One of the greatest investors of our generation, Warren Buffet once said “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates”. Investors always need healthy, growing businesses not only to maintain their purchasing power but also to compound capital. However, growth at all costs without considering the incremental capital required can be detrimental to long-term shareholders’ wealth.

For example, comparing the three businesses with the same growth trajectory of doubling earnings in ten years, but with different Fixed Assets profiles:

The terrible business doubled its earnings in ten years but requires ten times more in PPE, that business is just better off not growing at all, as it massively dilutes the returns on Property, Plant and equipment (PPE), making it a less valuable business over time. On the other hand, good businesses earn decent returns on incremental capital, as a result, maintaining the quality of the overall business.

Lastly, a great business can “earn more with less”, making the overall business a more valuable business over the long term. This situation is usually referred to as operational leverage, as earnings grew at a faster pace than assets. In this situation, reinvestment makes sense, and earning is highly preferred to being retained within the business to grow rather than paying out to shareholders. Alternatively, this surplus capital can then be returned to shareholders through dividend increases and buybacks.

As a result, these names are usually the safest to own but hardest to find as the list of names is usually short and they rarely trade at a discount valuation. Therefore, investors usually reward these companies with a premium valuation compared to the general market or its peers’ group.

Below we have screened for companies with the following criteria:

• Earnings before interest and taxes (EBIT) compounded annual growth rate (CAGR) in the last 10 years of at least 10%
• Market cap larger than $100 million
• EBIT 10-year CAGR is larger than Net Property/Plan and Equipment (PPE) 10-year CAGR
• Return on capital of at least 10%

Here is the screener:

The criteria above screens healthy growth companies in the last 10 years with at least a 10% CAGR in EBIT. We think if a company can sustain its growth over a decade, it may indicate high-quality underlying fundamentals or a certain tailwind in the business model. In addition, we filter companies with a 10-year EBIT growth larger than its 10-year PPE growth. This is the key point of this theme, as it will screen for companies that grew their earnings faster relative to their capital assets. As usual, we prefer companies that are over $100 million in market cap, as these companies have proven themselves to be mature entities with healthy trading volumes.

There are 12 companies out of the Canadian stock market that are eligible for these criteria. Therefore, we think the screener filters out a niche subset of the market that consists of high-quality names. A quick reminder is that valuation matters, nothing is worth an infinite price. Investors may not do well over the long term if all the optimistic assumptions are already priced in. Therefore, investors need discipline in how much to pay for a company.

Members will recognize some of the names that we cover in our Model Portfolios and coverage list such as Hammond Power Solutions (HPS.A), TFI International (TFII), and TMX Group Ltd (X).

Again, these companies on the list are not recommendations, but rather a starting point that helps investors generate potential investment ideas and strategies. Investors can view our previous screener blog here.

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Disclosure: The analyst(s) responsible for this report do not have a financial or other interest in the securities mentioned.