A growth maverick shares his ideas.
Kinnel: You've said you look for "compounding machines." Would you explain what that means?
Akre: When I started in the investment business a good while ago, I was not trained for it in a traditional sense. I had been a pre-med major, and then I was an English major. So, I quite naturally had all kinds of questions about the investment business, and among them were the questions of what makes a good investor and what makes a good investment, and taking a look and studying different asset classes using data from what is now your subsidiary Ibbotson and other places. I came across the well-known piece of information that over the last roughly 90 years common stocks in the United States have had an annualized return that's in the neighborhood of 10%.
So, my question naturally was, well, what's important about 10%? What I concluded was that it had a correlation with what I believe was the real return on the owners' capital of all those businesses across all those years, all kinds of different balance sheets and business models--i.e., that the real return on owners' capital was a number that was probably in the low teens and therefore that kind of 10%-ish return correlated with that, and it caused me to posit that my return in an asset would approximate the ROE of a business given the absence of any distributions and given constant valuation. So, then, we say, well, if our goal is to have returns which are better than average, while assuming what we believe is the below-average level of risk, then the obvious way to get there is to have businesses that have returns on the owners' capital which are above that.
Early in the 1970s, I came across a book written by a Boston investment counselor, whose name was Thomas Phelps. And the book he wrote was called 100 to 1 in the Market. You probably know from the history books that Peter Lynch was around Boston in those days, and he was talking about things like "10-Baggers." But here was Thomas Phelps, who was talking about "100 to 1." He documented characteristics of these businesses that caused one to have an experience, where they could make 100 times their investment. The answer is, of course, it's an issue at the rate at which they compounded the shareholders' capital on a per unit of ownership basis and those that compounded the shareholders' equity at a higher rate had higher returns over long period of years. And so that's what comes into play is this issue of compounding compound machines, and we're often identified with this thing in our process that we call the three-legged stool. The legs of the stool have to do with the business models that are likely to compound the shareholders' capital at above-average rates, combined with leg two, people who run the business who are not only killers at running the business but also see to it that what happens at the company level also happens at the per share level--and then number three, where because of the nature of the business and the skill of the manager there is both history as well as an opportunity to reinvest all the excess capital they generate to reinvest that in places where they earn these above-average rates of return.
The most critical piece of that is the last leg, that reinvestment leg. Can you take all the extra capital you generate and reinvest it in ways that you can get continued earnings above-average rates of return? And that's at the core of what we're after in our investments.
Kinnel: On the sell-side, deterioration on those key fundamentals may lead you to sell, but do you also sell on valuation?
Akre: So, in response to your first observation, deterioration to any one of those three will certainly cause us to re-evaluate it. It won't automatically cause us to sell, but it will certainly cause us to re-evaluate it. Our notion is that if we don't get those three legs right where there develop differently in the future than they have in the past, theoretically our loss is the time value of money that it hasn't always been the case. But the deterioration of one of those legs or more than one of those legs diminishes the value of that compounding and, indeed, is likely to cause us to change our view. That's number one.
Number two, the issue of selling on valuation is way more difficult for us. And what we've said is that from a matter of life experience, if I have a stock that's at $40 and I think it's way too richly valued and I sell it with a goal of buying it back at $25, my life experience is it trades to $25.01 or trades through $25 and back up and it trades 200 shares there.
The next time I look at it, it's $300, and I've missed the opportunity. It's my way of saying that the really good ones are too hard to find.
If I have one of these great compounders, I'm likely to continue to own it through thick and thin knowing that periodically, it's likely to be undervalued and periodically likely to be overvalued. The things that cause us to sell when one or more of the legs of the stool deteriorates. Occasionally, on a valuation basis, maybe we'll take some money off the table.
Lastly, if we're trying to continue to maintain a very focused portfolio, if we run across things that we think are simply better choices, then we may make changes based on that.
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