Chuck Akre’s Three-Legged Stool: A Long-Term Investing Framework

When it comes to long-term investing, Chuck Akre’s iconic "Three-Legged Stool" framework stands out as a lucrative approach for evaluating investment opportunities. According to Akre, three key characteristics can above all drive incredible long-term investment returns: Exceptional Business, Killer Management, and a Reinvestment Moat. Here’s a closer look at each of the three "legs" that make up this robust model.

The first leg focuses on identifying an “Exceptional Business.” Such a business should have enduring and predictable high Return on Equity (ROE) and Free Cash Flow (FCF) generation. These metrics not only signify financial health but also point to the firm’s ability to generate more capital than it consumes.

The importance of identifiable and sustainable competitive advantages in investing can’t be overstated. This could range from having a well-known brand and network effects, to patents, technology, switching costs, or economies of scale. Whatever form they take, these competitive advantages often translate into pricing power or significant cost advantages. These advantages are not just indicators of possible market dominance but also serve as safeguards against inflationary pressures. In a volatile economy, the ability to adjust pricing and keep costs low without losing customers can be a significant advantage.

Understanding the business model is also essential. The reasoning is simple: if you can’t comprehend how a company earns its money, you can’t possibly make an informed judgment on its future prospects.

Another point Akre emphasizes is the importance of avoiding industries where regulatory conditions are such that they limit returns on investment. Such environments often present challenges that even the most robust competitive advantages can’t overcome. For example, utility companies often face strict regulations that limit how much they can charge customers, effectively capping their earnings potential. Even if a company in a regulated industry has strong fundamentals, its growth could be severely hampered by external regulatory conditions.

Lastly, a strong balance sheet is like the safety net of the business, in essence the financial bedrock on which the company stands. A strong balance sheet often means healthy debt levels, assets, and liquidity, all of which provide a buffer against economic downturns and give the company the flexibility to invest in growth opportunities as they arise.

Investing in a business also means investing in the people running it. According to Akre, Killer Management has three main qualities: they’re skilled, honest, and really care about their work. These attributes often translate into excellent operational performance and thoughtful capital allocation.

Being skilled means they know how to run the business well. They make good, long-term decisions with the purpose of maximizing shareholder value. Honesty, or integrity, means they’re transparent and treat investors like partners. They’re also good people you can trust. Caring about their work, or having passion, means they go the extra mile to make the company better. They’re excited about what they do, and arguably have a meaningful impact on the company culture.

Additionally, a lean corporate culture that fosters independence and accountability can set the stage for dynamic growth and adaptability. In terms of compensation, Akre recommends seeking out companies where pay aligns with performance and long-term shareholder value; as Charlie Munger says: “Show me the incentives and I’ll show you the outcome.”

The last leg of the stool emphasizes the importance of a “Reinvestment Moat” – that is, a company’s ability to reinvest capital at attractive rates of return. Such companies demonstrate a disciplined approach to reinvestment, whether in existing operations or through strategic acquisitions.

Companies with reinvestment moats have competitive advantages around their core business, but unlike many other companies, they have the ability to allocate additional capital at high rates of return.

Connor Leonard, president of Arbour National explains this by taking Walmart as an example. As of 1972, Walmart had 51 locations open and the overall business generated a 52% pre-tax return on net tangible assets. These 51 locations were clearly running smoothly and generated great amounts of cash. Now, all companies can’t deploy this excess cash at adequate rates of return, and would many times do best by giving it back to shareholders through dividends or by buying back their own shares.

In Walmart and Sam Walton’s case however, the path was clear; reinvest the earnings in opening more Walmart stores. As of 2023, there are over 11,000 Walmart locations worldwide, and both sales and net income are up almost 500,000%. The concept worked, and why would Mr. Walton distribute the excess cash through dividends or share buybacks, when it clearly was better spent opening more stores?

Having a long runway to reinvest at high returns on capital suggests that the company has a range of growth opportunities ahead. Businesses with a vast reinvestment moat have the ability to continuously channel Free Cash Flow (FCF) back into the business, thereby creating an enduring cycle of value creation.

The Three-Legged Stool framework by Chuck Akre provides a systematic way to evaluate investment opportunities for long-term value creation. By emphasizing the importance of an Exceptional Business, Killer Management, and a Reinvestment Moat, Akre's model allows investors to focus on the critical elements that contribute to sustainable growth and robust financial returns. Whether you’re a seasoned investor or a beginner looking to build a solid investment strategy, the Three-Legged Stool offers a well-rounded approach to long-term investing.