Today's Randomness & High-Quality Compounders
Resilience and continuous growth is underpriced, even more so today
The Fine Line Between Predictability and Randomness in Investing
We've already explored the concept of randomness in our discussions, and it's a topic that continuously resurfaces, from last year's insights to our recent presentation. We've seen how factors like a company's reinvestment timing, its ROIIC, and implied real cash IRRs can significantly impact even seasoned serial acquirers, leading to unexpected challenges.
Consider the war in Ukraine. Who could have possibly predicted its outbreak and its profound impact on the EU's defense strategy? Companies like Rheinmetall have seen massive outperformance since the invasion. Yet, before this unforeseen event, Rheinmetall's financial metrics were uninspiring, low ROIC and ROIICs, and stagnant revenues. While we advocate for being open-minded about emerging quality growth opportunities, buying into Rheinmetall before the war would have been a speculative gamble, not a calculated investment based on traditional metrics, and even today, it’s outside our circle of competence.
The same unpredictable shifts apply to companies that have transitioned from low ROIICs (<10%) to above-average returns (>20%) fueled by recent inflation. Predicting these turns is incredibly difficult, and more importantly, discerning whether these changes will be sustainable is even harder. In hindsight, these obvious shifts are rarely obvious in real-time.
We believe there's a very thin line between true randomness and something that could have been foreseen. Ultimately, compounding is the cumulative result of various capital allocation decisions made over time, and randomness is always a factor. Companies must consistently identify and reinvest in growth avenues.
Take Constellation Software for example. It has consistently focused on small acquisitions in vertical market software, yielding a remarkable 25-30% unlevered 10-year IRRs. As it's grown, it has stepped into larger acquisitions, whose timing and size are inherently unpredictable.
Despite this, a baseline return outlook of 15-17% per annum was relatively “easy” to see by simply considering a 50% reinvestment rate, some organic growth, and focusing on its small acquisitions before 2020. Even with a more conservative 30% reinvestment rate, the annualized returns from a Constellation investment would still have exceeded 12%, consistently beating the market over the long run.
Noise or Relevant?
Yesterday, the US and EU reached a new trade agreement, and we immediately received questions from our premium members: "What's the impact on your largest positions, and do you plan to change your strategy?" This also brings up the broader question of how tariff policy changes might affect us, especially with a new US administration on the horizon.
Rather than offering political commentary, I want to emphasize why we remain laser-focused on companies with high ROIIC, strong cash IRRs, and management teams that deeply understand value creation. Many average or below-average businesses will undoubtedly feel the pinch of this tariff uncertainty, as we've discussed previously.
Our chosen companies generate high returns on newly invested capital and thus don't require massive capital outlays to achieve meaningful profit growth. This makes them inherently less susceptible to timing risks for investments or economic shocks.
Edit: As I was writing this blog, a fellow member posted a similar sentiment on Discord. Great minds think alike! ;-) 🐢
Another thought: Chris Hohn recently suggested that long-term investing is the "last free lunch." Wouldn't you agree that sticking to "boring," predictable, simple, high-ROIC companies offers a similar advantage?
Fortunately, very few companies truly meet these stringent criteria, especially those with a clear runway for balanced future growth. For us, this primarily means businesses in tangible sectors or serial acquirers with demonstrable returns and longevity in buying cash flow-generating businesses.
We're not chasing explosive growth, which is notoriously difficult to predict, let alone the inevitable cliff where growth dramatically declines. Chasing such trends often leads to a triple whammy: declining growth, steep multiple contractions, and management teams desperately overpaying for alternative growth. Unsurprisingly, this scenario is most common in fashion businesses or tech platforms, where corporate lifecycles have become increasingly shorter.
Given today's tariff rhetoric and usual macro volatility (inflation, interest rate hikes, banking turmoil), it's crucial to remember why companies with low ROI(I)C, low growth, or poor capital allocation are inherently more vulnerable to value destruction when negative randomness strikes. This is almost self-evident.
Ultimately, success hinges on generating strong IRRs on incremental capital employed for the long term, having a solid core business that requires minimal maintenance investment (whether tangible or through P&L expenses like marketing), and diligently performing various risk scenario analyses for when things don't go as planned. We’ve illustrated this in the below blog:
In today's dynamic economic climate, focusing solely on short-term movements won't lead us to the "Promised Land" of sustainable, quality compounding. Nor should we simply extrapolate a company's past growth rates and ROICs. As investors, we must remember that companies aren't simple sheets of paper; they are dynamic institutions with many moving parts.
The impact of randomness and luck versus skill is significantly underestimated these days. We're genuinely surprised by how so-called long-term investors daily tweet about stock market moves, claiming an inflection point has been reached after years of underperformance in a specific stock or sector.
The next day, if there are signs of a reversal, they'll see it as confirmation of their thesis, even if it's merely driven by quickly outdated tariff news. Let's be clear: short-term stock price moves (even over 2-3 years) can largely be driven by external factors or noise that will likely normalize for truly high-quality businesses.
Trade “Deal” between US and Europe
The US and the EU have reached a wide-ranging trade agreement, preventing the implementation of steeper tariffs threatened by the US. As part of the agreement, the EU has committed to purchasing an additional 750 billion USD in US energy products (over three years) and making 600 billion USD in new investments in the US. They also agreed to buy hundreds of billions of dollars in US military equipment.
Both sides agreed to zero tariffs on certain strategic products like aircraft and components, some chemicals, semiconductor equipment, and certain agricultural products. The 50% US tariffs on imported steel and aluminum are expected to remain in the near term, though further negotiations for a quota system are planned.
While many European nations and industry groups expressed relief at averting a full-blown trade war, some expressed regret over the 15% baseline tariff, acknowledging it would be a challenge for certain industries. Many crucial details of the deal still need to be finalized in the coming weeks and that the agreement requires approval from EU member states.
Let’s take a closer look at our two largest positions, and how they’ll be affected by this tariff “news”.