Emerging and Established Compounders

Details and examples including Upstart, Cloudflare, Visa, and Alphabet

Starting out my investing journey, I fell into the trap of the traditional labels as many investors do. I invested in value stocks almost exclusively, disregarding growth stocks due to their lofty valuation multiples.

Over time I have come to better understand the interplay between intrinsic value and valuation multiples. Intrinsic value is ultimately driven by long term durability, which can be better understood through assessing the competitive advantages and the type of economic moat a company may have.

I take a long-term approach to investing. I look to invest in compounders, companies that can generate a high return on invested capital and have access to attractive opportunities to reinvest earnings. I break the concept down into two categories; what I call emerging and established compounders.

Emerging Compounders

Emerging compounders are companies that have not yet reached maturity. These high-growth companies have found strong product-market fit and are focused on scaling their business.

While these companies may have relatively low earnings or even losses due to their aggressive re-investment, they typically demonstrate strong revenue growth and oftentimes positive cash flow.

It is important to understand the underlying economic model and ensure that the unit economics are attractive. In other words, while the company may not be generating a profit perhaps due to significant investment in new areas, the core business that is generating revenue should, in isolation, support a healthy margin. 

Given my experience in software engineering, I have a unique perspective on up-and-coming technology companies. I tend to focus on growth efforts in that light.

I look for category leaders that are disrupting and innovating.

Emerging Compounder Examples

Upstart, founded in 2012, is a leader in the artificial-intelligence lending space. Upstart gives banks the ability to better understand lending risk, ultimately resulting in higher approval rates and lower loss rates.

They began in the unsecured personal loan space, the fastest-growing yet smallest category of lending. They have significant reinvestment opportunities ahead. They recently acquired Prodigy, a software offering enabling streamlined car transactions, as a foray into the auto lending space. Given the size of the lending industry, there is a significant runway ahead in these two categories alone, not to mention the limitless opportunities in new markets such as credit card, mortgages, education loans, lines of credit, commercial loans, and much more.

Upstart had revenue of $241 million last year and is on track for over $730 million this year, representing growth rates of well over 200%. Their unit economics are quite attractive, as they do not take on the credit risk, but rather charge referral, origination, and ongoing servicing fees. Although they are rapidly expanding the team and investing in opportunities, revenue growth has handily outpaced reinvestment. Upstart has reported positive non-GAAP and GAAP earnings as well as positive cash flow.

Cloudflare, founded in 2009, is a leader in building out the infrastructure for the next generation of the web. Their mission is to build a better internet, with a focus on security, performance, and reliability.

Cloudflare’s initial offering was designed to deter attacks on websites with a cloud-based firewall. With a turn towards performance, this product manifested as a next-generation cloud delivery network, or CDN. Cloudflare has continually innovated off of this initial platform at an impressive rate, launching new products including more advanced performance and network offerings, distributed cloud computing and data store offerings for serverless applications, and zero-trust network protection offerings. Cloudflare is positioning themselves to compete against the existing cloud titans.

Cloudflare has been growing revenue at rates of 40-60% over the last 5 years. The recent acceleration in growth is notable and commendable. While the company has a strong growth margin in the high 70s, their investments in growth push the company into losses. Matthew Prince owns this intentional decision, stating on the most recent earnings call:

“We are investing for the long-term and we believe winning strategic customers proves how this strategy continues to pay off.” 

“As part of our long-term model, we have an operating margin target of 20%. When we say long-term, we really mean it. We remain confident in our ability to reach that long-term target, but we are not in a rush to get there. From the point at which we reach breakeven, we intend to aggressively reinvest excess gross profit back into growth. We are nowhere close to being out of ideas for new products to build for customers to buy them. Cloudflare is optimized for innovation and we plan to continue to launch new products, add more customers relentlessly execute and reinvest in growth for the foreseeable future.”

Quite encouraging for an emerging compounder.

Other examples of emerging compounders include CrowdStrike, a leader in cybersecurity endpoint detection, continually reinvesting in new related offerings to become an all-in-one offering, and Okta, a leader in cybersecurity workforce identity access management, extending into customer identity access management (CIAM).

Established Compounders

Established compounders are companies that have reached a steady state of operations, demonstrating consistent revenue growth and strong returns on invested capital. These are typically well-known companies with a proven track record and growing market.

Established Compounder Examples

These companies need no introduction.

Visa is a dominant payment platform, solidified by a strong network of consumers and merchants. Barring the COVID pandemic, Visa has demonstrated consistent double-digit revenue growth with a roughly 16% return on invested capital, generating significant amounts of free cash flow.

Visa continues to grow and invest in their ecosystem, both through new organic offerings as well as through acquisitions. Strategic acquisitions expand on and reinforce their existing offerings. Recent acquisitions include Tink, a financial API platform for open banking in Europe, and CurrencyCloud, a platform for international transfers. 

Alphabet, the parent company of Google, is another company worth highlighting. Needless to say, Google’s core business is based on advertisement.

Google has a history of successfully investing in new ventures such as YouTube, which was acquired for $1.65 billion in 2006 and today brings in roughly $20 billion of revenue per year.

In recent years, Google has invested heavily into building out Google Cloud and related services enabling developers to more easily develop artificial intelligence.

Google also has a division for more speculative investments, moonshots and other bets. Waymo, Alphabet’s self-driving car division, is making significant progress, most recently offering autonomous rides in San Francisco.

Other examples in the established compounder category include Facebook, Amazon, Starbucks, Moody’s, S&P Global, as well as some lesser known companies like Paycom, Veeva, Intuitive, and Arista Networks.

Closing

While compounders may often seem expensive on traditional multiples, trading at seemingly lofty valuations, the premium for a high-quality company can very well be worthwhile.

I believe compounders are the best way to build wealth over time.

Every investor is different and sees the world through their unique perspective. It is an important point to understand, since it is the conviction that comes from those experiences that allows an investor to succeed.

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Torre Financial is an independent investment advisory firm focused on emerging and established compounders.

Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com

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