Most investors want to take advantage of the high-flying U.S. equity market but remain worried about the daunting challenges the country faces. Charles Akre, former manager of FBR Focus, struck out in 2009 to launch Akre Focus. Concerned about the U.S. government’s huge debt burden and overextended household balance sheets, Akre loaded up on lower-end consumer names with attractive growth potential. He also established positions in financial firms that would benefit from rising interest rates and mounting inflation. He keeps a lot of cash on hand as both an insurance policy and a store of dry powder to take advantage of any opportunities that might arise.
Almost a quarter of your fund’s assets are allocated to cash. Why do you maintain such a high cash allocation?
In a recent Wall Street Journal op-ed, Charles Koch (chairman of Koch Industries and a prominent conservative) spoke about the problems facing our country, noting the amount of debt the federal government holds both on and off the balance sheet. He observed that the Social Security, Medicare and Medicaid systems are unfunded liabilities of over $100 trillion. Decades ago, former Congressman Everett Dirksen (R-Ill.) said, “A billion here, a billion there, pretty soon, you’re talking real money.” Decades later Koch said, each man, woman and child in this country owes $300,000 on that debt.
There’s an unsustainable amount of debt piled on this country. The U.S. needs to quit kicking the can down the road and begin to deal with this problem. The best solution is for the U.S. to grow out of its debt, but an unemployment rate of 9% or higher makes that scenario unlikely. Consumer spending accounts for 70% of U.S. gross domestic product. Elevated unemployment and decreased borrowing capacity through home equity lines and credit cards should cap economic growth for the foreseeable future.
The consumer is further constrained by a need to save for retirement. The assets households had set aside suffered steep losses in 2008 and 2009. Consumers also need to pay down personal debt, which has only declined by about 5% over the past few years. The consumer’s ability to spend has been greatly reduced. Don’t expect the U.S. economy to grow its way out of debt.
The most likely solution to our expanding debt is to devalue the U.S. dollar. This will make the dollars that the U.S. repays to its creditors worth far less than when they were borrowed. A 1970s-style inflation and interest rate spiral is possible. The odds of that outcome are better than even, though I’m not an economist and I don’t focus exclusively on this issue. Personally, I don’t expect a massive run-up in inflation.
Even starting to resolve these problems will cause discomfort in all parts of U.S. society. Therefore it’s wise to remain cautious. Although we’ve had velvet revolutions in the past, we’re now witnessing violent uprisings in the Middle East and North Africa. This turmoil continues to spread. No one knows how those revolutions will be resolved, but the concerns about this upheaval are reflected in higher prices of oil and gold.
We can see the impact of the Federal Reserve’s quantitative easing and asset inflation programs, which some claim are having a direct effect on food and other commodity prices.
The U.S. is in a slow recovery. I’m an optimist, a quality that’s essential to being a successful investor. That being said, it’s best to remain cautious. That means holding ample cash so that you can take advantage of the opportunities created when the market takes the occasional spill. After all, the market is up nearly 100% from its March 2009 lows.
Despite your concerns about U.S. consumer spending, you seem to have a very consumer-oriented portfolio. What explains this ostensible contradiction?
We hold shares of CarMax (KMX). New car sales are rising, but used car sales have rebounded as the economy remains less than robust. CarMax is the best in the business and controls about 3% of the U.S. used car market, so they have plenty of room to ramp up.
We also hold shares of Dollar Tree (DLTR), which operates a chain of dollar stores. The stock trades at 11 times earnings, and the company boasts a record of compounding free cash flow in the upper teens. This is a business that performed wonderfully in robust economic times and is well-suited for a time when consumers are still trying to stretch their dollars.
We also own Ross Stores (ROST) and TJX Companies (TJX), two retailers that specialize in off-price apparel. These stocks have similar characteristics, with a valuation of 10 to 12 times free cash flow and histories of compounding shareholders’ capital by nearly 20%. Ross Stores and TJX tend to do well when consumers are cost sensitive.
These three companies have wonderful balance sheets. One of them has no net debt and the other two have very modest amounts of debt. And they’re extremely well-positioned to attract cash-strapped consumers who still requires clothes, house wares and other necessities.
We also hold TD Ameritrade (AMTD) and optionsExpress Holdings (OXPS). These companies provide online trading for consumers who prefer to manage their brokerage accounts on the Internet instead of calling their cousin Dick down at Merrill Lynch.
These companies don’t have much to do with a constrained consumer. The investment case is related to individual investors returning to the market. The Federal Reserve’s efforts to inflate asset values have prompted investors to shift their assets into equities from cash, U.S. Treasury notes and other safe havens.
TD Ameritrade is also an indirect play on interest rates. The huge customer balances enable the firm to earn a spread on that money. Rising rates can make a substantial contribution to the company’s income and revenue streams.
OptionsExpress is a specialty company that deals entirely with options strategies. It’s a terrific business whose stock sports a modest valuation.
The one holding that provides our portfolio with direct exposure to the consumer discretionary segment is Penn National Gaming (PENN). Visits to casinos are down for the third year in a row. Play per visit is down. Competition within the space continues to intensify. The outlook for Penn’s organic growth isn’t as robust as it used to be.
Why do we own it? The CEO has been the best in the industry at building shareholder value. The company has been very aggressive in adding new casinos. Penn is building a new gaming location in Kansas City and two new facilities in Ohio that will beef up its existing presence in the state. The firm also has operations in Texas, Florida and Maryland.
We’re seeing a lot of heady predications that corporate earnings will break another record this year. Do you subscribe to this outlook?
First of all, many businesses - for instance, healthcare and manufacturing - aren’t directly consumer oriented. These will continue to grow nicely. Businesses cut costs to the bone three years ago and, by and large, have yet to rehire, so general and administrative costs are much lower than they were at that time. Add in solid growth and lots of sectors could post higher earnings.
Take the retailers that we own. They’re growing square footage and if all goes well they’ll have some margin improvement off a larger base. Some stores they opened last year will mature and grow sales. As a result, our retail holdings could post a free cash flow growth rate in the mid-teens.
If we focus on companies whose shares trade at very modest multiples, we can limit risk without constraining potential upside.
What’s your best piece of advice for investors?
Don’t be overwhelmed by a rising market and don’t be driven by the fear of missing out.
Make sure you have a margin of safety in your pool of assets. Also make sure that you’re prepared for a rainy day should it come - not that I’m predicting one.