Extraordinary business, talented management and great reinvestment opportunities and histories. These are the three criteria, or the “three-legged stool”, for Chuck Akre’s investment approach.
Chuck Akre is an American investor who founded Akre Capital Management. The firm is known for its long-term, concentrated investments in excellent businesses, leading to a 16.7% annualized return since its inception in 2009. It has assets under management of around $14.4B as of Nov 2023.
In this article, I am going to share with you his three-legged stool investment framework to find compounding machines.
Leg One: Extraordinary business
The first step is all about finding great businesses. This involves a quantitative assessment of companies that consistently yield solid returns on equity and free cash flow. Such metrics not only show the company’s financial health but also demonstrate the ability to generate cash while maintaining or expanding its asset base.
Next is to have a moat around the business. This could be brand, network effects, cost advantages or high switching costs. These competitive advantages allow companies to charge higher prices or produce things more cheaply. In a volatile economy, the ability to adjust pricing and keep costs low without losing customers can be a significant edge.
I must emphasize that understanding the business is also important. You can’t make an informed decision if you don’t understand how the company makes money.
Akre warns against investing in industries where regulations limit profits. These rules can be so strict that even the best companies can't overcome them. For example, utility companies are often capped on how much they can charge, restricting their earnings potential.
Lastly, a solid balance sheet is the business’s safety net. It's built with low debt, valuable assets, and plenty of cash. This strong foundation protects the company during tough times and allows it to seize growth opportunities when they come knocking.
"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." - Chuck Akre
Leg Two: Talented management
Investing in a business inherently means investing in its people. Akre says the best companies are run by talented management: skill, integrity, and passion.
Skill encompasses adept decision-making geared for long-term success. Integrity translates to honesty and treating investors as partners. Passion fuels a proactive drive to improve the business.
This management also established a lean corporate culture that emphasized a streamlined and empowering environment.
And when it comes to compensation, Akre suggests picking companies where pay matches performance and long-term value for shareholders. Remember what Charlie Munger says: “Show me the incentives and I’ll show you the outcome.”
"Not only do we want to have great business managers but we want see they treat public shareholders as partners even as though don't know them." - Chuck Akre
Leg Three: Reinvestment moat
The last leg of the stool highlights the “Reinvestment Moat” – that is, the best businesses know how to make their money work even harder.
Such companies know how to reinvest their profits, like expanding their operations or making strategic acquisitions, to achieve higher rates of return. They are using the free cash flow to fuel growth, creating an enduring cycle of value creation. This "reinvestment moat" keeps them ahead of the competition.
"Does the company have the capital-allocation skills necessary and the market potential to invest all the excess cash generated by the business in projects that can earn above-average returns? In my experience this is perhaps the single most important issue facing any CEO, and is also the area in which management can create or destroy value most quickly and permanently." - Chuck Akre
Akre's three-legged stool isn't just a fancy way to evaluate companies, it's a recipe for long-term wealth creation. It starts with an outstanding business, steered by talented management and a strong reinvestment strategy. Nail all three, and you've got yourself a "compounding machine."
The crucial next move? Snagging these businesses at a reasonable price.
As long as those three factors stay robust, hang onto them for the long haul. The magic of compounding will do the rest.
“We will be very disciplined about the price we are willing to pay, as in the end our rate of return will be determined not only by the quality of the businesses we choose to own, but importantly by the starting price as well.” - Chuck Akre
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