Chuck Akre 8th Annual Value Investor Conference: ‘An Investor’s Odyssey: The Search for Outstanding Investments’
One’s return from an asset will, over time, approximate the ROE, given the absence of any distributions and given a constant valuation. So one of you will jump and no doubt say, … fool, everyone knows there’s no such thing as constant valuation in the stock market. I’ll get the valuation in a minute, but I’ll just say here we’re very stingy. When we speak of ROE, what we’re really thinking about is the free cash flow return on the owner’s capital. Free cash flow in our thought process is simply GAAP net income + dna minus all.
Now it’s time to go fishing. The pond I want to fish in is the one where all the fish are the highreturn variety. Naturally, if my returns are going to correlate to high ROEs, then I want to shop among the high-return, high-ROE businesses. In our firm we use this visual construct to 3 represent the three things that we focus our attention on. This construct in fact is an early 20th century three-legged milking stool and before I go on to describe each leg to you I want you to see that the three legs are actually sturdier than four, and that they present a steady surface on all kinds of uneven ground, which of course, is their purpose in the first place.
1- Leg number one stands for the business model of the company. And when I say business model, I’m thinking about all the issues that have come into play that contribute to the above average returns on the owner’s capital. Earlier we called this the moat. You know the drill: Is it a patent, is a regulatory item, is it a proprietary business, is it scale, is it low-cost production, or is it lack of competition? There are certainly others but for us, it’s important to try to understand just what it is about the model that causes the good returns. And what’s the outlook? In our office we often say, “How wide and how long is the runway?”
2- The second leg of stool is what we describe, is the Peevol model, and what we are trying to do is to make judgments about the focus around the business. We often ask ourselves, do they treat public shareholders as partners, even though they don’t know them? My good friend Tom Gaynor who you heard from yesterday describes it this way: He said do they have equal parts skill and integrity? What we’re trying to do is get at is this: What happens at the company level also happened at the per-share level. My life experience is, once someone puts his hand in your pocket, he will do so again. And presumably, we’re examining the company in the first place because we already determined that the managers are killers about operating the business. And because we run concentrated portfolios, we literally have no time to mess with those managers about who we have real questions about in our real experience.
3- We refer to the third leg of the stool, which quite obviously gives it its stability, as something… as the glue that holds the opportunity together. My next question, therefore, is does an opportunity exist to reinvest all the excess cash generated by a business, allowing it to continue to earn these attractive above average returns? My experience tells me that the reinvestment issue is perhaps the single most important issue facing any CEO today. As in once place where value can be added or subtracted quickly and permanently. So this really relates to both the skill of the manager, as well as the nature of the business. One of my favorite questions to ask a CEO is, “How do you measure the ways in which you are successful in running a business?” And I can tell you that very few ever answer that they measure their success by the growth in economic value per share. Not surprisingly, we hear that the increase in the share price is the answer, rather simply say chief incorporate goals established in conjunction with the board is the answer, and some say that …accomplishments relating to customers and employees and the community and the shareholders are all the answer. Personally I’m deterred in my view that growth in real economic value per share is the holy grail. Just look at the opening pages of the Berkshire Hathaway annual report, and what do you see? You see a record of growth in book value per share, for 40 years. Forty years. Incidentally, in Berkshire that number, you know, is 20% a year for 40 years, and so it’s no wonder that Warren shows up here as the top of the Fortune 400 list
After we’ve identified a business that seems to pass the test in all three legs we refer it as our compounding machine. And as we describe it, our valuation discipline comes into play here and we describe it here as simply we are not willing to pay too much. Volatility is not part of our analysis of risk; rather we view it as an opportunity generator. What we say for our purposes is that risk involved the exposure of permanent loss of capital. Occasionally, we view it more narrowly. And we’re watching for a possible deterioration in the quality of the business, or any of the three legs of our stool. Is the economic moat getting smaller, are the managers behaving badly in some way, or is the reinvestment opportunity diminished or being abused?
So, if I own a business that’s got a 20% ROE, 20% free cash flow return on the owner’s capital, and I find that by their reinvestment they are compounding value at something like that, and I think that the runway is long and wide, I want to have a lot of capital there. If, on the other hand, I’m uncertain about how the business is going to behave or if I’m uncertain about both the reinvestment history as well as the discussion by… then I don’t want to have as much capital,