Renowned value investor Chuck Akre (Trades, Portfolio) gave this great interview on Wealth Track on the topic of compounding machine. This article is the compilation of my notes from this interview. The interview can be found on YouTube through the following link:
https://www.youtube.com/watch?v=eEO5G1SjCeU
Question: Can you define a “compounding machine?”
Answer: An example I use is the issue of a penny double day for 30 period, which turns in to 10.7 million in 31 days. That’s the effect of compounding. So when we look for businesses to do, we look at the ones that can reinvest their free cash flow back in the business to continue above average return on that capital and therefore, compound the owner’s capital.
Question: What does above average return mean?
Answer: Average return for common stock for nearly 100 years in this country is about 10%, dividend included, total return. In our case, we look for above average returns; we’ve done it for a long term.
Question: Why don’t you favor dividends as much as many other great investors?
Answer: Our goal is to compound our capital. There is no free lunch. Management only has three to four choices to do with all the free cash they generate. They can pay dividends, they can buy back stocks, they can invest back in the business or they can acquire other business. In order to compound their capital, the most efficient way is to invest in their own business or other business where they earn above average rate of return. If they pay dividends, they no longer have the dividend to do that. So it’s a marginally less efficient way for us to compound our capital.
Question: How do you deliver above average return with below average risk?
Answer: It’s intuitive. The businesses we own in the portfolio have more growth, higher return on capital, strong balance sheet and frequently lower valuation than the market.
Question: Akre Focused Fund is very focused. Your top 10 holdings are about two-thirds of the portfolio. And some of them you have held on for 20 some years through good markets and bad markets. Stock markets go up and the valuation is not as attractive. Isn’t that a high risk proposition?
Answer: Not necessarily. The requirement for a great business for us has three components. First of all, we spend a lot of time trying to understand what’s causing this above average rate of return to occur. Is it getting better or worse? Secondly, we want to see a shareholder friendly management. Lastly, we look for a history of reinvesting the free cash flow as well as the opportunities to reinvest the free cash flow at above average rates. None of these is constant. Business models get better or worse. People’s behavior changes from time to time. The ability to reinvest varies from time to time.
Question: Why is it so hard to find companies that have all these three characteristics?
Answer: Business models change over a period of time so they’ll behave differently in different environment and you watch that. People’s behavior will change over time.
Question: Let’s use Markel (MKL, Financial) as an example. You’ve owned it for more than 20 years, and you stuck with it for those 20 years.
Answer: I have. In 2013, the growth in book value per share was 18%. In the last five years, it’s 17%. Over the last 20 years, it’s probably 14%. It will go up and down with all kinds of issues. For instance, the level of interest rates is at a 30-year low. With a business that is leveraged in their investment portfolio, that makes a difference. Pricing in the property and casualty business was negative for seven or eight years, only began to get better about a year and half ago. So during the past 10 years, there was a period of time when the growth in book value dipped below 10% but that didn’t cause us to sell the security because in 2013, it was back to 18%. To have that kind of real economic earnings growth in zero percent interest rate environment is wonderful.
Question: So the return of the company is wonderful. What about the stock price?
Answer: The stock price has reflected what’s going on with growth in BV. In 2013, the growth in BV is over $70 per share. Today’s stock price is in the $620 range. That is still less than 10 times the real economic earnings of last year. The change in BV last year was in fact the real economic earnings.
Question: What do you look for in a underlying business?
Answer: America’s business probably has single-digit margins and return on equity is probably in low teens. If we can find a business that has margins and return on equity significantly higher, which causes us to get curious about why is that occurring? The simple reasons would be patent, lack of competition. Sometimes we say well we don’t know precisely why they are able to do this but this is what we think it is and that’s OK. We’ve learned to get comfortable with not being 100% sure. If it’s a really secret sauce that management is unlikely to share with us because it invites competition. And if you have a business that has high return on capital that will naturally invite competition. We spend a lot of time studying other companies in that line of business and other businesses that are related.
Question: Can you give me another example?
Answer: American Tower (AMT, Financial) for example. It’s a vertical business. The model is more towers, more tenants per tower and more rents per tenant. Their contract with the carriers typically has annual pricing escalators so every year they’re getting 3% to 4% more. In addition, when you go from 1G to 2G to 3G to 4G, each of these requires a denser tower network. Each is a profitable opportunity for American Tower. So it’s a very protective business. In the last half a dozen or more years, they’ve been growing extensively outside of the U.S in 11 different countries. You can see why they are getting higher returns on the assets. On the other hand, if you take businesses such as MasterCard (MA, Financial) or Visa (V, Financial), it’s much more difficult to figure out why they have such high returns on capital. They are unable to invest in other businesses that have as high return as theirs. So they still have something to do with the enormous amount of cash they generate. They invested in some small businesses such as mobile payments companies, but they can’t do it on a larger scale. So they’ve been paying dividends and repurchasing shares but doing so makes the compounding more difficult.
Question: It sounds like their sustainable model in the future is more difficult than it is for American Tower.
Answer: It might be. But there’s ubiquity of acceptance of Visa card and MasterCard anywhere in the world. It continues to grow. And their business model is that not only do they get paid on each transaction, but also they get paid on the currency on each transaction. It’s a wonderful inflation hedge. If the currency gets devalued against the dollar, they get more money. It’s a fascinating business model.
Question: You also have what you call the workbench companies. They are almost like workouts. Could you share one example?
Answer: Colfax (CFX, Financial) is one of those. We started with a very small piece. We are attracted to it for a number of reasons including what their business plan and model was. They acquire other industrial companies and through a technique of their own, which is based on Toyota’s continuous improvement system; they improve, rationalize these businesses dramatically. So they source these underperforming businesses, buy them, improve them dramatically and increase the rate of return. The company was founded by Mitch and Steve Rales, who had also founded over 30 years ago a company called Danaher (DHR, Financial), which has compounded its value by more than 20% for more than 30 years. They are both significant shareholders. And we thought this could be a Danaher reduct.
Question: Tell me what you look for in management.
Answer: You want find management that is terrific in managing the business and presumably they already have demonstrated that by the time we get involved. We ask them how do you measure your success in this company and by what means. We listen to them and make our judgment. Sometimes you get answers such as the stock goes up. Sometimes you have CEOs watching their stock price on the screen all day long. That’s not a characteristic we find attractive. Our quick judgment is that their eyes are on the wrong way. We are interested in how they discuss how they reinvest the free cash flow they generate, how they discuss the arrangement in their balance sheet, how much debt capital they plan to deploy and why. At the end of the day, if this business can be quantified, then I wouldn’t have a job.
Question: How many mangers out there can afford to think the way you think?
Answer: I don’t think any of them are striving to think the way we think. They’ll get to their own conclusions about how to operate the business. And many of our businesses have shareholder support, and they’ve attracted the type of shareholders that they deserve.
Question: Why is it so difficult to identify a good investor, and what’s your definition of a good investor?
Answer: Well, at the end of the day, it ends up having to do with outcomes and outcomes relative to goals. So the issue then comes down to is there anything that you can do or understand that can help you predict whether this manager can produce an outcome that is consistent with your goal. 2009 was a very difficult year, but people who understand what we stood for and were not worried about the balance of their accounts have done wonderfully since then by sticking to the program.
Question: One long-term investment for every investor, what would it be?
Answer: Markel. Everything about the business is terrific. Today they have a $17.5 billion investment portfolio on just less than 14 million shares outstanding. So they have enormous leverage to the opportunity of rising rates. Secondly, pricing on the property and casualty business has started to improve since a year and half ago after seven ugly years. Thirdly, they made an acquisition last year that doubled their gross written premium. Four, they have taken an attitude that is slightly more opportunistic about managing their balance sheet. And five they have a division called Markel Ventures that is growing a stream of income away from the insurance company. You can buy it less than 10 times economic earnings and have a good shot that it can compound our capital on average probably in the mid-teens for the duration.
