Compounders: how choosing quality growth stocks can strengthen your investment portfolio

Finding companies that continue to generate profits and deliver growth despite economic fluctuations is a challenge for any investor. But what makes a company a compounder? 'They are quality companies that achieve above-average growth year after year,' says Bart Daenekindt, a fund manager at KBC Asset Management.

Fellow Portfolio Manager Kris Wyns clarifies using the metaphor of the apple orchard. 'Think of a company that grows and sells apples. A good start is to have a tree that produces a decent yield. But the real potential lies in reinvesting that yield: planting saplings and allowing them to grow into an entire orchard. In that way, the value of the company increases, and so does the value of your investment.'

The focus with quality growth companies is on the mature growth stage. 'These are companies that already have a few apple trees, produce a reasonable apple yield, but have room to grow seriously into a large orchard’, says Daenekindt.
To evaluate whether a business has the potential to grow into a large orchard, these experts primarily look at cash flow. 'Many investors focus on short-term gains, but these do not tell the full story’, says Wyns. 'Two apple growers may make the same profit from the same crop, but one has to invest more to maintain the yield, for example having to use fertilisers because the soil is of poorer quality. In the long run, that makes a difference. The investor needs to know how much money will end up in the bottom line after deducting all costs and also all investments. That is the cash flow.'

It is therefore essential to work out how much cash flow a company will generate. That depends on three things: ROIC, revenue growth and how long a company can keep both as high as possible.

• 'ROIC stands for return on invested capital’, Daenekindt clarifies. 'How much does a company earn from its investments? The higher the return, the better. It’s a kind of quality criterion, and while it varies depending on the sector, in general 15 per cent is a very healthy return.' 'Companies that can keep their ROIC high are often able to sustain a competitive advantage. 'We call that a ‘moat’ - literally a moat around their business’, Wyns adds. 'These companies hold pricing power.'
• 'There are many levers a company can pull to achieve profit growth’, says Daenekindt. 'But the two most important are turnover and margins. If the company manages to consistently increase sales and combine this with continuous margin improvements, that leads to profit growth.'
• For a company to sustain above-average growth, two conditions have to be met: the opportunity must be there and the company must seize it. The two asset managers agree: it is important to look at the market or industry in which the company operates. And they don’t just mean looking at the numbers, but also at the business model, the strategy and the management’s track record. If the management's interests are in line with those of shareholders, that is good news for investors. 'It's important that you also understand the story behind the numbers’, Wyns stresses.