Investing is full of uncertainties. You know the story; there are known unknowns and unknown unknowns, but there ain’t no perfection, secret formulas or guaranteed riches. Investors have been searching for that elusive recipe for success for ages, and have mostly come up blank. Despite this, there IS one immutable law of investing, that if followed religously and diligently applied will ensure your wealth grows. And rapidly at that. What is it?
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Q2 hedge fund letters, conference, scoops etc
It is the ‘Power of Compounding‘.
And if there’s one investor that both understands and seeks to harness that power, it’s Charles T Akre.
“I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? ‘Penny.’ So that’s the question. Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer in this case is simply astounding. Double a penny a day for 30 days gets you, who knows, $10 million, $737,000 change.” Chuck Akre
“Striving for sustained, uninterrupted compounding over long periods of time is smart investing, and that’s precisely our goal. Many people think of us as a ‘value investor’ and others ask whether we are a value or a growth investor. We’ve started to say, we’re neither, we are a compounding investor.” Chuck Akre
Charles Akre, or ‘Chuck’ for short, runs his namesake fund, the $6b Akre Capital, out of a ‘one-traffic light‘ town in Virginia. Away from the hullaballoo of Wall Street, Chuck and his team spend their days searching for attractively priced ‘compounding machines‘; rare businesses that have contributed to Akre’s long history of market beating returns.
“At our firm we spend nearly every waking hour trying to identify what we refer to as ‘compounding machines‘. Chuck Akre
Over the years I’ve always enjoyed reading Chuck’s letters and interviews and to my great delight, I had the pleasure in meeting this down to earth and thoughtful investing legend in Omaha this year.
Like many successful investors, Chuck has studied and adopted many of the investing lessons laid out by Warren Buffett. Akre is far more latter-day Buffett, with a real penchant for identifying capital light, high quality businesses throwing off cash which can be deployed into high return opportunities.
The Three Legged Stool
Chuck Akre uses the visual analogy of an early 20th century ‘three legged milking stool‘ to describe his investment process; a metaphorical ‘stool’ provides a more stable and reliable footing than a standard four-legged stool amidst the topography of chaotic markets. It also leverages the Power of Compounding.
“The essence of our investment approach is perfectly captured by the visual of a “three-legged stool.” This metaphoric three legged stool describes what we look for in an investment: (1) extraordinary business, (2) talented management and (3) great reinvestment opportunities and histories. I have an old three-legged milking stool in our conference room and it is clear by looking at it that it is sturdy and durable. We believe our stool is just as sturdy and durable based on our many years of experience!” Chuck Akre
The investment process starts with the recognition that shares are really pieces of a business.
“Our focus remains entirely on the long-term prospects of the businesses we own. Our simple view is that we will be successful (1) if the businesses we own are successful, and (2) if we do not overpay when buying shares of these businesses.”
Let’s look at each of the stool’s legs in a little more detail…
Leg One : Extraordinary Businesses
The first leg of the stool is the Quality of the Business. The foresight for the first checklist item was in part a result of Chuck’s early investment in Berkshire Hathaway; Berkshire’s growth in book value was driving shareholder returns.
“I became the best student of Buffett I could and first bought Berkshire Hathaway shares when it had a $100 million market cap. From that happy experience, it became clear to me that the best way to see if a business is adding shareholder value is by the growth in its book value per share.”
Chuck also noticed that the long term annual US stock market return had approximated the aggregate return on capital of it’s constituent companies.
“I look at it this way: The average annual total return from equities over long periods of time has been around 10%. When you clean up the accounting, the real return on equity [ROE] of American business averages in the low teens.”
Over the long term, he figured that a company’s returns were determined by it’s ongoing return on capital. A fact well espoused by Charlie Munger.
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to do make much different than a 6% return even if you buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses.” Charlie Munger
When it comes to compounding, it’s the rate of return that matters.
“The bottom line of all investing, whether it be Aunt Tillie’s C.D. or Uncle Jack’s venture fund, is compound rate of return.” Chuck Akre
“We believe that all investing is ultimately about rate of return.” Chuck Akre
Not surprisingly, Chuck looks for businesses with superior returns on capital.
“Our conclusion is that a stock’s return will approximate the company’s ROE over time, given a constant valuation and absent distributions. So we choose to swim in the pool of companies where the returns are a whole lot better than average, in the 20% range.” Chuck Akre
“We recognize that over long periods of time, the share prices of our holdings should grow at a pace driven by the economics of the underlying businesses.” Chuck Akre
Source: Akre Capital
“If we buy companies in which shareholders’ capital compounds at a 20% rate of return over a reasonable time period and we pay a below-average multiple for it, our investors will do extremely well.” Chuck Akre
The trick is identifying businesses with high returns on capital and ascertaining what the key factors are that allow those high returns to endure. Often, the secret to those high returns lies in the qualitative, not the quantitative factors. They are not always obvious.
“We endeavor to look past the non-essential details and tune out the often deafening noise. We want to identify the “essence” of each business. So, for instance, what is it about MasterCard that enables them to generate after-tax margins approaching forty percent? Why have the Rales brothers been so successful buying and fixing businesses? How has Markel managed to compound book value per share at fifteen percent for the past twenty years despite falling interest rates and a competitive underwriting environment?” Chris Cerrone, Akre Capital
“The source of a business’ strength may not always be obvious. Therefore, understanding that first leg of the stool, the business model, has its own level of difficulty. It’s also where the fun is, I might add, and we believe it is absolutely critical. As I said, we spend countless hours at our firm working on these issues every week.” Chuck Akre
Some of the characteristics that Chuck looks for are set out in the adjacent table found on the Akre Capital website. Through his annual letters and a few insightful Value Investor Insight interviews, Chuck has expanded on the qualitative characteristics which can contribute to above average returns.
“High return businesses have something special which allows them to earn above average rates on employed capital. That may be intellectual property, scale economies, a regulatory advantage, high customer switching costs, or some sort of network effect. We want to see evidence the business model produces unusual returns, to understand why and to believe that’s likely to continue. Part of that is a function of the opportunity yet to be realized – we’re always asking, ‘How wide and how long is the runway?’” Chuck Akre
“We believe that the successful business reliably compounds owners’ capital at an above-average rate; provides a highly valued or essential service to customers, with limited competition, and is often a leader in a market that enjoys strong long-term growth.” Chuck Akre
“Our favorite businesses will be those which exhibit real pricing power with their brands, which require modest amounts of capital to prosper, which are run by people with equal parts skill and integrity, and which have demonstrated an ability to reinvest virtually all the excess capital that the business generates.” Chuck Akre
Another attraction of owning high quality businesses is the resilience they tend to display in difficult markets. Consistent profitability through business cycles combined with solid balance sheets protects against the permanent loss of capital.
“The practice of not losing money is significantly advanced by the selection of superior businesses.” Chuck Akre
“Our primary frontier of risk management isn’t wide diversification, but the quality of the individual businesses, their balance sheets and the people who run them.” Chuck Akre
Meeting the Investment Master Chuck Akre, Omaha 2018
“We want companies that are positioned to withstand almost any economic environment and that have the financial resources to take advantage of opportunities as they appear, be it acquiring new assets, or repurchasing their own shares at very attractive prices (the reinvestment piece).” Chuck Akre
“The relative low level of risk comes not from the absence of volatility, but rather, from the strength of the businesses themselves. This strength is reflected in their balance sheets, their superior returns on capital, and the outstanding quality of their managements.” Chuck Akre
Leg Two: Talented Management
Chuck recognizes the importance of management. Once again, a key learning from the world’s Investment Masters is that management matters. Ordinarily good management have a track record of success, are shareholder-orientated, and are capable capital allocators.
“You want to find management that is terrific in managing the business and presumably they have demonstrated that by the time we get involved. We ask them how do you measure your success at this company, by what means? We listen to what they have to say and make our own judgment. Sometimes you get answers such as ‘well if the stock price goes up’. Sometimes you find CEO’s with screens on their desk watching their stock price all day long. That’s not a characteristic we find particularly attractive. My quick judgment would be their eyes are on the wrong thing.” Chuck Akre
Source: Akre Capital
“We’re looking for managers who have demonstrated they are ‘killers’ at business execution, and who have a history of always acting in the best interests of all shareholders.” Chuck Akre
“We read piles of shareholder letters, proxy statements, and biographies. We frequently leave our offices in idyllic Middleburg to visit corporate headquarters, manufacturing facilities, and retail locations. We try to ask open-ended questions so we can see how managers think. It doesn’t always hit us over the head right away so sometimes we have to go back more than once.” Chris Cerrone, Akre Capital
“I’m not interested, for example, in CEO’s who appear personally greedy. I frequently ask CEO’s how they measure success. They often speak about meeting the needs of their various constituencies, including shareholders, employees, customers and the community. Many have said they measure their success by the rise in the share price. The closer they get to saying they measure success by growth in the company’s real economic value per share, the more interested I am.” Chuck Akre
“We want to invest not only in highly capable managers, but also those with clear track records of integrity and acting in shareholders’ best interest. I’ve found that when a manager puts his hands in shareholders’ pockets once, he’s much more likely to do so again.” Chuck Akre
It is paramount management show a history of acting in shareholders interests. Oftentimes helped by a strong alignment of interest.
“Not only do we want to have great business managers but we want see they treat public shareholders as partners even as though don’t know them.” Chuck Akre
“A company’s shareholders are often anonymous to its managers. Do managers nonetheless feel an obligation to treat those shareholders fairly? A close reading of the proxy statement can be instructive. We look at both the size of the pay packages as well as the incentives that trigger cash and equity bonuses. We love to find managers that have “skin in the game” through outright ownership of common stock.” Chris Cerrone, Akre Capital Management
“We look for managers who are owners, and who have always acted in the best interest of ALL shareholders. This leg is the trickiest: our experience shows us that we must follow what these managers have actually done, rather than what it is that they have said they have done. (You know, just the reverse of our parents’ admonition: “do as I say, not as I do”).” Chuck Akre
Leg Three : Great Re-Investment Opportunities
Chuck Akre’s final leg of the stool is capital allocation. Once again, a tenet that is well recognised by the Investment Masters.
“After ten years in the job, a CEO whose company retains earnings equal to 10% of net worth, will have been responsible for the deployment of more than 60% of all capital at work in the business.” Warren Buffett
It’s a company’s ability to redeploy capital at high rates of return that turns into a compounding flywheel.
“Over a period of years, our thinking has focused more and more on the issue of reinvestment as the single most critical ingredient in a successful investment idea, once you have already identified an outstanding business.” Chuck Akre
Source: Akre Capital
“Does the company have the capital-allocation skills necessary and the market potential to invest all the excess cash generated by the business in projects that can earn above-average returns? In my experience this is perhaps the single most important issue facing any CEO, and is also the area in which management can create or destroy value most quickly and permanently.” Chuck Akre
“The ability to earn earnings upon earnings is essentially the definition of compounding. In the long run, we feel strongly that the rate at which the value of a business compounds will approximate its returns on reinvestment.” Chuck Akre
“With an outstanding reinvestor at the helm, even an ordinary business can become a remarkable compounding machine. There are abundant examples, including of course Berkshire Hathaway, which began its compounding journey as a struggling textile mill.” Chuck Akre
And being a great CEO doesn’t imply someone is also a skilful capital allocator.
“Disappointingly, we often discover that managers who excel at running their businesses fall victim to “fuzzy thinking” on the issue of capital allocation. The most common example that we have encountered recently is the payment of a dividend solely to enlarge the potential shareholder base (some funds by charter will only invest in companies that pay dividends). The decision to pay a dividend, in our mind, should be based on a careful examination of alternative reinvestment options (namely, a lack thereof) and an expensive stock that makes more tax-efficient buybacks unattractive. Other commonly encountered examples of fuzzy thinking include a fixation on the near-term “accretive” or “dilutive” impact on earnings per share of acquisitions, or buying back shares irrespective of valuation.” Tom Saberhagen, Akre Capital
Three Legs = Compounding Machine
Chuck Akre understand compounding. When the three areas of the analysis line up, the business is referred to as a “compounding machine”.
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett
Source: Akre Capital
The next step is to purchase these businesses at a modest valuation. And then, provided the ‘legs of the stool‘ remain intact, hold for the long term.
“We will be very disciplined about the price we are willing to pay, as in the end our rate of return will be determined not only by the quality of the businesses we choose to own, but importantly by the starting price as well.” Chuck Akre
“Our timetable is five and ten years ahead, and quarterly “misses” often create opportunities for the capital we manage.” Chuck Akre
“If you are selling because of a missed earnings report or the trend of the market or something, you’ve stopped looking at the rate of return the company can achieve over time.” Chuck Akre
As Munger highlighted above, even if you pay an expensive looking price, you’ll be rewarded in the long term.
“If you paid 20 times for a business that was compounding the economic value per share in the mid-teens and have some level of confidence it is likely to do that for a reasonable long level of time, you will get to heaven doing that.” Chuck Akre
The key point, is holding on for the long term.
Summary
For more than a quarter century Chuck Akre has invested in compounding machines. His simple ‘three legged-stool’ process has delivered through different business and market cycles, and has consistently produced enviable returns. It’s little wonder he’s sticking with his process.
And as he has said, Compounding Machines are very rare. Akre Capital spend much of their time scrutinising organisations and management teams to determine if they fall into this small category, and most often find that despite holding one or two aspects of the ‘3-legged stool checklist’, many of these businesses fall short. But they do exist, and through diligence and research you will find them.
“Whatever the future holds, we will stick to our process. We are not guaranteed of getting what we want all the time—far from it—but we believe it is the best foundation for getting what we want over time.” Chuck Akre
Further Reading:
Akre Fund – Pitch Book
Speech: Chuck Akre – 8th Annual Value Investor Conference: ‘An Investor’s Odyssey: The Search for Outstanding Investments‘
Speech: Chuck Akre – Talks At Google
Chuck Akre Letters https://www.dropbox.com/sh/dvfi54xr6lzgynh/AAAtjtuDZmqRNJdqCW3EV-DEa?dl=0
Interview: Chuck Akre – Compounding Machine – Wealth Track
Interview: Value Investor Insight – Chuck Akre Interview 2006/2011
Website: Akre Capital
Note: This post is for educational purposes only. I have no relationship with Akre Capital.
Article by Investment Masters Class
