Utilising Our Greatest Shortcoming - ASA EQUITY Magazine Jan/Feb Issue

The late American physics Professor Dr Albert Bartlett is famous for his lectures on the contradictory nature of sustainable population growth and the flow on second order effects of this. On face value one may think that very low single digit population growth is suitable, however the end result, according to Bartlett, is a calamitous outcome. The reason being that small numbers can quickly turn into very large numbers…

“The greatest shortcoming of the human race is our inability to understand the exponential function” – Dr Albert Bartlett

Bartlett’s Population Analysis

What Bartlett means by this powerful quote is that as humans we think first in the short term sequential, or linear functions rather than thinking in the exponential that can occur from the sequential. Put simply, thinking exponentially is not intuitive.

Sticking with Bartlett’s topic we can see in the below graph a theoretical example of the world’s population growth. It shows what would occur if the current population of ~8.2 billion people continued to grow at the current population growth rate of ~0.9% p.a. out to the year 2100. The reality is this is not forecasted to be the case and the United Nations (U.N.) projects that by the mid 2080’s the worlds population will be ~10.4 billion. Still, the point remains, a continuation of a low static growth rate has the ability to produce exponential growth outcomes. A higher static growth rate can produce extreme changes over time.

You may be asking what has the trajectory of the world’s population got to do with investing? Simple. The laws of compounding are applicable across many facets, not least equity markets. Furthermore, the topic in question doesn’t just apply in the traditional sense of compound interest with respect to rates of return, rather it can also refer to companies, specifically relating to their operations and the associated characteristics that underpin the ability to generate long term, exponential (aka compounding) returns. Some of, but not necessarily a complete list of these characteristics, are outlined below.

Characteristics of Compounders

Our view at NAOS is that over the long-term, share prices follow company fundamentals, namely earnings, hence if a company wants to see long term share price growth, then it requires the appropriate foundations that can allow for earnings growth to occur over a long period of time. We have grouped these characteristics into the following categories: company characteristics, industry dynamics and capital allocation, all of which are essential to success.

“The thing about a compounding record - by its very nature, each link in the chain is equally important.” – Charlie Munger

Company Characteristics

• A genuine competitive advantage. What is it that makes a company special vs. others? Does it have a product or service which is not easily consumed/used from another provider or is there a continued preference by customers to purchase?
• Pricing power. Does a company have the ability to raise its prices for the product/service it sells on a consistent basis without seeing negative consequences? Regularly raising prices is important not only to offset cost inflation but ideally prices are increased over and above inflation as to be able to generate a base level of revenue growth from existing customers. This is not to suggest companies should raise prices unjustifiably, rather if you can give your customers a reason to purchase an increased level of goods/services from you (aka land and expand), this allows you to grow revenue from existing customers through getting a bigger proportion of their ‘share of wallet’.
• Low customer churn/high retention or repeatability of purchasing. The silent killer of a compounder is the churn (or loss) rate of existing customers. It can undo all the good work being done, hence looking after your customers is paramount. Why give them a reason to shop elsewhere? Furthermore, even if customers were going to shop elsewhere, are there other second order effects which make it more challenging to do so (aka switching costs)? A high switching cost, either through difficulty of moving to a competing product, or powerful benefits/risk mitigations to remaining a customer are examples of this. Think of a software company which has all of your data, do you really want to move? Or think of how easy it is to buy a can of Coca-Cola.  
• A healthy balance sheet that can stand the test of unknowns. Whilst unsustainable debt levels are not the only company killer, it is certainly one of the most common. Companies with low debt levels and an adequate level of cash are a core building block of long-term resiliency.

Industry Dynamics

Looking at a company in isolation is not enough; we must also understand the industry dynamics within which a company operates. There are a few factors to consider with respect to the industry fundamentals. These include:

• Is the industry characterised by headwinds or tailwinds? Is the industry growing at a sustainable rate and is there ample runway/addressable market for the company in question to take market share?
• Are the peer/competitors acting rationally or irrationally? Irrational behaviour could be defined by things such as a pricing war or a lack of differentiated product/service offerings. Think of the airline industry, which has been renowned for pricing wars, or a form of continual discounting over the years (albeit not in recent memory). Commodity type products/services are more susceptible to this type of activity.
• Are there high barriers to entry? Are there considerations (i.e. time, capital required, unique expertise, or customer behaviours) which mean that starting a competing company(s) is something which whilst not impossible, will be difficult to replicate? Think about the difficulty involved to compete at scale with Bunnings. Recall Masters Home Improvement, which despite the significant capital backing of Woolworths and US-based Lowes, failed spectacularly in 2016.

Capital Allocation

Having a high-quality business today and favourable industry dynamics is not enough to compound over the long-term through consistently delivering growth. Many great companies have not stood the test of time, either through a lack of reinvestment and/or reinvesting in lower quality areas that do not lead to satisfactory long-term outcomes. Being able to sustain and nurture certain fundamental aspects of a company’s strengths is what will drive exponential outcomes over the long term. How does this occur? Through having the following:

• A competent & trustworthy management team that is focused on a long-term horizon rather than the short term. A common challenge arises when what is good for the short term can be at odds with what is beneficial for a company over the long-term (i.e. not reinvesting or making a questionable acquisition to boost short-term profits).
• A business that can generate free cash that then has the ability to reinvest back in itself at high rates of return. Reinvestment can occur in many aspects such as capital expenditure, new technology, sales & marketing and/or acquisitions to name but a few. The crucial part of this process is that reinvestment needs to produce a high rate of return to ensure that overall, the company is becoming better than it is today (through expanding its competitive advantage). This needs to be systematic and occur over a long period of time. Should the opposite be true (reinvesting at low rates of return) then you’re simply ‘throwing good money after bad’.  

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” – Warren Buffett

Human Shortcomings

One could argue that being able to identify the characteristics of a compounder is the (relatively) easy part. Being able to invest in such a company for the long-term, that is the hard part. It sounds easy in theory, but the reality is far different.

As equity market investors, volatility is something we cannot avoid. Any long-term equity investment will most likely require an ability to withstand large fluctuations in share prices. After all, that is the temperament of ‘Mr Market’. The difference between volatility and risk essentially boils down to the likelihood of a permanent capital loss event occurring. Risk involves the probabilities of experiencing a loss, whereas volatility is simply a way of describing the degree in which share prices fluctuate.

The below graph shows three theoretical examples of share price movement, example one which demonstrates volatility and example two which demonstrates risk. We can see that two of the scenarios result in significant capital loss over the duration, despite having a lower level of volatility.

Example 1(volatility) actually has the highest standard deviation (a measure of historical volatility), yet despite this it has seen its share price increase multiple times over the theoretical 10-year period. Conversely, Example 3 (risk) has a significantly lower standard deviation than Example 1, yet has resulted in a permanent capital loss event with the share price worth $0, as the table below shows

Relying on compounding characteristics and holding one’s nerve during periods of share price volatility are crucial in order to enjoy the benefits of a compounding company. At the end of the day, there is no science behind when to sell and only in hindsight will we see whether or not that was a good decision. Given the asymmetrical nature of compounding (meaning that mathematically speaking, there is 100% downside and infinite upside), the opportunity cost of selling winners early is arguably the most painful investment mistake one can make. Remember, even Apple Inc. has experienced multiple -50% share price movements in its history as a listed company.

“Volatility is the price of admission. The prize inside are superior long-term returns. You have to pay the price to get the returns.” – Morgan Housel

NAOS Perspective

At NAOS we focus on investing in listed emerging companies. We do this in a concentrated manner with a long-term time horizon. The emerging companies segment of the equities market has most certainly been a challenging environment over the past 24 months with many companies trading at valuations one could describe as being at or near historical lows. As previously mentioned, volatility is part of the game.

In the world of emerging companies, the rapid interest rate increases have caused challenges to many companies, as has the ensuing drop in demand. With that being said, we are of the opinion that many emerging companies have used the past 24 months to do a lot of ‘hard yards’ internally, improving their operations to become more efficient, resilient businesses.

With the changes in investor appetite due to an increasing rate cycle environment now largely behind us, we believe that should interest rates start to reduce throughout 2025 as Australia follows the lead set by other nations around the world, this bodes well for a return in investor demand to emerging company equities. The past ~6 months have seen investor demand start to actively return to equities, particularly to large liquid companies. This takes time to trickle down to emerging companies.

As we have seen subsequent to similar periods in the past, emerging companies have experienced sustained periods of very strong outperformance once risk appetite does return. At NAOS, we are of the opinion that the price you are paying today for many quality emerging companies provides the framework for compounding to occur.

As the saying goes, the large caps of tomorrow are the small caps of today. Many ASX large caps hold true to this statement. CSL Ltd (ASX: CSL) is an extreme example, which had an initial market cap of $312 million when it first listed in 1994, and now has a market cap of well over $100 billion. Whilst many emerging companies will not amount to much, hence why emerging equities are a riskier asset class, there will always be another company that will compound returns for many years and turn into a large cap. It is impossible to know what they will be, all we can do is identify the characteristics which may allow this to occur. Remember, the shortcomings of human nature are ever-present in the short-term mindset of equity markets. Thinking long term, thinking in exponential (or compounding) terms, being conscious of downside risks and doing your analysis can be a competitive advantage for the individual investor.  

Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.

‍