CHUCK AKRE: COMPOUNDING MACHINES TRANSCRIPT
CEO and chief investment officer of Akre Capital Management, Great Investor Chuck Akre, explains how he finds “compounding machines” and why he invests for the long haul.
Consuelo Mack: This week on WealthTrack, the search for “compounding machines”, companies able to reinvest their free cash flow to deliver above average returns. Great Investor Chuck Akre says they are few and far between but once he finds them he holds on to them in his five- star rated Akre Focus Fund. A rare interview with Chuck Akre is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. What are the most shareholder friendly actions companies can take to enhance the value of their shares? Well talk to any investor and one of the first suggestions that comes to mind is increase their dividends, which are especially valuable in this income starved world.
Historically dividends have really counted. At least 40% of the 12% annualized stock returns over the last 50 years have come from reinvested dividends. What’s the outlook for dividends today? According to research from S&P Dow Jones indices, the trends are very positive. After setting records last year dividends are off to the races again. In the first quarter, dividend net increases, that’s dividend increases less decreases, rose $17.8 billion for U.S. domestic common stocks. And S&P’s senior index analyst Howard Silverblatt predicts at current declared dividend rates, companies could easily set new peak payments for this year. But Silverblatt also noted there is a risk- reward trade-off to all of these dividend payments particularly among the largest companies. All 30 Dow Jones industrial average stocks and 84%, or 421 of the large-cap S&P 500 companies pay dividends, the most since 1998. According to Silverblatt, “that security of income has come at a cost of capital appreciation, with the small-and mid-caps having returned significantly more in stock price”. Which is where this week’s Great Investor guest comes in; he says that dividends are a “less efficient use of capital”.
He is Chuck Akre, CEO and chief investment officer of Akre Capital Management which he founded in 1989 and portfolio manager of the Akre Focus Fund which he launched in 2009. The fund which is rated five-star by Morningstar has delivered nearly 19% annualized returns since its inception. Although Akre is new to us he has a long and distinguished investment track record including a 12 year stint as the sole portfolio manager of the once top performing FBR Focus Fund. Akre is known for running tightly focused portfolios with very low turnover. Two thirds of the fund’s more than $3 billion in assets is concentrated in its top ten holdings. As he puts it, he looks for compounding machines to hold for years. I asked him to define a “compounding machine.”
Chuck Akre: One example I use for compounding often is the issue of a penny doubled every day for a month for 30 periods, and that turns into $10.8 million. One penny turns into 10.7, 10.8 million in 30 periods, 31 days. That’s the effect of compounding, and so when we’re looking for businesses to do this, we want businesses that can reinvest their free cash flow back in the business to continue to earn the above average rates of return on that capital and, therefore, compound the owners’ capital.
Consuelo Mack: Above average rates of return. What does that mean these days?
Chuck Akre: So, sure. It’s important. The average return in common stocks for nearly 100 years in this country is around 10 percent. Whether it’s nine or eleven is of no consequence to us.
Consuelo Mack: And that’s dividends reinvested.
Chuck Akre: That’s total return, absolutely. So in our case we look to be able to return above average returns, and we’ve done so for a very long time, and depending on which vehicle we’re talking about, it’s a different level but substantially above that average return.
Consuelo Mack: Chuck, why don’t you favor dividends as much as many of the other Great Investors that I talk to do?
Chuck Akre: Well, we said at the outset that our goal is to compound our capital, and there is no free lunch. A management has three or four choices to do with all the free cash they generate. They can pay dividends. They can buy back stock. They can invest in their own business, or they can acquire other businesses, and so in order to compound our capital the most efficient way to do that is to invest in their own business or another business where they earn above average rates of return. If they pay a dividend, they no longer have that capital to do that, and so it’s a marginally less efficient way for us to compound our capital.
Consuelo Mack: And you also not only wanted to deliver above average returns. You also want to deliver above average returns with less than market risk.
Chuck Akre: Correct.
Consuelo Mack: Which you have done over time.
Chuck Akre: Correct.
Consuelo Mack: So what’s the secret to delivering below market risk?
Chuck Akre: So it’s not a secret. It’s really quite intuitive and straightforward, and that is the businesses which we own in the portfolio have more growth, higher returns on capital, stronger balance sheets and frequently valuations which are below market. So just on the face they have a below market average risk.
Consuelo Mack: And yet when I look at the Akre Focused Fund, for instance, it’s very focused. That is not a misnomer. In fact, you have about 30 holdings.
Chuck Akre: Correct.
Consuelo Mack: And the top 10 are about two thirds of the portfolio.
Chuck Akre: Correct, and the bottom 10 are less than 10 percent.
Consuelo Mack: And some of them you’ve held for 20 some-odd years through great markets and terrible markets. As stock prices go up and the valuations are not as attractive, isn’t that a high-risk proposition?
Chuck Akre: Not necessarily. The requirements for a great business for us have really three components. The first is we spend a lot of time trying to understand what’s causing this above average return to occur. Is it getting better or worse? The second thing we look for are the people who run the business, and not only do we want to have great business managers, but we want to see to it that they treat public shareholders as partners even as they don’t know them, and then lastly we look to see if there’s a great history of reinvestment of the free cash flow as well as a significant opportunity to reinvest free cash flow and earn above average rates of return. Those are the characteristics of the businesses. None of those things ever behave in a constant fashion. Business models get better, they get worse with time. People’s behavior sometimes changes modestly. The ability to reinvest or the results from an reinvestment will vary from time to time, and so we make a judgment about which ones are real keepers.
Consuelo Mack: So given the fact that there are thousands of companies to choose from, so why is it so hard to find companies that have those three characteristics?
Chuck Akre: Well, the first two things, the business model and the people, business models change over a period of time and so they will behave differently in different environments, and you watch that. People’s behavior will change over a period of time. Sometimes in my business I keep saying to myself actually I’m getting better with age, and I hope that’s true, the outcomes would reflect that.
Consuelo Mack: Let’s use an example, Markel, a property casualty insurer. You’ve owned it for over 20 years.
Chuck Akre: Over 20 years, right.
Consuelo Mack: And you’ve stuck with it throughout those 20 years?
Chuck Akre: I have, and in 2013 the growth in book value per share was 17 or 18 percent. It’s 18 percent I think, and over the last five years, 17 percent. Over the last 20 years it’s probably about 14 percent, and if you went back 10 years ago it might have been above 20 percent, and so it will go up and down with all kinds of issues. The level of interest rates in our country are at a 30-year low, and so with a business that’s leveraged in their investment portfolio, that makes a difference. Pricing in the property casualty insurance business was negative for seven years, or eight years, and only began to get better about a year and a half ago. So during that last 10 years there has been one period where the growth in book value per share fell below 10 percent; but it did not cause us to sell the security because, as I say, in 2013 it was back at 18 percent. To have that kind of economic growth in real economic value per share in what I’d call a zero percent interest rate market is a Herculean experience. I mean, it’s wonderful.
Consuelo Mack: So the returns of the company are phenomenal as far as their business is concerned. What about the stock price?
Chuck Akre: Well, the stock price has kind of reflected what’s going on with the growth in book value per share. Today we look at these things differently than much of Wall Street and much of the sell side. In 2013 the growth in book value per share was over $70 a share. I don’t recall right off hand but maybe mid 70s, and certainly all of 2013 the stock price was in the $500 range. Today it’s in the $620 range, something like that. That is still less than 10 times the real economic earnings of last year. The change in book value per share is in fact the real economic earnings. So it’s still selling for less than 10 times in our judgment, the way we look at it.
Consuelo Mack: Tell me what you look for in an underlying business.
Chuck Akre: Well, American businesses probably have single-digit net margins on average, and the returns on equity, returns in the owner’s capital as I suggested are probably in the low teens. So if we find a business as we’re looking around that has returns which are significantly greater than that, that causes us to get curious about, well, why is that occurring? And so the simple reasons would be they have patent or they have the absence of competition for one reason or another.
Consuelo Mack: That’s the moat.
Chuck Akre: Right, that’s the moat, the frequent phrase that’s used.
Consuelo Mack: That Warren Buffett and Ben Graham …
Chuck Akre: Right, and sometimes in a business we say, well, we don’t know precisely why they’re able to do it. This is what we think, and that’s okay, too. We’ve learned to get comfortable with that.
Consuelo Mack: Not being quite sure, but you just know they’re doing it.
Chuck Akre: Right, not being quite sure. This is what our hunch is. Managements…if it’s something that’s really a secret sauce, the managements are unlikely to share it directly with us because it invites competition, and if you have a business with very high returns, it will naturally invite competition. Everybody wants to get something that’s got better returns than they have. So that’s how we go about it, and we spend a lot of time trying to study other companies in that line of business or other businesses that are related and make our judgments that way.
Consuelo Mack: Can you give me another example? I’m looking at your top 10 holdings. Colfax, I mean, Moody’s, MasterCard, American Tower, Dollar Tree, Visa.
Chuck Akre: So some of them are quite easy to talk about, American Tower, for example. You know they are essentially the largest worldwide in the business of erecting towers which support antennae for wireless communications.
Consuelo Mack: Big growing business globally.
Chuck Akre: Right, and so it’s a vertical business. The model is more towers, more tenants per tower and more rent per tenant, and on the last item their contracts with the carriers typically have annual escalators built into the contract. So every year they’re going to get three or four percent more for that same service. In addition to that, as we’ve gone from what they call 1G to 2G to 3G to 4G and so on in our handheld sets and stuff, each of those requires actually a dense tower network because they require a greater level of complication as it were in the antenna, that sort of stuff. So each of those greater density requirements requires more towers and sometimes alterations of the antennas on the towers and that sort of stuff, and each is a profit opportunity for American Tower. So it’s a very protected business. And then in the last half a dozen or more years, they’ve been growing extensively outside the U.S. and are in 11 different countries as well as the U.S., and so, very protected. You can see why they get high returns on their assets. On the other hand, if you take a business like MasterCard or Visa, it’s much more difficult to figure out exactly why they have such high returns on the capital, and the returns are enormous. They are unable to invest in other businesses that have returns that are as high as theirs.
Consuelo Mack: What a problem to have.
Chuck Akre: What a problem to have, and so they still have to do something with the enormous amount of cash they generate, and what they’ve done is they’ve instituted a small dividend that they grow. They’ve instituted some share buybacks over the last couple of years where they’re buying back billions of dollars of stock, but they still end up with lots of extra cash, and that’s a little bit of a dilemma. It makes the compounding a little bit more difficult because they’re not reinvesting. So they buy small businesses that help them with advances in mobile technology or whatever else, that’s the mobile payments, all of those things, but they cannot make large investments in businesses which have those high returns.
Consuelo Mack: It sounds like, therefore, their sustainable model years in the future might be more difficult than it is than for an American Tower.
Chuck Akre: It might be, but there’s ubiquity of acceptance of a MasterCard or a Visa card around the world. It continues to grow, and their business model is such that they get paid not only on each transaction but they get paid on the amount of currency in each transaction. So it’s really a wonderful inflation hedge; that is, if currencies get devalued and the dollars involved in a transaction go up, they get more money out of it, that sort of stuff, so it’s a really fascinating business model. Consuelo Mack: You also have I think what you call your workbench companies. They are almost like workouts as far as you’re concerned. Could you share one of those companies with us?
Chuck Akre: Colfax was one of those, and it’s our largest holding these days, but we started with it in a very small piece, and we were attracted to it for a number of reasons including what their business plan and model was.
Chuck Akre: They acquire other industrial companies and through a technique of their own that is based on a Japanese Toyota manufacturing model of continuous improvement. They improve, rationalize these businesses dramatically. So they source and buy underperforming companies and buy them and improve them and dramatically increase the rates of return.
Consuelo Mack: Do they then sell them, spin them off or … ?
Chuck Akre: No, they don’t.
Consuelo Mack: They keep them.
Chuck Akre: They keep them going for the most part. The company was founded by Mitch and Steven Rales who had also founded over 30 years ago a company called Danaher, where, in Danaher they compounded the shareholders’ capital 20 percent a year for 30 years. I mean, and so we’re attracted to that. We’re attracted to that way of thinking. They’re both significant shareholders and are behind this business. So in one sense it’s sort of we thought maybe it’s a Danaher redux, and we got started as a small company. Then we went to visit them, and we’ve been to visit them again and so on, and watched how they performed with their acquisitions and see how things are going. So that’s an example.
Consuelo Mack: Tell me what you look for in management.
Chuck Akre: You want to find management that of course is terrific at managing the business, and presumably they’ve demonstrated that by the time we get involved. We’re very interested in how they think about lots of things. We ask them often, how do you measure your success at this company? By what means? By what? And so we listen to what they have to say and make our own judgments about that.
Consuelo Mack: What are the kinds of answers that you like?
Chuck Akre: Well, sometimes you get answers such as, well, if the stock price goes up; and sometimes you find CEOs that have screens on their desk. They’re watching the stock price all day long. And that’s not a characteristic that we find particularly attractive.
Consuelo Mack: Because you don’t care about the short-term stock performance?
Chuck Akre: Right, and I would say our quick judgment would be their eye is on the wrong thing. That’s our own parochial view. We’re interested in hearing how they discuss the reinvestment of the free cash flow they generated, how they discuss the arrangement of their balance sheet and whether they use debt capital, and so on, and how much they use. I mean, all of these kinds of issues are very important in helping us with our judgment. You know, at the end of the day, if this business could be quantified, I wouldn’t have a job. People would just punch a button on a computer and it would do all the investing for them.
Consuelo Mack: Lots of people are doing that.
Chuck Akre: Indeed. And in fact, some of them do it very well using very sophisticated mathematics, but that’s not what we do. They’re trading against prices in the market and using information that comes to them in their models to do that. What we are is we’re investors in businesses, and we’re trying to identify those unique businesses with very high returns because at the end of the day the core of our thought process says that our return in an asset will approximate that return on the owner’s capital that the business generates.
Consuelo Mack: How many managers are there out there that can afford to think the way you think, to think long term?
Chuck Akre: I don’t think any of them are striving to think the way we think. They’ll get to their own conclusion about how to operate the business, and many of our businesses have shareholder support in the way they go about it. They’ve attracted the kinds of shareholders that they deserve, a line that Warren Buffett has used for many years, you know. So the way they discuss their business and the way they discuss their outlook and their operations helps lead certain kinds of investors to them. So many of the businesses we own have attracted shareholders that are sympathetic with the way they run the business at least.
Consuelo Mack: Why is it so difficult to identify a good investor, and what’s your definition of a good investor?
Chuck Akre: 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 will help you predict whether this manager or that manager is going to have an outcome that’s coincident with what your goal was? Sometimes they’ll do that even when the results might have made you uncomfortable, but nonetheless they still met your goal. For example, we went through that period in 2008 and early 2009 which felt terrible. The stock market had very negative returns as you remember, and people who understood for example what we were about and were able to not worry about the balance of their account at a period in time have done wonderfully as a result of sticking with the program. We struggle with trying to make sure that our clients understand what our approach is, and we work very hard to try to get them to understand it.
Consuelo Mack: One investment for a long-term diversified portfolio, we ask every guest, what would it be? What would you have us own in a long-term diversified portfolio?
Chuck Akre: Well I think we talked about Markel earlier. Sort of 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. You know, rates have been declining for 32 or 33 years. Some day they won’t decline and so that kind of leverage on rising rates will be very important. Number two, pricing in the property casualty business began to strengthen about a year and a half ago after seven ugly years; and maybe it’s stable or improves a little bit. Three, they made an acquisition last year that doubled the size of their gross written premium. Four, they have taken an attitude that is slightly more opportunistic about managing their balance sheet, and then five, they have a division in the company called Markel Ventures that is growing a stream of income away from the insurance business a la Berkshire Hathaway. So you can buy it at less than 10 times our notion of economic earnings today and have a good shot that it can compound our capital on average probably in the mid teens for the duration.
Consuelo Mack: Chuck Akre, thank you so much for joining us on WealthTrack for the first time.
Chuck Akre: Thank you, Consuelo.
Consuelo Mack: We’re delighted to have you.
Chuck Akre: I enjoyed it. Thank you.
Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is one we have recommended several times over the years. It is: put the power of compounding to work for you. As Chuck Akre said this week and Chris Davis said last week, there are companies that are compounding machines and as we have identified several times, there are also mutual fund managers that invest in them and are proven compounders themselves. It just so happens that we have had several of them on WealthTrack recently. In addition to Akre And Davis they are: investment legends, Chuck Royce And Charlie Dreifus whose Royce Funds invest in high quality multi-cap businesses around the world, Franklin Income Fund’s Edward Perks who looks for both capital appreciation and reliable income streams, and Wintergreen Fund’s David Winters who seeks out value among leading global brands. All of these portfolio managers invest in top quality businesses and managements for the long haul to benefit from the power of compounding earnings, cash flow and in many cases dividends.
Next week we will sit down for a rare interview with Morningstar’s 2013 allocation fund manager of the year, FPA Crescent Fund’s Steven Romick who invests in what he calls compounders, in his words, companies whose businesses will be better off in ten years than they are today.
To see more of our interview with Chuck Akre, including his motto for life, visit the extra feature on our website.
Also in our new WealthTrack Women section, our panel of award winning financial advisors will offer specific advice for younger, older, single, widowed and divorced women on creating a financial plan that is right for their particular stage in life. In the meantime, have a great weekend and make the week ahead a profitable and a productive one.
