We had the honor to hear from Mr. Chuck Akre (Trades, Portfolio) from Akre Capital Management at the Value Investor Conference, which was held in Omaha on May 1-2, the days before the Berkshire Hathaway shareholder meeting. Mr. Akre’s topic is “Investing in Compounding Machines.” Below are the notes from his speech.
Good judgment comes from experiences and experiences come from bad judgment. Many years ago, when I was getting into this business, since I had no formal training, I started to think about what makes a good business and what makes a good investment. So let me ask you what’s a good investment?
Audience A: High return on Capital.
Audience B: Margin of Safety.
Mr.Akre: How do you judge that?
Audience B: Very low probability of permanent loss of capital.
Mr.Akre: How do you judge that?
Audience B: …….
Audience C: Low price compared to intrinsic value.
Mr.Akre: How do you judge that?
Audience C: Ask him (audience B).
Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at the average return on all classes of assets are and then I discover that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that?
Audience A: Reinvestment of earnings.
Audience B: GDP plus inflation.
Audience C: Growing population.
Audience D: GDP plus inflation plus dividend yield.
Audience E: Wealth creation.
Audience F: Continuity of business.
Akre: Now I forgot what the question was. But what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.
Our goal is to compound the capital at an above average rate while taking on below-leverage level of risk. By below average risk, I mean assert that volatility and risk are synonymous in the short term, in the long term, risk is permanent loss of capital. The businesses in our portfolio have lower risk on average, more growth, high ROC, stronger balance sheet, and frequently low valuation compared to the market. Our SMA has outperformed S&P 500 4.0% per year for 25 years; the private partnership outperformed 710 bps over the market over 20 years.
So what are the markers of great businesses that will compound capital at above average rates? We think there are a number of things. The first is the business model itself. To this day, MasterCard and VISA have net margins that are in the low 30% whereas average American business earns probably between 5-10%. You can cut MA and VISA’s margin in half and still better than average. The business is so good that it’s hard to reinvest the cash generated. There are certain things that we can understand and we try to stick to them. We spend time to figure out what it is about the business model that causes the above average returns. In other words, what are the moats of the business? If you ask me what the moat of VISA and MasterCard is, I can tell you we don’t know exactly what it is but here is what we think. There is the ubiquity of acceptance worldwide. The banks, which are their customers, give them enormous amount of trust. MA and VISA make some profit on exchange network but the banks make the most money. And we think the most important is that they have a very very and let me stress that, very complex pricing models. MA has more than 3000 pricing models and they have no transparency. Therefore, the cards are generating so much profit for the banks.
However, everybody wants a piece of the high return business, which makes sense. So today there’s the threat of mobile payment. VISA and MA pay a lot of money to buy new tech that involves mobile payment and they spend a lot of time buying back stocks. They face the dilemma of deploying the cash generated.
The second issue we deal with is the management. We spend time trying to see that if they treat all shareholders as partners. One of the questions I ask management is how do you measure the success of the business. And people say price of stocks or stuff like that. It’s rare to find someone to say it’s measured by growing real economic value per unit. It’s rare because they are not trained to think like investors. But that’s the answer I like.
And the third point is reinvestment. We talked about VISA (V, Financial) and MasterCard (MA, Financial). Their return is so staggering that they can’t find businesses that have those kinds of returns. But reinvestment is the one place where manager can create or destroy more value. So we look at the history of reinvestment and we look at the track record. We want to find businesses whose managers can reinvest the capitals at an above average rate of return. And when we have that, we have what we call the compounding machine. We are interested in compounding our capital and we don’t have a sell price. What we do is to buy exceptional business and hold them until they are no longer exceptional. It’s not complicated.
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