focused on the company and on making it better and better each year. For Ametek, a business that is widely diversified into industries such as aerospace, healthcare, energy and advanced technology, I learned the importance of excellence. So excellence is a trait that you know, anyone would love to have, but I think few actually possess. And in order to maintain it, it's a mixture of this natural inclination towards excellence and incentives. And I think Ametek really embraced excellence as part of its culture. Although Ametek runs a decentralized operation, there's always room for improvement. So Ametek has these specialists which they call black belts. These are Ametek's experts in eliminating waste and reducing variations and defects. These black belts will steer week long Kaizen events to help explore inefficiencies in a subsidiary and help create solutions to fix them. Now, I think this point on Ametek going to their individual subsidiaries is crucial because I believe there are some misconceptions with investors when looking at successful SEER acquirers and assuming that the good SEER acquirers only acquire perfect companies that don't require any coaching or help to improve. For instance, a former Constellation Software performance manager in the TIP Mastermind community told me, quote, at Constellation software, the portfolio CEO's job is mostly to coach their business unit leaders to high performance. Beside finding new deals. And as you've seen with a lot of the compounders that we've gone over today, there have been many bumps in the road on the way to success. So when you're looking for a compound in the future, just realize that just because a business is maybe going through some headwinds and the parent company needs to get involved with the individual business units, it doesn't mean that that business is not any good. And the last business that I'm going to cover today is Judges Scientific. They specialize in acquiring niche highly profitable instrument companies. I find Judges Scientific fascinating as they've only completed about 25 acquisitions since their IPO way back in 2003, yet it's already a hunter bagger. Their CEO David Securel has a great quote on acquisitions. We are not interested in the speed of acquisition, but in the speed of value creation. My big lesson from Judges Scientific is just how vital organic growth can be. So you know, when you think about it, for a business to compound at a 24% kegger, organic growth is obviously going to have to be massive if you are only acquiring new businesses at a pace of about one per year. And that's completely true. So Judges has averaged an organic growth rate of about 7% to 9% annually. Another aspect of Judges that I really appreciate is the emphasis on the KPI that they use, which is return on total invested capital or Rotic. Securel uses Rotec instead of return on capital employed because he feels that return on capital employed is just an accounting fiction. So returns on capital employed allows the denominator to get smaller as assets are amortized or goodwill is adjusted. Rotic does not secure. L being, you know, highly rational, believes that returns should be calculated based on the actual capital invested and not in make believe numbers. So a simple example will suffice here and we'll use Judges Scientific. So in Judge's latest earnings release they noted a row tick of about 18%. Now let's create an amortization of intangibles and goodwill of call it £40 million. Now this one adjustment makes the return on Capital employed 38%, which is obviously a much higher number than the Rotek that they use as their KPI. Now the key lessons from the compounders that I think investors can really take away revolve around recognizing the power of time, capital, efficiency and culture in driving long term wealth creation. The book emphasizes that shareholder value is created when companies consistently have a return on invested capital above their cost of capital and that the very few exceptional businesses that are capable of doing this over long periods of time deserve premium valuations. Traditional valuation frameworks often fail to capture the potential of these firms simply because investors tend to discount future cash flows too heavily. The company's profile demonstrate that a sustainable reinvestment at high rates of return combined with disciplined capital allocation is far more critical than short term valuations. What truly distinguishes these businesses is a combination of decentralization, performance driven culture and a durable reinvestment engine. The great compounders empower people closest to the customer, maintain a lean structure and use very, very clear incentives that align management and shareholder interests. This decentralization not only nurtures entrepreneurship and accountability, but also prevents bureaucracy from choking innovation Meanwhile, these companies protect their downside through diversification across industries and geographies, and they build resilience by continuously reinvesting profits into high ROIC opportunities, whether that be organic or through disciplined acquisitions. Ultimately, investors should recognize that identifying the next compounder requires pinpointing businesses that can leverage time as a competitive advantage. It's the rare combination of a long Runway, consistent reinvestment, and a culture that rewards excellence that drives exponential growth. Compounding is not just a mathematical phenomenon, it's an organizational one. The investor's job is to recognize and hold onto businesses that can sustain high returns over decades, even if they appear expensive in the short run, because the magic of compounding only reveals itself through time. That's all I have for you today. Want to keep the conversation going? Follow me on Twitter Rational Mrks or connect with me on LinkedIn. Just search for Kyle Grief. I'm always open to feedback, so please feel free to share how I can make this podcast even better for you. Thanks for listening and see you next time.
- [68:07]
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