Chuck Akre on the Search for Compounding Machines
by Russel Kinnel | 01-30-12
We talked with Chuck Akre who built an outstanding record subadvising FBR Focus before the two split and Akre launched a new fund, Akre Focus AKREX. He runs a concentrated growth style that really is unlike anything else you'll find.
Russ Kinnel: Can you tell us a little about how you built the team up and who is there?
Chuck Akre: I started off Akre Capital Management in 1989. So, we do have a new fund, which became effective Aug. 31 of 2009. The analysts who had worked with me on the fund and other things and the prior fund left, and we built a new team. In October of 2009, we added Tom Saberhagen, who had been a senior analyst at the Aegis Value fund. In November of 2009, we added John Neff who had been a senior analyst on the sell-side at William Blair. Then in September of 2010, we added Andrew Osborne, who falls in sort of the rookie category. I thought he had great instincts and done quite a lot of work in the investment business as an independent thinker.
Kinnel: Does each analyst have sector specialties or are they generalists?
Akre: Well, they are indeed generalists, but quite naturally their areas of expertise are slightly different. Tom has an undergraduate degree from Rice and an MBA from Stanford. Tom's background in the fund business was deep-value shop, and John's undergraduate study was at Colgate and then he attended Booth School at the University of Chicago. He came from a growth shop at William Blair. So, the stocks they follow tend to fall into the value and growth camps, respectively. The more richly valued companies are typically little higher growers, faster growth rates, and those are generally things that John is involved in, and Tom has been involved in things which are a little bit more modestly valued and more traditional in their nature.
Kinnel: You've said you look for "compounding machines." Would you explain what that means?
Akre: When I started in the investment business a good while ago, I was not trained for it in a traditional sense. I had been a pre-med major, and then I was an English major. So, I quite naturally had all kinds of questions about the investment business, and among them were the questions of what makes a good investor and what makes a good investment, and taking a look and studying different asset classes using data from what is now your subsidiary Ibbotson and other places. I came across the well-known piece of information that over the last roughly 90 years common stocks in the United States have had an annualized return that's in the neighborhood of 10%.
So, my question naturally was, well, what's important about 10%? What I concluded was that it had a correlation with what I believe was the real return on the owners' capital of all those businesses across all those years, all kinds of different balance sheets and business models--i.e., that the real return on owners' capital was a number that was probably in the low teens and therefore that kind of 10%-ish return correlated with that, and it caused me to posit that my return in an asset would approximate the ROE of a business given the absence of any distributions and given constant valuation. So, then, we say, well, if our goal is to have returns which are better than average, while assuming what we believe is the below-average level of risk, then the obvious way to get there is to have businesses that have returns on the owners' capital which are above that.
Early in the 1970s, I came across a book written by a Boston investment counselor, whose name was Thomas Phelps. And the book he wrote was called 100 to 1 in the Market. You probably know from the history books that Peter Lynch was around Boston in those days, and he was talking about things like "10-Baggers." But here was Thomas Phelps, who was talking about "100 to 1." He documented characteristics of these businesses that caused one to have an experience, where they could make 100 times their investment. The answer is, of course, it's an issue at the rate at which they compounded the shareholders' capital on a per unit of ownership basis and those that compounded the shareholders' equity at a higher rate had higher returns over long period of years. And so that's what comes into play is this issue of compounding compound machines, and we're often identified with this thing in our process that we call the three-legged stool. The legs of the stool have to do with the business models that are likely to compound the shareholders' capital at above-average rates, combined with leg two, people who run the business who are not only killers at running the business but also see to it that what happens at the company level also happens at the per share level--and then number three, where because of the nature of the business and the skill of the manager there is both history as well as an opportunity to reinvest all the excess capital they generate to reinvest that in places where they earn these above-average rates of return.
The most critical piece of that is the last leg, that reinvestment leg. Can you take all the extra capital you generate and reinvest it in ways that you can get continued earnings above-average rates of return? And that's at the core of what we're after in our investments.
Kinnel: On the sell-side, deterioration on those key fundamentals may lead you to sell, but do you also sell on valuation?
Akre: So, in response to your first observation, deterioration to any one of those three will certainly cause us to re-evaluate it. It won't automatically cause us to sell, but it will certainly cause us to re-evaluate it. Our notion is that if we don't get those three legs right where there develop differently in the future than they have in the past, theoretically our loss is the time value of money that it hasn't always been the case. But the deterioration of one of those legs or more than one of those legs diminishes the value of that compounding and, indeed, is likely to cause us to change our view. That's number one.
Number two, the issue of selling on valuation is way more difficult for us. And what we've said is that from a matter of life experience, if I have a stock that's at $40 and I think it's way too richly valued and I sell it with a goal of buying it back at $25, my life experience is it trades to $25.01 or trades through $25 and back up and it trades 200 shares there. The next time I look at it, it's $300, and I've missed the opportunity. It's my way of saying that the really good ones are too hard to find.
If I have one of these great compounders, I'm likely to continue to own it through thick and thin knowing that periodically, it's likely to be undervalued and periodically likely to be overvalued. The things that cause us to sell when one or more of the legs of the stool deteriorates. Occasionally, on a valuation basis, maybe we'll take some money off the table.
Lastly, if we're trying to continue to maintain a very focused portfolio, if we run across things that we think are simply better choices, then we may make changes based on that.
Kinnel: You've commented before that you've got some of the defensive names like Dollar Tree and others in part because you're concerned about a weak economy. Is that still the case?
Akre: Yes, the United States will continue to have what we call the constrained consumer. And the consumer, as you well know, represents two thirds or 70% of our economy. The consumer is constrained by something that the economists call U6, which is people who are not working, the people who have given up looking for jobs, and the people who are working fewer hours than they need to, and that number is certainly at least in the mid-teens, if not in the high teens, meaning one out of every six or seven working-age adults is constrained in the employment area. Either they're not working or not working enough hours to make ends meet.
So, one out of every six or seven consumers is constrained by employment issues. In addition to that they're constrained by diminished access to credit. Not only are home equity lines no longer ubiquitous, the ability to refinance houses and take out built-up equity is greatly diminished. And, furthermore, banks have tightened underwriting standards, and credit cards have tightened their lines of credit standards and so on. So, the consumer is simply not able to spend today as he might have spent in the first decade of this century. Being involved in businesses that allow the consumer to stretch the dollar is a great place to be, and among those are the names that you mentioned--Dollar Tree, also Ross Stores and T.J. Maxx and so on--and it turns out that they were extraordinary businesses in the good times. We just happen to think they are very well positioned to be very good performers in times that are less robust. So, we prefer to call it that rather than saying defensive plays. It may be that they are defensive, but you wouldn't have thought that by the way they've performed in the last couple of years, nor the way they've performed in the first decade of this century.
Kinnel: And another theme I see there is interesting financials, some of which are in the asset-management business like LPL, Hartford, Diamond Hill. What's the attraction there?
Akre: We are in that business, in the business of straight asset management, so we have a pretty good understanding of that business and think that overall it's a terrific business to be in. It has high returns and so on, and it will be affected by the overall returns in the marketplace and things of that nature, but we think overall it's a good place to be. It's just that simple, and valuations have been, generally speaking, reasonably attractive.
On Hartford, I can say quite directly that we are not in it because of their asset-management business. We just happened to think that at the very significant discounts to book value that, in the next two or three years, they will be able to substantially work through those in ways that will resolve in favor of shareholders and that would be what I would call a defensive position.
Kinnel: I wonder, if you could talk about cash. You've (often) held a significant amount, so generally how do you manage the cash position, and where is that today?
Akre: Well, I manage it as best I'm able, and it is in a period of great growth which we're experiencing right now. I mean, just so you know it, you wouldn't have any reason to know it, the fund is now at $700 million and two months ago it was just a little below $300 million.
So, that, obviously, materially affects our cash position. I tell people that on Sept. 1, 2009, we started with 100% cash, and generally it's come down since then. Our lowest cash balance in the last three months got down into single digits, and it's now probably up around 30% because of the inflows. And we like days where the screen is red, so you make your own judgment about how rapidly we are putting stuff to work because of whether the screen is red or green.
Kinnel: Is there upper limit on how big your largest position you are allowed to get?
Akre: Well, the thing that drives that most significantly are the rules in the industry which cause us to make sure that of all the positions which are greater than 5% at the time of acquisition, they can't exceed 50% of the fund's assets. So, we have that limitation going on all the time; that's number one. Number two, there is nothing magic about 10% per se, as it relates to an individual position. And we have in the past, and we've been managing mutual funds now for over 15 years. We have in the past that positions that have gotten considerably larger than 10%, and it has accrued to the benefit of the shareholders. And as you know, we as a group here and I personally are significant shareholders of the fund.
Russel Kinnel does not own shares in any of the stocks mentioned above.
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