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In Search of Compounders

July 21, 2021 by Jon

Finding companies that compound for decades has become the ultimate investment strategy. It’s also one of the hardest. The trouble is hindsight tends to obscure how difficult it may be.

A recent study by Henrik Bessembinder offers some insight into the difficulties investors face investing in compounders. He studied 25,775 stocks between 1973 to 2020 to find the most persistent “winners” of the bunch.

Bessembinder looked for companies that grew 5x, 25x, 125x, and 625x after its stock price reached a low point. Returns included reinvested dividends when applicable.

He found that:

Of these, 11,442, or 44.39%, achieved a 5x multiple relative to a prior low point at some time during the 48-year sample period. Among those that reached a 5x multiple, 3,306 stocks went on to achieve a 25x multiple relative to the same prior low point. The stocks that reached 25x comprised 12.38% of the full sample and 28.89% of those that achieved a 5x multiple. A total of 955 stocks achieved a 125x multiple. The stocks that reached 125x comprised 3.71% of the full sample… The stocks that reached a 625x multiple comprised 1.05% of the full sample…

In addition, 29% of the stocks that grew 5x went on to hit 25x. Of those that reached 25x, 29% hit 125x. And of the 125x, 28% hit 625x! At each hurdle, almost a third of the compounders went on to hit the next hurdle.

There are few things we can learn from his study.

First, if you hope to randomly pick compounders, you’re chance of picking one that might grow 5x is worse than a coin flip. You’re better off letting an index fund do the work for you.

Second, it takes time for companies to grow. The average company that grew 5x did so in 45 months. That’s 3 years and 9 months, on average. But it ranged anywhere from 8 months (top 10%) to 99 months (bottom 10%).

The time it takes a company to grow another 5x — i.e. 5x to 25x or 25x to 125x — increases at each successive hurdle. It took a company 91 months, on average, to grow 5x to 25x, then 127 months to grow from 25x to 125x, and 139 months from 125x to 625x.

When you add it all up, the lucky few companies that grew to 625x, did so in 31 years, on average. But the range is more dramatic. The fastest 10% reached 625x in 18 years. The slowest 10% did it in 44 years.

Any way you look at it, massive growth doesn’t happen overnight. Patience is required to own companies that go on to earn a 5x return. More patience is needed to earn 125x or more.

Third, only a tiny number of companies grow for decades. These are companies that grew 125x or more, for the most part. Less than 4% or 955 companies studied grew to 125x. Of those, only 271 or 1% of the companies studied grew to 625x.

Put another way, over half the companies never hit the 5x growth hurdle. Roughly 88% fell short of 25x. The reality is an overwhelming percentage of companies don’t have a big enough addressable market, the right management to execute successfully, and/or the competitive advantage to fend off competition and compound for decades. Few companies ever achieve real long-term growth!

Fourth, buying companies with a long growth runway at ridiculously cheap prices pays off. The time period in question kind of gives it away.

Only 88 companies studied had an inflation-adjusted market cap of $500 million when they hit the 5x mark that went on to a 625x growth. Of those, 64 were present during the two-year window of the 1973-74 market crash. The crash was the start of, at least, 625x growth for all 64 companies. Investors in those companies benefited twice: first from growing earnings and then from the rising valuation multiple.

Finally, you can miss years of growth and still make money in companies that have an extremely long runway. In fact, you might be better off. The simplest way to find companies with the potential to grow 25x or more is to start with those that have already grown 5x. It naturally eliminates thousands of stocks from consideration giving you a smaller number to work through.

It’s important to point out that dramatic growth is not always reflected in the company’s stock price. Stocks often have a mind of their own. Compounders are also not immune to the gyrations of the market. To put it simply: in the long run, stocks track the growth of a company but in the short run, they’re all over the place.

This can create multiple buying opportunities for investors looking for companies with the potential for long-term growth. It also makes the case that the hardest part of investing in compounders is likely not in the finding, but in the holding on.

Source:
Stock Market Winners: Conditional Probabilities, Elapsed Times, and Post-Event Returns

Related Reading:
What Makes Great Companies Great
Enduring Drawdowns in Wonderful Companies

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