Never sell the gems

Running a concentrated value portfolio comes naturally to Charles T. 'Chuck' Akre, who explains key tenets of his investment approach: the three-legged stool. In this interview, he shares his wisdom about compounding machines and his investment philosophy.

Can you tell us how you got into investing?
I kept moving in the direction of things that interested me and ended up getting involved in the stock market after I finished school. Then I became a stockbroker and did stockbroking for 21 years. I morphed over into the research end of the business and started putting those research ideas into an investment management firm at the brokerage in Washington in 1985-86. And, I started my own firm in 1989.

How has your thought process evolved?
The evolution of my thought process started way back when I was a broker. I was puzzled by the question of what makes a good investment and what makes a good investor. I started analysing the rates of return of all kinds of asset classes. I looked at the rate of return for common stocks for the preceding 60 years of recorded history. It stood at 10 per cent. I said to myself: 'What's important about 10 per cent?' What I concluded was that it was related to the real rate of return earned by all of these businesses on their owners' capital-what we call the ROE today.

This caused me to posit this notion that my return on an asset will approximate the ROE over a period of years, given constant valuations and the absence of any distribution of profits. Do a back-of-the-envelope calculation; take a $10 stock with a $5 book value and $1 worth of earnings. The ROE is 20 per cent. Distributing none of the earnings and keeping the valuations constant you get ten times earnings and two times book value. Grow the earnings by 20 per cent and we find the earnings become $1.20, the ROE is still 20 per cent, and the price at 10 times earnings goes to $12. Therefore, the return on the asset approximates the ROE.

The second piece is: How do you measure when an investment is successful? If I throw that question at you, you would say, 'If the price goes up!' Well okay, now suppose it is a private company and you do not have the opportunity for price discovery, then how do you tell? 'Well, if they pay me a dividend!' But suppose the company does not pay any dividend? The answer is that at the end of the year you either look into your lockbox or you ask your accountant and he tells you that the shareholders' capital went up by x amount.

Therefore, the way you tell whether an investment is successful is by growth in the real economic value per unit of ownership. We often use the visual construct of a three-legged stool to help us think about that. Leg 1 has to do with the business model-identifying high-return businesses. Leg 2 is what we call the people model-identifying managers who view public shareholders as partners. Leg 3 has to do with the reinvestment model-the skill of the manager and the nature of the business, whether there is an opportunity to reinvest all the excess capital generated in ways that will help it to continue earning high rates of return. When we find companies that have all the three, we call them our compounding machines. Then, we don't want to pay too much for them.

How do you go about looking for companies with moats?
That is a critical question. I grew up in the Washington area. A man by the name of Eugene Meyer bought the Washington Post in 1934 off the steps of the courthouse in a bankruptcy sale. For the next 65-70 years, the Washington Post was a great business with a great franchise and a moat that got better.

However, about ten years back or so, circulation at the Washington Post and all the other major dailies of this country started declining but at a very modest rate of 1-2 per cent per year. The Washington Post could overcome the impact of that with its pricing-its moat.

We could see a little erosion around the edges of the franchise in circulation but that was not worrisome. Then some years ago, the business model just fell off the cliff for the Washington Post and for every other major newspaper because the internet had struck at their principal revenue driver-advertising. The internet made it faster, cheaper and more focused for advertisers than print advertising. Therefore, here is an economic moat that prospered for nearly 70 years and then just disappeared overnight. It is a very interesting lesson and we see it in a lot of places.

I was reading a piece earlier where the author was reading a speech given by Charlie Munger to a bunch of students. It was about Coca-Cola and Munger never even once in his description talked about the balance sheet or the income statement or the cash flow or anything like that. He talked about market shares, brand name and all of those issues. So, whenever we are looking for businesses, we try to understand the nature of the moat and the economic conditions that cause the business to earn above-average rates of return.

Do you have a benchmark for the minimum return on capital you expect?
Years ago, I used to keep the threshold limit at 20 per cent in terms of ROE. Today I would say it is generally in the mid-teens. However, what we are really looking at is free cash flow return on owners' capital and then try to make adjustments for if they are buying back the stock above book, etc. What we are trying to understand is: What is the nature of the economic opportunity and is it getting better or worse?

Nevertheless, you have invested in companies with even lower ROEs.
Yes, I will explain with an example. We have owned a company called Markel Corp for 20 years now. It is a specialty property-casualty insurer. For the majority of that time, say, 15 years, it grew the book value per share at around 20 per cent. However, in the last five years it has been growing at about half that rate.

We continue to hold it for a couple of reasons. One, we are probably in our sixth or seventh year of weak pricing environment in the property-casualty business. My experience is that it will turn one of these days. And when it does, it will have a powerful effect on the economics of a company like Markel.

Two, the people who run Markel think about the business as owners and have a history of treating public shareholders in a fair and equal way. Many years ago, for instance, they eliminated their options programme and instead offered employees a programme to buy the shares at a discount. They found it made more economic sense for public shareholders.

Three, the reinvestment part of the business. In the last couple of years, Markel has embarked on a model that is similar to Berkshire's in that they are quite active in buying 80 per cent or even 100 per cent of the businesses that have nothing to do with insurance. They are building an economic engine inside the corporation away from their insurance business, as Berkshire has done. So we think the opportunity exists for them to compound the book value at a rate that is in the upper teens or higher and we expect to see it in the next couple of years. That's why we haven't sold it-great people, great history with great opportunities, but going through a bit tough period.

What is your rationale behind investing in loss-making companies?
One of my largest and most successful investments has been in a company called American Tower (owner and operator of wireless and broadcast towers). It is hard on a GAAP accounting basis to understand what is really going on because on a GAAP basis it does not really show up. In fact, they are growing their free cash flow per share in the upper-teens, if not in the low-twenties, and they have been like that for years. So, we take a look at that and we can see how the company is adding value by adding more towers, by adding more tenants per tower and by charging more rent per tenant. They have the shelter of depreciation, which makes it look like they are not making any money. You cannot look at the traditional measures there to understand it. But we can see the growth in the free cash flow per share. Looking at stuff that way has allowed us to make an investment which formed one of our major purchases in the October of 2002 at 80 cents a share. In the first ten years, the stock price was up more than 60 times and has been up ever since.

You don't seem to sell your holdings anytime soon. Why don't you have sell targets?
Our strategy is to compound our capital at an above-average rate and at a below-average risk. The way we hope to do so is by identifying what we call our compounding machines. We know that periodically the market will both overvalue and undervalue the businesses we own. Let us talk about the case of them being overvalued. If the business model is intact and if people's behaviour is the kind of thing that we respect and if the re-investment opportunities and the historical record continue to be terrific, then we rarely sell something simply because it has become expensive.

The reason is that the really good ones are hard to find. Remember, that we run concentrated portfolios; we do not want to own lots of things. We want to own exceptional things, and the really good ones are hard to find. That is the reason that we often hold things for the very long period.

Will I be better off if I sold them at the top and bought them at the bottom? Of course! Am I able to tell when that is going to be? No. My life experience is that if the stock is at $40 and I think it is worth $25 and I sell it at $40 because I want to buy it back at $25, it trades down to $25.05 and then goes to $300 and I don't ever get my position back. Therefore, we are always trying to make sure that we own the compounders.

How did you navigate the 2008 financial crisis?
Largely we stayed with our investments and they went down a lot. It was quite a frightening time for me and my clients and we have tried to make some adjustments as a result. We now try to better incorporate our world view into our individual security selection.

Therefore, we now have investments in Dollar Tree, which is a chain of discount stores that sells every item for $1.00 or less, and Ross Stores, which is another discount store. Those are two businesses designed to allow consumers to stretch the dollar. We think that is very appropriate in today's economy where we have very high levels of unemployment, reduced access to credit and higher food and energy prices. The consumer does not have as much cash to spend and so businesses designed to help stretch the dollar are particularly well positioned.

You have seen many decades in the market and have witnessed a number of booms and busts. When do you see the next boom?
I have no idea. But what I do believe is that because we have no clear path to solving the financial crisis in the United States and Western Europe, the US stock market and quite likely the markets of Western Europe can continue to be very volatile as they respond to good news and bad news, which will pop up on a regular basis. From my perspective, this is actually good news-that kind of volatility will increasingly give us opportunities periodically.

Two, I do not expect a boom in our economy anytime soon. But I also recall that in the middle of January 1991, US stock markets exploded. It was the day the US troops went into Kuwait to free the Kuwaitis from Saddam Hussein. The stock market went straight up all the way to the first quarter of 2000 with the exception of the big hiccups in 1998 of the Russian sovereign debt default and the failure of Long Term Capital Management (LTCM).

Now, our economy was in real bad shape from 1991 through 1994. We had the Resolution Trust Company (RTC), a government agency, absorbing financial institutions and spewing out the assets at distressed prices. For a period of three to four years, all economic activity had come to a halt. Yet the stock market went up all through that time. I think it was because it could see that there were solutions that were going to work. Therefore, markets can go up even when economic activity has not picked up. But my expectation is a fair amount of volatility for some time.

This story was originally published in June 2015.