Chuck Akre - The Three Legged Stool - [Invest Like the Best, REPLAY]

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1:29Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com. Patrick O'Shaughnessy is the CEO of Positive Sum. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of Positive Sum.

2:05This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Positive Sum may maintain positions in the securities discussed in this podcast. To learn more, visit p-s-u-m dot v-c. My guest today is Chuck Ocrie, a now widely famous investor who founded Ocrie Capital Management in 1989, which now manages approximately$10 billion. We discuss his investing style and his three-legged stool for evaluating companies. Please enjoy this great conversation. So given that Chuck, this is my first time here in Middleburg, I thought it would be a fun place to start with the place where we're sitting.

2:45You've talked a lot about the one traffic light town as maybe an advantage, something very different from the typical investor. Talk about Middleburg, why you're here and what you love about it. We're here because of, in effect, quality of life issues. And I happen to be a person who works well without a lot of commotion around. And I know lots of people in the business who love commotion. And I've worked with some of them. But the low level of activity around here is just helpful for us being able to sit there with our doors open and not be disturbed by outside events. And then as it relates to, let's say, Middleburg versus Central Park South, if my office were there, I'd have a thousand friends who are very bright and very interesting, and I would be distracted.

3:30I'd become curious and engage in their thought process, and it would distract me from what it is that I do well. So investing on an island, so to speak, in a very bucolic, beautiful spot. Yes, indeed. We live on a farm and that sort of stuff, so it all fits together. We're going to talk a lot about the ideas of nirvana investing, the three-legged stool, the components of that, et cetera. But I'd love to begin with, given that you've created this sort of interesting isolation for yourself, what a day looks like for you. So at this stage of your investing process, what are you literally spending your time on day-to-day?

4:03Is it looking through businesses? Is it checking in on existing businesses? How's that sort of allocated? My participation in the business evolves and continues to evolve and so on. And so I'm personally doing less pure fundamental research today than I did years ago. There are others here who do that. And we talk about ideas and stuff all day long. And I spent a lot of time reading. And that's how ideas bubble up in my universe. And others here use screens, but mostly where it is a serendipitous, inefficient, let's just say, non-quantitative approach. You mentioned before this idea that imagination is as or more important than knowledge.

4:43Can you talk about that concept a little bit? Well, it's very simple. I have, in my career, run across literally thousands of people who are very, very bright, who are not necessarily good investors. And so pure knowledge is in and of itself not a ticket to being a good investor. Imagination and curiosity are what's hugely important. And we've discovered things over the years purely by being curious and continuing to keep involved in the search process to find these exceptional businesses. Can you distinguish it all between curiosity and imagination? One sounds like a search and another sounds like more of a creative force.

5:18Well, they're both creative. My older son was a tenured college professor for a while. And he used to say that he worked at a university that, as he said, didn't have the luxury of being highly selective in its student body. And he said the thing that disappointed him the most was that even his best students, his students who got A's, typically only wanted to know what they needed to know to get an A rather than have curiosity. And I find that curiosity has been useful to me in search for investing and in relating real life experiences to allowing me to pursue lines of thought, whether it's trying to figure out why a stock cart track might be interesting or something else, that sort of stuff.

6:01So I guess I'm probably not very articulate in explaining the difference between curiosity and imagination, but they go hand in hand in being creative and identifying businesses. I think the manifestation I love is in the Nirvana three-legged stool idea. I'd love to hear the beginnings of that. Obviously, talk about what those three legs are in the stool. And then I'm always interested also in rates of change. Yeah, we literally have the stools here in the room that we're in, which is awesome. So talk about the origins of those three simple ideas. The one on the far left over there is a milking stool from Frederick County, Maryland.

6:34that belonged to the senior partner of my father's law firm and used as a milking stool. And if you could see it from this angle, the one leg there in the back is more of an angle than the other two. And the farmer who would sit down and milk an individual cow one at a time would take that long handle and stick it up under his behind as he sat down to milk a cow, got close to the ground where he could work. And if you observe that, it's actually the three legs are sturdier than forelegs. It can adjust to uneven ground easily that forelegs cannot do. I liked that notion and it had come to me from my father and it was just sitting on a table in my office one time and I sort of began to adopt that as the, what I call the visual construct for what we choose to describe as the pinnacle components of what makes a great investment.

7:26And that's something that I came to because I had no background whatsoever in the business world. And I was an English major and I'd been a pre-med student before I was an English major and I had no courses in business whatsoever. So I had a clean canvas and a willingness and a desire and a curiosity to learn. And so my voyage was what makes a good investment, what makes a good investor. In trying to put all this together, there was a quantitative aspect to it. But we end up describing what makes a good investment as each of those three legs. Well, I'll back up again a little bit and say that our investment goal has always been from the outset to try to produce an outcome that's above average.

8:09But stepping back even a step further, I examined early on and continue to rates of return in all different asset categories and made the observation that the rates of return in common stocks over a long period of time was higher than anything else on an unleveraged basis, on a consistent long-term basis. At the rates of returns on common stocks in the United States in, let's say, roughly the last 100 years is in the neighborhood of 9 % to 10%. And in fact, we don't care what it is precisely. We want to know what it is generally. We made a quantitative observation about why that's so. And that observation is that in our judgment, it corresponds, correlates to what the real return on the owner's capital is in those businesses.

8:55And we can have done many times a quick little show and tell about why that's so and conclude that our return in an asset will approximate the ROE. In our case, we usually use free cash flow return on the owner's capital. Given a constant valuation and given the absence of any distributions, you get that from your quantitative background completely. And then you would wisely say, well, Chuck, everybody knows you don't have constant valuation in the market. So we understand that too. So we work hard to have a modest starting valuation if we're just simply to try to reduce that risk. And so understanding that if our goal is to have above average outcomes, we need to have businesses that have above average returns.

9:38That's the first leg. We try to identify businesses that have had high returns on the owner's capital for a long time. And we've spent a lot of time trying to figure out why that's so and what's caused that. And then what's the runway ahead of them look like? Is it broad and long? Do they still have the opportunity to earn hybrid, above these above average returns on capital and so on? And then we want those businesses to be run by people who have demonstrated they're clearly great at running the business because they've achieved this, but also who, by our observation, treat us as partners, even though they don't know us.

10:12You've read it enough times, I'm sure, but I have an expression where I say that our experience is once a guy sticks his hand in your pocket, he'll do it again. And so we just have no reason to go there. I mean, it's human behavior. We constantly find people whose behavior is antithetical to our interest. And so leg one is the quality of the business enterprise. Number two is the quality and integrity of the people who run the business. And then the third leg is what is their record of reinvestment and what is their opportunity for reinvestment? And so we have all those things that we say, once we have those in place, then we're just not willing to pay very much for these businesses.

10:49Those are the three legs of the stool. People remember that, but they get confused by this. say, oh, yeah, you're the three stools, aren't you, or something like that. It was just a shorthanded way for us to sort of visually say, one, two, three, this is what's important to us. And our experience is that if we own exceptional businesses, one of the hardest things in the world is to not sell them. All businesses have hiccups in their business operations, and all businesses have things that occur that's unplanned for or thought about, but not necessarily expected, and that's life. I mean, nothing is perfect.

11:23Nothing is Jack Welch's 20 % a year, take it to the bank. Long after he's left, we found out that much of that was a house of cards. And so we just had our 30th anniversary for Ackley Capital Management and did some presentations. And one of our partners did one. It was entitled The Art of Not Selling. And it's truly very hard to do. And in fact, it may be one of our great assets is our ability to not sell. I'm a quant, but I recognize the art in each of those three legs of the stool, and I'd love to spend a few minutes on each. So I came across a really interesting story in preparing for our conversation about a company called Bandad.

11:59And I'd love to hear that as an example of trying to identify the essence of an underlying business's value creation and why its ROE can be above 9 or 10 for a long period of time. So this was actually in the days when I was at a firm called Johnston Lemon in Washington, D.C., and it was a brokerage firm. And I was a principal in the firm. And we had some interns around. And I took an inbox that was full of things I'd tear out of magazines and papers and put in a box and gave them to this intern and said, look through there and see if you find anything interesting. And a week later, he came back.

12:35And he said, well, here's a really interesting company called Bandag. And why is it interesting? Well, it had very high returns on capital and done well for a long period of time. And I said, well, great. What business is it? And he said, it's the entire business. And I looked at the returns in the capital and said, well, it's clearly not in the tire business. What do you mean? I said, well, take a look at the returns and then take a look at the returns of all the other tire businesses you find and see how they relate to each other. And bandags was three or four times what they were. I mean, I said, obviously, it's not in the tire business.

13:04It's in another business. Our goal is to figure out what business it's in. So we went out to see them. And a fellow by the name of Marty Carver was running the business that had been founded by his father. It was in Muscatine, Iowa. And I got to the meeting, and Marty had his feet up on the desk and was eating an apple during our interview. And so you got a different feel right off the bat. And their business was retreading truck and bus tires. It's something I really knew nothing about before then. And we had been through the oil embargo in the United States in the early 70s, where prices of gasoline went through the roof.

13:42and one of the principal components of tire molding and recapping is, of course, petroleum-based. And so it had caused all of their dealers to have a huge increase in the cost of doing business. And when prices began to come back down, Bandag took those savings and distributed them to dealers on the basis that they had to use the money in the business. They couldn't go buy new Cadillacs, but they could build a new store. And so their principal competition was the major tire companies, all of whom had company-owned stores. All the Bandag stores were franchised. So they were dealing with independent dealers who, as they say, got there at six in the morning and closed at nine at night, as opposed to the employee dealers who got there at nine in the morning and left at six at night.

14:30And these people were motivated by their own profits and whatnot. And so Bandag very wisely shared the wealth, as it were, with their dealers instead of passing it all on to their shareholders at that time. And it created a huge dealer loyalty. And the dealers were able to, they did very sophisticated things about identifying the cost of fuel to a trucking operation if they had a Bandag tread on their tire as opposed to some other kind of tread. And truck tires and bus tires are built and designed to be retreaded two or three times. Most people don't know that. Automobile tires are not. Truck and bus tires are constructed that way.

15:12At any rate, so they had built this huge loyalty network of independent dealers who continued to use the Brandeig name and product in their business instead of national tire companies. And as a result of that, the company had much higher returns on capital than other tire companies. And so that was an issue of curiosity and observation and imagination and doing that sort of stuff and making the mark of Marty Carver. And as I say, his father had founded the business and his father had sort of gone off the deep ends before this. He bought an enormous yacht, 100-foot yacht, and started going out with Las Vegas showgirls and all those kinds of things like this because the business had been very successful.

15:51And it was an interesting experience. You have to be curious and open to those things to have them work out. And at the end of the day, the business really ran into trouble expanding in some Western European countries where they land into labor issues and so on. And so we moved on after a while. We owned it for a long time, though. One of the major trends these days is enormous value creation by fairly young companies. That's happened very quickly, the big technology companies. In this period, you've managed to do quite well. Most, I guess I wouldn't classify you as a value investor, but value investing as a style has done very poorly.

16:23I'm curious how your assessment of underlying business value in that first leg of the stool has evolved, say, over the last 10 to 15 years. Are there major differences in what you're looking for in defining a great business? Well, so the first difference is that in the last 10 or 15 years, the overall returns of all businesses have gone down. And they've gone down, in my mind, in our judgment here, because of the lower level of interest rates, the pervasive lower level of interest rates. And while it doesn't, you don't necessarily A equals B plus C, it is a pervasive effect, and it's caused the returns in all businesses to be lower in our judgment.

16:58The second thing is that the way some of these businesses have earned their returns are ways that were new to us, and we didn't catch on to them. So our returns in the last few years, which have been, continue to be well above average, have been done entirely without any of the FAANGs or any of those businesses, without any of them. And it's just because we weren't smart enough and quick enough to figure them out and that sort of stuff. How do you think about that moving forward? Every day is a learning day. And we have to figure out which of those businesses, if any of them, are truly attractive and are not subject to rapid changes in technology or governmental intervention or retaliatory issues relating to different countries and different parts of the world and that sort of stuff.

17:43Maybe an interesting way to dive in deeper on that would be to talk about recent businesses that either you've bought. I know you hold for a very long time. So some of the recent ones might be seven years old or something, but talk about something, industries, companies, whatever that you find most interesting in recent times. Well, so we try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in or going out. So the issues are all the same. I mean, this is 2019. In March of 2010, we added our first position to MasterCard. And it was during the time of Dodd-Frank and issues at Congress, and then more specifically about what became known as the Durbin Amendment.

18:22And MasterCard and Visa were selling it 10 or 11 times. And when you dove into the numbers, we discovered that the operating margins, returns on capital were, there's not a word in English language that's superlative enough to talk about them. I would just say that you could cut the margins at MasterCard and Visa in half twice, and you'd still be above average for an American business. So clearly something extraordinary is going on there. What does it mean? I asked this question rhetorically around the office. What does that tell you? Well, it tells you, A, there's a big target on their back. Everybody wants some of that.

18:58B, it tells you that they're probably jamming every expense they can think of into the income statement to try to reduce how good the margin is that they're showing. And then three, we spent time trying to figure out what's causing that. We think we know, and we've quit talking about it. So I'm not going to talk to you about it. But I mean, if you read any research from Wall Street, and we'd read very little, there is no one who talks about that, who talks about rates of return that they're earning on their capital. I mean, no one does. Because Wall Street in general has a completely different business model than we have.

19:35Our business model is to compound our capital. Wall Street's business model, generically, is to create transactions, logically. Well, what's the best way to create a transaction? To create what we call false expectations. And what are false expectations? Well, earning estimates. O'Shaughnessy is going to earn$1.73 next quarter. And it comes in at$1.72. And the remark is, they missed by one. So we call it beat by a penny, missed by a penny. That's the syndrome. And that gives us opportunities periodically because the markets behave in ways that we happen to think are irrational relating to something like that.

20:14And so a name that's been in the news for four years now and had some controversy around it is Dollar Tree, where we own a big stake. The dollar store business was really in the oligopoly in the United States with three major players, Family Dollar, Dollar Tree, and Dollar General. Dollar General had been taken private and brought back public by KKR. Dollar Tree had not been headquartered in Chesapeake, Virginia. Now on basically their third CEO in their history. And there is a business that we, through experience, have learned were terrific retailers and terrific at logistics, building and managing 7 ,000 stores where they sell everything for a dollar.

20:52Dollar Tree, nothing was more than a dollar. The two competitors, Dollar General and Family Dollar. and Family Dollar, still run by the founding family, basically made itself available for sale. And Dollar General had had lots of private conversations with them over a period of years, and then it sort of became an auction. And Dollar Tree had a lower bid, but won the bid. Family Dollar selected them. Both companies, Dollar Tree and Dollar General, simply had to bid on that. If it's a three-company oligopoly going to two, they both had to bid on it. It was going to cause Dollar Tree to basically double the number of stores, how many opportunities you get to that once.

21:30I'm curious if there are other markers that you've used heuristics over the years in addition to this simple idea of really high ROEs or ROICs or something above the market to sort of be the lead generation for new curiosities. Yes. Yeah. What does it say? Everything should be made as simple as possible, but no simpler. There you go. So lots of very bright people can build really intriguing, complicated ways to figure out why something is cheap or expensive. And we try to keep things as simple as possible. And if you read the one right behind you. Sure. The bottom line of all investing is the rate of return.

22:05And so we use that as. That's the tool. As our key tool for everything. And we try to look at everything from a top-down basis. So we were talking about the FAANGs and modern technology. We say that as a generalization, all of that is about changes in distribution of all kinds, Whether it's information or cars or Amazon starting with books and then to selling everything in the world and then to selling cloud services, it's all about distribution. Distribution of saving information, that sort of stuff. And so that's looking at things in a simple fashion. Let's try to make it as simple as we can and understand the big context of what's going on because we're all at risk of getting caught in the weeds of what's going on.

22:46And that's misleading. Do you think it's fair to, I love this idea of innovation in models of distribution. Van Dijk was a kind of fun and interesting example of that. Do you tend to separate things into product innovation and distribution innovation? No. Evaluating a business? No, we're not that smart. Not that smart. Seems to be working okay, not being that smart. It works okay. That's important. That's an important observation. It's working okay. Let's talk about the second leg of the stool, which is the people involved in these businesses. So what are the, I love the feet on the table with eating an apple.

23:15What would you say are the most common characteristics of managers of the businesses that you've ended up owning those stocks for a long period of time? Well, they don't have a screen in their office showing them the price of the stock. And there are lots who do. And sometimes you find it in the lobby of a company and sometimes you find it on the CEO's desk. That doesn't interest us. We've had instances where principals and companies have called us up and said, why are you selling our stock? Once we recover from that affronting question, if in fact we have been selling the stock, which may be the case, or we may have sold it all, we say, well, actually, that was clearly the right decision, because we don't want to be partners with people who are concerned about those things running their business.

23:55Their focus is on the wrong thing, in our judgment. And so this is an interesting exercise. One of the questions that we like to ask of a CEO particularly is, how do you measure whether or not you've been a success in running this business. And as you might expect, some of them say, well, the price of the stock goes up, or we hit our earnings target, or we delivered in all the things that the board asked of us, and so on. It's a rare occasion where the CEO articulates an idea that shows that he understands the idea of compounding the economic value per share. They stand back and say, well, well, why is that so?

24:37And the answer is that they're not trained to do that. They're trained to run businesses. They're not trained to think about compounding the intrinsic value for the economic value per share is really the single most important thing. That sounds like a capital allocation story. I know you're a huge fan of business biographies. And some of my favorites have always been the Henry Singleton types of the world who are sort of master capital allocators and often very flexible. Talk about the role of capital allocation amongst the CEOs in the second leg of the stool. So we own a company called O 'Reilly Automotive, and it's also part of an oligopoly.