Notes on “The Peregrinations of an English Major Trying to Solve the Investment Puzzle”, Chuck Akre

These are my notes on a talk Chuck Akre gave at Google in February 2017. You can watch it here.

Akre’s book recommendations: The Money Masters, by John Train(Money Masters of Our Time is an updated version); 100 to 1 in the Stock Market, by Thomas Phelps, and Dear Chairman, by Jeff Gramm.

• Akre reads a lot of business biographies, which inform you about human behavior.

Rate of return is the bottom line of all investment.

• Public company stocks in the United States have compounded at +9% to +10% per year over the past ~70 years, better than all other asset classes
  • This is roughly equal to their ROE.
• Therefore, return of an asset will approximate the ROE over the long term, given constant valuations and the absence of capital distributions.

So, how do you identify a business with an above-average rate of return?

• “We like to fish in the pond of [historically] high-return businesses”, said Akre.
  • Mastercard or Visa net margins are in the mid-30s, for example, vs. high single digits for the average business.

Next question: what causes them to have those high returns (which, in turn, drives competitors to place a “bulls-eye on their back”)?

• Akre has a three-legged milking stool in his office, and he uses this as a metaphor for investing.
• The first leg is high returns, or the quality of the business.
  • What is the essence of this business and the explanation for these returns?
• The second leg concerns mgmt: they need to have skill & integrity.
  • Good operators treat shareholders as partners “even though they don’t know us.”
  • Company-level performance needs to be reflected at the per-share level.
    • The opposite of this is “talking like Warren Buffett but acting like Ronald Perelman”.
• The third leg–what really creates the value–is reinvestment.
  Akre notes that activists usually come in because of problems with reinvestment.
  • The compounding effect comes from this plowing of free cash back into a high-return business.
    • He didn’t understand the power of compounding until he experienced it.

Akre’s goal is to compound capital at an above-average rate (>high single digits/low double-digits) while incurring a below-average level of risk.

• Akre’s businesses typically have more growth, higher ROEs, stronger balance sheets, and frequently lower valuations than the market.
  • He dismisses volatility as a risk only in the short run.
• An aside: rate of return has a lot to do with interest rates.
  • Michael Steinhardt, for example, posted high rates of return, but treasuries were yielding 15% in the early 80s.
  • Returns for virtually all businesses are lower these days.

Akre aims to meet his rate of return goal over a 5- to 10-year horizon.

• About a third of the years he’s managed money, he has underperformed his goal.
  • Akre’s SMAs have compounded at 12.7% vs. 9.4% for the S&P over 27 years.
  • His private investment partnership has grown at a 15.25% CAGR net of fees for 23 years vs. 9.2% for the S&P over 2 years.
  • His 2 mutual funds combined have earned 13.2% over 19 years vs. 7.7% for the S&P.
  • The Akre Focus Fund (7 years old) has returned 14.75% vs. market returns of 13.5%.

In the late 80s/early 90s, Akre invested in International Speedway Corporation (ticker: ISCA).

• ISCA traded at a PE of 12, had 25% to 26% ROEs, and the owner-operator owned 60% of the stock.
• The company had great growth prospects because it was the dominant NASCAR racetrack owner.
  • Holdings included International Speedway, Darlington, and Talladega.
• ISCA is not an attractive business today because of subpar mgmt that replaced Bill France Jr., the architect of its growth, among other reasons.
• Akre made 10x-20x his money over 10+ years.

Another fruitful holding was Penn National Gaming (ticker: PENN).

• Akre heard about the company from his analyst, who got a recommendation from another investor.
• Penn National operated 5 off-track betting parlors in Pennsylvania.
  • The industry was tightly regulated, with only 23 parlors in the state.
  • The ROICs were fantastic: Penn National’s 5th off-track betting parlor cost them $2 M to build and generated $1.6 M in operating income over the next 12-14 months.
• Akre met with the CEO, a real estate developer by background.
  • The CEO’s father had owned the racetrack and the attendant gambling licenses, which the CEO built upon.
  • The CEO was ambitious & was not afraid to use borrowed money, but he told Akre he had avoided ever even having his wife co-sign a loan, which convinced Akre of mgmt’s talent.
  • The CEO went on to buy a racetrack in West Virginia, which he converted into a casino that now has 5,000 slot machines.
  • He soon became the largest non-Las Vegas, non-Atlantic City casino operator in the country.
• Akre made 10x to 20x his investment.
  • Once again, this company started out at a low valuation.

Akre originally purchased Mastercard (MA) stock in 2010.

• This was during the crafting of Dodd-Frank & the Durbin Amendment, which capped merchants’ domestic debit card processing fees.
• Akre bought MA $22.20 & made 5x his money in 6 years.
  • MA traded at a P/E of 13, which was low given its significant FCF/share growth.
• Akre and the other analysts were impressed by CEO Ajay Banga’s rapport with his colleagues.
• MA’s returns are so high that they can’t find anywhere else to put that money, which then modestly diminishes returns over time.

Akre bought Moody’s (MCO) in 2012.

• He paid $39 and has nearly tripled his money since.
• Rating agencies are market-driven, not regulatory-driven, and it’s a pretty stable 40-40-20 oligopoly between S&P, Moody’s, & Fitch.

Enstar Group (ticker: ESGR) has been a holding for ~10 years.

• Enstar buys insurance in runoff; in other words, insurance lines that other insurance companies want to exit.
• Regulators require an insurance company to maintain assets to support the insurance liabilities until it winds down.
  • Up-and-coming insurance executives do not want to work in a dying business division.
• Enstar’s executives scour the world for runoff acquisition opportunities and work patiently to land deals.
• In 2007, had compounded BV/share at 20%+ per year.
  • However, it also traded at 3x book.
• Akre bought in initially at $103 per share, and it trades at below $200.
  • It wasn’t a very good investment, but he also bought more when the valuation was favorable: for example, at $56 in 2009.
• Enstar hasn’t been able to continue to compound BV/share at its historic rate, either, primarily because of the 36-year backdrop of declining interest rates.

He threw in some Einstein quotes:

• “You should make everything as simple as possible, but no simpler.”
• “The genius between stupidity and genius is that genius has its limits.”
• “We cannot solve our problems with the thinking we used to create them.”
• “The only source of knowledge is experience.”
• “Imagination is more important than knowledge.”
• “The true test of intelligence is not knowledge, but imagination.”

And some Akre originals:

• “Just because you have a big brain, doesn’t mean you can be good at investing.”
• “There is no correct answer.”

And an old saw: “good judgment comes from experience, and experience comes from bad judgment.”

He lives and works in Middleburg, Virginia, a one-traffic-light town. He reasons that living in a metropolitan area and having so many other smart people around him would distract him from what he does well.

• Investors should be able to apply what they’ve learned & found valuable rather than just listening to others.

Peter Lynch, when running the Magellan Fund, would buy every company in an attractive industry and then eliminate the ones that weren’t good, one by one.

None of Akre’s kids are investors.

• “Struggle in my own life has been very valuable,” he said.
  • He has observed other wealthy kids who were actually damaged by their family’s prosperity.
  • “We don’t want to deprive our children of the opportunity to struggle.”

Berkshire Hathaway and American Tower (ticker: AMT) have been his only 100-baggers.

• “You really only need to have one great success” in investing, he said.
  • His search is trying to figure out the characteristics of these outstanding investments.
• You can buy many exceptional businesses at reasonable valuations.
  • American Tower, Moody’s, or Mastercard can be had at ~19x forward FCF for an earnings yield of 5.1%.
    • In a 1.5% interest rate environment, that’s attractive.
  • If the business compounds FCF or BV in the mid-teens and you pay in the upper teens for it, “you’ll get to heaven”.
  • Periodically, you get the opportunity to buy one of these businesses at a discount.
  • Very rarely, you can get it for a steal.

He starting buying BRK at $105/share.

American Tower is the toll booth of the wireless communication business.

• Each additional “G” in mobile networks requires a denser tower network & more sophisticated antennas.
• American Tower’s marginal return for an additional tenant above 1.2 per node is 90%+.
• American Tower is now in 15 countries, compared to just the US, Mexico, & Brazil when he first invested.
• In 2000, all telephony businesses fell off a cliff.
  • American Tower was leveraged 16x.
  • The company deleveraged through asset sales at distressed prices.
  • Akre bought stock at $5 in the beginning of 2002, down from its 1999 peak in the $60s.
  • In September, the position declined to $2/share.
    • Akre went to visit the founder & CEO, Steve Dodge.
    • The market was worried that the company had $200 million of its $6 B debt pile due 15 months later, payable in cash or shares.
    • Since the company couldn’t raise cash, a lower price meant more share dilution.
  • In October, the stock reached a low of $.60.
    • Akre bought several million shares at $.80.
    • The business itself remained terrific, but it was masked by a bad balance sheet.
  • Even so, Akre wonders, “Did I make a mistake by not really putting a lot of money to work?”

The moderator asked, “Does there come a point in the life of a good compounder where the valuations are becoming too optimistic and future rates of return are too low?” (I.e., “How do you think about selling?”)

• His answer: “The most difficult thing to do in our business is to not sell, if you’re a long-term investor.”
  • “The ones which are really great have been hard for me to identify. It’s taken me a long time to understand how good the really good ones are.”
  • The temptation with a disappointing quarter is to sell. With a great stock, that’s probably a bad decision.
  • He’s bad at market-timing, too, so he tries not to do that.
• Akre used Markel (ticker: MKL) as an example: it barely doubled since 2006.
  • Markel, like Enstar, had had a record of 20 years of BV/share compounding of ~20% per year.
  • MKL traded at about 2.5x book when he bought in.
    • He overpaid, considering that the company could not sustain its historic returns (again, partially due to the secular interest rate decline).
  • Markel has now fully adopted the Berkshire model with Markel Ventures.

The moderator asked, “Since you recommended Moody’s, how about S&P (ticker: SPGI) as a business?”

• The fine Moody’s received for laxity during the financial crisis was much smaller than S&P’s, in large part because there was no damning email trail at MCO.
  • This suggests that Moody’s has a better culture than S&P.
• Akre’s parter, John Neff, pushed for the investment in 2009, encouraging Akre to meet with the Moody’s executive team.
  • In 2012, after several visits, Akre finally bought the stock.
• Akre purchased both Visa & SBA due to mutual fund concentration limits wrt MA & AMT, respectively, but he hasn’t bought S&P.

Miscellaneous:

• Akre has “never been able to learn from other people’s mistakes.”
• Most of the financial industry is eyeball- or transactions-focused.
  • The best way for brokers to make transactions happen is to create false expectations.
    • E.g., when trading occurs based on earnings beats & misses.