The Akre Focus fund looks a bit different since legendary investor Chuck Akre began turning the reins over to co-managers John Neff and Chris Cerrone, but the goal is still transcendence. The duo still buy the companies Akre described in the late 1980s as “the nirvana in investing”—superior businesses that are exceptionally well-managed.
Over the last couple of years, the pair have found more nirvana in technology and less in the financials and insurers that Akre favored years ago—and helped the fund earn an average annual return of 19% over the past decade, beating 89% of its peers. Neff and Cerrone still run a concentrated fund of about 20 stocks, and the fund has returned 18% so far this year, beating 90% of its large-cap growth peers, according to Morningstar—and they did it without owning some of the market’s biggest and most-loved tech companies.
Barron’s spoke with Neff, who began co-managing the fund with Akre in 2014, and Cerrone, who worked as an analyst on the fund for years before becoming co-manager a year ago. (Neff, by the way, isn’t related to the late John Neff of the Barron’s Roundtable.) Our edited conversation tackles stock-picking while inflation is rising, the $25 trillion shift into alternative assets, and more.
Barron’s: You look for “quality” companies. What does that mean, and where are you finding them?
John Neff: We’re talking about durable competitive advantage—and that has to be something we can understand and monitor. It’s why a business wins, and why it should continue to disproportionately win.
[MCO] is a quantitatively outstanding business in terms of its margins, returns on capital, and long-term growth. But our investment centers on its competitive advantage: Moody’s acts as a toll bridge to the capital markets for debt issuers of all stripes. The fundamental product that Moody’s sells to debt issuers is credibility with debt investors. Moody’s has built its credibility for its credit ratings over the past 120-plus years over every economic cycle.
How does a newer competitor with less credibility to sell to a debt issuer tend to compete with Moody’s? They tend to offer higher ratings, a lower price, or both. But competing that way undermines the already much lower credibility those competitors have in the first place. That makes for a powerful competitive advantage for Moody’s, and explains why we’ve always believed the credit ratings business to be a natural oligopoly.
Your fund has more technology than in the past, but just two-thirds as much as the average large-cap growth fund, according to Morningstar. Why?
Neff: Industry classifications can be misleading. Moody’s is categorized as a financial company, but neither lends nor invests money.
[KMX] is categorized as consumer discretionary, but makes roughly half of its earnings from auto loans.
You own several software companies. What is the draw?
Chris Cerrone: A business like a software company has network effects—the more people who use it, the stronger it gets. That makes it much more difficult for [even] a better product to take those customers away. Switching costs are so enormous that it’s unthinkable somebody would rip out and put in something else, or there’s a complete lack of alternatives. Those are the businesses you can hang your hat on without being a technologist.
What is a software company that fits that profile?
[CSU.Canada]. You take all of the attractive aspects of a software business—the essential nature of the product, a great business model, high margins, and a great runway for software to continue impacting new areas of our lives—and marry that to one of the best capital allocators of our generation in founder Mark Leonard, who started off as a venture capital investor.
Mark created Constellation in 1995, acquiring small, vertical-market software businesses, those focusing on just one niche market, like software for a bowling alley or a golf course. He’s a brilliant case study on capital allocation and governance of a large organization. There truly is a feeling of trusteeship, which to me means fiduciary duty to the shareholders. Mark also has skin in the game; he and his interests own just shy of 7% of the company, collectively over $2 billion. As part of the compensation structure, instead of receiving stock options, he gives employees [a cash bonus] but requires them to buy shares.
Why is insisting employees buy shares better than stock options?
Cerrone: There’s no dilution, and they are consciously clicking a button to say I want to buy these shares, which leads to a psychologically different experience than receiving shares for free.
Cerrone: We are trying to harness big secular trends, companies with the wind at their back. That includes the enormous shift of sovereign wealth funds, large public pension plans, and other institutional investors moving trillions of dollars out of stocks and bonds and into alternative asset classes, like private equity, real estate, infrastructure, and private credit.
Rising interest rates, if they are consistent with inflation, will be a new investment regime.
In 2000, most large institutional investors were targeting a 5% allocation to alternative asset classes. Most recently, that has been about 25%. If you believe Brookfield CEO Bruce Flatt’s long-term assessment [that we’re] in a low-growth, low-interest-rate environment, that allocation could reach north of 50%. So we’re talking about as much as $25 trillion of capital rotating out of other asset classes into alternatives over the next decade or so. The managers of those alternative assets could be really interesting.
Why those two?
Cerrone: It goes back to their approach to reinvestment and culture.
Apollo Global Management
[CG] pay out the vast majority of cash flow through variable distributions to their shareholders. KKR did that until the co-founders and leadership realized there was a cost to distributing that cash flow: If they were to hold onto businesses for longer, or reinvest the cash from selling businesses, there was a great compounding opportunity. Brookfield similarly has a “retain cashflow and reinvest” mentality.
Both are also unique culturally. Everyone’s compensated based on the success of the firm as a whole. It’s less of a mercenary, eat-what-you-kill situation. That really appeals to us; it’s how we structure our business. KKR is probably pretty fairly valued here. At today’s prices, it suggests a midteens return, which means you’d double your money in five years.
We may see higher interest rates in the not-too-distant future. How does that affect your thinking?
Neff: Rising interest rates, if they are consistent with inflation, will be a new investment regime. If we were to move into a higher interest rate, higher inflation environment, having high returns on tangible capital [assets like property and equipment]is going to be a very important consideration.
Our portfolio average had [in March] a 179% return on gross tangible capital, which is astronomically high. The businesses that we own don’t need a great deal of tangible capital to operate, and earn very high returns and high margins. The higher the returns on the tangible capital needed to support the sales and earnings of a business, the more efficiently and profitably a business can stay ahead of inflation.
Are you concerned about inflation?
Cerrone: We invest in “all-weather” businesses. That said, you can see [the impact] of wage inflation and higher energy prices on some retailers, like
[DLTR], which pays for a substantial amount of their products to be shipped from overseas.
Inflation has averaged 2.5% per year since Dollar Tree opened its first $1-only store in 1986. Against all odds, they have maintained the $1-only price point. They have some of the best margins in all of retail, helped by its purchasing scale, buying direct from suppliers overseas, and tight supply chain management. All of that gives us confidence they will navigate today’s inflationary challenges.
How are you thinking about some of the behavioral changes that came out of the pandemic?
Neff: The pandemic accelerated the proportion of commerce being done online by about three to five years. I don’t see that dipping back to where it was. The pandemic also put a spotlight not just on companies benefiting from the shift to “online everything,” but also on companies resistant to that imperative. Both can be valuable.
For example, we last purchased shares of
[ORLY], a leading aftermarket auto parts retailer, during the first half of 2017 when the shares were under pressure due to concerns that ecommerce—
—was threatening its brick-and-mortar retail business. Part of our thesis was that O’Reilly’s business was particularly well-insulated from online competition, due to the acute need of its customers to have parts available at the instant time and place of need. O’Reilly’s 5,700 physical stores are ideal for serving this unique market.
How did O’Reilly fare during the pandemic, when everyone was buying everything online? It had its best same-store sales performance of the past 25 years in 2020, with very little help from online sales.
What risk are you monitoring?
Neff: High valuations for many otherwise attractive businesses. We are not bearish, but there will be better opportunities [to buy].
Thanks, John and Chris.
Write to Reshma Kapadia at firstname.lastname@example.org