How to spot high-quality compounder stocks

• Companies with a high ROOCE (return on operating capital employed) grow efficiently without needing constant cash injections. It indicates strong profitability and efficient use of its money.

• Firms with high gross margins are usually better at controlling costs and maintaining profitability, even when their costs rise. These companies often have a competitive edge, allowing them to invest more in growth areas like innovation and marketing.

• Companies with strong pricing power can raise prices without losing customers, helping maintain healthy margins during periods of high inflation or rising costs. This makes them excellent candidates for long-term growth and compounding returns.

Investing doesn’t have to be difficult. All you have to do is find a solid company, buy its shares, and let them work their magic. That’s where compounding comes in. It’s a powerful force, where your gains make more gains over time. If you invest $1,000 at a 10% annual return, for example, your money will double in seven years. Let it grow for another ten years, and you’ll have over $6,000.But to really make this work, you’ve got to do two things: find companies that can grow steadily over the long haul (we call them “compounders”), and don’t pay too much for them. Even the best business can be a bad investment if you fork over too much cash.The analysts at Morgan Stanley spilled their secrets on how they spot those winning companies and avoid the usual traps. Here’s what they say you should look out for.

1. Return on operating capital employed (ROOCE).

You won’t find ROOCE in a quick search on FactSet or Bloomberg because it’s a more specific version of return on invested capital (ROIC). While ROIC takes into account things like goodwill and past capital allocation decisions, ROOCE focuses solely on how much new capital is needed to grow the business.

It’s basically a measure of how efficiently a company uses its money to generate profits.To put it simply, if ROIC is like looking at both the car’s engine and the driver’s past performance, ROOCE is like looking at the engine alone – how well it runs, no matter who’s driving.ROOCE consists of two components: return and operating capital.

Return comes from the company’s profit and loss statement, specifically from its EBIT (earnings before interest and taxes). Operating capital, meanwhile, comes from the balance sheet and includes the net value of the company’s property, plant, equipment, inventory, and working capital (the net of debtors and creditors).

A high ROOCE means a company can grow its revenue without constantly throwing buckets of cash around – a sure sign it’s running a tight, efficient ship. To nail a high ROOCE, a business needs to be super profitable (that’s the "RO" bit) while keeping its capital use to a minimum (the "OCE" part). In other words, it should have high earnings relative to the amount of capital it uses to run its business. This often applies to asset-light companies with high margins.

Historically, companies with high ROOCE have outperformed those with lower ROOCE. From 2004 to 2023, companies in the top tier of ROOCE achieved annual returns of 10.5%, while those in the lowest tier managed only 7.5%. This difference may seem small, but when compounded over time, it leads to significantly higher returns. For example, investing $1,000 at 10.5% for ten years results in $2,456, while the same amount at 7.5% grows to only $1,917.

2. High gross margins.

Another crucial factor in identifying compounders is gross margin – the percentage of revenue a company keeps after accounting for the cost of goods sold. Firms with high gross margins are typically better at controlling costs and maintaining profitability.

These businesses often have strong pricing power, meaning they can pass rising costs onto customers without sacrificing profits.In fact, historical data shows that companies with the highest gross margins have outperformed those with lower margins. In the same two-decade span, companies in the top gross margin tier delivered annual returns of 11.5%, compared to 8.5% for those in the bottom tier.

A high gross margin suggests that a company has a competitive edge, allowing it to generate strong profits while keeping costs down. This gives the company more financial flexibility to reinvest in its business, whether that’s through hiring top talent, conducting research and development, or expanding its marketing efforts.

3. Pricing power.

You can think about pricing power as a kind of corporate superpower. When a company has this kind of muscle, it can keep or boost its profits, even when inflation or other costs creep up.Take a firm that makes everyday household items – if it’s got strong pricing power, it can bump up prices when raw materials get more expensive, and be confident that its customers will still stick around.

This helps them maintain fat margins and keep growing.If you’re sizing up a company’s pricing power, look for ones that hold onto solid margins, no matter how the market shifts. Those who consistently pass cost increases onto customers without sacrificing profits are often good long-term compounding candidates.

4. Unsustainable ROOCE increases.

Sure, a high ROOCE is great, but if it suddenly shoots up, that could be a warning sign. Sometimes companies inflate short-term profits by skimping on key investments like research and development (R&D) or marketing. See, that might boost ROOCE for a while, but in the long run, it can hurt the company’s ability to grow.

Think of it this way: if a firm slashes its R&D budget to pad profits, that could lead to fewer innovations down the line, which could slow revenue growth, drag down profitability, and give an advantage to its competitors – ultimately shrinking the company’s value.

5. Misguided acquisitions.

Expanding through acquisitions can be a good move, but not if it waters down the firm’s ROOCE or lowers its overall quality. If management overpays for a mediocre business, that could destroy long-term value. When you’re evaluating a company’s growth strategy, make sure it’s not just gobbling up other businesses for the sake of size, but is also focused on keeping or improving its ROOCE.Finding a high-quality compounder is just the first step.

To make sure your investment is sound, you’ll want to regularly monitor the company to ensure its compounding potential remains intact. This involves checking whether its ROOCE and gross margins are stable, its pricing power is still strong, and its valuation is reasonable.In investing, there’s no such thing as a "set it and forget it" approach. Vigilance is key to ensuring that the companies you invest in continue to compound returns over time.