One of the four filters which Buffett and Munger applies before investing in any company is – able and trustworthy management. The key person in the management is the CEO. He needs to do two things well to be successful (1) Run the business operations efficiently (2) Deploy the cash generated by those operations.
In the book The Outsiders: Eight Unconventional CEOs - William N. Thorndike, writes about 8 terrific CEOs who did these two things well for a long time and hence made their shareholders wealthy. Given below are their results comparing with their peers in the same industry and S & P 500.
|CEO/Chairman||Company||Period||Return||Peer’s Return||S & P 500 Return|
|Tom Murphy||Capital Cities||1966 to 1995||19.9%||13.2%||10.1%|
|Henry Singleton||Teledyne||1963 to 1990||20.4%||11.6%||8%|
|Bill Andres||General Dynamics||1991 to 2008||23.3%||17.6%||8.9%|
|John Malone||TCI||1973 to 1998||30.3%||20.4%||14.3%|
|Katharine Graham||Washington Post||1971 to 1993||22.3%||12.4%||7.4%|
|Bill Stiritz||Ralston Purina||1980 to 2000||20%||17.7%||14.7%|
|Dick Smith||General Cinema||1962 to 2005||16.1%||9.8%||9%|
|Warren Buffett||Berkshire Hathaway||1965 to 2011||20.7%||not available||9.3%|
These are extraordinary returns. For example $1 invested with TCI at the beginning of the Malone era was worth over $900 by mid 1998. That same dollar was worth $180 if invested in the other publicly traded cable companies and $22 if invested in the S & P 500. How did these 8 CEOs achieve extraordinary results but their peers could not. The author calls these 8 CEOs as outsiders and they all share few common traits and differ from their peer CEOs.
|Outsider CEOs||Peer CEOs|
|Experience||First-time CEOs with little prior managerial experience||Experienced managers with Gladwell’s 10,000 hours|
|Primary Activity||Capital Allocation||Operations management and external communication|
|Objective||Optimize long-term value per share||Growth|
|Key metrics||Margins, returns, free cash flow||Revenues, reported net income|
|Personal qualities||Analytical, frugal, independent||Charismatic, extroverted|
Let us look at examples for some these traits.
The outsider CEOs handed over the operations to their able managers and they spent most of their time allocating capital. Thus day to day operations of running the business is decentralized. But capital allocation is centralized. There were no investment bankers, committee, and, excel sheets to come up with the plan for allocating capital. It is the CEO who allocated capital independently.
Buffett, already an extraordinarily successful investor, came to Berkshire uniquely prepared for allocating capital. Most CEOs are limited by prior experience to investment opportunities within their own industry – they are hedgehogs. Buffett, in contrast, by virtue of his prior experience evaluating investments in a wide variety of securities and industries, was a classic fox and had the advantage of choosing from a much wider menu of allocation options, including the purchase of private companies and publicly traded stocks… Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition.
One of Benjamin Franklin’s quote – Watch the pennies and the dollars will take care of themselves. These outsider CEOs have internalized this quote. Profit equals revenue minus costs. If the costs are controlled then the profit will go up automatically. It is that simple. Tom Murphy of Capital Cities is known for his frugality
Murphy even scrutinized the company’s expenditures on paint. Shortly after Murphy arrived in Albany, Smith asked him to paint the dilapidated former convent that housed the studio to project a more professional image to advertisers. Murphy’s immediate response was to paint the two sides facing the road leaving the other sides untouched (“forever cost conscious”).
Executives at ABC take limos for even a few blocks to have lunch. Capital Cities acquired ABC and the executives stopped taking limos.
Murphy, however, was a cab man and from very early on showed up to all ABC meetings in cabs. Before long, this practice rippled through the ABC executive ranks, and the broader Capital Cities ethos slowly began to permeate the ABC culture. When asked whether this was a case of leading by example, Murphy responded, “Is there any other way?“
Optimize long-term value per share
Long term value per share increases if the operating business generates decent return on capital. You can reinvest the cash back into the same business and continue earning decent returns. Most of the times the business does not grow on forever hence this excess cash needs to reinvested in other new business ventures. This is called as diversification. What if you cannot find business to buy at sensible prices? You return the excess cash to shareholder in the form of dividends or share buybacks. Dividends is an inefficient way to return the money as it is double taxed at the corporate and individual level. Share buybacks is a terrific way to increase the long-term value per share. The outsider CEOs bought back a lot of shares when it was selling way below its intrinsic value. Henry Singleton of Teledyne is known for his buybacks.
Prior to early 1970s, stock buybacks were uncommon controversial. The conventional wisdom was that repurchases signaled a lack of internal investment opportunity, and they were thus regarded by Wall Street as a sign of weakness. Singleton ignored this orthodoxy, and between 1972 and 1984, in eight separate tender offers, he bought back an astonishing 90 percent of Teledyne’s outstanding shares. As Munger says, “No one has ever bought in shares as aggressively.” Singleton believed repurchases were a far more tax-efficient method for returning capital to shareholders than dividends, which for most of his tenure were taxed at very high rates… These repurchases provided a useful capital allocation benchmark, and whenever the return from purchasing his stock looked attractive relative to the other investment opportunities, Singleton tendered for his shares.
Imagine that there are 100 shares in a company earning $100 of profits. Each share is earning $1 ($100 / 100). Now 90% of the shares are bought back. Which means there are only 10 shares earning $100 of profits. Each share after the buy back is earning $10 ($100/ 10). Buffett wrote about this in 2011 letter.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price.
The outsider CEOs at their core are rational and pragmatic. They did not have ideology and are fox like. They are not man-with-hammers. When the share price is below the intrinsic value they bought back shares. If it is overvalued they used it as a currency to acquire other businesses. Henry Singleton of Teledyne also issued stocks for acquisition. He followed buy-low-and-sell-high approach.
Singleton took full advantage of this extended arbitrage opportunity to develop a diversified portfolio of business, and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to specialty metals and insurance. All but two of these companies were acquired using Teledyne’s pricey stock. Singleton was a very disciplined buyer, never paying more than twelve times earnings and purchasing most companies at significantly lower multiples. This compares to the hight P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.
Bill Stiritz of Ralston Purina used to play Poker and he applied his poker skills in capital allocation.
Effective capital allocation … requires a certain temperament. To be successful you have to think like an investor, dispassionately and probabilistically, with a certain coolness. Stiritz had that mindset. Stiritz himself likened capital allocation to poker, in which the key skills were an ability to calculate odds, read personalities, and make large bets when the odds were overwhelmingly in your favor. He was an active acquirer who was also comfortable selling or spinning off business that he felt were mature or under appreciated by Wall Street.
As an investor if you can associate with one outsider CEO then your financial future is taken care. Of course you need to be lucky to find one and hold on to the investment for a long time which is very hard as we sell-winners-and-hold-losers. Of the 8 outsider CEOs Buffett associated with 4 of them – Tom Murphy, Katharine Graham, Bill Andres, Himself. No wonder why he is one of the richest man in the world. If you are an investor or planning to invest in public companies The Outsiders: Eight Unconventional CEOs is a must read. You will not put the book down until you finish it.