The following interview was recorded in 2012 and is sourced from the MOI Global archives. We are pleased to provide below the audio and an edited transcript.
The following transcript has been edited for space and clarity.
MOI Global: Before we talk about your investment approach, please tell us about your background and how you started investing.
Chuck Akre: In college, I started as a pre-med student then changed to a literature major. When I graduated, I had interest in creating financial success. To help guide my interest, I talked to career counselors in New York. They suggested I seek work as a securities analyst or broker. I returned to my home in Washington, D.C. after that visit. A couple of the firms I approached entertained the idea that, even though I had no finance background, they would consider hiring me. I started in the industry as a rookie stockbroker in the summer of 1968.
New to the industry, I asked questions like, “What makes a great investor?” and, “What makes a great investment?” My firm was a leader in brokerage and investment banking. It had raised capital for Geico, Myriad Genetics (MYGN), and all of the department stores, drug stores, and utilities in Washington, D.C.
The firm changed slowly in response to industry and other world changes because of changes in generations at that firm. These changes allowed me to follow my own nose to address questions about great investors and investments. Also, I helped the firm’s research department and participated in a boutique institutional, idea-based broker in the early 1980s.
Along the way I confronted historical data about sources of the best returns in different asset categories. Common stocks yielded the best long-term returns. At the time, about 60 years of historical data suggested common stock returns equaled about 10%, which was better than all other asset categories unlevered. This discovery led me to ask, “What’s so important about 10%?”
I concluded then, and I still believe today, a compound annual return in the high single digits or low teens loosely correlates with the return on the owner’s capital. I discovered this correlation prevailed across different businesses, different kinds of balance sheets, and over the previous sixty years. From that realization, I concluded the return on an asset would approximate its return on equity (ROE) over a long period of years given the absence of many distributions and given a constant valuation. You and your members would object to a constant valuation model. I grant that fact, so we estimate modest valuations at the outset because we know our return will improve dramatically.
My approach evolved, and I set a goal to compound clients’ capital at an above average rate over a period of years while assuming a below-average level of risk. I expected to assume lower risk from corporations producing higher returns on capital with stronger balance sheets and with valuations often lower than the market.
We tell our clients the investment goal aims to compound their capital at an above-average rate while assuming below-average risk. We also tell them we expect their long-term return to approximate each corporation’s ROE, measured as free cash flow to the owner’s capital. To achieve those results, we focus on a smaller number of businesses with a history of above-average returns. We identify these firms using our three-legged stool model.
The first leg of the stool concerns the nature of the business enterprise. We devote significant time to researching why a given business has earned above average returns on the owner’s capital. Then we analyze the runway in front of the business, whether or not it is both long and wide.
The second leg concerns the people who run the above-average return businesses. We try to get in the managers’ minds to assess whether they treat shareholders like partners. This approach leads us to issues like compensation, whether it is a self-aggrandizing approach, and whether they view themselves as servants of the shareholders.
Leg number three gives our stool the necessary support to hold weight. This leg represents reinvestment opportunity. We evaluate whether managers have made wise use of free cash flow to continue earning above-average rates of return.
When our three-legged stool analysis is complete and businesses satisfy our criteria, we have discovered compounding machines. They can earn a higher return on capital and they can reinvest excess capital to earn high rates of return. Our investment return will approximate the return on the owner’s capital over a period of years, and we expect these businesses to yield the majority of our investment returns.
When we identify a compounding machine, we don’t want to pay too much. That is, our principal valuation concerns a free cash flow multiple and its growth rate. You and your members might have seen on our website our historical returns for individual clients, for our mutual fund clients, and for our accredited investors and partnerships. We believe our results offer significant evidence for the value of our process. We continue to generate returns well above average while assuming below-average risk.
MOI: How much has buying at a discount to intrinsic value contributed to your investment results?
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