Last week, I introduced you to Chuck Akre, a small-cap growth manager with an enviable track record who focuses on fast-growing companies sporting an annual return on equity (ROE) of 20% or higher. His simple but effective investment philosophy is that you will outperform the market if you invest in companies that are more profitable than the average company. Above-average profitability leads to above-average stock price appreciation.

First Some Peter Lynch Wisdom

But yesterday’s article ended with a cliffhanger: how can an investor tell if a company’s ability to generate above-average profitability is sustainable? A profitable investment depends upon the future, not the past. In his book One Up on Wall Street (page 111), legendary Fidelity fund manager Peter Lynch wrote about the perils of investing in high-growth stocks that slow down:

Sooner or later every fast-growing industry becomes a slow-growing industry, and numerous analyst and prognosticators are fooled. There’s always a tendency to think that things will never change, but inevitably they do.

Once a fast grower gets too big, it faces the same dilemma as Gulliver in Lilliput. There’s simply no place for it to stretch out.

But for as long as they can keep it up, fast growers are the big winners in the stock market. I look for the ones that have good balances sheets and are making substantial profits. The trick is figuring out when they’ll stop growing, and how much to pay for the growth.

In his next book, Beating the Street (pp. 158-59), Lynch explained that selling a fast-grower too early can be just as damaging to your wealth as selling too late. He gives the example of Wal-Mart (NYSE: WMT) which had increased in value 20-fold between 1970 and 1980. An investor in 1980 who shied away from buying Wal-Mart stock because it had already gone up so much would have missed out on a further 50-bagger during the next 11 years (1980 to 1991). Lynch wrote that the key to analyzing back in 1980 whether Wal-Mart’s fast growth was sustainable or about to end was its market opportunity:

The important issue to analyze was whether Wal-Mart had saturated its market. The answer was simple: even in 1980, after all the gains in the stock and in the earnings, there were Wal-Mart stores in only 15 percent of the country. That left 85 percent in which the company could still grow.

In a retail company or a restaurant chain, as long as same-store sales are on the increase, the company is not crippled by excessive debt, and it is following its expansion plans as described to shareholders in its reports, it usually pays to stick with the stock.

Chuck Akre’s Three-Legged Stool

Chuck Akre thinks similarly to Lynch about how to analyze profit sustainability. At his investment firm, a picture of a three-legged stool is displayed prominently because it encapsulates Akre’s investment philosophy. For a complete description of the three-legged stool, you should read pp. 5-6 of his 2002 annual shareholder letter, but here it is in a nutshell:

1. Business Model: Does the business currently generate high profitability? Is it a predictable and understandable business?

2. People: Is the management team shareholder friendly? Does it take seriously its responsibility as a steward of investor capital?

3. Reinvestment: Does management have the capital allocation skills necessary to invest corporate money in projects that earn a return above the cost of capital? Is the market the company operates in big enough to offer substantial reinvestment opportunities or is it already saturated?

Stool Leg #1. In analyzing the first leg of the stool – business model – Akre tries to understand why the company is earning high returns. What is the company’s competitive advantage, if any, and is this advantage sustainable? Examples of competitive advantages include intellectual property that is patented, economies of scale that allow a company to be the low-cost provider, and government regulations that limit competition. Akre uses an airport runway as a metaphor for competitive advantage and seeks to determine “how wide and long is the runway?” If the runway is too narrow, there isn’t much room for reinvestment and growth. If the runway is too short, there isn’t much time before competitors will match the company’s processes and erode its ability to generate abnormally high returns.

Akre tells the story of Bandag, a manufacturer of tires and tire retread services. An intern at his firm was the first to recommend Bandag as a potential investment because it was highly profitable, routinely generating an annual ROE above 20%. Akre was skeptical because he viewed the tire industry as a highly competitive and commodity business with little room for competitive advantage. But when he looked deeper, he discovered that Bandag actually did possess a competitive advantage but it was not in the manufacture of tires. Bandag’s competitive advantage was in its relationship with independent tire distributors, who were fiercely loyal to Bandag. Akre determined that these distributor relationships were sustainable and ended up investing in the company.

Stool Leg #2. In analyzing the second leg of the stool – people – Akre evaluates management from two different perspectives: skill and integrity. Both are crucial to business success: skill without integrity and integrity without skill are equal roads to ruin. According to Akre, a manager’s skill and intelligence are easier to identify than a manager’s character and integrity. The same is true when evaluating potential hires at his investment firm. Akre says that ascertaining management integrity is “the tough question and the answer which often takes us years to discover.” One short cut Akre uses is to favor “owner operators,” which refers to managements that own a lot of company stock. The thinking is that if management’s financial interests are aligned with shareholders, they will do right by shareholders regardless of integrity. He also makes sure that management’s compensation is not excessive. Second, Akre looks for management that is in the hands of the founding entrepreneur, because he finds entrepreneurs to be people with passion and pride in having creating a business, rather than just a business suit collecting a paycheck.

As an example of an entrepreneurial CEO, Akre discussed an investment he made back in 2002 in American Tower (NYSE: AMT), a provider of mobile communication towers. By June of 2002, Akre had accumulated half a million shares in the company at an average price of $5 per share. He thought he had purchased the company at a bargain price, given the stock had traded as high as $50 two years earlier. But the stock price continued to decline into the autumn of 2002, falling to a closing low of only $0.71 per share in early October.

Akre obviously wasn’t pleased, but he didn’t panic and sell out of his position because he had confidence in American Tower’s CEO Steven Dodge, a serial entrepreneur who had founded three separate successful companies. Akre visited Dodge in September 2002 and left impressed with Dodge’s vision for the company and Dodge’s supreme confidence that he could turn the company’s fortunes around. Although American Tower suffered from a heavy debt load, Dodge promised Akre that he could pay off the debt by generating cash flow and would not hurt existing common shareholders by issuing new shares. Akre held on to his position and within a year, the stock had risen 1000% percent and Akre had more than doubled his money.

Stool Leg #3. In analyzing the third leg of the stool – reinvestment opportunities – Akre provided his 2002 investment in American Tower as an example yet again. It turns out that building cell phone towers is an extremely simple business that can grow fast with very little incremental capital expense. More than one mobile operator can place its transmitters on a tower. This means that for each new mobile operator American Tower signed up for a given tower, the company’s profit margin was extremely high (70%) because the cost of tower construction had already occurred and did not need to be repeated. Akre calls this high profit-margin business model “vertical real estate.” With mobile communications growing like wildfire – everyone and their mother was buying a cell phone – Akre was confident that American Tower’s profits would ramp up quickly as more mobile operators installed equipment on its towers. Akre was proven right; American Tower’s free cash flow rose quickly and it was able to easily pay off its excess debt. To this very day, American Tower remains one of the largest stock positions in Akre’s fund. Now that’s what I call sustainable profitability!

Valuation Matters

Successful investing requires not only identifying strong businesses with sustainable profitability, but also a clear understanding of what a company is worth and only buying when the market price of the stock is below the stock’s intrinsic value. Akre doesn’t spend much time with Excel spreadsheets and detailed discounted cash flow (DCF) analyses – his college major was English literature, after all. His favored valuation metric is price to free cash flow. Since he focuses on businesses with predictable and stable cash flows, using a snapshot multiple of cash flow works for him because the cash flow denominator is unlikely to decline from year to year. Any cash flow multiple in the 10 to 12 range represents good value for Akre, since this is below his 20% ROE profitability threshold.

When you combine high and sustainable profitability with low valuation, you have investment nirvana. Akre refers to this combination as the “Davis Double Play,” which refers to the great investor Shelby Davis who turned a $50,000 initial investment into $900 million over his lifetime. Davis looked for investments that would generate stock price appreciation from two different sources: (1) earnings growth; and (2) a revaluation of the company’s P/E ratio based on increased investor confidence. If a company grew its earnings from $10 to $20 but the company’s P/E ratio remained at 10, the company’s stock would double from $100 (10*$10) to $200 (10*$20). But if the company’s P/E ratio also increased from 10 to 15, then the company’s stock would triple from $100 (10*$10) to $300 (15*$20).

To demonstrate the importance to investor returns of buying fast-growing companies at cheap prices, Akre provided the following table on American Tower’s stock performance from different purchase dates until the present:

The price you pay for a stock does matter!

Profitable Investing Requires Evaluating the Future

Bottom line: stock screens are a good first step, but they measure only the past. To find the big stock market winners of the future, you need to evaluate a company’s future ability to maintain its competitive advantage and high profitability, the future integrity of a company’s management, and a company’s future opportunities to reinvest and grow.