Chris Cerrone - A Simple, Quality Discussion
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Bill: This episode features Chris Cerrone, a partner at Akre Capital Management. Akre Capital Management is best known among my colleagues, at least for their patient approach, long-term focus, and selection of high-quality businesses. I enjoyed talking to Chris immensely. I hope that all of you enjoy as listeners. There's no need for me to ramble on when you've got an hour and 50 minutes of Chris to listen to. As always, none of this is investment advice. We are not your fiduciaries, and we are not your investment advisors. You know the drill. So, get your own advisor and do your own work. Nothing disgust is a solicitation or invitation to buy or sell a security. Please remember that the securities identified and described throughout this podcast do not represent all of the securities held, purchase, sold, or recommended for ACM client accounts.
As a listener, you should not assume that an investment in the securities identified was or will be profitable. Past performance does not guarantee future results. Everything expressed here are the opinions of Chris and I. This is all entertainment. So, please keep that in mind as you listen and enjoy the show. We're going to get to Chris, the investor, but we're going to start with Chris, the Josh Waitzkin fan here, and we were having a brief conversation, and then I just said, "Whatever, let's turn on the mic and start recording," what we were talking about is how limited the feedback loop can be in investing and how it would be nice to have some idea, or product, or whatever that would allow you to get feedback in real time almost like a paper trading, but a paper investing product. Then we started talking to Josh Waitzkin. I said, "Let's just go and record this." So, that's the background for people that are just coming in.
Chris: Should we give a little background on who Josh Waitzkin is just in case? [crosstalk]
Bill: Sure. Yeah, man. You're driving this conversation as much as I am.
Chris: All right. Do you want to do it or do you want me to [crosstalk]
Bill: No, you do it. I had Adam Robinson on and Adam's friends with Josh. I think you know better than I do, Josh. You seem to be a big Josh Waitzkin fan.
Chris: Well, so, I consider him a mentor of sorts, even though we've never met. He doesn't know that I exist. It's mentorship in the spirit that Derek Sivers talks about an essay that he wrote called "How to ask your mentors for help," which I recommend checking out. The thing with Josh to me is that, he's an inspiring example of someone who to use his own words embraces his funk. He lives his life unapologetically true to himself. There're some other people out there, who I would describe that way, and those are usually the people who I gravitate towards, and who I have just the most respect for. He is a very private person, but he wrote a book, The Art of Learning, which is a great, great read for anyone who hasn’t picked it up.
Bill: Josh is the kid, who they wrote searching for Bobby Fischer after, right?
Chris: Yeah, exactly. He was the subject of searching for Bobby Fischer. He was a chess grandmaster. He basically learned how to play in Washington Square Park in New York City against the guys who play there, rain, sun, snow, what have you. They're out there playing and he learned a very, I think scrappy, intuitive form of chess. The book is great because it chronicles his evolution. He became just passionate for the game. He loved it. Then somewhere along the line, they started trying to teach him the proper way of playing chess and he lost the love for the game. I think that really seems to inform [crosstalk] a lot.
Bill: Dude that's happened to me with golf.
Chris: Yeah?
Bill: Yeah. When I was growing up, I was a field player. I think I was reasonably good. I don't know. I was somewhere around a three, or a five, or something like that. But to get to the next level, it got so technical, and there were-- I don't know. It took the fun out and then I started dating somebody said, "I'm too far away from being great" and I'd rather date somebody. But it's an interesting comment, because I feel once I got really, really technical and swing thoughts, I lost part of what made me good.
Chris: Well, pin this up, because we'll come back to this, I hope. Because I think one of the most interesting things that he talks about is the importance of doing it your way that, if you follow someone else's path, you'll never achieve that world class performer status. Because you have to really embrace the core of who you are in whatever it is that you're doing, whatever art or activity in order to be really great. But anyway, so Josh, in addition to being a chess grandmaster was a Tai Chi Push Hands world champion as well. He's tackled Brazilian Jiu Jitsu. He tackled multiple mountains, I think, as he calls it in different disciplines, and then he realized, he sat back. I think and he said, "Look, these seemingly unrelated activities where I've had this tremendous success." What do they share and the realization he had, which led to the book, The Art of Learning was, it was his approach to learning these disciplines that allowed him to become world class. He both writes about himself in the book but also shares some of those lessons that he picked up.
Anyway, I think it's fantastic. Somebody asked him, as you're-- He is new and this is as of a little while ago, but the last time Tim Ferriss interviewed him, he was talking about how he is trying to learn the next mountain, which is climb the next mountain, which is this foiling, which is a form of surfing, I guess. Bill: I watch it on Instagram a lot.
Chris: You're out of the water, right?
Bill: Yeah.
Chris: There's a fin, and that's in the water, and it's very fast.
Bill: Yeah, it's pretty cool.
Chris: It looks amazing.
Bill: I'm pretty sure it's what Zuckerberg was doing when he was holding the flag on the 4th of July or whatever.
Chris: [laughs] Is that right?
Bill: Yeah.
Chris: Okay. Josh did and this is where it comes back to what we started talking about with the reps. I guess, he figured out a way to put a motor on one of these things, so that he didn't have to wait for the waves. He didn't have to get dragged in by a jet ski or paddle through. He was able to motor out there and just increase the number of reps that he had on different waves and different falls to the point maybe he could get in a thousand days' worth in a week or something like that, what he would have otherwise been able to do. Because when you're surfing, I'm not a surfer, but I think you wait a while between being able to catch a good wave to practice on. Then the parallels to investing are obviously there, which is we get a limited number of reps. Unlike surfing, I guess, where you would pretty immediately get some kind of feedback, if you found yourself being pounded under the wave, or eating sand, or something like that.
For us, we often have to wait years before we really get definitive feedback as to the success or failure of an investment. So, the idea was somebody asked him, they said, "Well, if you're an investor, how would you increase the rep frequency? How would you increase the speed of that feedback loop?" His answer to the question was, "Well--" He went in a different way. Actually, our mutual friend, Jake Taylor is pursuing this I think a little bit with this idea of somatic feedback.
Bill: Yeah.
Chris: Paying really close attention to the physiological and mental state you were in when you made the decision. How many hours of sleep did I get last night, how do I feel, am I agitated, am I comfortable, am I relaxed when you're making these decisions? Then tracing back the outcome of the decisions to the somatic state, when you made the decision and then hopefully, there's so much information now. You have the watch, the Apple Watch that tracks VO2 Max and your heart rate at all times, and there's the Dexcom, where I guess you can track your blood sugar levels [crosstalk] on a continuous basis.
Bill: Oh, yeah. Don't you have a little needle in your arm the whole time?
Chris: I think so. I'm not a big fan of needles. The idea doesn't work super well for me. Yeah, exactly. You could track all this and you could have a decision journal that doesn't just outline, how could this be the greatest investment I ever make? How could this be the worst investment I ever made in valuation, price, at time of decision but what your blood sugar was and how many hours of sleep you got, and whether you've worked out? So, that was Josh's response, which is really interesting and I think it could be fascinating.
But the other idea that came to my mind was, could you create using historical case studies anonymized situations, where you had a software program, you opened it up, and it said, "Okay, here's this business," and it could be something from 1993. "Here are the transcripts, here's the management team, here's the financial statements, here are a couple industry reports, something." It gave you some amount of information, but made it so that you didn't necessarily know which company it was, so that there was some chance that you could come at this without hindsight bias and knowing what ultimately took place, and then you made a decision based on that, and then it immediately told you how that situation ultimately played out over a long period of time. You could just dramatically increase the number of reps.
For a trader, you would think that would be a lot easier to do, because there would just be so many short-term intervals that you wouldn't necessarily know. But if somebody put the American Express salad oil scandal before you, if you're a student of business, you probably would identify what that case study would be, and then you would know how to answer it. The tricky part would be trying to anonymize it, so that you didn't already know. But I think then, you just like any software, good software program you sell it for a subscription fee to all the professional investors out there, and all the traders, and you're in business.
Bill: Yeah. It's so interesting to watch. I'm sure you have been through-- My tenure as an investor is maybe five years since I've known what I've been doing. The QVC fire is something that, so, I own QVC, and they had this big distribution center that had a fire, and I have never lived through having 20% to 30% of my fulfillment capacity taken offline. I didn't have some framework to work through of how big of a deal is this. The best I could do was call my contact over there and she walked me through how they were thinking about it. They didn't even know. She was like, "Look, people want answers right now. We're more concerned with employee safety. People still can't even get in the building." Is everything okay? They're very real-world operator questions that people have, not a spreadsheet. I think it's an example. I think we're recording on the day that Netflix is off 20%. But people are experiencing a growth pocket and a long-term secular thesis. There're these things I think you almost have to live through to really know how you're going to respond. But living through it, how do you prep yourself for that is really difficult, I think as an investor.
Chris: Well, I think, I've been fortunate. I've worked with and learnt from Chuck Akre for the last 10 years. One of the things that that Chuck brings, which is always super valuable from my point of view is, he has that collection of experiences, that's cumulative, over all those years, and he can draw on past events, and that have parallels to what's going on today, and that can be really helpful. I think that's why as you go along, investors get better up into a point probably. If you could somehow increase the reps, then maybe you could accelerate that a little bit.
Bill: Circling back to Josh, am I correct that he said that the way that he learns is slowing down? When he was learning push hands, didn't he practice a motion really, really slowly to train his muscles, how to do something?
Chris: Yeah, I think he calls it the mastering the micro in order to master the macro or something. I'm paraphrasing and I'm sure he said it a lot more eloquently than that. But yeah, I think that is exactly what he does. I think you can do that in this example as well with investing, where you could take micro examples and say to your point about Netflix today, instead of trying to get Netflix, the 30-year history exactly right from an investment point of view. Maybe it's just, what is the proper response today based on the information that you've been given over the next three or five years, or something like that. Or, even something smaller and more micro than that, and look at transcripts and say, "Should this comment that was made in this transcript in the third quarter of 2016 be taken as important or not?"
I think that's something that we think a lot about here because of course, as you know, we try very hard not to sell our businesses unless it's absolutely necessary to do so. There's a lot of noise and you're trying to sift through all that noise and make some sense of it and determine whether or not something's a relevant data point or not. One of the things that we do to try to resist the urge to sell or to trade in general is, we do essence statements. So, we write down, it can be a sentence, it can be paragraph, but you're basically trying to get down what the real key idea is about a business.
The other thing I do and it keeps coming back to Josh Waitzkin, but he tells us about this most important question exercise, where I think the way that he uses it is at the end of the day, he basically asks himself, "What's the most important question that I'm facing right now?" Then he turns his mind off, and he lets his subconscious work on that overnight, and then revisits it in the morning. What we do is we try to write down what the most important question or questions are for all the businesses we own, and then what's really important that you do as a follow up to that is you do what he calls gap analysis. How has your articulation of those most important questions changed over time? Because that will show you a little bit about how the evolution of your understanding of a business is changing over time as well.
You don't want to just have a Word document, which you re-save every time you change them. You want to at least have a PDF somewhere, where you've documented-- [crosstalk]
Bill: Yeah, red line [crosstalk] or something.
Chris: Yeah, exactly, and then you track that over time. When you have that essence statement or you have that most important question, and then something comes up on the second quarter call, you just look back to that and you say, "Well, does that impact in a material way what I've written down as being the most important question or the most this essence statement? If the answer is no, then it makes it a lot easier to set it aside and not get too agitated about it. If the answer is yes, then you can take further.
Bill: Then you have work to do. [laughs]
Chris: Yeah, exactly. Then you got to roll up your sleeves and get after it. But it's a great filtering mechanism, I think.
Bill: Yeah.
Chris: We find it really helpful.
Bill: Man, all right, so, first. Subconscious working on it. Is this way you're interested in meditation a little bit, do you think?
Chris: I think for meditation to me what I think meditation holds the key to is being a little bit more present, which is something that I think is a major work in progress for me. It is diligent as I am and as disciplined as I am about getting enough sleep at night, or eating clean, or getting to the gym. I've struggled my entire adult life to cultivate a consistent, meaningful meditation practice. It's just one of these things that I haven't done well and I have also struggled to be as present as I would like to be, and I think the two probably go hand in hand. But no, I haven't really tried to do the subconscious MIQ overnight, and then wake up in the morning and journal. That's the best practice I think is you write down at the end of the day, point that most important question as you go, you go home, you spend time with your family, you sleep on it, you wake up in the morning, and before you check your phone, before you look at email, you look at the news, anything like that, you just journal.
Bill: Start writing on it.
Chris: You start writing and you get that discipline.
Bill: This might be a Tim Ferriss thing, but it could be Shane Parrish, too. I don't know, but stop mid-sentence when you're writing.
Chris: Mm-hmm.
Bill: Write the most important question, and maybe start one more sentence, and just stop halfway through.
Chris: Yeah.
Bill: I [crosstalk] know that's pretty cool.
Chris: Hemingway said that, because that was his way of-- If you stop the sentence halfway through, then you know exactly where you have to pick up the next day, and you get momentum. You're already moving in the right direction, because sometimes if you carry it all the way through to the end of that thought and you end or the end of that task, and you close your book, and you go home, then the next day, you get to your desk and you're looking around and you are like, "What am I going to start with?"
Bill: Yeah. You've got writer's block all over again.
Chris: Yeah, exactly. But if you've got something half written, you just finished that sentence and now you're rolling.
Bill: Ah, that's really smart. I thought that it was because your mind would keep working on it overnight.
Chris: Well that happened too.
Bill: Yeah. I like the idea if it gives you something to write. Something that was interesting, I think that Adam said it on Jim O'Shaughnessy's podcast that the three of us did together, but I had asked Adam or maybe Jim did. This concept of reading 500 pages a day, or a week, or whatever, however, the legend has morphed. Adam's comment was he said, "I like to read one thing and then really focus on it." I think going back to your idea of simplification, getting a lot of bang out of the buck of the work you're doing rather than thinking about five different places or trying to turn through info, it certainly has helped me a little bit. I don't know. I got a long way to go on this.
Chris: Well, I think focus to me is one of the keys to how we approach investments. There's a great line by Phil Fisher goes something like, "I don't want a whole bunch of good investments, I want a few outstanding ones," which goes to that issue of focus. I think it can be hard to keep up with everything. All the documentaries, all the podcasts, all the new books that are being written all the time, it's overwhelming. I like Tim Ferriss very much, and so I've subscribed to his 5-Bullet Friday, and sometimes, I just have to say no because there's so many little things in there that I wanted to read or watch, and I just have to stay focused on what I'm working on. A lot of times the best thing to do is just to go back and reread something that you already know, it's on the bookshelf, and it's in the part of the bookshelf where you put things that you want to reread.
Bill: Yeah. [laughs]
Chris: The other 80% is stuff that I'll probably never look at it again, but that one right there, those are the things I want to reread, and you go back, and I think you just get a lot more out of it sometimes. You see something resonates with you that didn't resonate the last time you looked at it. Anyway, I think there's a lot of value in just being really focused.
Bill: Huh, I like that. I'm thinking of some of your answers that you provided me with and books that I should reread Shantaram. That's the thought I have, anyway.
Chris: Well, I'm halfway through.
Bill: Are you?
Chris: Yeah.
Bill: It's fantastic.
Chris: It is. It's beautifully written. It's a very long book. [laughs]
Bill: It is long. People ask me what it's about. I'm like, "Well life, love, drug running, escaping prison." I don't know what they don't cover in that book, India, but it's incredible.
Chris: The audio book is also-- That's how I consume most books these days is by listening to them. There's a pretty outstanding narration actually on Audible.
Bill: The audio book you got to listen to is Sam Zell's.
Chris: Oh, really? Okay.
Bill: Oh, yeah.
Chris: I'll read them.
Bill: Because he reads it.
Chris: Those are the best.
Bill: And it's like, that raspy voice that he's got, it's amazing.
Chris: [laughs]
Bill: Anyway, let's talk about Akre Capital, and your firm, and whatnot, or I apologize if I said it wrong. If I did is asset management, what is the official title of your firm?
Chris: The official title is Ake Capital Management.
Bill: There you go. All right.
Chris: Yeah.
Bill: You want to inform people on the three-legged stool, and then we can get in a little to some of the more advanced concepts?
Chris: Yeah. If you don't mind, maybe the thing to do is a little bit of a history lesson to start, because I think that might interest people. Because I think it's hard to understand Akre Capital without knowing Chuck and understanding Chuck.
Bill: Yeah.
Chris: So, will you indulge me for a minute?
Bill: I'll tell you what, I would love to. Chuck is a hero of mine. Everyone that I respect loves Chuck. I got to talk to Chuck for two minutes once and I asked him, "If Telesites was the next American Tower." He looked at me and he said, "Son, American Tower might be the next American Tower."
Chris: [crosstalk] American Tower exactly.
Bill: I said, "All right."
Chris: [laughs] What do you do about it?
Bill: I didn't buy American Tower and here I sit poor.
[laughter]
Chris: Okay. All right, so, the story for Akre Capital, I think starts summer 1968. We're going back little ways. That's the time when Chuck became a stock broker in Washington DC. Worked for a business called Johnston, Lemon, which was one of the Premier Washington, D.C. based investment banks back then. Brought Marriott public, for example. In his own words, he described himself as a "Know-nothing" back at that point. He had an English degree, he had been premed at one point, but he had no formal business training of any kind. He started off by asking some pretty basic questions like, "What makes a good investment, what makes a good investor?" He's basically just trying to solve this investment puzzle that we all struggle with.
Bill: Man, Imagine Chuck Akre as a "Know-nothing." That's insane.
Chris: Blank Canvas.
Bill: Yeah.
Chris: Nothing. He actually said that he'd taken one of those vocational quizzes. He says, "What do you like to do and then it tells you what you should go be [crosstalk] when you grow up kind of thing?
Bill: Yeah.
Chris: This is what I told him. Anyway, he's trying to figure out the investing world in 1968. They were two books I think that really made a big impact. One was John Train's Money Masters, which is by the way in that group.
Bill: I like that book.
Chris: Its one of the best.
Bill: That's a good book.
Chris: It's fantastic. Every time I read it, I get something new out of it. In that book, John Train interviews Warren Buffett, and Warren provides a list of what makes a good investor and what makes a good investment in that chapter. As Chuck says, I don't think he's ever gone and said all of that in such a concise way anywhere else. So, that made a really important imprint on Chuck's early thoughts about, what you look for in investment. In fact, since everyone's going to say, "Well, then what does it say?" Might as well tell them. "Wonderful businesses, there are four characteristics. Good return on capital without accounting gimmicks or lots of leverage, understandable businesses, one should be able to grasp what motivates the people working in them and why they appeal to their customers, that's two. They see their profits and cash, that's three and they have strong franchises and thus freedom to raise prices," that's four.
Then in terms of the list of what It takes to succeed as an investor, he says, you have to have six qualities. First is, "You must be animated by controlled greed and fascinated by the investment process," that's one. "You must have patience, you must think independently, you must have the security and self confidence that comes from knowledge without being rash or headstrong. You have to accept it when you don't know something and you have to be flexible as to the types of businesses you buy, but never pay more than the business is worth." That made a really big impression on Chuck in 1968. Then the other book that he came across, he came across in 1972 100 to 1 in the Stock Market. [crosstalk]
Bill: Ah, that's a great book.
Chris: Which is a classic.
Bill: You know what? That's seasoned really well.
Chris: Yeah.
Bill: Then Chris Mayer did a re-up of it with 100 Baggers.
Chris: He did a great job with that. I think re-energized the original to, I think, I bet you the book sales went through the roof after Chris' book came out.
Bill: Yeah, that's probably right. I know that's how I bought mine.
Chris: Yeah. 100 to 1 was written by Thomas Phelps, who was an investment manager based in Boston back then. What he did in the book was he went back and I think he looked at 300 or 400 businesses that one could have purchased between basically 1932 and 1967, and they still would have returned hundred times your money by 1972. A few hundred 100 baggers, basically, that he chronicled in the book. Some in depth and some in the list form. So, the big takeaway for Chuck from that was the importance of compound returns. I think that sets this whole thing into motion. The whole Akre Capital comes out of that.
What we say is, we focus on rate of return here. That's our north star. Chuck likes to say that the bottom line of all investing is rate of return. We actually have it written on the crown molding of our conference room.
Bill: Oh, nice.
Chris: There are three other things written on the crown molding of our conference room that we may get to organically as the conversation goes along. You see, one of them is focused. We already touched on that. What he did was he looked back and he said, "Okay, let me study the historical rates of return for all these different asset classes over long periods of time. What you find out is that public companies that are based in the US are a pretty outstanding asset class. They've compounded at basically 10% on average annually over the past. At that time, that was 70 years. If you carry the analysis through today, it's still roughly 10% rather over now 100 years on an unlevered basis. What we say to our clients is that our goal is to compound their capital at an above average rate. We're trying to meaningfully exceed that 10% long-term average.
The way that we do that the foundational notion that we have, it goes back to those attributes of a wonderful business from John Train's chapter on Buffett is we're trying to buy businesses with above average rates of return, return on their invested capital that are purchased at reasonable valuations, that are managed by outstanding teams, people who have both scale and integrity, and who can reinvest their capital at high rates going forward. That's three legs. A lot of people who know Akre Capital know that we use the three-legged stool as a construct for what we're looking for and finding these above average businesses, business quality, people quality, and reinvestment. So, that's the firm in a nutshell. I can't tell you about Akre Capital without talking about Middleburg, Virginia really quickly. Do you know Middleburg?
Bill: I don't. I know Richmond and I like Virginia a lot, but I don't know Middleburg. I assume it's a smaller sleepy town and the people are really good people. That's my assumption.
Chris: It's a small, I think, an official census population of 500-
Bill: Wow.
Chris: -here in Middleburg. It's in the Virginia, Piedmont. I think its original claim to fame was that Jackie Kennedy would come here to ride horses when the Kennedys were in the White House. Now, it's a three street, one traffic light town with some restaurants, and shops, and a higher end resort. Then here we are managing capital in what used to be a tavern that prior to being a tavern was a Ford dealership.
Bill: Wow.
Chris: We've remodeled the inside, but the exterior looks the same so occasionally somebody will come and tap on the glass and say, "Is the tavern open?"
Bill: [laughs] That's awesome.
Chris: There are 13 of us. There are five of us, who do investments and 13 of us total. I like to compare it to some New York City. I don't know. Do you have a guess? This is a fun game. How many traffic lights there are in New York City?
Bill: Oh, man. No, I don't. I don't even know how to go through it on a podcast.
Chris: [laughs] 13,000, I believe. That's what Google tells me anyway. I just like to say we simplify things. I came from Goldman Sachs. That's where I started my career at a school. I was there for a couple of years, and then in 2012, 10 years ago, I came down to Middleburg to work with Chuck. From 13,000 traffic lights and 8 million people to 500 people on a single traffic light. So, we simplify things.
Bill: Yeah, what made you say yes.
Chris: It was Chuck and it was the opportunity to learn from somebody like that. I was 24 years old, completely blank canvas for the most part. It was the idea that I could learn from this legendary investor.
Bill: He was already Chuck Akre at the time? Because I feel he's become legendary over the last, I don't know, 10 years or maybe I just know him now.
Chris: I think over time, it's definitely, his popularity has increased since the time or I guess it's the number of people who've gotten to know him seems to have increased in the time since I've been here. But at that point, it was still very clear based on his investment track record that he really was a great investor and somebody who was interested and willing to teach me, and so that was just hugely appealing. Honestly, I was never a big city kind of person. I welcomed the opportunity to come down here. In fact, I learned how to ride horses since I moved here.
Bill: Oh, yeah?
Chris: Yeah. That was a thing. I've embraced Middleburg.
Bill: I would ride horses but I'm deathly allergic.
Chris: Really?
Bill: Yeah. I learned to ride when I was a kid. My grandma's got some horses and it was snot everywhere. It was a terrible experience for me, but I like horses.
Chris: Was it the [crosstalk] or was it the hay?
Bill: I think it was something that they were spraying on them in the barn actually. Because my dad has some horses, and when I see him, I'm not quite as allergic but cats get to me, hopefully, dogs. I grew up with Labs. I'm about to get a golden in three weeks. So, hopefully, I am not allergic to dogs. We'll see. I don’t think I am, I grew up with them.
Chris: I have my assistant.
Bill: Yeah. You got a black one, right?
Chris: Yeah. If the people who watched this, well, I don't know how to do this. But anyway, he's lying on the floor right next to me, Duke, and he's just a fantastic dog. Labs are wonderful.
Bill: We had a yellow one, big box head. His name was Ringo. Dog was just like Marley, except like a moose, and then we had a black one, Ruby. She was fantastic. I don't know. I know my second specifically, I think he feels-- He's a middle. So, I think the dog would be good for him.
Chris: They're the best.
Bill: Yeah.
Chris: They are absolute best.
Bill: Unconditional love.
Chris: Yes, exactly. Yeah. That's in a nutshell. Well, let me throw in three other quick things about Chuck, and I think I have some things that might interest you, some Chuck-isms.
Bill: Dude, I'm telling you, I'm here to listen. Whatever you want to talk about, I'm here for.
Chris: All right. Chuck taught me all this. We talked about the power of compounding, and not selling unnecessarily, a couple other things just to note, I think. We run a very concentrated strategy. If you go back over the years, typically the top five holdings account for anywhere between 50% and 70% of the assets in our portfolios and low turnover. Typically, less than 10% each year.
Bill: Can I ask you a follow up on this?
Chris: Yeah.
Bill: All right, because I'm curious. When you let a position grow, how do you think about portfolio construction, either as a static portfolio or as new money comes in? Because this has been one of the things that as I've studied your writing, specifically, The Art of (Not) Selling, I've thought of a little bit. David Gardner, who I've also interviewed, I think when he lets things run, he gets pretty concentrated and you got to be comfortable with letting it run. It’s something I wanted to ask.
Chris: Let's start with the static portfolio because that's a little easier. If you have a static portfolio and certain things are doing well, it's absolutely our preference to allow them to grow in size up to a limit. The follow up question is, "Well, what's the limit?" It depends. In some cases, so we manage a mutual fund, and there are explicit diversification requirements imposed upon us by the SEC.
Bill: Yeah.
Chris: That dictates to some degree how concentrated you're able to allow the portfolio to get.
Bill: Isn't that why you guys had to buy not that you don't like S&P Global, but wasn't it you got to your limit on Moody's or something and you had to get S&P also?
Chris: Yes, American Tower preferred SBAC. It became the double down. We own MasterCard, and then we were able to increase our exposure to that business model by buying the Visa.
Bill: The Visa. That makes sense.
Chris: Yeah, exactly. That helps a lot. Even though, the mutual fund has 22 holdings, there're some repeats in there that make the number of business models per se, fewer. We have both KKR and Brookfield Asset Management, for example. Again, it's giving you exposure to the same major trends and themes. But in an unconstrained portfolio, the size of the positions can get in excess of 20% and that doesn't cause us any indigestion, I think. If pressed on what exactly the max would be, I think, if you go back and look historically, as you get closer to 30, I think there's been an inclination to pare back that hasn't happened recently.
The idea of trimming is one that we just don't really trim. It goes to a bigger issue of optimization. This idea of portfolio optimization and I guess, what I've learned from Chuck is that, in some ways, optimizing is insatiable and I think there's a certain amount of humility that comes into play where you say, "I'm taking money out of this business that's doing really well, and I'm reallocating it over here to something that hasn't done as well, and I'm right in both of these instances "Whereas if you allow a business to run, they're earning their position sizing as opposed to you dictating. So, there's not a lot of that optimization that goes on. [crosstalk]
Bill: You know where I screwed up? I'm trying to add value to the conversation. I'm curious to hear your take on this. This happened to me with Charter. Funny enough, you were talking about transcripts that had things three years ago. When I got involved in Charter, the reason I got comfortable with the integration issue as I was reading old transcripts and they called it out as an issue. When I was at BMO, I had lived through an integration. It just made sense. But here, I was looking at Altice, which it's maybe too early to determine whether or not it was the right or wrong decision, but I traded execution for a multiple. I think had I not been so concerned with optimizing at the time. People will say cable has its issues now, whatever, I'm comfortable with that argument. But I probably should have just let it be and I was like, "Well, this one's stretched and this one's not, and I have a view on the asset base, so I can sacrifice a little on management." Then it's like, "Well, crap, why did I even do that?" It wasn't perfect, but my perception of the need to optimize put me in a scenario where I got myself in quicksand.
Chris: It sounds like the prioritization. You've got the valuation above the management quality, which I think--
Bill: Yeah, and I'd argue asset quality.
Chris: Yeah, right. Leverage and a number of other factors as well.
Bill: Yeah, you can feel free to keep kicking me if you'd like.
[laughter]
Bill: But you know what I mean?
Chris: If you want to spend the rest of the podcast on my mistakes, we'll run out of time before I run out of mistakes. [laughs]
Bill: Well, I could kick you back and I want you to-- Please, if I say anything that's offensive, understand that you guys are awesome to me and I'm only trying to say it to learn. But I have thought to myself as I've looked at some of the stuff you've own, like, Dollar Tree versus Dollar General was an interesting choice.
Chris: It was, yeah.
Bill: I don't know. I mean, this is the art of it all, I think, but how do you think through when that gap in valuation exists and is justified versus it's not?
Chris: Well, no, you're absolutely right. There are a number of examples we can run with Dollar General or Dollar Tree, where in the early days when we first were invested in Dollar Tree, it was a much simpler story than it is today. It was just the Dollar Tree everything for a dollar concept. I used to say in those days that I could literally give the conference call. Bob Sasser, who was the CEO at the time was just very consistent in the message to shareholders. I think he was very consistent with his message to his employees and to the customers as well, and I think there was a lot of value and power in that very clearly defined purpose, and then they acquired Family Dollar, and I remember when that announcement was made looking at the slide presentation, and there were mentions of EBITDA in that slide deck. I went back and I looked at every transcript, you can do document search in Bloomberg.
I went back and I document searched every document, every transcript, presentation that Dollar Tree had ever given in search of the use of EBITDA, and it did not exist anywhere in any prepared comment that they'd ever made before. I thought to myself, "Well, that's interesting and mildly concerning." Not that EBITDA is such a horrible metric, but it was something new.
Bill: It's a focus [crosstalk] on a non cash term that they'd never talked about before.
Chris: They never talked. What it made me think was this, I don't know where this idea came from, but I don't know that it came from inside of Dollar Tree. I still don't know where the idea really came from. But it made me think that somebody had made me convinced them that this was a good thing to do and it was taking them away from that really simple idea that had been so powerful over time, and it turned the business into something far more complex, and they've struggled mightily, it's no secret since that time and they won. They won that bidding war against Dollar General with a lower offer. It was a really interesting case study in game theory and the way that all went down. But there was a winner's curse associated with that, because Dollar General's business stayed simple.
Bill: Yeah.
Chris: And they were able to continue just executing on what they have been doing for years, and they have run laps around what Dollar Tree has been able to do since then.
Bill: Looking at the locations, it would have been interesting if Dollar General had won because Dollar General's footprint is quite a bit different from Family Dollar's from what I've seen driving around.
Chris: Well, the business models are just so much more like Dollar General and Family Dollar than what Dollar Tree was doing. I think maybe there was some frustration at Dollar Tree, because they'd become just excellent merchandisers and supply chain wizards as well. They would go over to Asia and they would find these great products that they could sell at their margin for $1, and then they would basically pick them up at the factory gates and arrange for all of the transportation, and sorting, and shipping to the United States. They were really, really very good at that. But they were coming across in those shopping trips products that they couldn't sell for a dollar. That I think they said, these are great products and wouldn't it be great if we could have a place to sell these. They had at that time a concept that they were testing called Deals, which was a multi price business similar to what Family Dollar and Dollar General are and maybe that was part of it as well. I'm not sure.
But you're absolutely right and this is where The Art of (Not) Selling, I think if you really wanted to push me on this, you would say-- I think you made a comment on a prior conversation about being a frog in boiling water. At what point do you realize the water's boiling and at what point in this business degradation process do you know it's time to get out. If you're too slow to finally come around to the idea, because we say in the paper, it's not the art of never selling, it's The Art of (Not) Selling with parentheses around the not, and that's maybe too subtle. But the idea is, we're not selling unnecessarily, we're not interrupting compounding unnecessarily, which is the first rule of compounding as per Charlie Munger. Then, what is the right time to sell? It's when the business or people cease to be exceptional all right. So, at what point did Dollar Tree cease to be exceptional? Was it a year after the Family Dollar acquisition, was it three years after? You would have made a lot more money had you pivoted at the time of the acquisition, purchased Dollar General sold Dollar Tree and owned that, and it's been a great business. But that's what's hard about The Art of (Not) Selling is knowing when to sell on the business [crosstalk].
Bill: And The Art of (Not) Selling, is there ever valuation? I have to think the answer is yes and it's a very hard question to answer. But it's something that I've been fascinated with. It seems as though mathematically at some point selling is the right decision. That said, I don't know, I was looking up stupid things I've said in the past, and I told you like, I sold Apple thinking that mathematically I was correct and my analysis was obviously garbage, because it was not the right time to sell. We're on the back end of what people would call bubble valuations coming in. How do you think about when something gets really stretched just sitting still? I think that's a really hard skill to develop.
Chris: The answer to the direct question is, I think there is a time when valuation can become so egregious that you would sell based on valuation. I think if you're looking out five or 10 years, and you can't conceive of a scenario where you're going to generate a satisfactory return, then it could be a situation where you would sell on the basis of evaluation. The hard thing is, from our experience, the very best businesses surprise you. They start a new line of business or there's some enlightened acquisition that opens up a new area of growth, or they are able to expand margins to a place where you never thought possible. We've had businesses that have, I mean, O'Reilly, which is a retail business that's brought its working capital negative and been able to use the proceeds to fund repurchases, stuff that you would have never imagined. A retailer with negative working capital, how's that even possible? It's really painful to look back with remorse at a decision to sell what you knew is an outstanding business, because it got a year or two ahead of itself in terms of the price. I think you wrote it somewhere that it's more important to be really sure about the quality of the business than it is to be whether it's 10% or 20% too expensive.
Bill: Well, I may have written that, but then I bought Altice. What does that say about me? But yes.
[laughter]
Bill: I have gotten to that point and I thank you for writing that paper. That paper is something that I've spent a lot of time on and it's bent my mind a lot. People have asked me recently, because I talk about Peloton. I like the product a lot, a lot. I've avoided the stock and at the end of the day, the reason that I have is like, "I just don't think it's a high enough quality business that I want to own it versus the other universe." If I didn't study what you guys wrote, I wouldn't have come to that conclusion and have gotten waxed on that. So, thank you.
The other part of it is, how do you think about these great businesses versus base rates? Everybody knows, well, not everybody, but a lot of people know, the paper that shows what all the equity returns from such an infinitesimal percentage of the market like--
Chris: Tiny.
Bill: Yeah. That's what I mean, very small. How do you think about, this is a great business today, but boy, is the competitive advantage period going to go away or why is this going to continue? Should capitalism kill this?
Chris: I think that's what we all are driven by as investors is we have this belief that we're going to be able to pick out. I think you guys were talking about it on a podcast. The number was one in 20, I think, that really drive the returns over the long period of time. We all think that we have the ability to identify that one in 20. There's a quote by Richard Koch something to the effect of most of what exists in the universe, the actions, resources, ideas have little value, yield little result. But then on the other hand, there are a few things that work fantastically well, and have this tremendous impact, and he states that is a universal concept. I think it absolutely applies to investing. When you go back and you look at the track record that Chuck and our team has assembled going back to 1989, a dozen or so businesses account for nearly all the returns over that period of time, even though the portfolios have contained hundreds of businesses.
One of the challenges that we face and Chuck talks about this a lot is that, it isn't always obvious to us right away which businesses are going to be the truly exceptional ones. They reveal themselves to us over time, so, there are these false starts and businesses that we think are exceptional, don't turn out that way, managers who we think have that unique combo of skill and integrity disappoint us, come up short in one way or another and so we're always sifting. That's what keeps us going. That's what we love to do, but that's the reason why the portfolio, if you look back over the investment partnership, I think, since its inception in 93, it's owned 120 or 130 businesses. But again, it doesn't really have accounted for all the returns over that period of time because a few things work out fantastically well.
What's really interesting about it is some of the businesses that have had the greatest impact over time like American Tower, for example, weren't sized to be the largest position initially. But yet they still over the fullness of the track record were the ones that really made the difference. To me, that's really encouraging, because it means you don't have to get the position sizing from day one. But it also argues for allowing those businesses once they've earned that bigger piece of the portfolio to keep it as opposed to trimming them back. They've sort of righted your mistake for you, and now, you should let them run, I think within reason of course. But I think it's a different story if they've earned a bigger slice of the portfolio because they've grown their underlying earnings or free cash flow per share versus the valuation quintupled or something like that.
But yeah, we start with the idea that there are a few truly exceptional businesses that have durable competitive advantages that will withstand the test of time, whether it's regulation or innovation, competition, and those just don't come around very often. That's why when we find one, we try to hold on to it really tight. Because they're so rare, we fill a portfolio we can get. We can find eight or 10 or 12 of those, concentrate all your capital there, and have enough sense to leave it alone, then you're in business. The issue is when you bury those exceptional businesses in a portfolio of hundred others that are less exceptional, and you trim them as they get to be larger and you never really let them make that impact.
Bill: For some reason, I have this thought in my head and maybe it makes sense and maybe it doesn't, but it's almost as if, Charlie talks about investing as a pair of mutual system and thinking about horse racing. It's like, if you're familiar with horse racing, you pay this stud fee, and then you get a horse and you have no idea what you have. It's just the small horse and it's all speculation until they hit the track. This really great stud or this really great fowl or whatever that you paid almost nothing for comes out and can run like crazy and then instead of heaping resources on that young horse, what I think I have done and what I think investors do is like, "Well, there's this fatter horse that I spent more on or something, so can I turn this fat horse into this horse that is really ready to run?" Or, you say like, "Well, boy, this fat horse can pay me more if it wins." It's like, "Yeah, but that thing sucks. This other thing is ready to go." It's interesting to me how flawed my thinking has gotten at times because I've allowed the odds offered to justify a fundamentally flawed idea.
Chris: Interesting.
Bill: If you think about it, it's like, I have these two horses and it's clear that one is better, but I'm like, "Well, the odds are not worth the bet. So, I'll just take the one that can't win, but the odds are better." It's like, "Well, you better size that right."
Chris: I think that's the very natural evolution of a lot of investors where you hear about folks who start off as being deep value investors in the Graham and Dodd sense, because there's a quantifiable value that you can point to and say that's what I'm investing in. Then a lot of these investors go along the same learning curve that Warren went on, and Charlie helped him, and they graduate to understanding that it's far more important to find that exceptional manager and pay a little bit more that outstanding business franchise and pay a little bit more than that quantifiable value. It's replacing the quantitative with the qualitative, the quantifiable with the unquantifiable, and then now you're basing everything on a judgment, and you're on much less firm ground when you start doing that in a sense, and you have to trust your judgment and your intuition. I think people make mistakes there and one of Chuck's favorite lines is that, "Good judgment comes from experience and experience comes from bad judgment."
Bill: Yeah.
Chris: That happens. The other thing that he says a lot is, "I'm lucky in this business if I learned something new, and I'm doubly lucky if it doesn't cost me too much."
Bill: [laughs]
Chris: The two kind of go hand in hand, right?
Bill: I like that one. That one's great.
Chris: But I think that's a very normal evolution for an investor to take what you described.
Bill: It's tough because that judgment requires self-conviction, it requires the ability to trust in something that you can't point to it, but I really like your concept of writing down the most important question, because I have to think that that's a good true north to come back to when those judgment questions come up. It's like, "Okay, does this impact my most important question?"
Chris: I think it's our north star. It's what Chuck is always encouraging us to simplify. He's very impatient in a good way in terms of long-drawn-out explanations. If you can't articulate in a very short period of time, what you're saying is important enough for his attention, then you lose it. You lose it. You have to earn that. It's hugely helpful to us all. But at the beginning, when I was tepid 24-year-old analyst going into his office to pitch him an idea and you could tell you lost his interest after bumbling around for a couple minutes, so, over time, you get better at that essence. Even now, he'll say, "You know, Chris, that's all really interesting but I don't think you've really honed in on the essence of this business" and he'll challenge you. You'll say, "What you think is the essence?" He's like, "No, no, you're not there yet." It's that boiling it down process. Once you get there, gosh, that's really valuable, that's so helpful to have.
Bill: Do you think he knows the essence of the business or do you think he knows when you know the essence of the business?
Chris: The businesses that we already own, I think he has in his mind what an essence is. For businesses that are new to him, I think he knows when I've articulated it clearly in such a concise way that it's probably close to being true. I think he's probably responding more to the length and lack of directness. He's a very direct person. I think he appreciates that directness more than-- When I first would tell him about a new software business, I don't think that he necessarily has the essence of this random horizontal market software business stored in the back of his mind. But as I articulate my way through it, I think he says, "Oh, you're a lot closer now than you were a minute ago." That's, I think, a product of a career in investing and unfortunately for us we benefit from that a lot.
Bill: You know a story that I liked reading about was, you had mentioned a company that you all went out to see, and you were asking questions of the managers around the CEO, and nobody felt the need to look at the CEO, and when you're when you're talking about interacting with Chuck, and then thinking of that story, he's got to be a good guy at reading people.
Chris: Yes. I'll tell that story if you think [crosstalk] interesting,
Bill: Yeah. As long as you are comfortable, I just don't want to say anything that you want to say or whatever.
Chris: No. We were visiting Roper. At the time, it was called Roper Industries. Today. it's named Roper Technologies. It's a business we still own and think highly of. Originally, it was an industrial conglomerate. Then the board hired Brian Jellison to be the CEO and he had this idea that improving the returns on capital for the portfolio would over time improve the stock price performance. He began this process of evolving the company much in the same way that Danaher evolved from being an industrial conglomerate into being this life sciences, high-quality recurring revenue business that is today. Roper went through that same process rather than the end result being life sciences, recurring revenue business. It's largely a vertical market software recurring revenue business today. But it went on that same journey, and Brian, at the time for much of that was at the helm, and then he very unexpectedly, tragically passed away, and the new management team is doing a great job.
But we were sitting there with Brian and his team, and this was probably in 2014. I was only 26 and I've been here a couple of years. I thought it was a great meeting, and we got out of the meeting, and the first thing that he observed in the car was the fact that we were asking questions of the CFO and the President and Chief Operating Officer, and they were freely responding to our questions without first glancing over to Brian to make sure that he was giving them the thumbs up to go ahead and say whatever they were thinking. Then as they were talking, they were clearly not again checking back for approval from the boss. He said that's a really important thing and that's a really great sign. You're right. He's a great observer of people. Then, he'll share that little tidbit.
Then I took that and years later, 2018, I was visiting, I won't mention the name of this company, but I was visiting with a company in New York, and it was the exact opposite. There was a Chairman and there was a CEO, and the Chairman was the big personality and the CEO was running the business on a day-to-day basis. I would ask a question to the CEO, and the Chairman would interrupt the CEO and his response. He would challenge the premise of my question often. He wouldn't even just answer the question, but he would challenge the premise. Finally, the Chairman's phone rang and he picked up the phone and he left the meeting.
You could see the relief on the CEOs face when he left the room and he could answer my questions freely. I remember my mind went back to the comment that Chuck had made about Roper, and I said, something just doesn't feel right here. It wasn't any more than that and we ultimately didn't make the investment. I think from the time that we met with those guys in late 2018 to maybe a year later, the business had lost something like 80% or 90% of its value. Both of the guys had left. Both of them had been ousted. It was the reason because the founder interrupted the CEO, of course, not. But it may have just been luck on my part, I like to think that that's some of that pattern recognition that you accumulate and develop over time. So, that was really helpful for me.
By the way, I think I was reading a transcript in a conversation that you had where you were talking about, what is the optimal portfolio? I think the comment you made was, "Well, it has to be optimized for me and my personality and it's in my [crosstalk] portfolio--"
Bill: It's terrifying how much due diligence you've done on me.
Chris: I have help.
[laughter]
Chris: I can't take all the credit.
Bill: Yeah. That is what I said. It's got to be something that I can live with and I can live with the draw down. Really, I hope that somebody that's listening to this hears this at the right time and I know there's pain in the market right now, but I think "go to war with the soldiers you can win with."
Chris: That goes back to the Josh Waitzkin embrace your funk kind of thing. You have to build a portfolio that is in harmony with your unique disposition, which makes it so that there was never a right and wrong answer as it relates to somebody else looking at your portfolio and saying, "Well, my portfolio is better. For example, the reason I thought of this was because we're talking about this outspoken founder, who is challenging my premise on every question. If you say, "Well, how does my unique personality show up in the portfolios that I build?" I would just say, "There are plenty of examples of outspoken and boastful CEOs, who receive a lot of stock options, who use a lot of leverage, who have compounded magnificently over time, but that's just not my cup of tea." I prefer the Mark Leonard-Warren Buffett prototype. They are founders, they own a lot of stock outright, not through options. They look at shareholders as a fiduciary would look at a client.
Phil Fisher refers to that as trusteeship and I really love that word because that's a higher standard, I think. Then, legally, what a management team has to have. But Mark Leonard will tell you outright when he thinks the shares are overvalued. How many managers do you know of who would do that? Warren refused to buy back stock for years, because he didn't want it to be predatory, because he knew he had more information than the selling shareholders would have, and he's only doing it now, because he's making it perfectly clear to everybody who dares sell their shares back to him that he thinks that they're selling to him for less than what the business is worth. That's just another level of honesty. There aren't that many folks like that out there, but there are enough of them that you can build a portfolio, I think.
Bill: Yeah.
Chris: In both cases, share count doesn't go up. There have been 21 million shares outstanding at Constellation Software since 2006. Yeah, they're not diluting the shareholders. That's my own unique disposition. I find it offensive and I'm just put off when there's the boastfulness or putting down competitors openly, that sort of thing.
Bill: I wonder if that doesn't upset me so much because I like hip-hop.
Chris: [laughs]
Bill: The guys that talk shit and back it up don't really bother me. But I will say that I do try to keep a pretty open mind and my eyes fairly open that like, if push comes to shove, where do I sit in the equation here? Because I think there are certain people that I think you got to be aware that you're probably on the lower end of the priority list than others.
Chris: Yeah. One of the interesting questions about some of the software businesses today because in the old days what were shareholders, they were capital providers for a business. They were unnecessary partner for growth over time. But if you have businesses that generate enough cash flow that they don't really need shareholders to play that capital provider role, they're more of a liquidity provider. It puts shareholders in a fundamentally different position than they've been in historically. I just think it means that you have to be even more discerning about who you partner with as far as the management team goes and how they view you as a shareholder.
Bill: I like how you said that. I think with share-based comp, it's almost as if the employees are the people willing to finance the growth and the role of the share prices to keep them interested in working there. I thought an interesting interview or article that came out today was apparently Peloton's employees are watching the share price crater. I can assure you that happens everywhere. I think managing through a really volatile stock price would be very, very difficult endeavor. I know at BMO, our share price was not particularly volatile. Everyone knew when it was down. People talked about it constantly. Maybe not everyone, but enough that everyone in the office knew what the share price was doing. So, it's interesting.
Chris: It's a risk factor. I believe, if you read the Salesforce 10k, there's a risk factor in there that has to do with being located in Silicon Valley and having such a competitive labor market there, that is a factor. If the share price declines meaningfully, then you have an unmotivated labor force, who can very easily take their skills, which are your assets at the end of the day right out the door and go over someplace else, which has a more promising trajectory and was willing to issue options. It's a real conundrum. We do a lot of software research here and we all else equal would rather find businesses that aren't located in some of those really competitive labor markets. I think it changes the dynamic to be a little bit less mercenary.
Bill: Yeah, that makes sense. Then the other thing that stinks, if you have such competition, when things go badly, you probably have to pay people a lot more to stay and it's one of these negative cycles that can get going, at least from the minority shareholder liquidity provider standpoint.
Chris: Yeah. Well, and it's one of the cases where the stock-based comp add back with this idea that it's a non-cash item. Well, to the extent that that non-cash item is replaced by cash, higher cash payments than it really becomes an expense quickly. It can contribute to the downward feedback loop that you're talking about there.
Bill: Yeah, it's one of those things that doesn't matter until it matters.
Chris: Yeah.
Bill: How often do you personally or as a firm think about macro and what's going on? Part of why I'm asking this is, we're at this period where on Twitter Spaces, people are saying, "the correction of the century is coming, SaaS is correcting, that's going to rein in spending, all your AWS assumptions are completely bogus, because it's based on inflated VC spending." It's a very elegant theory. I think there's probably an element of truth to it. I think that the probability that that results in the crash that is the end all be all crash is very low. But there's a tension between there's something smart being said versus it doesn't matter, versus when should I pay attention?
Chris: The answer is, we think about some of those big questions less so when you say macro or not. Of course, we're paying attention, but we have no view on the direction of GDP, or inflation, or interest rates. Ultimately, we're trying to invest in businesses that we would classify as all-weather, who are not subject to exogenous factors like oil prices or inflation that same way. I think a lot of our clients recently are asking us how is the portfolio positioned to withstand a higher level of inflation and whether that's a MasterCard, where it collects a number of basis points on the dollar volume, so as the dollar volume rises this inflation that will adjusts [crosstalk] automatically-
Bill: It's nice hedge.
Chris: -very nice hedge. American Tower, a number of their contracts have pricing escalators built into them, either fixed or based on inflation depending on where in the world you are. Then there's just the good old fashioned pricing power businesses. We try to position the portfolio that way. You have that all-weather element that can withstand and that was a lesson for me to talk about my mistakes. Earlier, you said, Chuck told you that the next American Tower is probably American Tower. Well, years ago, I thought that the next Danaher was a business called Colfax, which was founded by the Rales Brothers, the same guys, Steven and Mitchell Rales, who founded Danaher. But the difference was that while Danaher had moved towards these recurring revenue businesses, Colfax was still in macro sensitive businesses that were highly sensitive to swings in currencies, and commodity prices, and just general GDP growth. So, that was a painful lesson for me and the importance of being all weather.
We don't think a lot about the macro in that sense, but we do think about some of these big questions that you're alluding to. For example, just let's talk for a minute about SaaS multiples. What do you think about the--? Because if you look at a historical chart of software multiples, it's pretty--
Bill: Stretched relative history is not the--
Chris: Yeah.
Bill: Yeah, that's not controversial.
Chris: That's a fair way of saying.
Bill: Yeah. Corrected a fair amount when you factor in sales growth and multiple compression today.
Chris: Yes. Right. Yes, we're working. What we would think and this would be my version of macro is I would say, there's absolutely no question that some of the multiples that you're seeing now are implying substantial growth for a long time to come. I understand why investors are willing to pay those multiples because if you look at a business with a 98% or 99% customer retention rate and you extrapolate that you're going to be in business for a very long time. Of course, the problem is the extrapolation, and you just have to be really confident that there's not going to be some adverse change in that retention rate in the future. What you're essentially doing, especially with the yet to be profitable software businesses is that, you're essentially underwriting management's assessment of customer lifetime value.
Bill: Yeah.
Chris: They're laying out the cash today in the form of either new customer acquisition expenses or product development, and they're justifying those investments based on an expectation about future customer retention. If they get that math wrong, then there could be a lot of shareholder value destruction taking place, but you don't know it again. It's a lot an insurance business. You don't really know the wisdom of an underwriting decision for multiple years a lot of times in the insurance business.
Bill: Yeah. Longer tail, right?
Chris: Longer tail. That's a macro issue that we think about. We ask the question, "is it possible that LTVs are harder to come by today than they were 20 years ago when SaaS was first taking share from a lot of the on-prem solutions back then because there's just more competition?" There are more young, bright folks who are receiving a lot of venture funding, trying to disrupt the existing software providers, because now there's a better appreciation for how fantastic these businesses can be. If so, what does that mean for the current vintage of early-stage unprofitable software businesses? Can you just apply the long-term 30% operating margin to all these businesses? That's a question. That's the macro-ish idea that I would wrestle with. Of course, there is no answer. I don't know the answer to that. I'm in Middleburg, I'm not in San Francisco. So, I'm probably the last person you want to ask for the answer to this question. But that's what I'm wondering about. The way I answer it is on a micro basis. We're largely, we own a number of software businesses, but the average multiple EBITDA margin for our software businesses in the 30s. We've tended towards the more mature--
Bill: Yeah, let it prove out, and then you can analyze what it's probably going to be at end state rather than making guesses.
Chris: Yeah.
Bill: I got nervous and maybe to my detriment, maybe not. But I have a buddy, who has a lot of friends in Silicon Valley ran his own company and he said to me a little while back, he said, "I have friends that are hiring engineers at a pace that they know doesn't make sense, but they also know that this is maybe one of those times that they can make generational wealth, and people want to see engineer hiring, and they also want to see growth." One, how much of that anecdote is reality? Two, how much of that decision making is driving growth forward, whereas in a real world scenario without those incentives, and maybe stocks correcting takes away some of those incentives, what does growth look like then? The unanswerable questions from [crosstalk], but it's what has kept me away in certain instances.
Chris: It's really hard. I don't think accounting conventions help us very much. You look back and I think Michael Mauboussin has done a really nice job recently in helping us think about this issue, which is back when Walmart was a young business, and was growing quickly, and was opening all these stores, they were able to capitalize and then depreciate the cost of opening those new stores over what they thought was the useful life of that asset that they were investing in. You had a version of the financial statements that was a little bit more useful and forward looking than what we have now with a lot of the businesses out there that are investing through their P&L and their income statement, because of course, there's a little bit less flexibility around. There are obviously investments in product development that are happening that will benefit these businesses for multiple years and they're being expensed entirely in the year incurred. I think the same holds true for sales and marketing. So, if there was a similar concept as useful life of those assets and the businesses were thinking in those terms and reporting financials in a way that helped investors think in those terms, it would be really useful from my point of view.
We can make those assumptions, but you're stacking assumptions upon assumptions upon assumptions at that point in an attempt to get to what we would consider owners earnings, it's just more difficult. I don't know. He put out a paper, I think we looked back and said, "Look, we think that this percentage of sales in marketing for the average business over this period of time could be capitalized and depreciated over this amount of time. You can take that and apply it." I think that's helpful as a base framework. It definitely is pointing you in the right direction, I think, but it's still really hard.
Bill: You know what [crosstalk] about that for me too, though, is like, "Okay, fine. I agree with that." But if it is cultural, I think, I don't know what I'm talking about here. It's all speculation. But I suspect in these high growth companies, it's cultural to go out and win, and it's cultural to go out and I don't want to say overspend because that's not the right way to frame what I'm trying to say. But if tough times hit, and the stock price comes down, and some of the expenses come in, to what inhuman organizations that it feels it can break when there are substitute companies to go work for. At Accenture, that's a business that people are going to stay at, I think. It offers a good quality of life and its enterprise sales, business to business. I don't worry about everyone from Accenture moving to the next big consulting firm. But some of these SaaS Salesforces, I do worry about the turnover, especially with how much money you can make if you're good at enterprise sales. It's crazy. It's what I should have done. I feel I could have been a pretty decent salesperson had I started 20 years ago.
Chris: Right code.
Bill: Yeah, well, that ship has sailed. I'm trying to get my kids into the Minecraft, the one that you can code and I think I got a reasonably good chance of doing that.
Chris: Somebody asked me today, somebody young said, "Well, blank slate, I could be happy doing anything. What should I do?" I said, "I think you should learn how to write code."
Bill: Yeah, it probably would have been a better use than trying to learn Spanish for me.
Chris: [laughs]
Bill: Just because I grew up in South Florida. If I had just gone to Miami more often, I probably could have picked it up. But I didn't use it enough. Oh, well, such as life, is a better use of time than Latin for me. You know what I like reading just I'm jumping around here, but you said something, it's important to cultivate quality as a way of life, and listening to you talk and listening to your selection process and stuff, I like how I'm going to call it simple. It's not simple, but it is. In my opinion, what you've articulated today is taking an idea, and taking it seriously, and I respect that a lot. There's a lot of discipline in how you guys go about your business.
Chris: You said the Q word, quality. I have to preface this by saying, I'm a member of the Robert Pirsig fan club so to speak, and so we can go down a rabbit hole on quality static versus dynamic quality and the balance between the two of them and how that applies to investing.
Bill: Yeah, let's do this.
Chris: Yeah, quality and discipline are I think, if I had to pick four words that would describe, because at the end of the day, you think about this and you say, "Well, what value do we bring at the end of the day? What does Akre Capital bring to the table for our clients that they couldn't do on their own?" I think its quality, its discipline, its focus, its compounding. Those are the four words that you would say. Quality relates to our judgments about business quality. Hopefully, over time, cumulatively, all of our experiences put us in a better position to judge which businesses are of higher quality than others, which management teams are of a higher quality than others. The discipline piece relates to valuation. Chuck talks a lot about being an investor in the underlying value of a business as opposed to the speculator and the price movement of shares. So, waiting until the deck is stacked in your favor to buy some of these outstanding businesses.
Focus is just managing concentrated portfolios and we've talked about that. Then, the last one is the compounding, which is a mindset. There's a lot of discipline that's around compounding. I would tell people it's always been harder to convince Chuck of the wisdom of selling a business than buying a new business for the portfolio always. If we had this portfolio, and there were 20 businesses in it, and I came to him and I said, "Here's something new, you've never heard of it before. I think we should make an investment here. The bar would be lower to get that new business into the portfolio at an equal position sizing." Let's say, as taking an existing position at that same size and exiting it.
Bill: That's because he already knows what he owns with what he owns?
Chris: He knows what he owns and he knows the danger of selling. Not to go backwards and revisit all that. I'm just saying that is an [crosstalk] engrained mindset.
Bill: No, we can because this is important.
Chris: That's something that you as a professional money manager can bring, I think, to the table. Anyway, that's how I would think. What is the value add that we have captured in those four words there?
Bill: Is a tangential thought to what you just said, is that why holding a business at a valuation that you maybe wouldn't buy the business at? It's just the default like, "Look, I believe I know with a fairly high degree of certainty that over the next 10 years, this is going to work out." If it's a little overpriced today, who cares? We bought it better, just let them do their thing.
Chris: Mm-Hmm. Exactly.
Bill: Yeah.
Chris: Yeah, for sure.
Bill: That makes sense, man. I wish I had learned this 10 years ago. Oh, well.
Chris: It's hard. The practical reality is that in the last 12 months I've sold a couple businesses. Even being armed with all of this and having Chuck's at 20-feet in that direction from me, and having worked with him for 10 years at this point, there still are times when you sell things, and you face all this stuff, and you try to process it, and make a good decision and sometimes you get it right and sometimes you get it wrong. It's still really hard. I think it's the hardest thing we do. I think evaluating people maybe the hardest thing that we do, but then the next hardest thing is when to sell is probably the two hardest things, because people can be tricky.
Bill: Yeah, there's no flashing light that comes on a huckster, right?
Chris: No, and they're actively trying to deceive you. That makes it harder.
Bill: Yeah.
Chris: Or they have some self-interest that's opposed to your own and so same [crosstalk].
Bill: I tell you what I've noticed, man. I think sometimes people are attracted to the fact that I'm honest and it's like, "Well, I have a lot of warts," and then people will say to me like, "You're wrong on this or that." It's like, "I know. I don't know what to tell you." But sometimes I wonder if in the evaluation of people, it's like, "Well, what I like about this person might be the reason that I shouldn't listen to this person or whatever.
Chris: Yeah.
Bill: Yeah, I don't know. It's weird. I have another buddy, who, on Twitter, he picked up a bunch of followers, because he talked about how badly he had messed up. He did it for himself, and he wrote me, and he's like, "It's crazy to me that people are following me because of everything that I've done wrong." I said, "Well, I think it's really that people appreciate somebody being able to say that they did something wrong." But that emotional tie of liking that quality in a person can maybe lead to other conclusions that are incorrect. I don't know. But it's just reading people's stuff.
Chris: I think what we're all looking for is authenticity to some degree, which is gets at the heart of what you're talking about, was that enough? If somebody who says, "Look, I'm self-labeling yourself as humble is one of those challenging things, because is that authentic or is that done with some other motive in mind?"
Bill: Yeah.
Chris: It's so difficult to accurately assess people. I think it's iterative, it's like dating, and you get to know these managers better over longer periods of time, and that's another reason why, if you feel you invested the time and do have that confidence in a management team, let's say, for example, this comes up a lot. You invested in a business and 10 years later, while it was growing at 15% per year, when you first made the investment, now, it's a much more mature business and it's growing at 12, and you're trying to decide whether or not to move on and you found something else new that's growing at 15, so, you can recover back to that original higher growth rate and keep the portfolio's weighted average growth rate at that higher level. But it means starting that process over again, and having to learn a new team, and you trade that 12 that you feel really good about that the distribution of outcomes around that 12 is pretty narrow in your mind, because you know the people and you know the business really well. Now, you're going back, and resetting the clock, and you've got a wider distribution of outcomes, and there's the uncertainty around the quality of the people. That's a really hard decision.
At some point, if the goal is to generate above average returns over long periods of time and 10 is the average and you're charging fees, you can't let it get too far below 12. But that becomes really hard. That becomes the challenge with owning something like Berkshire, for example for us, because it's just below the hurdle rate. If you think it's going to grow in a market like 10% over a long period of time, but you have absolutely no questions whatsoever as it relates to the integrity of the people involved at least at the top.
Bill: Yeah, that particular business, the only thing that keeps me up at night, and if anyone works for Berkshire or any portfolio company, please reach out to me @billbrewstertbb on Twitter.
Chris: [laughs]
Bill: Do people go to work for Warren and Charlie or do they go to work for Berkshire? When Warren and Charlie are not there, what does that look like? I was fortunate to meet Ted Weschler for two seconds and that guy is a gem of a person. Within a second, I was like, "I like this guy." If Berkshire is filled with that, then I'm not too concerned. But I don't have insight into whether or not it is. I can just take Charlie and Warren at their word, but they're not going to sit there and tell me that their baby's ugly. Nobody says that. So, we'll see.
Chris: Well, it's gotten so big. Your question is an interesting one. Do they go to work for Warren, Charlie, do they go to work for Berkshire, or do they go to work for one of the subsidiaries? Where's this sense of identity-
Bill: Yeah, that's right.
Chris: -as you get to be that big?
Bill: Yeah, I know a family that's old to Berkshire. I don't know that their tie is-- The man that started the company is older, Warren and Charlie are older. I don't know that the family's tie is to Berkshire in the same way. You've got layers of succession planning here to worry about. It's not just one. That can get complicated when growth is also slow on top of that. Your skew can get out of whack. I say that it's a big holding of mine. It's something I haven't acted on this, but it is something that keeps me thinking throughout the day. That would be my most important question. Can the engine continue to run when they're gone?
Chris: There you go. Any hint that you get that is helpful in answering that question, you realize that's a really important piece of information, and then everything else you can move past.
Bill: Yeah, that's right.
Chris: It's why it's such an awesome exercise.
Bill: It's a good way to lead into the idea of quality being static and dynamic.
Chris: Oh, yeah.
Bill: You want to go down that rabbit hole real quick?
Chris: Okay. Robert Pirsig wrote two books. There's the Zen and the Art of Motorcycle Maintenance. I wrote a piece called Advice for Aspiring Investors. It's a white paper and it's on our website. The reason I wrote the piece was because younger college aged students were reaching out and saying, "What's your advice as far as getting into the investment business?" I found myself repeating a lot of the same tidbits over and over again. I said, let me write this down, and I'll put this out there, and then at least maybe it could help some more people, and save me from repeating myself, and anyway. In that, I include a list of investing books that I would recommend. A few people have looked at that list and they've noticed that Zen and the Art of Motorcycle Maintenance is on the list. Well, that surprised me, because what does that have to do with investing.
I also have Josh Waitzkin's, The Art of Learning on that list, which is indirectly applicable to investing. But I think the bigger concepts apply and I know that, for example, Nick Sleep references some of the metaphysics of quality in some of his letters, and that's Robert Pirsig's invention. But the reason why Zen and the Art of Motorcycle Maintenance is important, I think, is because as we talked about it a couple minutes ago, one of the things that we bring to the table is judgment about quality of businesses and the people. What Zen talks about is how to think about quality. It helps us think about quality, this issue of quality and then both in terms of the object and of the process. I have it framed on my desk, and it says, this is a line from Pirsig. "It can be at a level as simple as sharpening a kitchen knife, or selling a dress, or mending a broken chair, the underlying problems are the same. In each case, there's a beautiful way of doing it and an ugly way of doing it. In arriving at the high-quality beautiful way of doing it both an ability to see what looks good and an ability to understand the underlying methods to arrive at that good are needed."
Bill: I like that.
Chris: It's just an absolute gem from my point of view. As an investor, we both need to understand what looks good, but we also need to understand the process required to arrive at identifying that quality, that business and so that means looking at the elements of competitive advantage and having your business quality checklist if you will, which I think most people have either explicitly written down or in their mind. But then also, how do I make my process, how do I structure my day in a way that maximizes the likelihood that I'm going to be able to identify quality when I encounter it. That for us, those are process questions, and that involves the MIQ, the most important question that involves the essence statements. It involves decision journaling, and writing, and focus, which is super, super important for me. I'm naturally an attention deficit mind. So, I can't have a lot of things going on at once, I need to be really focused on just one thing, and trying to get down to what really matters in a situation requires my exclusive focus over time. That's why Zen and the Art of Motorcycle Maintenance is really interesting to me. Then what Robert Pirsig did was he wrote a subsequent book, I think it was 15 or 16 years later called Lila, which is not--
Bill: [crosstalk] I never hear this interest mentioned.
Chris: Yeah.
Bill: Interesting.
Chris: This is the more important of the two books.
Bill: Really?
Chris: Yes, because in Zen, he talks about quality but he refuses to define it. He says, you would know it if you encountered it, but there's no way to define it. We're getting really philosophical now.
Bill: Yeah. Well, it's the Supreme Court's definition of porn.
Chris: Exactly. His example was, if you're in a classroom of young students and you read a good essay to them, but you haven't taught them about construction of arguments, intros, body, conclusion, any of the structural pieces, but you read them what is a good essay, and then you read them a not good essay, they know which one has quality and which one doesn't have quality.
Bill: Yeah.
Chris: His argument is that quality precedes language and the ability to define it. He refuses to define it. So, that's really not super helpful, though.
Bill: [laughs]
Chris: Because he is not giving us much to work with in that way. You're left with this idea that you should go pursue and cultivate quality, but you don't exactly know what that means. He tries to splice it in a couple different ways, classic versus romantic and these different-- but it's not super helpful. Then he writes the sequel, Lila and in Lila he explains, I think, in a much better way how you should think about defining quality, and he categorizes quality in two separate ways. He has static quality and dynamic quality. There's an example in there and analogy, a metaphor where he says, "The first time you hear a song, you're walking down the street and a car goes by, and they're playing a song, and you love the song, it's the first time you've heard it, and there's just something you love about it, that's dynamic quality." It's newness. You listen to the song a few more times and every time you listen to it, maybe you're a little bit less enthusiastic about it than you were the first time and it gets to the point eventually, where it's a good song, you like listening to it, but it doesn't have that new energy that it had at the beginning, that's static quality.
If you have only dynamic quality, then you have chaos. If you only have static quality, you have degeneracy. You can't have just one or the other. The whole idea is you want to have some balance of the two. Again, this is a lot of philosophy. Then, how do you bring it back to investing? Well, you think about businesses, and you pick any business and you say, "All right, where do I think on the spectrum of static to dynamic this business falls?" Then the real question is, "Do I think that they have a good balance? Are they out over their skis trying new things that have never been shown to work well before?" Maybe that means there's too much dynamism, too much dynamic quality there, and you're taking a lot of risk as the investor or maybe there's just not a lot of cutting-edge thought taking place, things are just too static. You would say maybe it's out of balance in that way and there's maybe risk of being disrupted.
You really can bring this metaphysical idea of quality to investing if you want to. I've a few investing friends, who we love to kick this stuff around and find it really interesting. It's definitely out there. There are two of the more difficult books to get through I realized. And then, the great thing is you can apply this to your life outside of investing as well, which was great.
Bill: This is probably the top for this poor stock, but as you were talking, I think about Google and their philosophy were search, I think-- I don't think it's actually static quality, because I think it's still as amazing as it was the first time I found it. But the idea of continuing to focus on some of the moonshots, and other bets, and keeping that energy in the organization, it's got this natural tension. It's top of mind for me for a number of reasons.
Chris: Oh, it's precisely. I think that's exactly the application 100%.
Bill: Yeah, it's cool.
Chris: Oh, you would ask a question you'd say, we talked about Charter before, like what's the balance of static versus dynamic quality and a cable company? How much does it need? The balance will be different for every business.
Bill: Yeah.
Chris: Or, there are a lot of innovative businesses out there right now that are publicly traded very, very innovative, on the cutting edge, maybe not very profitable. There's a lot of excitement around them. Then from an investable point of view, you just look at them and you say, is keeping in mind that all dynamic quality is chaos, how does that work its way into what you're thinking about? It's a judgment call. Everything at the end of the day is a judgment. Pirsig is not giving you the keys to the kingdom in terms of making the judgment call, but he's helping you think about it in terms of a framework that could be useful.
Bill: Yeah, I like it. Google obviously resonated, but going back to Charter, one thing that I like about that is, what I like about what you're saying as it pertains to that particular entity is they are using a current asset base and wireless agreement to penetrate the wireless market to move the company forward. If we circle back to Altice, that had an MVNO agreement with Sprint, which is not quite the same wireless offering. I was relying on a low multiple and a static, again, it's not quite precise the language but static quality, but I traded an entity that I think is going strategically in a better direction with a better set of assets, and one got hurt. So, I really like this concept. I'm going to have to noodle on this. I may write you about this if that's okay because this is interesting to me.
Chris: Sure. The other thing you look for now I got your attention and you're interested in this is, there's always somebody who does the new thing first, the first person to eat lobster. But somebody had to be the crazy person. [crosstalk]
Bill: Yeah, that person was insane.
Chris: Yeah. What are you thinking like?
Bill: Yeah, the first guy lost his finger. The second guy ate the lobster.
Chris: Yeah, right. First guy, yeah. It's sometimes fun to look inside of one of these businesses for that first person. Who's the instigator of change, who's the person who's challenging the accepted collective wisdom? Sometimes, that can help you determine whether or not there's a good balance of dynamic and static quality, if somebody in a position of authority is that figure who's open to new things and is always innovating is probably a good way of thinking about it, then there's probably amount of presence of that dynamic quality. If you can't find that any place, at least in the top ranks of the business, then it's fair to ask where it might be at all. There's quite a bit of discussion about that. I believe in Chapter 9 of Lila, if you wanted to go in there.
The way of read, Pirsig, by the way, just because I know they're probably a bunch of people who tried and failed to read it, because I did the first bunch of times. You read the first few chapters, then you read the last few chapters, so, you read the first few chapters, so you get away the land. Then I like to read the last couple chapters, because then you know where he's going, which is really helpful. Then, you attack the [unintelligible [01:38:34]
Bill: Yeah. You can watch how he weaved it together.
Chris: Yeah. Otherwise, you read it and then you got to reread it. Because it's only after you finished like, "Okay, I see where he's going with this and now, I have to go back and reread the beginning part because I didn't comprehend what all that meant." If someone's listening who's struggled to make sense of these books before reading them just sequentially chapter by chapter, I might try to do it that way instead.
Bill: Thank you for that tip.
Chris: [laughs]
Bill: I got to be mindful of your time and also, we're coming up on two hours. But I do you want to circle back. What are the last things that are transcribed in the crown molding in the conference room?
Chris: We've already covered the bottom line of all investing as rate of return. We have focus, and there's an Albert Einstein quote, "Everything should be kept as simple as possible, but no simpler,". which there's another quote that I absolutely love, which is Yvon Chouinard, who's the founder of Patagonia. I got this framed over here. He says, "It seems to me if there's an answer it lies in these words, restraint, quality, and simplicity."
Bill: Yeah, this is the essence of what I have gathered from talking to you. That is a very good quote for you to have in the office.
Chris: I leave you if there's a good quote to leave on, we'll leave on that and I just have to thank you for this. This was a lot of fun.
Bill: Oh, please, man. I'm honored to have you. The fact that you want to talk to me is a dream come true for me [crosstalk] not even blow and smoke.
Chris: There aren't a lot of people who will talk to me about the metaphysics of quality and [laughter] Josh Waitzkin. In the same conversation, we talked about The Art of (Not) Selling. From my point of view, there's just no more enjoyable way to spend a couple hours. So, I really appreciate it.
Bill: Well, I appreciate you stopping by and I'm sure that there are a ton of listeners that will as well. So, thank you for your time.
Chris: Great.
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