Some time ago, we (also) had the epiphany of compounding: Great businesses are not those with high dividend yields but those who can reinvest cash flows at high returns. Wal-Mart in the 1980s, for example, is a benchmark case of profitable organic growth. Other companies, such as Berkshire Hathaway, generate the compounding effect through acquisitions. To separate the wheat from the chaff, we have analysed the characteristics of successful and disastrous corporate histories. (A big thank you to Dhiren Joshi for his work on this internship project). After more research, we bought two candidates who possess the elements of a great acquisitive business.
The Canadian company systematically acquires small software businesses. The firm is led by CEO Mark Leonard, who acts as an internal teacher, passing on the wisdom of capital allocation and culture to his operating managers. The individual operating units generate steady, recurring revenues from customers who integrate the software product into their workflows and are therefore unlikely to switch to competitors. The businesses require little capital to maintain profits, and thus free cash flows can be invested in new acquisitions. Where others catch one fish at a time, Mark Leonard and his team use fishing nets. Over the last 10 years, he has bought more than 211 small businesses and trimmed them to efficiency through a decentralized management system. Since he mostly fishes at the lower end, the average purchase price is only 3-4x EBIT. The result for shareholders is a com-pounding effect par excellence.
Size eventually becomes the enemy of great returns, but we believe that the period of abnormal profit growth will last longer than expected. For us long-term investors, the combination of growth, high returns on equity, and excellent management is worth more than the purchase price of about 23x the adjusted profit. We have therefore established a medium-sized position at current prices.
Judges Scientific (short: Judges) is a UK company with a market capitalization of less than GBP 100 million. The founder and CEO David Cicurel is a trustworthy, prudent capital allocator. Cicurel holds a 19% stake in the company and in 2015, he permitted himself a CEO salary of only 120,000 GBP plus a bonus of 40,000 GBP. He truly thinks and acts in the interest of his shareholders. Judges invests in small specialized companies that produce measuring instruments for scientific applications. The individual businesses have high entry barriers due to their niche positions. The market opportunity is large, as there are thousands of small, owner-operated com-panes, for whom Judges can offer a long-term succession solution. Just like Constellation, Judges is fishing for extremely small candidates that can be acquired at 3-5x EBIT. Combined with organic growth, this results in high operating returns on capital of more than 30%. If Cicurel can repeat this recipe we will see more substantial profit growth over time.
Last year, Judges suffered through a dip in demand that lead to a 50% drop in the stock price. We took the opportunity and bought shares at GBP 13.80, which corresponds to a PE ratio of around 14.
This post has been excerpted from a recent letter of Polleit & Riechert Investment Management.
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