What is a Compounding Machine?
A compounding machine is a business that maintains high returns on equity while reinvesting most of its earnings back into the business at similarly high rates. Instead of paying dividends, it compounds value internally. Berkshire Hathaway, Amazon, and Costco exemplify this: they retain earnings and deploy them at 15%+ returns, creating exponential value growth over decades.
Three Requirements
A compounding machine needs: (1) High capital returns: ROE consistently above 15%. (2) Reinvestment runway: ample opportunities to deploy retained earnings at similar returns. (3) Economic moat: structural advantages that prevent competitors from eroding returns. When all three align, business value compounds at 15%+ annually, doubling every five years.
The Investment Implication
Finding and holding compounding machines is the ultimate investment strategy. No frequent trading is needed; the business does the compounding for you. The challenge is that the market recognizes these qualities, so compounding machines rarely trade at bargain prices. Buffett's evolution from 'buying fair businesses at wonderful prices' to 'buying wonderful businesses at fair prices' reflects this reality.