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What Do We Mean By Reinvestment?

Chuck Akre's essay on the critical role of reinvestment in achieving extraordinary compounding returns

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What Do We Mean By Reinvestment?

Author: Chuck Akre Published: October 20, 2014 Source: Akre Capital

Overview

Chuck Akre explains why reinvestment is the third critical leg of his investment stool, alongside a strong business model and exceptional people. The ability to compound capital at high rates is, in his view, the defining characteristic of truly great investments.

The Three Legs of the Investment Stool

  1. Extraordinary Business Model — A sustainable competitive advantage
  2. Exceptional People — Management with integrity and capital allocation skill
  3. Abundant Reinvestment Opportunities — The ability to grow capital at high rates

Why Reinvestment Matters

"The ability to earn earnings upon earnings is essentially the definition of compounding. In the long run, we feel strongly that the rate at which the value of a business compounds will approximate its returns on reinvestment."

The Dividend Reality

Many investors focus on dividends, but Akre argues this leads to average returns:

"The reality is that dividends are the route to average returns, and our goal is decidedly to seek above-average returns. Excellence in reinvestment is the route to such returns."

The Mathematics

Consider a business with 21% return on capital:

Scenario Result
Purchased at 3x book, 100% dividend payout 21% / 3 = 7% return (average)
Retained and reinvested at 21% 21% annual growth

The key insight: The price you pay for a business determines your returns, not just the underlying business quality.

Reinvestment Strategies

Different companies have different approaches:

  1. Acquisition-focused — Expert at bolt-on acquisitions
  2. Organic reinvestment — Fixed assets and inventory to expand
  3. Opportunistic allocation — Flexibility across asset classes

One company described their capital allocation as: "Each day, we get to choose from a varied menu as to how to allocate capital to continue to build the value of your company."

The Compounding Machine

"With an outstanding reinvestor at the helm, even an ordinary business can become a remarkable compounding machine."

Berkshire Hathaway exemplifies this — beginning as a struggling textile mill and compounding at extraordinary rates through reinvestment.

Key Quotes

"The price a shareholder pays for a wonderful business is typically a substantial multiple of the actual capital invested in that business."

"Excellence in reinvestment is the route to above-average returns."

Related

Source

Original essay from Akre Capital, October 2014.