What do 300 million rabbits in Australia in 1898 have to do with compounding of investments? Chris Elliott co-manager of the TB Evenlode Global Equity Fund explains.
Thomas Austin is infamous throughout Australia. Not an outlaw in the mould of Ned Kelly, nor a bodyline bowling cricketer under the visiting Douglas Jardine. Instead, Austin is remembered for one of the greatest ecological disasters to hit the antipodean continent: the introduction of rabbits.
Austin, a first-generation British migrant, settled in the new continent in the mid-19th Century. His unfortunate legacy was cemented on Christmas Day 1859, when he released 24 non-native rabbits for hunting onto his Victoria estate.
With no natural predators and plenty of food, the population grew rapidly. Only eight years later, the descendants of these rabbits provided a hunting party with a haul of 14,000 on his estate. By 1898 the Australian rabbit population was estimated at 300 million. Austin’s rabbits showed the raw power of exponential growth.
Compounding: Einstein’s eight wonder
In investment, exponential growth is referred to by another name, “compounding”. As with the Australian rabbits, many would scarcely believe the consequences of compounding an initial investment until the mathematics are laid bare.
A single pound invested at an annual return of 8% will double in nine years, quadruple in eighteen and increase eight-fold in twenty-seven. An investor that can achieve consistently high returns will reap rewards over time, but the challenge is not just in finding the rates of return but maintaining them.
With the launch of Evenlode Global Equity, we focus on attributes shared by serial outperformers and created a checklist of three factors. To consistently compound, a company must have structural market growth, a durable competitive advantage, and the ability to sustainably invest. To understand why, we undertake thought experiments and borrow from German mathematician Carl Jacobi, “man muss immer unkehren” – “invert, always invert”.
Consider the first factor, structural market growth. Taking the inverse, can companies in a declining industry outperform the market over the long term? Imagine a company, DeclineCo, in a failing industry, and grant that DeclineCo has both a strong competitive advantage and resources to invest.
DeclineCo’s superior product attracts more customers, and it consolidates the industry. Eventually, few firms are left sharing the spoils. Then what? Industry revenues are declining and winning share from a rival is prohibitively expensive. It is now overwhelmingly likely that capital returns and business performance will decline.
A structural growth driver can allay this by providing continued demand. For example, Mastercard benefits from the society’s move to a cashless economy. Alternatively, companies can pivot to adjacent markets. Microsoft’s transition to cloud provided a growth opportunity beyond operating systems and business software.
Maintaining an edge
Next, consider the competitive advantage factor and again invert. Imagine DisadvantageCo, a company that competes with several stronger peers and has few barriers to entry. The company operates in a structurally growing industry and invests sustainably. Again, our imagined company does well at first. Competition is weak as there are plenty of new customers to share.
DisadvantageCo invests and enters new geographies, earning attractive returns on investment. Then what? Those high returns attract new entrants. As customer churn increases, price competition intensifies and returns on investment fall. It becomes harder for DisadvantageCo to compete and returns on capital to converge with the cost of capital.
Companies with a competitive advantage and high barriers to entry can delay the decline for a surprisingly long time. The advantages can come in many forms. LVMH has historic luxury brands that resonate with consumers and have storied histories. Microsoft has switching costs, as businesses are unwilling to move outside of the Microsoft ecosystem due to retraining costs and the loss of file compatibility. In both cases, a new entrant would struggle to replicate the competitive advantage.
Finally, examine the sustainable investment factor. Imagine DrainCo, a “cash cow” company that cannot sustainably invest. Initially, the company has a structural growth opportunity and a competitive advantage. DrainCo wins share, extracting every penny of free cash flow from its new revenues with lean processes to boost shareholder returns.
Low investment prevents DrainCo from creating new revenue opportunities, but the existing market position is secure as barriers prevent new entrants. Then what? DrainCo fails to innovate and the distance between the product served and the potential product grows. This innovation gap is the primary ingredient for disruption.
A disruptive newcomer jumps technological generations ahead, better addressing consumer demand and creating a new market. DrainCo’s capital structure and lack of innovation means it cannot catch up. Worse still, closing the gap would force DrainCo to cannibalise their highly optimised and consequently high profit legacy businesses.
Companies that focus too much on immediate returns are not acting in the interests of long-term shareholders. Microsoft came close to falling into the disruption trap in the noughties after failing to invest initially in cloud technologies, but redirection of the R&D budget and improvements to the development culture enabled a recovery.
Looking down the rabbit hole
These thought experiments illustrate the three key factors are needed to achieve long-term returns. In each scenario, the inverted company initially performed well before the absence of specific factor led to their downfall.
The lesson for investors who seek to leverage the power of compounding is that understanding the factors that are driving growth is an absolute necessity and the returns on careful analysis are significant.
This brings us back to the Australian rabbits. The continent was being transformed agriculturally in the late 19th Century, with increased farming providing additional food (market growth).
Without any natural predators, the rabbits had a material advantage over native species (competitive advantage). And it goes without saying, that the rabbits had the ability to multiply (sustainable investment).
When Austin requested the rabbits to be sent from England, he wrote “the introduction of a few rabbits could do little harm and might provide a touch of home,”. The estimated population of rabbits in Australia peaked at 10 billion.