What is my strike zone?

I've recently updated the What is the Gorilla Game page and posted an article on my long-term objectives here. Have a read.

Starting with $500k, to be a billionaire, you need to compound at 17% for 50 years, but lets make it a little easier and assume you want to compound at 15% for 50, for a still respectable $350m. What is the actual math behind this compounding?

The Basic Math

The way I see it, there are 3 variables to your 15% return.

1. FCF yield. This is the FCF available to shareholders today after funding all capital requirements including capex, working capital, and debt repayments to achieve FCF growth.
2. FCF growth. This is the long-term growth in FCF/share. The higher my ROIC, the less FCF I need to use to fund my growth and vice versa.
3. Multiple expansion or contraction. If I invest at a cheap multiple or if the business' moat widens over time, I may get a tailwind from multiple expansion and vice versa.

The Different Zones

The table below shows how you might get to 15%. If you pay 50x FCF and that multiple compresses to 25x over 10 years, you need 18% FCF growth over 10 years to achieve 15% IRR. Conversely, if you pay 5x FCF, the multiple can actually stay flat and the FCF can actually shrink but you can still achieve 15% IRR. To be clear, these are stylized examples. The best investments are when you pay 5x for a company growing 18% and this does happen from time to time.

What is the “Value Zone”?

The value zone refers to your Ben Graham style cheap stocks. Pay a low multiple, get more FCF today, and protect your downside, in theory. Once in a while, the company turns out to be a gem and will keep compounding. There are several arguments for and against the value zone.

For:

• You are more likely to benefit from multiple expansion from the multiple reverting to the mean
• You get more of your IRR in the earlier years meaning you don’t have to rely on distant out-year cash flows, which are harder to forecast
• Paying a low multiple can protect against permanent capital impairment
• Many of these companies are unloved, unpopular, and underfollowed creating a fertile hunting ground.

Against:

• Value names tend to be worse businesses. Time is the enemy of bad businesses so if you make a mistake, there is no “waiting it out”.
• Risks are exponential, not linear, for bad businesses. You might be able to get a 20%+ IRR buying a traditional auto OEM but the risks they face are increasing exponentially, not linearly.
• You are reliant on management’s capital allocation abilities for you to realize on those IRRs, i.e. will a cheap auto parts supplier return capital or do some weird M&A? With some growth businesses, capital allocation is often a matter of reinvesting back into the business at high returns.

If you can find a Value company where you are confident the moat will be stable and where you are confident in management’s capital allocation abilities, by all means but for the most part, I tend to avoid real deep value ideas. They don't fit my strike zone.

What is the “Growth Zone”?

The growth zone refers to companies that can compound FCF at close to 20% a year. For clarity, I'm referring to "normalized earnings power" as many of these businesses don't have any FCF. These tend to be companies with a new disruptive flywheel. Think retailer that can grow their store count by double digits for a decade while maintaining strong same-store-sales, a disruptive tech company, or a company that can redeploy all their FCF into M&A at decent returns. There are several arguments for and against the growth zone.

For:

• Growth companies are growing for a reason. They normally have a compelling product or a better flywheel and their moats are often getting wider over time.
• The majority of returns from the S&P has come from earnings growth, not dividends or multiple expansion. Honing in on businesses that can drive earnings growth increases your chances of success.
• A small percentage of all companies disproportionately drive all of an indexes returns, and these are normally growth companies. Honing in on these companies increases your chances of outsized returns.

Against

• Growth companies are "popular" and full of hype which means upside gets priced in.
• Growth companies are often in "new" or "disruptive" areas where the moat is less stable meaning these companies face disruption.
• I am reliant on out-year cash flows to generate my IRR which are inherently harder to forecast.

I will selectively play in this area if a business is in my circle of competence. Sometimes, I find a retailer or vertical SaaS company where I can gain confidence in the moat and long-term economics allowing me to make some bets. Often times, accounting and investment spending obscures the underlying profitability of growth companies allowing shrewd analysts to find bargains, but growth companies are not in my strike zone.

What is the “Core Zone”?

That leaves me with companies in the 15x to 30x FCF range where I’ll still be reliant on growth in FCF of 7% to 15% but I’ll have some balance in terms of my FCF yield and multiple contraction. I think the "Core Zone" is pretty compelling.

For:

• Core businesses have more stable economics so are not prone to large forecasting errors.
• Core businesses are less likely to face technological disruption or existential risks.
• Core businesses have more levers to generate growth including organic growth, M&A, cost cutting, and capital returns.
• A lot of situations are tails I win and heads, I modestly lag the market. With deep value or high-growth, it's often tails I win, heads I lose my shirt, despite what Mohnish Pabrai says.

Against:

• Lots of people can analyze "stable" businesses so things get priced-in

Call me boring, but in the core zone, there are plenty of opportunities where a deep analysis can uncover a management team that can consistently redeploy 50% of FCF at a high-teens return or a services business with a disciplined capital return strategy that can supplement 8% to 10% organic growth with an additional 5% to 10% growth from buybacks or M&A. Most companies are priced whereby the returns on capital revert to the mean, but a good analyst can find companies that can, as WCM puts it, “fight the fade”,

With that said, the "core zone" is arguably more "competitive". In many cases, the differentiated insight is less to do with any numbers 3 years out, but rather, some insight on the organizational design, company culture, or the durability and longevity of a growth runway rather than the growth rate itself. In many cases, my differentiation is simply my willingness to look past a short-term hiccup or issue.

Types of Growth

So how am I getting my 7% to 15% FCF growth? I focus on a few stylized buckets.

Capital-Lite Organic Growth (Most Preferred). In an ideal world, a business can grow 7% to 15% without taking any capital. An example is a high growth software company or an IT services company where the FCF mirrors or even exceeds GAAP earnings because there is minimal capex and working capital. A second variation is companies with high incremental margins. If you are running at 10% EBIT margins but revenues are incrementally 30% margin, growth is capital-lite as the costs required to generate growth are already in place. An example might be a payments company or a specialty distributor. In this example, a business growing 5% can grow FCF 10% in a capital-light manner.

Good ROIC Organic or M&A Growth (Preferred). If a company has 20% ROIC and can consistently redeploy 75% of FCF at that ROIC, you can generate 15% growth in FCF. A serial acquirer is a variation of this where some can consistently find acquisitions at high returns. While I would prefer to have capital-lite growth, having a long runway to reinvest at high returns is second best.

Buyback Growth (Interesting). Finally, buybacks can get you significant growth. Many prefer companies be opportunistic with buybacks but from my experience, most management teams simply aren’t. Rather, I find that decent companies trading at reasonable multiples with a systematic buyback can drive very good growth. Any company trading <20x FCF growing HSD can pencil out to a double digit return on buybacks dollars. Buybacks are especially interesting as they 1) are tax efficient and 2) eliminate capital allocation risk as the playbook is stated upfront and analyzable.

Conclusion

• Returns are a mix of yield today, future growth, and multiple expansion or contraction.
• There are multiple ways to get to 15% IRR. I personally prefer the Core Zone because your returns are based on your ability to assess the moat, which is what I enjoy doing and in most cases, offers good returns with low risk.
• There are multiple ways to get to growth. However, the most preferred is capital light followed by high-ROIC followed by buybacks.