Chapter 147 - The Compounders: From Small Acquisitions to Giant Shareholder Returns
What I learned from serial acquirers such as Constellation Software, Lifco and Bergman & Beving
Today’s Chapter is based on the book “The Compounders: From Small Acquisitions to Giant Shareholder Returns” by Oddbjorn Dybvad, Kjetil Nyland and Adrian Hadziefendic.
Dybvad, Nyland and Hadziefendic are part of REQ, an equity fund that focuses on investing in companies with strong free cash flow, outstanding capital allocation, and a proven track record of shareholder value creation. Their portfolios are built around acquisition-driven compounders, companies that have the acquisition of smaller private firms at the heart of their strategy. In this book, the REQ team goes over nine high-performing conglomerates, led by exceptional capital allocators and describes the common traits among them.
Here’s What I Learned:
Power of Decentralization
“There are two main reasons Berkshire has succeeded. One is its decentralization. Decentralization almost to the point of abdication. There are only 28 people at headquarters in Omaha. The other reason is our extreme centralization of capital deployment. Our centralization is just as extreme as our decentralization.”
— Charlie Munger
The REQ team mentions that a common trait among successful compounders according to their research is the heavy-use of decentralization in decision-making. This philosophy shifts daily operations and strategic choices closer to the customer, fostering agility and empowerment. This idea is rooted in the belief that those nearest to the action, such as employees and local managers, are the ones that are the most informed and effective in making decisions.
In fact, they explain that “These acquisition-driven compounders operate with a simple and profoundly effective philosophy: decentralization. Push daily decision-making as close to the customer as possible, give extraordinary customer service, empower people with responsibility, accountability, and shareholder-friendly incentives, and give them ample room to grow.”
One clear example of success through decentralization can be illustrated by Lifco, a Swedish compounder where this decentralized approach became a cornerstone of Lifco’s growth and success. They mention that “Between 2006 and Lifco’s IPO in 2014, Fredrik Karlsson led the company through a period of strong growth, completing 23 acquisitions across its three business areas. The acquisitions and organic improvements helped Lifco achieve an impressive 13% annual sales growth and an EBITA CAGR of 17%. During this time, EBITA margins expanded from 10% in 2006 to 14% by 2014.” As a matter of fact, Lifco’s culture can be summarized to “strip away everything that does not create shareholder value, and focus on accountability through managerial ownership.”
“At Lifco, managers aren’t just encouraged to specialize and improve profitability—they’re only rewarded when they grow profits organically. No bonuses are tied to acquired growth. This sharpens the focus across the organization, and ensures consistently high performance among its companies. It also encourages discipline in the acquisition process and incentivizes group managers to propose acquisitions of high quality. If they don’t manage to improve performance of the companies they acquire, it will in turn impact their bonuses.“
— Oddbjorn Dybvad, Kjetil Nyland and Adrian Hadziefendic
Furthermore, it is clear that decentralization is not merely a structural preference, but a prerequisite for scaling businesses while retaining the nimbleness of smaller entities. In fact, REQ explains that “decentralized decision-making isn’t merely a preference for conglomerates; it’s a prerequisite for scaling and retaining the agility of a speedboat within a tankship-sized group. Without this, for instance, Constellation Software would not have been able to scale its organization to conduct over 100 acquisitions annually.”
This can be explained by the simple fact that by granting autonomy to its acquired companies, it creates a culture of ownership. Managers are not just employees; they are treated as true owners of their businesses. When people feel and act like owners, their focus shifts from short-term metrics to long-term value creation, fostering a resilience and ingenuity that a centralized command structure could never replicate.
“If you have companies that are led by capable management and you give them autonomy to run their operations, they will also act like true owners of the businesses.”
— Oddbjorn Dybvad, Kjetil Nyland and Adrian Hadziefendic
This reminds me of what we have learned from Ken Iverson at Nucor, a company structured around decentralization, granting divisions near-complete autonomy to make decisions locally, which fostered innovation and responsiveness. This model contrasted with centralized bureaucracies, allowing Nucor to adapt quickly to market changes while holding managers accountable for results. By keeping divisions small and pushing authority downward, Iverson ensured that those closest to the work drove the business, rather than distant executives.
As a matter of fact, Iverson mentions that “Each division operates its one or two plants as an independent enterprise. They procure their own raw materials; craft their own marketing strategies; find their own customers; set their own production quotas; hire, train, and manage their own work force; create and administer their own safety programs…. In short, all the important decisions are made right there at the division. And the general manager of the division is accountable for those decisions. That’s where the buck stops at Nucor.“
For Iverson, this autonomy was non-negotiable and managers at Nucor enjoyed this decision-making responsibility and accountability. However, to maintain this autonomy, managers were expected to deliver a 25% return on assets and follow the ethical standards of the company.
“At Nucor, we chose long ago to build our company on a decentralized model in which each operating division enjoys true autonomy. We have told our managers to “trust your instincts”—and we have meant what we said. We’ve urged them to confer the same kind of decision-making autonomy to their people—to make their own decisions based on what they think is best for the business—and we have never backed off our commitment.“
— Ken Iverson
The main reason why Iverson believed in decentralization was because he believed that the frontline employees were the one that were closest to the problems and by consequence, have the best innovative ideas. He once said, “That is, by the people closest to where the work actually gets done. Those businesses must tell people on the front lines to “trust your instincts.” And businesses that tell their people to “trust your instincts” generally should be decentralized. A decentralized structure pushes the power to set strategy, spend money, make decisions, and create policies out toward the marketplace. It promotes local autonomy.“
As such, he believed it was primordial for managers to be maintain close contact with their employees. As he explained, “Managers are supposed to do what’s best for the business. And what’s best is to remember we’re all just people. Managers don’t need or deserve special treatment. We’re not more important than other employees. And we aren’t better than anyone else. We just have a different job to do. Mainly, that job is to help the people you manage to accomplish extraordinary things.”
“That’s the main reason we’ve tried to keep our divisions small. When a business grows beyond 400 or 500 people, it’s hard for management and employees to stay connected. I don’t order our managers to keep in close contact with their employees. But I do nag them. I say, “Andrew Carnegie was a financier. He could afford to treat people like peasants. We’re managers. We can’t.” They may not appreciate my nagging, but I do it with their interests in mind.“
— Ken Iverson
Capital Allocation
“Capital allocation is the CEO’s most important job.”
— William Thorndike
One key takeaway from the book is that compounders do not rely on a single growth lever. Their unique power lies in having two complementary engines: organic growth from their existing businesses and a programmatic, relentless acquisition of small, private companies by using their free cash flow. The REQ team mentions that “Their power lies in their ability to perfect two engines of growth: organic reinvestments and programmatic acquisitions of small private companies. These dual engines provide a unique level of capital deployment that single-engine companies, relying only on organic growth, can rarely match.”
They note, furthermore, that these acquired companies are usually not constrained by industry or geography. The entire global market of small and medium-sized enterprises tend to be their playground. As Lifco’s CEO once said, “if we were forced to only buy companies in our dental division, we would not been able to grow as much or profitably as we have done.”
This relentless acquisition of companies creates a virtuous cycle: the cash flows from existing businesses fund new acquisitions, which in turn generate more cash flow. This self-sustaining cycle is the mechanical heart of the compounding machine, ensuring that growth is not a sporadic event but a predictable, repeatable process.
“With the money we earn we buy quality companies that generate more money, which enables us to buy more quality companies—it’s that simple.”
— Johnny Alvarsson, ex-CEO of Indutrade
However, for the compounding effect to work, it is clear that reinvested capital must generate high returns. As such, CEOs of compounders are, first and foremost, masters of capital allocation with a fanatical focus on metrics like Return on Invested Capital (ROIC) and Return on Total Invested Capital (ROTIC). They must be extremely disciplined when it comes to valuation as overpaying for an acquisition is a cardinal sin.
REQ explains that “Avoiding overpaying for acquisitions is crucial. Paying a 10 × multiple for a private company, compared to 5 ×, is the difference between 10% ROIC and 20% ROIC assuming 100% cash conversion. The higher the price paid, the greater the need for cash conversion to support self-financing growth. If you overpay, the deal has to work a lot harder to pay for itself.” As a matter of fact, the key for a compounder is to have the newly subsidiary quickly repay itself and to generate free cash flow back to the main company.
This can be perfectly illustrated by the success of Bergman & Beving, whose founders always had a distinct focus on profitability. They invented a profitability benchmark which involved maintaining profits divided by working capital (P/WC) at levels exceeding 45%. REQ explains that “According to the Superinvestors of Bergman & Bevingsville, a business is considered self-financed when the return on working capital (P/ WC) is higher than 45%. By achieving P/ WC > 45%, the business can generate the necessary cash to cover taxes, interest, and dividends, and make required investments in existing businesses through capital expenditures, working capital, and financing acquisitions. The goal of being self-financed means that growth, whether organic or through acquisitions, will not dilute current shareholders through equity raises or rely heavily on debt financing. It highlights the importance of capital efficiency in generating cash.”
This reminds me of an episode of The Knowledge Project where **Palihapitiya explains that he would be livid for a company to declare dividends if it could reinvest and generate superior returns.
“If you, as a CEO Shane, if I was an investor in your company, and you said, “Chamath, I generate 30% free cashflow, and I’m going to give you a dividend.” I would say, “Shane, f*ck you.” I don’t want that money. What am I supposed to do with it? Reinvest it. Grow faster, please.”
— Chamath Palihapitiya
Similarly, this reminds me of what we have learned from Terry Smith, the founder and CEO of Fundsmith. He argues that true value creation occurs when a company earns returns above its cost of capital. As such, he believes that the key metric to identify when evaluating investment opportunities is the return on capital employed (“ROCE”). For example, a company that earns a 10% annual ROCE, pale in comparison to companies that can achieve 20% or 30% ROCE. Smith explains that “A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ.”
As Charlie Munger once said, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”
“Return on capital employed is one of the most important measures of corporate performance—it is the profit return which the management earns on the capital shareholders provide.”
— Terry Smith
Inside Ownership
“Show me the incentives and I will show you the outcome.”
— Charlie Munger
The REQ team reveals that long-term ownership combined with a strong, enduring culture are pivotal to generating giant shareholder returns. In fact, they argue that companies led by founders or insiders with a vested interest usually outperform their peers, as their commitment extends beyond quarterly results to decades of value creation. This ownership mentality fosters a culture that prioritizes sustainability over short-term profitability, a trait shared by many of the featured companies in the book.
This long-term approach can be exemplified by Fredrik Lundberg, the founder of L E Lundbergsföretagen who once said, “Our commitment to the portfolio companies is long-term. It is simply not possible to pursue active ownership successfully without taking a long-term view. Time is an important factor for an investor.” This patient approach allows the compounding effect to amplify returns over decades rather than years.
As such, it is not uncommon, according to REQ, to have “Forever CEOs” at the helm of these successful compounders. And, more likely than not, these CEOs owns a lot of shares in the company they are running. As they mention, “This heightened ownership mentality makes them prioritize long-term value creation over short-term profitability. This focus, in turn, safeguards against management decisions driven by empire-building ambitions or short-term financial strategies that might prove suboptimal. Therefore, high insider ownership is a vital investment criterion that bolsters the assurance of sustained value creation over time.”
They also reiterate that “CEOs who align with a company’s core values and share a unified strategic vision tend to generate more value for shareholders than those who perceive the position merely as a stepping stone in their career.”
“Substantial evidence supports the notion that companies with founders actively involved in key roles—such as CEO, chairman, board member, or owner—tend to outperform their peers. Notably, the founder-led decentralized approach is a recurring feature among the companies highlighted in this book. Owners, with their vested interests, tend to behave differently from employees. If you own your car, you treat it differently than a rental.”
— Oddbjorn Dybvad, Kjetil Nyland and Adrian Hadziefendic
This is eerily similar to the concept of investing with owner operators that we have learned from Lawrence J. Goldstein. In his Santa Monica Partners’ shareholder letters, Goldstein mentions that his most successful investments have been in companies led by owner-operators, individuals who manage and hold significant stakes in their businesses. This insight of his was inspired by the research done by Murray Stahl who suggested that owner-operators bring a level of dedication, alignment of interests, and strategic foresight that drive exceptional long-term compounding, making them a key ingredient in wealth creation.
In fact, Goldstein explains that “Over the last 53 years we have invested in many closely held companies which until now I never thought to categorize as owner-operator companies, investments or stocks. But that is exactly what most of our closely held and inactively traded successes have been. I’m going to go back and examine all of them one of these days. Intuitively I can tell you such companies have been our biggest winners compounding at very high double digits and earning us thousands of percent in profit over long periods of time.”
Furthermore, Goldstein also studied previous companies that performed extremely well on the stock market such as Wal-Mart, Microsoft and Teledyne. He believed that the main common theme of these companies are that they are led by owner-operators. In fact, Goldstein believes that investing in owner-operators lead to better returns than the S&P 500.
“I began looking at companies like Wal-Mart at the time when Sam Walton ran the company and he owned most of the stock, or Hewlett-Packard, in the days when Mr. Hewlett and Mr. Packard ran the company or Microsoft in its Bill Gates era or Teledyne in its Henry Singleton era or Apple Computer in its two Steve Jobs incarnations. I absolutely promise you, if you did that calculation, you would never buy the S&P. What I’m telling you is that the bulk of the return of the indices—and not just in the United States, but in all nations—the bulk of the return was earned by these owner-operators.”
— Lawrence J. Goldstein
As such, it is not surprising that investing in owner-operators is a key requirement in Santa Monica Partners’ investment philosophy. In fact, Goldstein writes that the ingredients for long-term compounding and wealth creation are straight forward:
Competitive advantages that allow for superior margins, predictable market shares and high returns on capital.
Continuous capital reinvestment (paying a dividend goes against the goal of wealth creation).
An attractive price/value relationship at the outset.
Executives who manage the business aggressively and conservatively with the incentives of ownership.
This reasoning can be explained by the fact that owner-operators are more likely to make decisions that are in the best long-term interests of the company, even if those decisions are unpopular in the short term. They also tend to be more focused on building long-term value rather than maximizing short-term profits. This is, in my opinion, a perfect example of the power of incentives.
As we have previously learned from Charlie Munger, the most important mental model to understand comes from psychology: the power of incentives. And yet, he believes that not many people understand how powerful incentives are.
“For instance, I think I’ve been in the top 5 percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”
— Charlie Munger
As investors, it is often advised to invest in companies where management have skin in the game and Lawrence J. Goldstein confirms this thought process. In fact, as shareholders, it is important to invest your money with management teams that also have most of their assets invested in the company, as you can be sure that their interests are aligned with you.
Beyond the Book
Read "A Deep Dive into Shareholder Value Creation by Acquisition-Driven Compounders" by REQ Capital
Listen to "Chamath Palihapitiya: Understanding Yourself" on The Knowledge Project
Read "The Surprising Power of The Long Game" by Farnam Street
Read "The Power of Incentives: The Hidden Forces That Shape Behavior" by Farnam Street
Watch "Winners Keep Winning w/ Billionaire Terry Smith (RWH054)" on YouTube
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