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ChuckAkreontheSearchforCompoundingMachines
byRusselKinnel|013012

WetalkedwithChuckAkrewhobuiltanoutstandingrecordsubadvisingFBRFocus
beforethetwosplitandAkrelaunchedanewfund, AkreFocusAKREX.Herunsa
concentratedgrowthstylethatreallyisunlikeanythingelseyou'llfind.
RussKinnel:Canyoutellusalittleabouthowyoubuilttheteamupandwhoisthere?
ChuckAkre:IstartedoffAkreCapitalManagementin1989.So,wedohaveanewfund,
whichbecameeffectiveAug.31of2009.Theanalystswhohadworkedwithmeonthe
fundandotherthingsandthepriorfundleft,andwebuiltanewteam.InOctoberof2009,
weaddedTomSaberhagen,whohadbeenasenioranalystattheAegisValuefund.In
Novemberof2009,weaddedJohnNeffwhohadbeenasenioranalystonthesellsideat
WilliamBlair.TheninSeptemberof2010,weaddedAndrewOsborne,whofallsinsortof
therookiecategory.Ithoughthehadgreatinstinctsanddonequitealotofworkinthe
investmentbusinessasanindependentthinker.
Kinnel:Doeseachanalysthavesectorspecialtiesoraretheygeneralists?
Akre:Well,theyareindeedgeneralists,butquitenaturallytheirareasofexpertiseare
slightlydifferent.TomhasanundergraduatedegreefromRiceandanMBAfrom
Stanford.Tom'sbackgroundinthefundbusinesswasdeepvalueshop,andJohn's
undergraduatestudywasatColgateandthenheattendedBoothSchoolattheUniversityof
Chicago.HecamefromagrowthshopatWilliamBlair.So,thestockstheyfollowtendto
fallintothevalueandgrowthcamps,respectively.Themorerichlyvaluedcompaniesare
typicallylittlehighergrowers,fastergrowthrates,andthosearegenerallythingsthatJohn
isinvolvedin,andTomhasbeeninvolvedinthingswhicharealittlebitmoremodestly
valuedandmoretraditionalintheirnature.
Kinnel:You'vesaidyoulookfor"compoundingmachines."Wouldyouexplainwhatthat
means?
Akre:WhenIstartedintheinvestmentbusinessagoodwhileago,Iwasnottrainedforit
inatraditionalsense.Ihadbeenapremedmajor,andthenIwasanEnglishmajor.So,I
quitenaturallyhadallkindsofquestionsabouttheinvestmentbusiness,andamongthem
werethequestionsofwhatmakesagoodinvestorandwhatmakesagoodinvestment,and
takingalookandstudyingdifferentassetclassesusingdatafromwhatisnowyour
subsidiaryIbbotsonandotherplaces.Icameacrossthewellknownpieceofinformation
thatoverthelastroughly90yearscommonstocksintheUnitedStateshavehadan
annualizedreturnthat'sintheneighborhoodof10%.
So,myquestionnaturallywas,well,what'simportantabout10%?WhatIconcludedwas
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thatithadacorrelationwithwhatIbelievewastherealreturnontheowners'capitalofall
thosebusinessesacrossallthoseyears,allkindsofdifferentbalancesheetsandbusiness
modelsi.e.,thattherealreturnonowners'capitalwasanumberthatwasprobablyinthe
lowteensandthereforethatkindof10%ishreturncorrelatedwiththat,anditcausedme
topositthatmyreturninanassetwouldapproximatetheROEofabusinessgiventhe
absenceofanydistributionsandgivenconstantvaluation.So,then,wesay,well,ifour
goalistohavereturnswhicharebetterthanaverage,whileassumingwhatwebelieveis
thebelowaveragelevelofrisk,thentheobviouswaytogetthereistohavebusinessesthat
havereturnsontheowners'capitalwhichareabovethat.
Earlyinthe1970s,IcameacrossabookwrittenbyaBostoninvestmentcounselor,whose
namewasThomasPhelps.Andthebookhewrotewascalled100to1intheMarket.You
probablyknowfromthehistorybooksthatPeterLynchwasaroundBostoninthosedays,
andhewastalkingaboutthingslike"10Baggers."ButherewasThomasPhelps,whowas
talkingabout"100to1."Hedocumentedcharacteristicsofthesebusinessesthatcaused
onetohaveanexperience,wheretheycouldmake100timestheirinvestment.Theanswer
is,ofcourse,it'sanissueattherateatwhichtheycompoundedtheshareholders'capitalon
aperunitofownershipbasisandthosethatcompoundedtheshareholders'equityata
higherratehadhigherreturnsoverlongperiodofyears.Andsothat'swhatcomesinto
playisthisissueofcompoundingcompoundmachines,andwe'reoftenidentifiedwiththis
thinginourprocessthatwecallthethreeleggedstool.Thelegsofthestoolhavetodo
withthebusinessmodelsthatarelikelytocompoundtheshareholders'capitalatabove
averagerates,combinedwithlegtwo,peoplewhorunthebusinesswhoarenotonlykillers
atrunningthebusinessbutalsoseetoitthatwhathappensatthecompanylevelalso
happensatthepersharelevelandthennumberthree,wherebecauseofthenatureofthe
businessandtheskillofthemanagerthereisbothhistoryaswellasanopportunityto
reinvestalltheexcesscapitaltheygeneratetoreinvestthatinplaceswheretheyearnthese
aboveaverageratesofreturn.
Themostcriticalpieceofthatisthelastleg,thatreinvestmentleg.Canyoutakeallthe
extracapitalyougenerateandreinvestitinwaysthatyoucangetcontinuedearnings
aboveaverageratesofreturn?Andthat'satthecoreofwhatwe'reafterinourinvestments.
Kinnel:Onthesellside,deteriorationonthosekeyfundamentalsmayleadyoutosell,but
doyoualsosellonvaluation?
Akre:So,inresponsetoyourfirstobservation,deteriorationtoanyoneofthosethreewill
certainlycauseustoreevaluateit.Itwon'tautomaticallycauseustosell,butitwill
certainlycauseustoreevaluateit.Ournotionisthatifwedon'tgetthosethreelegsright
wheretheredevelopdifferentlyinthefuturethantheyhaveinthepast,theoreticallyour
lossisthetimevalueofmoneythatithasn'talwaysbeenthecase.Butthedeteriorationof
oneofthoselegsormorethanoneofthoselegsdiminishesthevalueofthatcompounding
and,indeed,islikelytocauseustochangeourview.That'snumberone.
Numbertwo,theissueofsellingonvaluationiswaymoredifficultforus.Andwhatwe've
saidisthatfromamatteroflifeexperience,ifIhaveastockthat'sat$40andIthinkit's
waytoorichlyvaluedandIsellitwithagoalofbuyingitbackat$25,mylifeexperience
isittradesto$25.01ortradesthrough$25andbackupandittrades200sharesthere.The
nexttimeIlookatit,it's$300,andI'vemissedtheopportunity.It'smywayofsayingthat
thereallygoodonesaretoohardtofind.

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IfIhaveoneofthesegreatcompounders,I'mlikelytocontinuetoownitthroughthickand
thinknowingthatperiodically,it'slikelytobeundervaluedandperiodicallylikelytobe
overvalued.Thethingsthatcauseustosellwhenoneormoreofthelegsofthestool
deteriorates.Occasionally,onavaluationbasis,maybewe'lltakesomemoneyoffthe
table.
Lastly,ifwe'retryingtocontinuetomaintainaveryfocusedportfolio,ifwerunacross
thingsthatwethinkaresimplybetterchoices,thenwemaymakechangesbasedonthat.
Kinnel:You'vecommentedbeforethatyou'vegotsomeofthedefensivenameslikeDollar
Treeandothersinpartbecauseyou'reconcernedaboutaweakeconomy.Isthatstillthe
case?
Akre:Yes,theUnitedStateswillcontinuetohavewhatwecalltheconstrainedconsumer.
Andtheconsumer,asyouwellknow,representstwothirdsor70%ofoureconomy.The
consumerisconstrainedbysomethingthattheeconomistscallU6,whichispeoplewho
arenotworking,thepeoplewhohavegivenuplookingforjobs,andthepeoplewhoare
workingfewerhoursthantheyneedto,andthatnumberiscertainlyatleastinthemid
teens,ifnotinthehighteens,meaningoneoutofeverysixorsevenworkingageadultsis
constrainedintheemploymentarea.Eitherthey'renotworkingornotworkingenough
hourstomakeendsmeet.
So,oneoutofeverysixorsevenconsumersisconstrainedbyemploymentissues.In
additiontothatthey'reconstrainedbydiminishedaccesstocredit.Notonlyarehome
equitylinesnolongerubiquitous,theabilitytorefinancehousesandtakeoutbuiltup
equityisgreatlydiminished.And,furthermore,bankshavetightenedunderwriting
standards,andcreditcardshavetightenedtheirlinesofcreditstandardsandsoon.So,the
consumerissimplynotabletospendtodayashemighthavespentinthefirstdecadeof
thiscentury.Beinginvolvedinbusinessesthatallowtheconsumertostretchthedollarisa
greatplacetobe,andamongthosearethenamesthatyoumentionedDollarTree,also
RossStoresandT.J.Maxxandsoonanditturnsoutthattheywereextraordinary
businessesinthegoodtimes.Wejusthappentothinktheyareverywellpositionedtobe
verygoodperformersintimesthatarelessrobust.So,weprefertocallitthatratherthan
sayingdefensiveplays.Itmaybethattheyaredefensive,butyouwouldn'thavethought
thatbythewaythey'veperformedinthelastcoupleofyears,northewaythey've
performedinthefirstdecadeofthiscentury.
Kinnel:AndanotherthemeIseethereisinterestingfinancials,someofwhichareinthe
assetmanagementbusinesslikeLPL,Hartford,DiamondHill.What'stheattractionthere?
Akre:Weareinthatbusiness,inthebusinessofstraightassetmanagement,sowehavea
prettygoodunderstandingofthatbusinessandthinkthatoverallit'saterrificbusinessto
bein.Ithashighreturnsandsoon,anditwillbeaffectedbytheoverallreturnsinthe
marketplaceandthingsofthatnature,butwethinkoverallit'sagoodplacetobe.It'sjust
thatsimple,andvaluationshavebeen,generallyspeaking,reasonablyattractive.
OnHartford,Icansayquitedirectlythatwearenotinitbecauseoftheirasset
managementbusiness.Wejusthappenedtothinkthatattheverysignificantdiscountsto
bookvaluethat,inthenexttwoorthreeyears,theywillbeabletosubstantiallywork
throughthoseinwaysthatwillresolveinfavorofshareholdersandthatwouldbewhatI
wouldcalladefensiveposition.
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Kinnel:Iwonder,ifyoucouldtalkaboutcash.You've(often)heldasignificantamount,
sogenerallyhowdoyoumanagethecashposition,andwhereisthattoday?
Akre:Well,ImanageitasbestI'mable,anditisinaperiodofgreatgrowthwhichwe're
experiencingrightnow.Imean,justsoyouknowit,youwouldn'thaveanyreasontoknow
it,thefundisnowat$700millionandtwomonthsagoitwasjustalittlebelow$300
million.
So,that,obviously,materiallyaffectsourcashposition.ItellpeoplethatonSept.1,2009,
westartedwith100%cash,andgenerallyit'scomedownsincethen.Ourlowestcash
balanceinthelastthreemonthsgotdownintosingledigits,andit'snowprobablyup
around30%becauseoftheinflows.Andwelikedayswherethescreenisred,soyoumake
yourownjudgmentabouthowrapidlyweareputtingstufftoworkbecauseofwhetherthe
screenisredorgreen.
Kinnel:Isthereupperlimitonhowbigyourlargestpositionyouareallowedtoget?
Akre:Well,thethingthatdrivesthatmostsignificantlyaretherulesintheindustrywhich
causeustomakesurethatofallthepositionswhicharegreaterthan5%atthetimeof
acquisition,theycan'texceed50%ofthefund'sassets.So,wehavethatlimitationgoing
onallthetimethat'snumberone.Numbertwo,thereisnothingmagicabout10%perse,
asitrelatestoanindividualposition.Andwehaveinthepast,andwe'vebeenmanaging
mutualfundsnowforover15years.Wehaveinthepastthatpositionsthathavegotten
considerablylargerthan10%,andithasaccruedtothebenefitoftheshareholders.Andas
youknow,weasagrouphereandIpersonallyaresignificantshareholdersofthefund.
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RusselKinneldoesnotownsharesinanyofthestocksmentionedabove.

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