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Here’s an experience lots of advisors can identify with: for an allocation to small cap, they find a small-cap fund that consistently outperforms in both good and bad markets only to discover that–it’s closed! Small-cap funds tend to close sooner in their large-cap brethren because finding enough attractive small-cap companies that have the requisite liquidity to deal with flows of cash into and out of small-cap funds can be difficult. So when you find an interesting small-cap fund–and it is open–well, it can make your day.

There is a small-cap fund, the $1.6 billion FBR Small Cap Fund (FBRVX), that had closed to new investors in October 2004, when, “at the time we had roughly $350 million in cash on a maybe $900 million fund and we just weren’t able to put the money to work in an efficient way and in a timely way,” says Chuck Akre, who has managed the fund since its inception in 1997 His firm, Akre Capital Management, is sub-advisor to the fund.

Standard & Poor’s gives the fund five stars overall, as well as in the one-, three-, five- and 10-year time periods. Within S&P’s Small Cap Growth style, the fund’s performance rank is number three out of 569 funds for the three years ended March 30; number two of 444 funds for the five-year period; and number six of 175 funds for the 10-year period. The fund has had annualized total returns of 17.36% compared with 12.85% for the S&P/Citigroup 600 Growth Index for the three-year period; 19.61% for five years versus 10.95%; and an average return of 18.20% for 10 years, compared with 11.80%.

Perhaps more remarkably, in 2001, when the average domestic equity fund was down (-11.88%), this fund was up 32.63%; in 2002, the fund was up 2.63% while the average equity fund declined (-22.09%), according to S&P. The fund’s expenses are a relatively low 1.40%, compared with a peer group average of 1.91%, in part because of the fund’s low turnover of 3%, versus peers’ average turnover of almost 107%.

Why did you open the fund again?

That’s the obvious question. The trustees came to us in the late summer and said would we consider reopening. At the time we closed, 2 1/4 years ago–we’d asked them in the summer of 2004 if they would close the fund, and it occurred at the end of October. At the time we had roughly $350 million in cash on a maybe $900 million fund and we just weren’t able to put the money to work in an efficient way, and in a timely way, so they did close it.

When they came back to us [to talk abut re-opening] we had cash balances of 4% or 5%, had had that for a while, and our response to them was: Over the next couple of years we think we’ll have some opportunities, we don’t know when they’ll be. Valuations were much more attractive at the time they asked us than they are today; we’re pleased to have the fund reopened. I remain a seven-figure investor in the fund, and have been for a long time; put money in the fund, and 401(k) plan, even for my adult children, every month. So we think there will be opportunities, maybe some significant ones, over the next couple of years, and in the meantime we’re still finding some places to put money to work in our usual style, which is gingerly and patiently.

How many people do you have working with you on the fund?

On the idea side there are four of us, myself included, and there are a total of eight people in the firm.

Where’s your firm based?

It’s in Middleburg, Virginia, which is about 45 miles west of Washington D.C. It’s in what’s known as the Piedmont; it’s in the horse country; it’s a town with one traffic light, about four or five places to have lunch, or get your prescriptions filled, or have your saddle fixed, and 30 minutes from Dulles–we travel a lot, and it’s easy to get to the airport and travel. I live on a farm, and a couple of other people in the office live on farms and are involved in horse things, so it’s an issue of both lifestyle–quality of life–as well as the fact that in terms of my own wiring, I like things to be quiet.

Our firm is called Akre Capital Management–we’re sub-advisors of the fund. I was an employee of FBR at the time we started the fund in January 1997, and I separated my business from them at the end of ’99 and the relationship became [that of] a sub-advisor, so I’ve always managed the fund for its 10 years.

Would you tell me about your investment philosophy? I know you keep the number of holdings fairly low.

Right. We observe that for 80-odd years in the United States the annual returns in common stocks are in the neighborhood of 10%. That leads us to the question: Why is that so? Why isn’t this a make-believe number, and what’s causing that? What we conclude is that it relates to what we believe the real return on equity in all of those businesses is, across that whole period of time, when you get rid of all the accounting garbage. That is, the real economic return on equity is in the low teens and therefore those numbers correlate. Sort of in a scientific way we’d postulate from that and say, well, our return in an asset will approximate the return on equity over a period of time given a constant valuation and an absence of any distributions.

We say to people, here’s an easy way to think about it: take a $10 stock with a $5 book [value], and $1 worth of earnings, apply whatever return on equity you want to that, keep the valuation constant, and see what happens to the share price, so then it becomes axiomatic when you work that out in your mind; it becomes very straightforward.

If the average of all these American businesses is around $10, we want to fish in a pond where the returns are substantially higher. In the mutual fund, we’ve fished in a pond where the returns are closer to 20% than 10%. If you just stand still for a minute and say, gee, businesses on average have a return on owner’s capital of around 10%, and here’s a group of businesses where the return is, call it 18%, then something unique must be going on there that allows them to have those much-better-than-average returns. We spend a lot of time trying to figure out what that is, why is it so, and is it getting better or worse? Because what we’re looking for are businesses that have the opportunity for these way-better-than-average returns for some period of time in the future and that we have a high level of confidence that that will occur. That’s the first point in our investment approach that we focus on–we call that the business model. Way-better-than-average businesses that have had a terrific record and we think are likely to continue to have that way-better-than-average experience going forward.

The second piece of this investment process is what we call the people model. We can take some level of comfort that the managers that have created this long record of way-better-than-average results are likely way-better-than-average managers. The other part of [the people model] that we focus on is: do they have a record of having acted in the best interests of all shareholders? Does what happened at the company also happen on a per-share basis? We talk to them, we read what they write, we listen to them, we see how they behave, we see what things are important to them, because it’s very important to us that what’s happening at the company is in fact happening all the way down on a per-share basis.

With options accounting, in the past one of the things we would do is compare the compound rate of growth in the net earnings with the compound rate of growth in the net earnings per share, and we would always find a discrepancy, and the discrepancy almost always was related to options and we’d look to see how wide that was, because options were simply a way of taking money out of a company and giving it to a group of individuals instead of to the shareholders. If you were the recipient of the options, you naturally want that system to stay in place; if you’re a shareholder you want that system to be de minimis.

Last is the reinvestment model. We have a presumption that this great business and these great managers are gong to have excess profits to reinvest, and so this third leg is the reinvestment model. We want to see that because of the skill of the manager, and the nature of the business, there’s an opportunity for them to reinvest their excess profits to continue to earn these unusually high rates of return. It’s a compounding machine when you have that. It creates a compound return. We’re great believers in compound returns.

Then we get very quantitative; we’re just not willing to pay very much for it. We measure free cash flow; we’ll put a multiple on that. To be perfectly honest we’re thrilled when we can buy things that have multiples that are in the low- to mid-teens, and we’re less thrilled when they’re higher than that. We can do the arithmetic, and we’re having this debate in our office today, as we’ve had last month, and last year, and all good managers have it all the time, and that is: Should I pay 20-times or 25-times for a business that there’s a high degree of confidence that it will grow at 15% a year for a decade? Well you can do the arithmetic and know that if you pay 25-times for it you’ll do just fine, if in fact they grow at 15% for a decade.

The risk it creates for us is that, in the uncertain economic and uncertain market times, which we have no ability to predict, it gives us a lot of price-volatility exposure that we choose not to have; we’re just stingy, and it’s created a record that is better than average, and hasn’t had enormous downdrafts associated with it over the 10 years we’ve been in existence, and I think part of that has to do with our discipline about valuation. But it’s a constant question–you can do the arithmetic and you’ll have a terrific return even if you pay those multiples, you’ll just have a lot of risk in the price in some interim period, whether it’s a year, or two.

So free cash flow is your primary metric?

At the end of the day it’s the most important thing–it’s the way you measure the business: how much cash is produced by the business for the owners to reinvest–to do something else with. The reason we’re really interested in the reinvestment, obviously, is because if they pay it out to us, it’s a very inefficient way for us to compound capital; we have to pay taxes on it, or if we’re tax-exempt and we don’t have to pay taxes, we’ve got to put it back somewhere where we hope we can get one of these high rates of return, so it’s integral in terms of trying to compound the value. If we’d had nothing [other] than the investments we’ve had over these years, and they paid out all their excess capital, our returns would have been way below 18% compounded annually because we’d have had to take it and put it somewhere else. You’d get frictional [transactional] costs associated with that.

Have you had upside or downside surprises over the years?

What we say to people is, if an investment doesn’t work out, theoretically our cost is the time value of money. In actuality, of course, that’s not true. We’ve had businesses that have gone down in value because there had been some aspect of it we simply didn’t understand well.

It’s always taken me a very long time to understand how good the ones are that are very good. An example: many years ago there was a company out on Long Island that we owned some shares of called American List; it was a list broker, and you’ll see maybe one or two list brokers that are public companies. There’s no reason for them to be public–they make so damn much money–why do you need shareholders? American List literally has 50% after tax margins. The guy who ran it was the fellow who founded it, and he was a sweetheart, terrific at the business, [but] he didn’t get the investor’s equation at all. He had actually sold his majority interest in the company to a Wall Street firm ten years before, this must have been the late ’70s, and he’d gotten 10% munis and he thought that was nirvana. As a result of not being able to accommodate all that extra cash, he just paid it out in a dividend. It was very inefficient–so it had a great business model, great people model, and a lousy reinvestment model.

I had a very small business, and I really wanted to have a business large enough to be able to acquire him, and have it sitting inside my business just throwing off this cash for me to invest elsewhere–it’s like Buffett: send the check to Omaha. Ultimately, Snyder Communications bought it–Snyder owns the Washington Red Skins. At the end of the day we basically broke even in an investment for a year and a half or something like that–there were some accounts that had little losses and some accounts that had little gains. I use it as an example because it was missing this integral piece of reinvestment and we lost the time value of money, essentially, for maybe close to a two-year period.

Each of the pieces is really integral–if you threatened me with my life and said I had to name one of those that was most important–I would say the people. Human behavior is probably more important than anything else in terms of the outcome of an investment, but all three are important.

Have any companies surprised you on the upside?

Perhaps our largest holding or right around there is Penn National Gaming (PENN). When we originally bought shares of Penn National–it may have actually even preceded the mutual fund, probably around 1996. It had a collection of small, four or five, Off Track Betting locations in Pennsylvania, and one thoroughbred track there, and that was all there was. Today it’s the third largest gaming company in the United States–10 years later, 11 years later. Compounded shareholders’ book value at probably close to 40%, just top-of-class of all public companies, and it’s because the CEO, Peter Carlino, with his family, are major shareholders in the company; [he] has been highly disciplined in creating shareholder value; doesn’t talk about it in Wall Street terms but has really done it. His record is spectacular, and so our shareholders have been the beneficiaries of that. In fact, it’s grown book value per share or economic value per share at a rate faster than we’ve grown the mutual fund.

I noticed that it’s a big holding in the fund.

It is. Here’s what’s surprising: it’s got this record, it is selling today at 12 1/2 , maybe 13 times the 2007 free cash flow per share, and I would say to you that over the next five years, it’s likely to compound the shareholders’ value at something probably north of 20%. It certainly accrues to our benefit, and it doesn’t make any difference what your definition of rich is, if you can buy something at 12 or 13 times that’s growing your book value at 20 times, you’ll get rich.

Are they strictly horses?

No–they moved into the slot machine venue operation. Their first purchase was a horse track in West Virginia about an hour and 10 minutes from Washington and Baltimore called Charles Town. They opened with 150 machines there, and today they have 4,250 and they’re on their way to 5.500 slot machines at that location. It’s a full-fledged slot machine casino. The horse track still goes on because the horse track was the ticket in West Virginia, as it is in several states, in order to have this slot machine gaming, but they’re the third largest gaming company in the United States today, behind Harrah’s and MGM, and they weren’t even in the business 10, 11 years ago.

And they’re not in Las Vegas or Atlantic City?

They’re not in Las Vegas or Atlantic City, they have a bunch of riverboats, some in the Mississippi Gulf Coast; they have Baton Rouge; Lawrenceburg, Indiana; and outside of Cincinnati; St Louis; one small boat in Iowa; three boats up in the Chicago market.

So then they’re unaffected by the recent crackdown on offshore [internet] gambling?

They’re not affected by that.

What else do advisors need to know about the fund?

One of the most difficult issues is for investors to understand the probability that an investment that they’re involved in is going to perform at some level of expectation. Investors have both the problem of figuring out what their expectations ought to be, and then trying to figure out the kinds of managers or funds, or whatever, that are going to help them achieve that.

When I talk to you about long-term rates of returns on common stocks being around 10%, we have a process where we end up choosing businesses where the fundamentals are distinctly different from that. In fact the businesses that end up in the portfolio have more growth, higher returns on capital, more-often-than-not stronger balance sheets, and lower valuations than the market. We say it is intuitive that you’d understand that your returns are more likely to be better than the market with those characteristics, and with what we believe is a below-market level of risk: higher returns on capital, more growth, stronger balance sheets and lower valuations–we think that represents a level of risk that’s below market. That’s an important notion: that is, we’re not speculating on the price movement of stocks. We’re trying to locate businesses that are compounding the economic value per share at a rate that’s above average, not pay very much for them, and have them create the value in our shares. I would just say that this 10-year record reinforces that notion.

Would you say this would be, potentially, a higher allocation than a regular small-cap allocation might be?

I don’t involve myself at all in this issue of allocation, whether it be large cap, small cap, such and such a sector. I view this as a core holding in my own account, I’m a seven-figure investor, have been for a long time, I’m not in the business of making allocations. From my perspective, this is an investment vehicle, which is suitable to be an important investment vehicle in anybody’s portfolio for the reasons that I’ve just described.

You’ve kept turnover very low. Did I read 3%?

You probably have, but I can’t validate that because I don’t pay any attention to that number. So why is it low? We’re trying to find these compounding machines, and if business model, people model, reinvestment model stay intact, we’re not likely to sell them just because they get too highly valued at some point in time; that will change; when it changes and they get too modestly valued, if we have cash we’ll add to them. Remember, what we’re trying to do is have those businesses compound our capital. So we only think about selling those businesses when something goes wrong in the business model, or the people model, or the reinvestment model, which would cause us to reevaluate the business. Occasionally, we’ll get a business that behaves in a way that is different than that which we thought it would, and this is a long-term deal.

You think about businesses that have monopoly characteristics in the United States–and I’m not talking about anything that’s in the portfolio right now. Network TV stations–when Warren Buffett bought one for a college in Iowa when he was on the board, he said, “I’ve come to believe you can pay almost anything for these.” That’s when people had four choices; nowadays people have 250 or 500, whatever it is… the value of that network TV station has been diminished in ways that weren’t visible then. It used to be that every town in the country had a morning and afternoon newspaper; [that] became less valuable–work habits changed. Nowadays it turns out even the morning newspapers are less valuable; the still have good economics but they’re a whole lot less good than they used to be. My point is, business models change, so when I made that statement up front about our examining a business model, we’re always trying to see if we can understand if it’s getting better or worse and whether that’s a short term or long term thing, and we won’t always see that correctly.

We own some smaller companies that are related to the construction industry, the housing industry, in the portfolio, and we’ve spent a lot of time in the last three or four years thinking about the homebuilding industry. It’s had a really long run of terrific returns as they went from being private businesses to public businesses–their ability to finance more cheaply and everything else, and they’ve had a big stumble in the last year-and-a-half. Our debate internally is: should we spend any more time thinking about this space? Because there are a lot of issues about the homebuilding industry which are simply unknowable; we can’t know whether the economy is going to get better or worse. We can’t know about the issues of affordability. Some statistical stuff like supply and demand, market by market, we can figure out. Those are the kind of things that go on in our office, in terms of how we go about this process.

How much money are you managing overall in this fund and outside?

About $2 billion. Only the mutual fund has a market-cap restriction; the balance of the money is market-cap agnostic

What’s your market-cap restriction on the fund?

It’s, $3 billion for 80% of the assets at time of purchase, so statistically the average market cap at year-end in the portfolio is a little over $3 billion. The median market cap was about $1.5 billion, so we remain true to what it is we’re trying to do, number one; number two, we’re not making a silly choice that we have to sell something because it was successful. The bottom line of all investing is rate of return. It doesn’t make a difference whether it’s a CD, or private equity, or a mutual fund–there’s a continuum of risk across that line. We’re trying to have an investment vehicle where the returns are better than average with a below-average level of risk, it’s that simple. We would say look at the record, we think that’s indicative of this process–we haven’t changed the process.

When the fund started in January 1997 it was called the FBR Small Cap Growth Value Fund, and then they changed the name to Small Cap Value Fund, and then they changed the name to Small Cap Fund. People who rank these things at first called it a value fund; then they called it a core fund, and now they call it a growth fund, that’s how they rank them; at least one of them has called it a mid-cap fund. I say growth, core, value, you pick them–we haven’t changed what we do one iota from the beginning. It is absolutely clear that there are strong elements of growth, growth is part of what we do–you can’t get those high returns without growth, but what we do from an evaluation point of view also is very much a value player’s [perspective] so we are both. We are both growth and value, and from my perspective we ought to be considered as very much a core holding because of the way we go about what we do, and the results that it’s likely to produce. Those results are likely to be better than average with a below average level of risk, and average being, over a long period of time around 10%.