“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't... pays it.” - Albert Einstein
Much like Einstein’s famous quote, we too believe in the incredible power of compounding over the long term. In fact, we’ve built our investment process to identify just that – companies that will compound value over the long term.
So what exactly does compounding value mean to us? Here’s a real world example, The Middleby Corporation.
Middleby is a company we have owned in the Global Equity and Growth Companies portfolios at Cambridge for a number of years. They design, manufacture and service kitchen equipment for commercial and residential use – not exactly the flashiest business on the surface, but of course our analysis goes much deeper.
In 2004, the year their current CEO took control, they made $271m in sales, brought in $0.54/share in adjusted earnings and generated $17.3m in free cash flow. At the end of that year they had a market capitalization of $382m and you could have bought a share of the company for $8.45 (split adjusted). Fast forward to 2016, the same company is expected to make over $2.2b in sales, deliver $4.88/share in adjusted earnings and generate over $264m in free cash flow. At the end of 2016, they had a market cap of over $7.4b and their shares were trading at $128.81 – an incredible +25% annualized growth rate in their share price over that twelve year span.
Other than a single equity raise of $78m in 2005, their growth has been completely funded through internally generated cash flows. How did they achieve such impressive performance? Many factors led to their success, but they can be distilled into two categories:
- An intense focus on driving ROI for customers, which leads to pricing power and strong cash flows generated by the business, and
- A disciplined capital allocation process to invest in merger and acquisition opportunities and maintain their competitive advantage
These two steps (how a company generates cash flow and what a company does with that cash flow) are what we work hard to identify in the businesses we own. It is important to note that the impressive performance at Middleby wasn’t generated without a number of setbacks along the way. The stock price has had eleven corrections of greater than 20% since 2004. However, in value-creating businesses, these sell-offs create opportunities and it is our deep understanding of the fundamental drivers that allow us to distinguish between a market overreaction and a broken business. Greg was first to attend a Middleby investor day in 2012 and came away so impressed that he asked Brandon to come along in 2016. After a four hour flight to Memphis and a two hour cab ride to Greenwood, Mississippi, Greg was among the few investors to make that initial trip. Developing direct relationships with management and asking the right questions give us a unique insight into the risks and opportunities that a company faces.
We are often asked by clients – what keeps you up at night? While there are always risks with investing, both known and unknown, we focus on what we can control. By investing in strong businesses at reasonable prices, we sleep soundly knowing that the underlying value of these businesses, and by extention our portfolios, are growing day, after day, after day. That’s the power of compounding value and we are firm believers in its awesome power. The secret’s out, thanks Einstein.
Data source: Bloomberg
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