Hidden Compounders - What They Are & The Best Examples

Most investors are familiar with the term compounder. It is often used to describe companies that have been able to earn high returns on capital and reinvest earnings at similar rates over time. When returns on capital and reinvestment rates remain above average, the stock will usually deliver life-changing returns over a long enough time frame. There are plenty of well-known compounders. Apple, Amazon, Google, Starbucks, and UnitedHealth have all delivered outstanding returns since their respective IPOs. These companies are protected by large moats such as global brand recognition and network effects. Well-known compounders do not necessarily refer to the largest companies, and even smaller businesses like Monster Beverage and Domino’s Pizza are familiar to investors because their stock prices have compounded at fantastic rates.? On the other hand, hidden compounders are companies protected by hard-to-identify moats, or invisible moats. These companies may have compounded returns over a long time but often fall under the radar because they operate in overlooked industries and investors have difficulty pinpointing exactly what makes the business unique.? Unlike tech or consumer staples, where well-known compounders often operate, hidden compounders are more likely to be found elsewhere - like needles in the haystacks of average businesses that rarely deliver long-term shareholder value. Here are some of those industries and the best players in each:

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Low-Margin Industries1. Use “Short-termism” To Your Advantage

Highly competitive industries that only allow businesses to earn razor-thin margins, such as retail, restaurants, and airlines, are generally not great places to look for compounders. Of course, there are well-known exceptions - Costco and Wal-Mart have both created immense value for shareholders over decades.

In most cases, though, low margins signal a lack of pricing power and low barriers to entry in an industry. Most retailers cannot increase prices as consumers would respond by shopping at the store across the street instead.??

Despite this, there are several hidden compounders in low-margin industries. Tractor Supply (TSCO) has carved a niche in rural lifestyle retailing that has allowed it to be one of the best-performing stocks in the S&P 500 since 2000.??

Since 2010, Tractor Supply has earned returns on capital north of 20% every year. At the same time, rewards members in the “Neighbor’s Club” have increased from a few million to 37+ million. Rewards members continue to account for a larger chunk of revenues, and members typically shop more frequently and in bigger baskets while providing Tractor Supply with data on customer behavior and sales trends.?

Similarly, O’Reilly Automotive (ORLY) and AutoZone (AZO)? have built competitive advantages that separate them from other vehicle aftermarket suppliers. Both companies have extensive distribution networks that allow quick delivery in an industry where time is essential (for mechanics waiting for parts), and they can consistently outperform competitors in speed and service. Unsurprisingly, these companies have earned fantastic returns on capital for many years.

Furthermore, it is somewhat hard to comprehend how Ulta Beauty (ULTA) has become a favorite among beauty enthusiasts; beauty products are fairly easy to shop online, and there are plenty of well-established shopping channels. Ulta has defied the odds by building a brick-and-mortar retail business that customers keep returning to (in addition to its e-commerce platform).?

Whatever the secret sauce is - likely a mix of product procurement, staying on top of new trends, knowledgeable staff, and a value-enhancing rewards program, Ulta evidently has figured it out. Returns on capital have consistently been above 20% since 2010, and margins have slowly but steadily expanded. The stock has compounded at 16.4% annually since going public in 2007, including an 88% drawdown amid the financial crisis.?

Furthermore, even a hated industry like passenger airlines can produce winners. Between 1990 and 2020 (the aftermath of covid and subsequent inflation has wreaked havoc on airlines), Southwest Airlines (LUV) stock compounded at 14% annually. With Southwest’s reputation of being a low-cost carrier (founder Herb Kelleher was famous for keeping costs low) and the most customer-friendly airline, operating income grew at a similar clip as the stock price.

No-Growth & Cyclical Industries

Industries where players are price-takers are rarely good hunting grounds for compounders. Because these companies more or less offer the same product as competitors and sell it at market price, there is no opportunity for differentiation (i.e. no pricing power). Yet, there are a few diamonds in the dirt that have created long-term shareholder value through disciplined cost control and good capital allocation.

Canadian Natural Resources’ (CNQ) business model allows it to operate with a low breakeven price of oil, which means the company is flush with cash at most parts of the cycle. The company also has the second largest oil reserves among global energy producers in addition to a solid balance sheet - making it well-positioned to handle lower oil and gas prices as opposed to most competitors. Canadian Natural is one of very few cyclicals that have a long-term track-record of outperforming the S&P 500.?

Though the dynamics can be different, no-growth industries will produce only a handful of winners - similarly to cyclicals. Gasoline (the type used in vehicles) volumes tend to be flat or even slightly decreasing most years, but a few convenience store players have increased gross profits significantly despite demand remaining flat.??

Alimentation Couche-Tard is no longer a hidden gem, but U.S. similars such as Casey’s General Stores (CASY)? and Murphy USA (MUSA) are still in relatively early innings. Casey’s recently expanded outside of the U.S. Midwest (most locations are in Iowa) by acquiring 198 convenience stores in the South through Fikes Wholesale in 2024. Even though Casey’s number of locations has grown at a ~4% clip since 2012, profits have increased by 13.5% annually through disciplined M&A.

What often happens in these industries is that costs, such as packaged food, labor, rent, and electricity, keep increasing. While bigger operators can spread increased costs out over a larger store base and negotiate better prices from suppliers, a single-store gas station operator will have to raise prices at the pump to keep margins stable. Over time, that is not a competitive strategy. And as smaller operators struggle, the bigger players can swoop in and acquire the most attractive locations at reasonable prices.

Boring & Unknown Industries

Investors and analysts often overlook unsexy industries for a few reasons. Imagine a fund manager explaining to clients that their money has been allocated to a cement producer or a manufacturer of drainage systems. In the era of fast money, few clients will accept the slow and steady approach to compounding, not to mention how unappealing these business models sound.

However, boring businesses can deliver significant alpha. These companies tend to trade at very reasonable multiples, and as the business performs over a long time, more investors are attracted to the prospects. That gives the stock a “twin engine” of earnings growth and multiple expansion.

Advanced Drainage Systems (WMS) has increased free cash flows by more than 22% annually over the past decade, and the stock is up 7-fold over the same time frame. Similarly, Waste Connections (WCN) has grown free cash flows by nearly 25% annually over the past decade, even as a pretty mature company.?

Conclusion

Because hidden compounders, by definition, are protected by hard-to-spot moats, investors have to dig deep to understand how sustainable the returns on capital are and why these businesses are superior to competitors.?

The best ones are arguably found in neglected industries that do not offer the potential for obvious network effects or global brand recognition. Instead, many of the companies featured above have carved out niches by appealing to a specific type of customer - and continued to do just that instead of jumping into other ventures. These companies are run by capable management that allocates capital thoughtfully to expand the moat and reward shareholders along the way. There are a few needles in the haystacks out there - dig deep and let compounding work its wonders once you find one.

Author

This Newsletter's Author

This newsletter was written by J?rgen Pettersen. You can find him on?Twitter/X.

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