Buying high-yield dividend stocks is a popular investment strategy here in the UK. It’s easy to see why – with this strategy an investor can reinvest their dividends and capitalise on the power of compounding (earning a return on past returns).
But dividend stocks aren’t the only way to compound returns in a Stocks and Shares ISA or SIPP. There’s another strategy and it can often be even more lucrative.
Compounders can make investors a lot of money
There are certain companies in the stock market that are not only very profitable but also capable of continually reinvesting their profits for future growth. These companies (often called ‘compounders’) frequently turn out to be brilliant long-term investments because they’re able to compound their returns internally.
With these kinds of companies, annualised returns of 15%-20% over the long run aren’t unusual. On the downside, they tend to pay very small dividends (or none at all) because it makes more sense to reinvest profits for future growth than pay out earnings to shareholders.
What to look for
When it comes to finding these companies, there are a few things to look for.
One is a high (15%+) return on capital employed (ROCE). This is a profitability ratio that measures how effective a company is at turning capital at its disposal into profits.
“If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
Warren Buffett’s late business partner, Charlie Munger
Another is a source of growth. Ideally, the company operates in an expanding industry where it can put its reinvested profits to work.
Additionally, it’s worth looking for a strong competitive advantage (which stops competitors from stealing market share), a strong balance sheet, and a good management team.
A British compounder
A good example of a compounder on the UK market is InterContinental Hotels Group (LSE: IHG). It’s a leading hotel operator that owns a range of well known brands including InterContinental, Holiday Inn, and Kimpton.
Last year, its ROCE was about 37%. So, it’s a very profitable business.
It also has a source of growth – the travel industry is growing as wealth is rising globally and cashed-up Baby Boomers are retiring.
As for the stock’s returns, they’ve been amazing. Over the last 10 years, the share price has climbed from around 2,600p to 10,075p, which translates to an annualised return of about 15% per year.
Investors have received small dividends of around 1%-2% per year on top of this. So overall, long-term returns have been magnificent.
Now, I’m not saying that this stock is a Buy to consider right now – it’s had a good run recently and now looks a little expensive. There are also some risks around a slowdown in consumer spending.
But there are plenty of other stocks like this on the London Stock Exchange. And they could be worth a look today.
