Three-Legged Stool

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Charles “Chuck” Akre manages ~$11.8B from a small town in rural Virginia, far removed from the frenzy of Wall Street. His team dedicates their time to hunting for what they call “compounding machines,” and their track record speaks for itself (1.2% outperformance over 16 years).

To find these compounders, Akre uses a simple framework he calls the "three-legged stool." The visual below is from Akre's website where they describe this approach:

Below, we'll walk through each leg of the stool in more detail, based on our learnings from Akre’s website, annual letters, and Value Investor Insight interviews conducted over the years.

The first leg focuses on business quality. Akre developed this insight partly from his early investment in Berkshire Hathaway, where he noticed that growth in book value per share drove shareholder returns over time.

He also recognized that long-term stock market returns have tracked the aggregate return on capital of the underlying companies. Average annual equity returns have hovered around 10%, while real return on equity for American business has averaged in the low teens.

Over decades, stock returns follow business returns. Charlie Munger made the same observation:

This explains why Akre targets businesses generating returns on equity around 20% rather than settling for average performers. When you're after compound growth, the rate of return matters more than almost anything else.

Businesses earning exceptional returns usually possess some durable advantage. That edge might come from proprietary technology, cost advantages from scale, regulatory protection, sticky customer relationships, or network dynamics that strengthen with size.

Akre wants to understand what produces those unusual economics and whether the advantage can persist.

Future runway matters too. A company earning 25% on capital today won't help investors if those returns fade to 10% within five years. Akre always asks how much opportunity remains and how long strong returns can continue.

His preferred businesses share common traits:

Quality businesses also tend to hold up better when markets turn ugly. Steady profitability through recessions combined with conservative balance sheets protects shareholders from permanent losses.

The second leg assesses management. Strong operators have demonstrated success, treat outside shareholders fairly, and make smart decisions about deploying capital.

Akre's team conducts extensive due diligence. They dig through annual reports, compensation disclosures, and executive backgrounds. They tour facilities and meet with leadership teams. They pose broad questions designed to expose how managers actually think about their businesses.

One question Akre routinely asks executives is how they define success at their company. The responses tell him whether their priorities align with shareholders.

Some CEOs point to stock price appreciation. A few even keep real-time stock tickers on their office monitors. These aren't characteristics Akre finds appealing. Watching the stock price all day suggests misplaced focus.

Executives who talk about growing the company's intrinsic value per share get Akre's attention. That answer signals they're thinking about building the business rather than managing perceptions.

Compensation structures also matter. Akre examines total pay levels and the metrics that determine bonuses. He favors managers who own meaningful stakes in the businesses they run rather than relying purely on options or restricted stock grants:

History tends to repeat itself with management behavior. Executives who have treated shareholders poorly in the past usually do so again.

The final leg evaluates capital allocation. Over time, Akre has come to view this as the most important factor:

Warren Buffett once calculated that after 10 years, a CEO whose company retains earnings equal to 10% of net worth will have directed the deployment of more than 60% of all capital in the business. How management reinvests profits shapes long-term outcomes more than almost any other decision.

Compounding only works when profits can be reinvested at attractive rates. A business generating high returns today but lacking places to deploy that cash won't compound wealth for shareholders, as our visual below illustrates:

The question is whether management can find enough high-return opportunities to put all that excess capital to work.

This is where many strong businesses disappoint. Akre has observed that talented operators frequently make questionable capital allocation choices. Typical mistakes include:

Each decision might seem defensible in isolation, but they sacrifice long-term compounding potential.

Akre views capital allocation as the single most important responsibility any CEO faces, and the area where executives most quickly create or destroy permanent value.

Skilled capital allocators can transform even mediocre businesses into wealth compounders. Berkshire Hathaway, for instance, started as a failing textile manufacturer before Buffett redirected its cash flows into better opportunities.

When all three legs check out, Akre considers the business a compounding machine. These opportunities don't come along often. His team spends considerable time evaluating companies, and most fail to meet the full criteria.

Once Akre identifies a compounder trading at a reasonable price, the goal is to hold indefinitely:

Paying what appears to be a full price can still produce excellent results if the business keeps compounding at high rates. What matters is staying invested through short-term noise.

Akre thinks in 5 and 10-year increments. Selling after a disappointing quarter or during a market pullback means abandoning the compounding process before it can work.

True compounding machines are scarce. But patient investors willing to do the work can find them!