Renowned value investor
) gave this great interview on Wealth Track on the topic of
compounding machine. This article is the compilation of my notes
from this interview. The interview can be found on YouTube through
the following link:
: Can you define a "compounding machine?"
: An example I use is the issue of a penny double day for 30
period, which turns in to 10.7 million in 31 days. That's the
effect of compounding. So when we look for businesses to do, we
look at the ones that can reinvest their free cash flow back in the
business to continue above average return on that capital and
therefore, compound the owner's capital.
: What does above average return mean?
: Average return for common stock for nearly 100 years in this
country is about 10%, dividend included, total return. In our case,
we look for above average returns; we've done it for a long term.
: Why don't you favor dividends as much as many other great
: Our goal is to compound our capital. There is no free lunch.
Management only has three to four choices to do with all the free
cash they generate. They can pay dividends, they can buy back
stocks, they can invest back in the business or they can acquire
other business. In order to compound their capital, the most
efficient way is to invest in their own business or other business
where they earn above average rate of return. If they pay
dividends, they no longer have the dividend to do that. So it's a
marginally less efficient way for us to compound our capital.
: How do you deliver above average return with below average risk?
It's intuitive. The businesses we own in the portfolio have more
growth, higher return on capital, strong balance sheet and
frequently lower valuation than the market.
Akre Focused Fund is very focused. Your top 10 holdings are about
two-thirds of the portfolio. And some of them you have held on for
20 some years through good markets and bad markets. Stock markets
go up and the valuation is not as attractive. Isn't that a high
Not necessarily. The requirement for a great business for us has
three components. First of all, we spend a lot of time trying to
understand what's causing this above average rate of return to
occur. Is it getting better or worse? Secondly, we want to see a
shareholder friendly management. Lastly, we look for a history of
reinvesting the free cash flow as well as the opportunities to
reinvest the free cash flow at above average rates. None of these
is constant. Business models get better or worse. People's behavior
changes from time to time. The ability to reinvest varies from time
: Why is it so hard to find companies that have all these three
: Business models change over a period of time so they'll behave
differently in different environment and you watch that. People's
behavior will change over time.
: Let's use
) as an example. You've owned it for more than 20 years, and you
stuck with it for those 20 years.
: I have. In 2013, the growth in book value per share was 18%. In
the last five years, it's 17%. Over the last 20 years, it's
probably 14%. It will go up and down with all kinds of issues. For
instance, the level of interest rates is at a 30-year low. With a
business that is leveraged in their investment portfolio, that
makes a difference. Pricing in the property and casualty business
was negative for seven or eight years, only began to get better
about a year and half ago. So during the past 10 years, there was a
period of time when the growth in book value dipped below 10% but
that didn't cause us to sell the security because in 2013, it was
back to 18%. To have that kind of real economic earnings growth in
zero percent interest rate environment is wonderful.
: So the return of the company is wonderful. What about the stock
: The stock price has reflected what's going on with growth in BV.
In 2013, the growth in BV is over $70 per share. Today's stock
price is in the $620 range. That is still less than 10 times the
real economic earnings of last year. The change in BV last year was
in fact the real economic earnings.
: What do you look for in a underlying business?
America's business probably has single-digit margins and return on
equity is probably in low teens. If we can find a business that has
margins and return on equity significantly higher, which causes us
to get curious about why is that occurring? The simple reasons
would be patent, lack of competition. Sometimes we say well we
don't know precisely why they are able to do this but this is what
we think it is and that's OK. We've learned to get comfortable with
not being 100% sure. If it's a really secret sauce that management
is unlikely to share with us because it invites competition. And if
you have a business that has high return on capital that will
naturally invite competition. We spend a lot of time studying other
companies in that line of business and other businesses that are
: Can you give me another example?
) for example. It's a vertical business. The model is more towers,
more tenants per tower and more rents per tenant. Their contract
with the carriers typically has annual pricing escalators so every
year they're getting 3% to 4% more. In addition, when you go from
1G to 2G to 3G to 4G, each of these requires a denser tower
network. Each is a profitable opportunity for American Tower. So
it's a very protective business. In the last half a dozen or more
years, they've been growing extensively outside of the U.S in 11
different countries. You can see why they are getting higher
returns on the assets. On the other hand, if you take businesses
), it's much more difficult to figure out why they have such high
returns on capital. They are unable to invest in other businesses
that have as high return as theirs. So they still have something to
do with the enormous amount of cash they generate. They invested in
some small businesses such as mobile payments companies, but they
can't do it on a larger scale. So they've been paying dividends and
repurchasing shares but doing so makes the compounding more
It sounds like their sustainable model in the future is more
difficult than it is for American Tower.
: It might be. But there's ubiquity of acceptance of Visa card and
MasterCard anywhere in the world. It continues to grow. And their
business model is that not only do they get paid on each
transaction, but also they get paid on the currency on each
transaction. It's a wonderful inflation hedge. If the currency gets
devalued against the dollar, they get more money. It's a
fascinating business model.
You also have what you call the workbench companies. They are
almost like workouts. Could you share one example?
) is one of those. We started with a very small piece. We are
attracted to it for a number of reasons including what their
business plan and model was. They acquire other industrial
companies and through a technique of their own, which is based on
Toyota's continuous improvement system; they improve, rationalize
these businesses dramatically. So they source these underperforming
businesses, buy them, improve them dramatically and increase the
rate of return. The company was founded by Mitch and Steve Rales,
who had also founded over 30 years ago a company called
), which has compounded its value by more than 20% for more than 30
years. They are both significant shareholders. And we thought this
could be a Danaher reduct.
Tell me what you look for in management.
You want find management that is terrific in managing the business
and presumably they already have demonstrated that by the time we
get involved. We ask them how do you measure your success in this
company and by what means. We listen to them and make our judgment.
Sometimes you get answers such as the stock goes up. Sometimes you
have CEOs watching their stock price on the screen all day long.
That's not a characteristic we find attractive. Our quick judgment
is that their eyes are on the wrong way. We are interested in how
they discuss how they reinvest the free cash flow they generate,
how they discuss the arrangement in their balance sheet, how much
debt capital they plan to deploy and why. At the end of the day, if
this business can be quantified, then I wouldn't have a job.
How many mangers out there can afford to think the way you think?
: I don't think any of them are striving to think the way we think.
They'll get to their own conclusions about how to operate the
business. And many of our businesses have shareholder support, and
they've attracted the type of shareholders that they deserve.
Why is it so difficult to identify a good investor, and what's your
definition of a good investor?
Well, at the end of the day, it ends up having to do with outcomes
and outcomes relative to goals. So the issue then comes down to is
there anything that you can do or understand that can help you
predict whether this manager can produce an outcome that is
consistent with your goal. 2009 was a very difficult year, but
people who understand what we stood for and were not worried about
the balance of their accounts have done wonderfully since then by
sticking to the program.
: One long-term investment for every investor, what would it be?
: Markel. Everything about the business is terrific. Today they
have a $17.5 billion investment portfolio on just less than 14
million shares outstanding. So they have enormous leverage to the
opportunity of rising rates. Secondly, pricing on the property and
casualty business has started to improve since a year and half ago
after seven ugly years. Thirdly, they made an acquisition last year
that doubled their gross written premium. Four, they have taken an
attitude that is slightly more opportunistic about managing their
balance sheet. And five they have a division called Markel Ventures
that is growing a stream of income away from the insurance company.
You can buy it less than 10 times economic earnings and have a good
shot that it can compound our capital on average probably in the
mid-teens for the duration.
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