Chuck Akre - Investing In Compounding Machines
Hello investors, welcome to my substack channel, where I study the best Investors and businesses from around the world. This week, we take a look at Chuck Akre, who is on of the greatest investors of our generation. His thoughts are especially interesting on the idea of compounding returns. Let’s hear what he has to say.
Lets breakdown what he said in greater detail to really understand the effect of compounding:
He says - “One example I use for compounding often is the issue of a penny doubled everyday for a month for 30 periods and that turns into $10.8 million. One penny turns into 10.7, 10.8 million in 30 periods, 31 days. That's the effect of compounding and so when we're looking for businesses to do this, we want businesses that can reinvest their free cash flow back in the business to continue to earn the above average rates return on that capital and therefore compound the owner's capital.”
So you can see how he outlined the magical power of compound interest. Chuck is one of the best modern day investors there is and he’s been outperforming the market with about a 17 to 18% compounded return since 2009. He is a very concentrated, long-term investor; and the businesses he is searching for he calls compounding machines.
Let’s look at how Chuck Akre finds and defines these compounding machines. He says: “Average return in common stocks for nearly 100 years in this country is around 10%. Whether it's 9% or 11% is of no consequence to us and that's dividends reinvested. That's total return absolutely and so in our case we look for to be able to return above average returns and we've done so for a very long time and then depending on which vehicle we're talking about it's a different level but substantially above that average return.”
This explains the average return for the market is about 10%. So realistically this should be our target of what to beat if we are stock pickers and investors. If you aren't willing to or don't think you can achieve better than a 10% return per year, then you're better off just putting all of your money into an index fund and accepting that over the very long time you can reinvest your dividends and get about a 10% overall return.
Chuck Akre is well and truly outperforming that 10% benchmark. He's achieved about an 18% return since 2009 and in that period, the S&P 500 returned about 14%. He has done that by finding these compounding machines in a concentrated portfolio and we'll dive into a little bit more how he's finding these companies and what those companies look like.
Chuks Akre was asked, why don't you favor dividends as much as many of the other great investors that I talk to do?
He replied by saying, “Well we said at the outset that our goal is to compound our capital and there is no free lunch and management has three or four choices to do with all the free cash they generate. They can pay dividends, they can buy back stock, they can invest in their own business or they can acquire other businesses. So in order to compound our capital, the most efficient way to do that is to invest in their own business or another business where they earn above average rates of return. If they pay a dividend, they no longer have that capital to do that and so it's a marginally less efficient way for us to compound our capital.”
This explains why he doesn't want these companies to be paying a dividend. The reason is quite simple, with the free cash flow that each business generates, there's certain ways they can allocate that capital. The best way he thinks and I would agree is that you reinvest that capital back in the business or spend that capital to acquire other businesses and achieve great returns on those investments. By reinvesting that capital back into the business like that, it's able to compound over time. If you just pay that capital out as a dividend, straight out to all of your shareholders, that money is not compounding anymore. That's not to say that there aren't great businesses that pay dividends, but if we really want to compound our money, the most effective way we want that capital reinvested back into the company with high returns. Chuck Akre certainly agrees that if you want these companies to be able to reinvest that capital continuously at high rates into the future, sustainable returns on invested capital moving out into the future is required for a very long period of time. He says that there are three components he looks for in a great business.
The first is we spend a lot of time trying to understand what's causing this above average return to occur. Is it getting better or worse?
The second thing we look for are the people who run the business and not only do we want to have great business managers but we want to see to it that they treat public shareholders as partners even if they don't know them. and then lastly,
We look to see if there's a great history of reinvestment of the free cash flow as well as a significant opportunity to reinvest free cash flow and earn above average rates of return.”
That is how Chuck Akray is looking for these businesses that compound better than the S&P500. He calls it the three-legged stool. Those three things he's looking for in a business. The absolute most important thing is a competitive advantage or moat, a solid management team that treats their shareholders like owners of a business and a business that can reinvest capital and have successfully in the past and can continue to do that successfully into the future.
That's as simple as investing can get, if you are looking for those three things and you can successfully identify them, you are going to do very well in investing.
He was also asked about his view and what he looks for in an underlying business?
He said - “Well, American businesses probably have single-digit net margins on average and the returns on equity returns in the owner's capital as I suggested are probably in the low things. So if we find a business as we're looking around, that has returns which are significantly greater than that that causes us to get curious about why is that occurring? And so the simple reasons would be they have patents or they have the absence of competition for one reason or another. That's the moat right that's the moat, the frequent phrase that's used and sometimes in a business we say well we don't know precisely why they're able to do it, this is what we think.”
The first thing to take note of is that he's looking for a business with above average net income margin. Now looking at his portfolio, he's not looking for these really excessively high margins like some companies have. Although two of his biggest positions are in MasterCard and Visa. Those two companies have some of the best margins in the stock market, so that's definitely something Chuck considers. The other thing he mentioned is this high return on owner's capital, which is another way of saying return on equity but really we just need to look for all of those return metrics, the return on assets, the return on equity, the return on investor capital, the return on incremental investor capital. All of these metrics are going to help us get a guide at how this company is reinvesting back into their business. We want these numbers to be fairly high. He said that we want the company to have a moat or a competitive advantage that can be seen by those high returns on capital numbers. Sometimes we can't exactly pinpoint what that competitive advantage is and that we may just have to trust management can continue to do this into the future but of course we want to, to the best of our ability, really understand these competitive advantages and whether they're going to be sustainable into the future.
Let’s break down what he said in greater detail: “We're interested in hearing how they discuss the reinvestment of the free cash flow they generate and how they discuss the arrangement of their balance sheet and you know whether they use debt capital and so on and how much they use. All of these kinds of issues are very important in helping us with our judgment. At the end of the day, if this business could be quantified, I wouldn't have a job, people would just punch a button on a computer and it would do all the investing for him.”
Here, Chuck is talking about some of the things he wants to hear management teams saying to their shareholders. The communication that they're putting out, he really wants to see them talking about how they are going to be reinvesting that free cash flow. That's just one way we can identify the quality of a management team and whether or not they are trying to act in the best interest for their shareholders. But as Chuck said earlier we really want a management team that treats the shareholders like owners in the business because really, that's what we are as shareholders. Benjamin Graham says, “We really want to think of ourselves as the owner of the business.” The other thing that Chuck touched on there is that investing can be more of an art than a science and of course there's plenty of people that take a scientific approach or more so a mathematical approach to investing. Being quant type investors and of course you can achieve great returns like that but Chuck argues that it's better to take that more creative and that more art based approach to investing and we have to make some of these judgments like that. It's not all math and numbers and analytics that we can make our decisions on. We also have to get a little bit creative and try to understand the story and the management and all of those things.
He believes that return on invested capital or that return on equity number can realistically be the return we see as investors approximately over the long term. That's assuming that they're not paying out a dividend of course because that's going to take away from that return but if they're reinvesting capital and generating returns at about say 20 percent consistently over a long time.
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