Great Compounding demands low friction

Yesterday, I merged my Substack newsletter into this community. One of the main reasons I did that was to lower friction.

Friction is the enemy of great business.

I alway look to invest in businesses with low friction.

And to paraphrase Warren Buffett, "I am a better investor because I am a businessman and a better businessman because I am an investor.”

Therefore, for my own business to work, it had to be low friction.

One of the places where I lowered friction was in payment. Since Stripe is not available in my country (that's why we need Dlocal!), I was never able to monetize Circle or Substack, and always had to rely on workaround.

But each time you take the customer to a new page, you add a layer of friction, which lowers conversion.

Don't believe me?

Ask Jeff Bezos, who patented 1-click payment in 1999.

Friction in a business goes beyond what the customer can see.

And the good news is that investors can see the friction and avoid it.

The friction you don't see

It makes sense when you think about a business that needs to operate large factories to make its products that these will incur friction.

After all, factories are made up of machines and machines break down. You need to repair them and if you want to grow, you need more machines.

The best way to measure friction will be through capital expenditures, which is the amount of cash spent on acquiring new physical assets for the business.

Capital expenditures is often ignored when looking at the accounting of companies since they are not expensed immediately but depreciated over time. But they are real cash outflows in the business. In fact, you have to take cash out of the business first before you make any money.

The Big Tech companies started out as low friction companies but they are increasingly becoming more capital intensive because of AI investments.

Microsoft, for example, grew so rapidly because it only had to make the software once and could just sell it to millions of people with little additional costs. This is a low friction business.

But now with the AI capex, they need to spend money to grow.

Microsoft went from investing about 20-30% of its operating cash flows into capex to now over 50%.

I'm not going to talk about whether this will work or not today. But these companies are becoming more and more capital intensive. In other words, friction. The data centers that run the AI models consume a lot of energy and water for cooling. They are not factories in the common sense. But they generate friction nonetheless.

I prefer investing in businesses that can operate and grow with little capital requirements.

For example, Booking Holdings.

This is a low friction business. You don't need any number to prove it. Just think about it. They don't own any hotels. They don't need to maintain any planes. But they help millions of people each year travel.

The total physical assets of Booking Holdings has been around $1.3 billion since 2019 with capex around $300-$400 million a year. But operating cash flows has almost doubled in that period.

Another way to look at it is total capital.

How much debt and equity has been provided by creditors and investors respectively to the company.

The total capital is currently at $10.2 billion, same level it was in 2014, with about 3X the operating cash flows.

In the last eleven years, Booking Holdings for every dollar in cash generated from operations, it reinvested only $0.06 and was able to return $0.95 to shareholders through buybacks and dividends.

A $10,000 invested would be worth $48,000.

This is why Booking Holdings is such a great compounder. It can grow with friction and return the cash it doesn't need to shareholders.

It is not the only one.

And if you look at the businesses we own. They all have one thing in common. Low friction.

Subscribe to our newsletter for the full post