In the search for high-quality stocks, we look for several things - a superior return on capital, economic moat, able and honest stewardship, decent growth prospects, robust cash generation and high predictability. Do all these altogether suffice for the business to create tremendous shareholder wealth, if we assume a buy-and-hold approach? Not necessarily, though we do admire such a business as a good investment in terms of downside risk protection for its owners. What makes a good investment a powerful compounding machine is the ability of the company to reinvest its retained earnings on behalf of its owners at an attractive rate of return. We think that investors can more "safely" pay up a bit for these powerful compounders.
One quick and dirty metric to gauge the current rate of return on reinvestment is the incremental return on equity. Nonetheless, past results are not always a good indicator of the future. Hence, investors may also want to beware of the length of the growth runway, industry dynamics, capital allocation style as well as the long-term corporate strategy so as to make sure that the compounding machine does not lose streaming power.
Browsing through our investable universe, we came up with a list composed of our hand-picked compounding superheroes based on the criteria below:
- Three-year incremental return on equity above 50% and above any of the returns on equity from recent years.
- Management's commitment to reinvesting a sizable portion of earnings.
- A promising market share opportunity or industry tailwind.
- A clear growth strategy that remains steady.
Cincinnati-based Chemed (NYSE:CHE) operates two wholly-owned subsidiaries - VITAS Healthcare, the provider of end-of-life hospice care, and Roto-Rooter, the provider of plumbing, drain cleaning, and water cleanup services. The hospice business, which represents nearly two-thirds of total sales, has become the primary growth engine for the company. Although being the largest provider in the U.S., VITAS shares around 7% of the fragmented $18 billion hospice market. The company plans to grow through both geographic expansion and acquisition while benefiting from a demographic tailwind.
Based on our calculation, Chemed delivers a three-year incremental return on equity of 57%. Over the last three years, the company earned an annual return on equity between 18% and 36%, while increasing its equity capital by 40% in total. Typically, only 10% of earnings are paid out as dividends.
OTC Markets Group
New York-based OTC Markets Group (OTCM) is the financial market providing price and liquidity information for over-the-counter securities. To grow the business, management has been devoting resources to its international sales force and continuous investments in infrastructure, products and technology. The strategy appears to have been working well as the company achieves a three-year incremental return on equity of 162%. For the past three years, the business earned an annual return on equity between 83% and 105%, retained around 50% of net income and increased the equity capital by 15% in total.
California-based Ross Stores (NASDAQ:ROST) operates the off-price retail business through its Ross Dress for Less and dd's DISCOUNTS brands. The company has been taking advantage of the structural challenge facing the traditional brick-and-mortar space to keep capturing market share and inventory opportunities from retailers closing stores or going out of business. Same-store sales growth has been stable over the years. Management expects the company to continue profitable growth by expanding its store footprint with asset-light operations.
Based on our calculations, Ross Stores delivers a three-year incremental return on equity of 87%. Over the last three years, the company earned an annual return on equity between 47% and 50% while increasing its equity capital by 23% in total. Around 80% of earnings are retained annually.
New York-based The Estee Lauder Companies (NYSE:EL) is one of the world's leading manufacturers and marketers of quality skin care, makeup, fragrance and hair care products. The company shares around 15% of the global prestige beauty market, which can benefit from the increase in middle-class consumers embracing premiumization in emerging markets and an expanding SHEconomy due to the increasing economic participation among women.
Estee Lauder has been investing in stretching its distribution outlets with a focus on travel retail and digital channels. The strategy seems to have been quite effective as the company has achieved a three-year incremental return on equity of 84%. For the past three years, the business earned an annual return on equity between 24% and 39%, retained around 60% of net income and increased the equity capital by 20% in total.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of OTC Markets Group.
Read more here:
- Urbem's 'Quality Strategy' Series: Incremental Return on Equity
- 3 Compounders to Empower the Digital World
- Coloplast A/S: A Quality Growth Story
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This article first appeared on GuruFocus.