Chuck Akre has one particular goal for his fund, Akre Capital Management:
“Compound capital at an above-average rate while incurring a below-average level of risk.”
Of course this is what every investor wants, but Akre’s unique approach is perfectly outlined in his 2011 talk “An Investor’s Odyssey”. This talk significantly influenced Chris Mayer, the author of “100 Baggers”, reshaping his perspective on investing (value towards quality). In this article, I will delve into the insights from Akre’s talk and hope it will have an impact on you as well. Enjoy the exploration!
Unveiling the Magic: The Power of Compounding
The power of compounding begins with a compelling question: Would you prefer one million dollars right now or a penny doubled for thirty days? Initially, it’s likely you would reason that the penny will be worth more than the one million dollars. (Otherwise, why all the theatrics?) However, by just how much might surprise you.
It turns out that after doubling 30 times, the penny would be worth $10,737,418.24! This is a terrific exercise because it highlights the not-so-obvious power of compound returns (in this case, the penny compounds at 100% for 30 periods).
What do we mean with “not-so-obvious”? Well, this example demonstrates a crucial insight. You would have been better off taking the one million dollars until the 27th (!) day. It is in those final four days that the value of the penny increases from less than $700,000 to more than $10.7 million. Patience and a long-term perspective are required to give the power of compounding an opportunity to do its magic.
This riddle teaches a valuable lesson: by holding on to great companies, we allow our investments to compound undisturbed for long enough, allowing the extraordinary effects we saw in days 27 to 30 to unfold within our portfolios.
The Holy Grail: Return on (Invested) Capital
Akre dedicates much of his time to identifying businesses with the greatest potential to compound shareholders’ capital at an above-average rate (as we saw previously). While value investors typically aim to sell companies that have appreciated the most relative to their predetermined value, Akre considers this as a costly mistake. Doing so stops the opportunity for continued compounding (missing out on the magic discussed earlier!), in addition to incurring operational costs and tax implications - a lesson vividly illustrated in the earlier riddle.
Historically, the annual compound return for common stocks hovers around 10%. When Akre first discovered the world of investing and more specifically stocks, the main consensus was that stocks returned 7% to 10%, based on historical data. While this may seem a lovely thing to just accept and anticipate, Akre offers insights behind this figure. The 10% figure closely corresponds to what Akre suspected as the real return on capital, that is across all companies large and small. The real return on the owner’s capital, adjusted for what Akre calls “accounting garbage”, was in the low teens (just like that 10% number that keeps coming up when talked about stock returns over the long term).
Hence, Akre lays out the following hypothesis:
“One’s return from an asset will, over time, approximate the ROE, given the absence of any distributions and given a constant valuation.”
ROE represents the free cash flow return on the owner’s capital. Essentially, it comes down to the cash a business generates and makes available to management for making reinvestment decisions. The choice of metric depends on the company (ROIC, ROE, ROCE); personally, I rely mostly on ROIC. However, I plan to delve into these metrics in an article in the future (so stay tuned!).
Akre illustrates this concept with an example to show that ROE is the holy grail:
“Start with a $10 share price, $5 book, 20% ROE produces a dollar’s worth of earnings, you know the metrics are easily ten times earnings, two times book, 20% ROE, we’ll add the earnings of the book and have another look, the new book is $6, keeping the valuation constant, providing no payouts of earnings, apply 20% ROE, the new earnings are $1.20, ten times that is $12, two times the new book is $12, so our point is the share price is up 20% consistent with 20% ROE.”
This demonstrates that your return will be the same as the ROE if there are no earnings distributions (such as dividends) and the valuation remains constant (with the same price multiple). High-return businesses are special! Shree Viswanathan explained a relevant economic law stating that high-return businesses attract competitors, which means that those high returns get arbitraged away and become low returns over time. However, a few companies can defer this reversion due to their competitive advantages, commonly referred to as a “moat”. This is where Akre’s three-legged stool concept comes into play.
The Three-Legged Stool
Now it is time to go fishing for great investments, and since our returns are going to correlate to high ROEs/ROICs (as we saw in the example above), we want to fish in a pond with high-return, high-ROE/ROIC businesses. Akre has a visualization for the three key aspects he looks for in an investment, which he calls “the three-legged stool” (because three legs are sturdier than four). These themes include:
Business: What is the company’s business model?
Management: What is the primary focus of the management?
Reinvestment: Is there an opportunity for the company to reinvest all excess cash generated by the business, thereby sustaining these attractive above-average returns?
Let’s delve deeper into each of these themes.
Business
The first leg of the stool isn’t just about understanding how the business makes money (as the point 1 may have implied). It encompasses all factors that contribute to the above-average returns on the owner’s capital, primarily defined by the company’s competitive advantage (i.e., the “moat”). Relevant questions regarding the moat include whether the company possesses patents, regulatory advantages, proprietary technologies, economies of scale, low-cost production, or a lack of competitors?
It’s crucial to understand the specific elements of the business model driving these good returns. Equally important is to evaluate the potential duration and breadth of the business’s runway. Remember, moats are always widening or narrowing, and as an investor, it’s your task to assess which direction it is heading.
However, answering this question can be challenging; the competitive advantage might not yet be fully realized, or even the company’s management might not have envisioned it. Think about Bill Gates’ attempt to sell Microsoft to IBM at one point, only to witness what happened next.
The point is to try to understand what it (really) is that’s causing the good returns and for how long they are likely to last.
Other critical considerations for the first leg of Akre’s stool include:
Enduring, predictable high ROEs and FCF
Identifiable, sustainable competitive advantages
Pricing power in excess of costs, inflation protection
Easy to understand
Normally avoid return-regulated industries
Strong balance sheets
Management
As a quality investor, Akre advises us to also assess the management of the business. Does management view shareholders as partners, even though they may not know them? Tom Gayner, CEO of Markel, shared his thoughts with the question: “Do they have equal parts skill and integrity?” You want managers with skill and integrity.
What happens at the company level also reflects at the per-share level. Once someone puts his hand in your pocket, he will do so again. Given our concentrated portfolios - of 8 to 12 companies - we literally have no time to mess with managers who raise real concerns based on our experiences. In practical terms, this underscores the importance of focusing on management actions, their incentives, and to be especially alert when there’s a new CEO at the helm. This is one of the reasons why I favor owner-operated or family businesses. In many cases, their vision is clear, and they act with great integrity, even among successors aiming to preserve the family legacy.Additional key considerations for the second leg of Akre’s stool include:
Management with exceptional skill, integrity, and passion
Treat shareholders like partners
Indifferent to Wall Street’s short-term focus
Lean corporate culture fosters independence, accountability
Compensation rationally determined
Reinvestment
The issue of reinvestment stands out as perhaps the most important challenge facing any CEO today. It relates to the skill of the manager, as well as the nature of the business. That’s why one of Akre’s favorite questions to ask the CEO: “How do you measure the ways in which you are successful in running a business?” The answer mostly centers on the increase in share price, corporate objectives established in collaboration with the board, or accomplishments relating to customers, employees, shareholders, and the community.
Very rarely does a CEO mention measuring their success by the growth in economic value per share - something Akre considers the holy grail. The fact that Berkshire Hathaway shows the growth in book value per share in the opening pages of their annual report (over the past 40 years!) serves as a testament to this notion. It’s no surprise that Warren Buffett consistently ranks highly on the Fortune list.
The main points for the third leg of Akre’s stool are:
A track record of disciplined reinvestment
Extensive opportunities to reinvest FCF organically or through acquisitions
A Compounding Machine
Together, these three elements form a real compounding machine. Business, management, and reinvestment are the key components of what Akre refers as the “three-legged stool.” When he encounters a business that meets all three criteria, he labels it a “compounding machine,” and aims to purchase shares at a modest valuation. He understands from experience that these businesses are rare. While Akre is cautious about overpaying, he isn’t hesitant to invest in high-quality companies at higher multiples than the market typically offers (such as 15 times earnings).
One essential concept to bear in mind is what he calls “The Davis Double Play,” wherein a business not only compounds your capital at an above-average rate but also commands a higher valuation from the market (i.e., a higher multiple), which is like a double play.
All in all, the price you pay significantly influences your eventual compounded return. However, this doesn’t imply that you should never pay a premium for exceptional quality companies capable of reinvesting at high rates for a long period of time.
Moreover, Akre does not pay attention to volatility in his risk analysis, viewing it instead as an opportunity generator. He defines risk as the permanent loss of capital, rather than the temporary loss of it. After making a purchase, he consistently evaluates whether the economic moat is shrinking, if managers are behaving badly, or if reinvestment opportunities are diminishing or being misused.
Luuk
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Disclaimer: This analysis is not intended as investment advice but as a personal opinion and can serve as a supplement to your own research. The information is explicitly not intended as advice to buy or sell certain securities or securities products, but to provide an overview of the underlying company/companies. You are solely responsible for the decisions you make regarding your investments.
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