Chuck Akre’s presentation to the 8th Annual Value Investor Conference: ‘An Investor’s Odyssey: The Search for Outstanding Investments’
8th Annual Value Investor Conference, University of Nebraska at Omaha
This is the transcript of Chuck Akre's presentation to the 8th Annual Value Investor Conference in April 2011, Omaha, right before the annual shareholder meeting of Berkshire Hathaway. The upcoming 9th Annual Value Investor Conference will be held May 3 – 4, 2012, again in Omaha. Thank you Bob, and it’s great to be here. My chat today is called “An Investor’s Odyssey: The Search for Outstanding Investments.” It’s a loose summary of my experience in the investing business. I won’t tell you how many years I’ve been in it, Bob just did. I didn’t, obviously, start yesterday. I want to thank Bob for both asking me to come and for his comments. Some years ago Bob asked me to do a presentation in an earlier conference he was hosting, and I turned him down. I said then that I just don’t do that. Of course, I didn’t recognize what an honor it is to be included in this group, so you should treat my remarks with appropriate suspicion. I might also add that paybacks are hell. You notice that he scheduled me today opposite what’s called the wedding of the century.
I’ve gained enough weight and lost enough hair over the years to be able to allow me to write up some thoughts about investing, so today I’m going to share with you some of these thoughts, which collectively have added value in my career. Many years ago when I started my investing career in Washington D.C., I was puzzling with several questions about investing, and mind you that as Bob suggested I came into this with a BA degree in English Literature, having also been in a pre-med program, so I actually had a great many questions. Among the questions are, “What makes a good investor?” and more to the point, “What makes a good investment?” Today we tell all of the clients in our firm that our primary goal is to compound their capital at an above-average rate while incurring a below-average level of risk. So I usually ask my friends this question: Which would you rather have, $750,000 today or the outcome of doubling a penny a day for 30 days. What do I hear? Penny. So that’s the question. Compounding our capital is what we’re after, that’s what makes it a great investment for us. What’s the value of compounding? Well the answer in this case is simply astounding. Doubling a penny a day for 30 days gets you, who knows, $10 million, $737,000 change.
The reason why we use the notion of compounding our capital at above average rates is that we can think of no better method of measuring the success of any business. Think for a moment about that, if you will. How else is someone able to judge the success of a business enterprise than through some measurement of the growth in real economic value. Granted, we all know about the importance of customers and employees and community, and obviously they’re important, but throughout my odyssey I’ve been trying to identify and measure financial success in a manner other than whether the share price rises or falls. In fact, in a private business one is not afforded the luxury of share price discovery, so that some other method of measuring success must be present. I’ve heard... send the check to Omaha. This of course, is what happens when one is unable to compound their own capital. As an aside, Albert Einstein has often been credited with the following quote: “Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.” Likewise, I read over the years that the eighth wonder line is attributed to Will Rogers. My own research cannot connect Will Rogers to any such quote. Finally, an authority called Miller’s Philmore Bathtub, honest, a website which holds itself out as a prodigious checker of facts, in which was entirely unknown to me as recently as two weeks ago, says, with confidence, that “Albert Einstein never wrote or said anything about compound interest.” So not only is compound interest/compound return poorly understood, we can’t even say with confidence who we should credit with these pithy statements. It remains an enigma.
In 1972, I read a book that was reviewed in Barron’s and this book was called “101 to 1 in the Stock Market” by Thomas Phelps. He represented an analysis of investments gaining 101 times one’s starting price. Phelps was a Boston investment manager of no particular reputation, as far as I know, but he certainly was on to something which he outlined in this book. Reading the book really helped me focus on the issue of compounding capital. Also, from Boston, you all know Peter Lynch, who often spoke about ten-baggers. Here was Phelps talking about 100-baggers, so what’s the deal? Well Phelps laid out a series of examples where an investor would in fact have made 100 times his money. Further he laid out some of the characteristics which would compound these investments. So in addition to absorbing Phelps’ thesis, I’ve been reading the Berkshire Hathaway (BRK.A)(BRK.B) annual reports since I’ve made my first purchase in 1977, so this collective experience moved me along to a point where I’ve developed my own list of critical insights and ingredients for successful investment.
Again, compound return really is the center point, and ultimately we spend much of our time trying to identify those businesses which are most likely to compound the shareholder’s capital at an above-average rate. Were we simply a pure value investor, we would be regularly looking to unload those securities, which appreciated to some predetermined notion of present value, and we would lose out, in our minds, on the opportunity to compound our capital because of these sales. Further, we have our operational costs and tax costs for those accounts, which bear tax liability. Continuing this quest, I found the data, this is EBIDTA data, relating to returns in different asset classes, across nearly all of the 20th century. You all know the figures; common stocks outperformed all other asset classes on leverage across most of this time period. You notice that Robert and his last talk had a slide that went back to the 19th century, ended up producing the same type of data. The annual compound return number falls in the neighborhood of 10%.
So I’d like to have you examine these numbers, which are in ten-year intervals. And the obvious conclusion is that both an annual return as well as a ten-year number is unknowable. So my takeaway as it remains today is that while the number is the in vicinity of 10%, 10% itself is not precisely the point. Might be 9 or 11, generally in the neighborhood of ten, and by the way I just tell you that as an aside I feel exactly the same way about earnings estimates and outcomes, and that for us, the precise number is never the point.
My next question then is, “So what’s important about 10%?” Over the years I’ve considered a lot of reasons for the 10% figure and I ultimately concluded that the 10% numbers bear some relation to what I suspected was the real return on... capital, that is across all companies large and small, leveraged and debt-free, manufacturing service oriented, hard assets, cloud assets, across all these businesses, my surmise was the real return on the owner’s capital adjusted for all what I call the accounting garbage, was in the low teens. Today... suggested that they are correlated.
Throughout most of my career, it’s been popular to believe that the RVs of all American businesses are in the mid-teens, and again Robert’s last chart showed it varies from the mid-teens to mid-single-digits and so on. However, I’m suggesting that without any academic support, that the number unencumbered by GAAP accounting is in fact lower. And you all know that GAAP-accounting does a reasonable job helping us with these judgments, but it clearly has its deficiencies.
So now it’s the case of intuition, perhaps common sense, that I propose the following hypothesis: 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 …
Of course, there are examples that are more complicated, but as a business owner this is what interests me. How much cash does the business produce and make available to the management, for them to make the reinvestment choices? So now I have this hypothesis, where’s the proof? Well return on capital really matters. I don’t know if you can see those numbers or not but just take an example: Start with a $10 share price, $5 book, 20% ROE produces a dollar’s worth of earnings, you know the metrics are easily ten times earnings, two times book, 20% ROE, we’ll add the earnings of the book and have another look, the new book is $6, keeping the valuation constant, providing no payouts of earnings, apply 20% ROE, the new earnings are $1.20, ten times that is $12, two times the new book is $12, so our point is the share price is up 20% consistent with 20% ROE. So in this example, one’s return does in fact mirror the ROE, where there are no distributions and the valuation is kept constant. And this generalization has been very useful to me in thinking about … expectations. One of the acknowledgements I think we’ll all gladly accept to is that high return businesses have something unusual going on which in fact allows them to earn above average rates on unemployed capital. Often these special circumstances are referred to as moats. In our firm is the properly identify what is the nature of the moat; what exactly is it that’s causing this good result. And to us this is a really critical point. Because the investment business can have so many issues that upset the apple cart, being confident about what it is exactly that’s causing the results is a huge advantage for us. In point of fact, we have on occasion been able to add to positions in time of tumoil, because the confidence in understanding a business allowed us to see through all the noise in the marketplace.
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.
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.
