(Image Credit, dailymotion.com)
Chuck Akre is the founder of Akre Capital Management LLC. His firm has $4.8 Billion in Assets Under Management (Form ADV from 2015-11-01).
Akre uses a classic value approach in selecting companies for his portfolio. He likes to buy companies with strong business model demonstrating consistent earnings growth, high return on equity or high compound growth rate in book value per share. He also looks at the quality of the management.
Back in 2008 he gave some great insights into his investing philosophy at the 8th Annual Value Investor Conference, University of Nebraska at Omaha. It’s a must read for all value investors.
Here is an excerpt from the 8th Annual Value Investor Conference, University of Nebraska at Omaha.
Let’s see what he had to say…
Now it’s time to go fishing. The pond I want to fish in is the one where all the fish are the high-return 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 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.
The First Leg of the Stool
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?”
Let me tell you a quick story. About 25 years ago I had an intern working with me and I gave him a box of articles I’d saved relating to businesses which had caught my eye but which I had done no work. And he came back some days later with a piece on a company called Bandad, which was located here in the Midwest in Muskoteen, Iowa, and my intern explained to me that we should look at the business that had 20% ROE, low valuation, growth opportunities and so on, and I said “What business is it in?”
And his reply was that it was in the tire business. And so I said that’s interesting, why don’t you go look at all the returns in capital and all tire companies? And he did and he came back and he reported that all those companies had returns on the owner’s capital in single-digits. So here we were with a business which described itself as the largest independent truck-and-bust tire recapper, but our quick return analysis said no way, it can’t possibly be in the tire business.
So our mission therefore was to discover what was the real source of the earnings power for the business, allowing them to have such returns. Well if you went to Musketeen to meet with the CEO, who by the way, greeted us with his feet on the desk eating an apple. I won’t bore you with all of the bizarre history – and it is indeed bizarre – but we concluded that the company’s tie to its independently owned distributers and service centers was at the core of its business value.
And those independently owned business men were incredibly loyal to Bandad, especially because of the outstanding way that they’ve been dealt with by Bandad during and after the 1973-74 oil embargo. It turns out that each of these independent business men who typically work from 6 a.m. to 8 p.m., unlike their Goodyear stores who had managers who worked from 8 a.m. to 6 p.m., were enormously grateful for what the company had instituted called the power-fund during the oil embargo.
They put this in place to collect all of the excess profits that the company made when the price of oil began to decline, and they made a deal with all of these independent managers that they would return money to them in direct proportion to the sales. You know, they bought the tire tread, which was an oil-based derivative, from Bandad, and used it during the recapping process.
So, the independent businessman wasn’t allowed to go buy a new Cadillac, but he could buy a new shop, build a new shop, get new equipment, whatever, all through this power fund that Bandad had put in place. And so this power fund in fact really lost its economic underpinnings and the company ran into difficulty and years later, it was later acquired actually, in 2007 by Bridgestone.
We owned the shares for several years and had a very profitable investment, but sold them when we lost confidence in the business model. It was unique, but my point is, simply trying to understand what it is that’s causing the good return, and how long is it likely to last.
It was a profitable investment for us, but not a great compounder. Another quick story along these lines relates to Microsoft (MSFT), during the early years. According to Bill Gates’ first book, “The Road Ahead,” he and Paul Allen tried to sell the company to IBM some years earlier and they were turned down. And so… hindsight my inescapable conclusion is that neither party of the proposed transaction understood what was valuable about Microsoft.
In my mind it’s a huge irony at least because in my point of view Microsoft became the most valuable toll road in modern business history. But here again, even the people running the company at an early stage did not understand what it was that made it valuable. And it wasn’t even visible to them.
So my point here is simply that the source of a business’ strength may not always be obvious. Therefore, understanding that first leg of the stool, the business model, has its own level of difficulty. It’s also where the fun is, I might add, and we believe it is absolutely critical. As I said, we spend countless hours at our firm working on these issues every week.
The Second Leg of the Stool
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.
Here’s another story: About 30 years ago, I owned a very, very, very, let me emphasize, very tiny interest in a company called Charlotte Motor Speedway, which over the years has come to be called Speedway Motorsports. And the principal shareholder then, and possibly still is, is a person who had a negative history with the SEC.
The agency had barred him from having any association with the company for a period of several years. And this was perhaps 35 or 40 years ago. At any rate, this majority shareholder returned to the scene, and by the mid-‘80s had accumulated 70% of the stock of Charlotte Motor Speedway, and he … tendered for all of the minority shares that he didn’t own.
When I joined … in Charlotte, North Carolina, which after discovery was successful in getting us a settlement that was several times the proposal going private price. This issue confined the CEO, which in all likelihood caused him to settle with a long list of misbehavior including improper valuation, failure to include corporate assets, a lack of independence of outside opinions, and so on.
Quite naturally he demanded that a settlement be sealed and it was. I’ve never since held a position in any of that CEOs public or private companies, because he had indeed put his hand in my pocket.
Following my Charlotte Motor Speedway experience I bored down a new holding in International Speedway (NASDAQ:ISCA), and I discovered that it was in fact the best out of the three public companies involved in NASCAR racing.
And my experience in International Speedway was a good example of our approach. When we first invested in ISCA in 1987, the metrics were as follows: The ROE was in the mid 20% range, the income margin was over 50%, book value per share had a CAGR 28%, there was no leverage, it had a modest valuation, it had attractive growth prices, and there was huge, over 50%, insider ownership.
We owned shares in International Speedway for a good many years, and had good experience of compounding our capital at generally between 10 and 20 times our cost, depending on when the shares were purchased. We later sold all of our shares when we became concerned with the management’s approach to all aspects of the business.
The CEO had died, and other family members were running the show, and in addition we were concerned about the runway for their business, as times were changing. So our sales decision was judgment relating to the second leg of the stool, the management model, as well as our view of the business model itself.
The Third Leg of the Stool
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?
Theoretically, if we have the three legs correctly identified then our only risk is the loss associated with the dying value of money. In practice, it never happens exactly this way. But we believe firmly that if we’ve identified the key ingredient for both preserving and enhancing our capital, we’ll be in good shape.
Another story, if you will. Many years ago, I owned a position in the list company that was based in Long Island, New York. Now you don’t see many, or even any list companies that are in the public market because they mint money. A list company, as you may know, collects and sorts data about people and subsequently sells the list to various users.
A good example is Gilette, which collects data about high school senior boys. And the reason was, that their research showed them that while a boy was still at home, his mother purchases razor blades. And once he graduated from high school, with the likelihood that he was going to leave home, he would begin making choices about what razor blades to buy.
So Gilette would buy these lists of high school seniors and mail them free razor blades, getting them used to a brand before… now this company, which was called American List, was run by a founder who had some years earlier sold a controlling interest to a New York private equity firm. And the CEO was a very decent guy, and in exchange for partial interest he had sold he was able to put his money into double digit-return bonds, and he was in investment heaven.
At any rate, the company had 50% net margins. Either because the New York firm had control of the CEO, or because he was so risk averse, or perhaps he wasn’t imaginative enough. The CEO could never find a place to reinvest the excess capital he generated in order to compound the shareholder’s capital. So he paid it out in dividends long before we had a 15% dividend tax rate.
Incidentally, someone else by the name of Dan Sneider, had a public company those days and he purchased all of American List. My great regret at the time, of course, was that I didn’t have a vehicle to purchase all of American List. It was a pure send-a-check-of-Omaha kind of business. The opportunity ended up simply being… money lost for us, as the reinvestment portion of the triangle was missing. Even that loss was offset by the rich dividends.
At our firm we have this quaint notion that in certain economic environments and in certain stock market environments both of which we have an abysmal record of predicting, we are well served by owning things which were a modest valuation, at least to start.
There’s an old Wall Street ad agent attributed to Goldman Sachs…which says, “Something well bought is half-sold.” Taking a completely different tact, if we had properly identified the compounding in machines and had bought them at modest valuations, we would be set up for the famous Davis double play.
That is, the business… will compound our capital at an above-average rate, and we’re in line for an increase in market valuation, but double play indeed. So we have shared our experience relating to business models which fade, core executive behavior and reinvestment.
Now let’s look at a business success that we’ve had. Incidentally, our compliance folks have asked that we make sure you understand that not all of our investments turn out as well as American Tower. I’m about to discuss, and not to mislead you, we have indeed had others which have not done so well.
This first slide gives the share price detail from the time it was created out of American Radio in 1998 to the market bottom in 2002. And between those periods, we have bought and sold shares and essentially broken even on our transactions. By June of 2002, we had accumulated a half million shares at the cost of $5, and as we like to say, we were proud of our holdings.
By September the share price was $2, and we got on a plane and went up to Boston to see the CEO, and founder, Steve Dodge. The market was focused on $200 million convertible debt issue, by the way out of a total of $3.3 billion in dollar debt, which was to come due in November of 2003, more than a year later. It was payable both in cash or in shares of the company’s option. As a shareholder, my risk was massive delusion.
So Steve Dodge, the CEO, discussed his thought process about handling the debt issue in the following year. Further, we could take a full measure of both his pride and his anger relating to the share price and the market action, and we came away believing that the debt issue would be managed successfully.
Along with an increased level of confidence in the business, we were better prepared as the market tanked in October of 2002. Market liquidity disappeared. Many of you will remember and the shares traded at an inter-day low of 60 cents per share, finishing the day on October 9th at 71 cents per share. The circle on this chart, marks the point at 80 cents per share where we took a larger position, several million shares yet still not significant to our assets.
So what was the market seeing in 2002? Among other things, the company had a ratio of debt to EBITDA greater than 16 times. You can see on the right hand column, 16.4 times. Not unexpectedly, it was showing huge net losses in income as well. You can see that in 2002 alone, it lost $350 million. What did we see?
We saw a basic business model in its simplicity, which is more towers, more tenants per tower, and more rent per tenant. What else did we see? Well we saw that tower level… margins were about 90%. We saw that cash flow margins were approaching 50%. The 2010 experience for American Tower was EBIDTA to margin itself was 68%, and the free cash flow margin was 46%.
So back to the basic business model. Tower count remained flat in 2004, and the company improved its balance sheet. Beginning in 2005, tower count began to rise both domestically and outside the U.S, and from 2005 to 2010 tower count grew by 133%. What happened after 2002?
Well beginning in 2003 EBIDTA began growing again. In 2005, free cash flow turned positive, debt to EBIDTA fell to below 6 times in 2005, and from over 16 times to just 4 times in 2010. Free cash flow reached 46% of revenues. So this is what I call the “aha” event. Return on invested capital from 1997 to 2010, that should be 1998, was 30%.
Compound return on investment from the market low in October 2009 was 66%. While the return periods did not exactly overlap, the point is the same. The difference, the excess return is the very definition of the Davis double play.
So an important observation to us is that price matters enormously. The starting price has everything to do with your compound return, and here we see that the difference between buying the shares in February 1998, March of 2000, October of 2002, and January of 2003, and if you can’t see the chart very well, from February of ’98 to present, there’s an 11% CAGR.
From March of 2000 to present, it’s a 3/10% cagger, from January of 2003 to present, it’s a 38 and a half percent cagger, and by the way, from the market bottom, October 9th, 2002, it’s a 66% cagger. So that is indeed the Davis double play.
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