The power of compounding value

Geoff Scott's picture

“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: 

  1. An intense focus on driving ROI for customers, which leads to pricing power and strong cash flows generated by the business, and
  2. 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 

Disclaimer:
This commentary is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. All charts and illustrations in this guide are for illustrative purposes only; they are not intended to predict or project investment results. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This report may contain forward-looking statements about CI funds, future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments.

 

 

 

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