This conversation is part of our special series, Intelligent Investing 100. Every week for one hundred weeks we bring you an exclusive segment with a recognized thought leader in the field of investing. Stay tuned for a new release every Thursday at 11:30am ET.
We continue this series with a classic interview with superinvestor Charles T. “Chuck” Akre, Jr., founder of Akre Capital Management.
In the wide-ranging conversation, Chuck talks about his early days in investing, how he refined his investment approach over time, red flags when it comes to evaluating management teams, how some companies erode shareholder value imperceptibly but materially over time, and other topics related to long-term outperformance in investing.
Chuck founded Akre Capital Management in 1989 after 21 years in the securities business at Johnston, Lemon & Co. From 1993 to 2000, Chuck operated the business under the umbrella of Friedman, Billings, Ramsey & Co in Washington, DC. In 2000 he took the firm private again, this time moving Akre Capital to the rural village of Middleburg, Virginia. With over 50 years of experience in managing private funds, mutual funds and separately managed accounts, Chuck continues to share his insights and wisdom as the Chairman of Akre Capital Management.
This interview was conducted by Alex Gilchrist of MOI Global in 2021.
The following transcript has been edited for space and clarity.
Alex Gilchrist, MOI Global: While working for Johnston, Lemon & Co. for 20 years [1968-1988], you dedicated yourself to learning about investments and investors. Could you share with us what drove your curiosity and passion to learn about investing as well as some of the milestones during that period?
Chuck Akre: After graduating as an English major, I had no formal education in business, economics, or any of those things. I started life as a stockbroker in the summer of 1968. I was a clean slate; I was a clean canvas. I knew nothing. I set about trying to figure out what makes a good investment and what makes a good investor because I was bombarded on all sides by ideas, including whether the ideas were a matter of luck or whether they worked. I tried to put some perspective on it. That’s what I’ve done for the rest of my career.
Gilchrist: If you started this learning journey again, would you go about it differently?
Akre: The process of learning is still the same. The tools of learning are vastly different today because of the internet. When I started the business, if you wanted an SEC document you had to go to the SEC to get it. Then you had to pay them to make copies of it. The next thing that evolved was people started services that sent runners to the SEC on your behalf. When they first started doing things online, trying to download the documents – it was always in the wrong print size or some silly stuff. It’s come a long way over the years. The availability of information today is much different than it was then. That was true in the ’60s and early ’70s. It was true in the ’40s and ’50s as well. Each generation has a slew of new improvements and ways to gather information. Consequently, people are better informed. They have more information at their fingertips to help them make judgments. We have this expression about making judgments: good judgments come from experience, and experience comes from bad judgments. This whole business, this odyssey is a process. It’s about trying to discover pieces of information or factors that could have some better-than-even odds of predictability about how an investment return will work for you. We still do that.
Gilchrist: You distilled understanding investments into a three-legged stool of the business, the people, and the reinvestment runway. Could you tell us how understanding these three legs for business flows into how to choose the tools for valuation?
Akre: In my office I had an old-fashioned three-legged milking stool, and it just hit upon me one day as an idea for making it easier for people to follow how we thought about making investments. The first leg represents the business model and the data around it. Is it a high-return business? What causes the high return? Is it getting better or worse?
The second leg is made up of the people who run the business. Not only have they done a terrific job in terms of outcomes of running the business, but they’ve also acted in ways in which they treat us investors as partners even though they don’t know us for the most part. We say things like, based on experience, once a guy’s put his hand in your pocket, he’ll do it again. We learned the kinds of things we want to stay away from.
The third leg ties this together – there’s an expectation for substantial free cash flow on these businesses. It asks whether the history of reinvestment of free cash flow is better than good, whether the opportunity for reinvestment of free cash flow is high quality, and whether the runway is broad and long. When we have those things – we’d call it investment nirvana if we had five stars in each one of those – then the question concerns what you pay for it. That’s particularly relevant in today’s market where valuations are higher than they were two or even five years ago. You must make judgments about what you can pay for it. But the environment is affected by the low level of interest rates worldwide. Because interest rates are so low, in our judgment, that means you can pay more for some rate of growth today than you would have five years ago.
Gilchrist: When coming across compounding machines, to understand their mechanics broadly speaking, do you find it necessary to make significant adjustments to the financials? Or is it simply clear?
Akre: In the last 30 years the SEC has purportedly tried to make the accounting in companies easier for people to understand, but my notion is they’ve made it more difficult. We try to make any necessary adjustments when we look at the financials. We want to see what’s happening from a cash basis perspective. One of the areas today we pay particular attention to are the issues of options and others of that nature because they disguise what is an expense as a capital transaction that takes place over a long period. The use of options to encourage people to work there – it’s easy to understand why businesses do that, but the fact is that in most cases, they dilute the investor by maybe a couple of percentage points per year. That adds up a lot over time. Therefore, we make adjustments to understand what the real expenditures are, which ones are capital and which ones are operating in terms of trying to understand the cash that’s available to the operators of the business.
Gilchrist: Especially during these difficult times, a company like Facebook might do it because it’s trying to motivate creative individuals to have a long-term focus and think like owners of the business. In another case, management might be trying to make itself wealthy at the cost of other shareholders.
Akre: Right.
Gilchrist: I just think that’s an extra moving part of that analysis.
Akre: Yes, you get these big, rapidly growing companies that are darlings of the market. It just seems like it’s nothing that they give away 2% or 3% per year in options. But the fact is they’re giving away 2% or 3% of your capital per year. You give an option for somebody to buy shares at $100 per share and then turn around and say, “Yeah, but we bought back an equal amount of shares.” “What did you pay?” “Well, we paid $150.” So what’s the tradeoff? The tradeoff comes out of our pocket. That’s all. We’re realistic enough to know that’s the way the world works. We like to find people who are thinking about that seriously on behalf of the owners. If you find executives who are significant owners with their own money, that makes a difference. We’ve seen some businesses with powerful business models where the executives running the business claim they own 12% of the company. As you keep looking at it, you find they never owned any of it. When they exercise their options, they always sell them! They’ll probably say, “No, we own 12% of the company.” Would you mind showing me where that is?
Gilchrist: One of your favorite quotes is attributed to Einstein: “Everything should be made as simple as possible, but not simpler.”
Akre: It’s written on the crown molding in our boardroom.
Gilchrist: Could you give some examples of when you have seen analysts overcomplicate trying to understand the businesses?
Akre: Almost always. I don’t mean to be haughty about this, but we operate in a substantially different way from the investment world as a whole. In simple terms, earnings momentum drives the investment world. That’s evidenced when you hear everybody speak about whether they missed by a penny or beat by a penny. We don’t think that’s a particularly good way to go about this. We’re interested in trying to identify businesses with high returns on the owner’s capital, know the returns will not be smooth, and that over a long period we’ll compound our capital at rates that are much better than average. The average continues to be in the 9% to 10% range, but it’s much harder to get there these days with 0% interest rates. When you get businesses earning 15% on owners’ earnings, that’s a terrific experience in today’s world.
Gilchrist: Being a long-term investor and holding compounding machines over a long period, they must change and become almost unrecognizable from when you first bought them. Indeed, you must outstay many members of management.
Akre: We’ve had some businesses on their third CEO since we got involved. We’ve seen several businesses go through the transitions. They’ve changed somewhat, but for the most part not too dramatically. The business might be larger, but for the most part the business models that attracted us have not changed significantly.
Gilchrist: When you first come across a business, what are a few red flags and a few elements that drive your curiosity?
