Buy Little Compounding Machines

In 1972, Wal-Mart (NYSE: WMT  ) was a tiny retailer with 51 stores in five states. It had plenty of room to grow, and over the next five years, Wal-Mart began to show signs that it was going to be a major player:

Year

1971

1972

1973

1974

1975

Number of stores

51

64

78

104

125

Return on equity

27%

18%

20%

17%

24%

Source: Wal-Mart annual reports.

Not only was Wal-Mart expanding rapidly, it was also generating solid returns to investors year after year. Over the next 32 years, Wal-Mart sustained that performance in its business and generated 23.8% annualized returns for investors -- turning a $1,000 investment into $926,960 today.

That simple, huh?
While a small company like Wal-Mart would have seemed like a risky investment back then, the example illustrates the profit potential in finding high-quality small businesses and giving them time to flourish. Because while small stocks can be volatile (just look at the past few months), quality stocks are rewarding long-term propositions.

This philosophy has worked for FBR Focus Fund (FBRVX) manager Chuck Akre, who has posted greater than 14.5% annualized returns since 1997. His fund was recently highlighted as one of Fortune magazine's "six standout funds" and currently counts CarMax (NYSE: KMX  ) , 99 Cents Only Stores (NYSE: NDN  ) , and American Tower (NYSE: AMT  ) among its top holdings.

To put FBR Focus' stellar performance in perspective, the Vanguard Extended Market Index (VEXMX), which tracks the broad domestic small- and mid-cap universe with stocks like NYMEX (NYSE: NMX  ) , GameStop (NYSE: GME  ) , and Intuitive Surgical (Nasdaq: ISRG  ) , has produced just 7.5% annualized returns since December 1997.

The key, of course, is quality, and Akre has found a reliable gauge to assess that important trait.

What's his strategy?
In an interview with Fortune, Akre said he looks for " 'little compounding machines' -- businesses that have a relatively high return on capital (15% or higher), with solid management teams and opportunities to reinvest extra cash to juice returns."

Wal-Mart was clearly generating those high returns back in 1976 thanks to its competitive advantages (low prices and efficient inventory management) and wide market opportunity. Companies that can do that can constantly reinvest in their businesses and reward shareholders year after year.

Perhaps what is most remarkable about Akre's fund, however, is its buy-and-hold disposition. At a time when the average mutual fund has a turnover rate of 100% or more, FBR Focus' turnover is a minuscule 3%.

And that's another key: Once you've found stocks that create long-term value for shareholders, hold on.

D-I-Y
Fool co-founder Tom Gardner and his Motley Fool Hidden Gems team employ this very strategy when finding stocks for subscribers. For example, back in November 2003, Tom recommended Middleby, a small commercial oven maker that was led by a management team that owned nearly 50% of the company's stock, generated free cash flow, and posted a return on capital north of 15%. Since it was recommended in 2003, Middleby has returned more than 700% -- and the team still likes its prospects.

On average, Hidden Gems picks are beating the market by 21 percentage points. If you'd like to learn more about the service and our philosophy, join us with a free 30-day trial. Just click here to get started.

Fool contributor Todd Wenning will never drive 1,500 miles over the holidays again. He does not own shares of any company mentioned. CarMax and Wal-Mart are Motley Fool Inside Value picks. Intuitive Surgical is a Rule Breakers choice. GameStop is a Stock Advisor selection. The Fool's disclosure policy has been around the world and still can't find its baby.


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