“It is almost impossible to overpay the truly extrodinary CEO… but the species is rare.” – Warren Buffett
“Establishing and maintaining an unconventional approach requires… frequently appearing downright imprudent in the eyes of conventional wisdom.” – David Swensen, Yale Endowment
In the book “The Outsiders: Eight Unconventional CEOs and Their Radically Rationale Blueprint for Success” by William N. Thorndike Jr.”, eight legendary capital allocators that both outperformed their peers and the benchmark S&P 500 index over their lengthy tenure are featured. Over the course of reading the book I attempted to extract all the similarities and parallels I could find between most or all of the people examined. These CEOs included:
1. Tom Murphy and Capital Cities Broadcasting
2. Henry Singleton and Teledyne
3. Bill Anders and General Dynamics
4. John Malone and TCI
5. Katherine Graham and The Washington Post Company
6. Bill Stiritz and Ralston Purina
7. Dick Smith and General Cinema
8. Warren Buffett and Berkshire Hathaway
Low Capital-Intensive Businesses with Industry- Leading Margins While Eliminating High Cost of Capital Business and Re-Deploying Capital in Better Alternatives
The businesses operated under the umbrellas of the original vehicles chosen by the CEOs were in nature low capital utilizers, continually deploying operating cash flow at above-average returns, able to pass price increases to the consumer through established brands, and held industry-leading margins either a byproduct of low-cost producing characteristics or an oligopoly, duopoly or monopoly-like industry.
One simplified example comes to mind. Imagine a bridge that was constructed today for $8 million and it produces income of $1 million this year. We expect the bridge to cost very low amounts of capital to maintain annually, about $50,000. Inflation is running at 2% annually, but the company decides it is able to increase toll fees by 4% annually (before inflation) because it is the only bridge in town. Assuming a “no growth” scenario in the surrounding city, in 30 years the bridge would cost us roughly $1.5 million to maintain, plus our initial investment of $8 million, for an adjusted cost basis of $9.5 million.
This bridge, fortunately for us, now produces $5,743,000 and has given us $125,004,683, good for a 8.96% CAGR (assuming we opportunistically re-deployed capital as we received it, at the same rate of return, in bridges with the same characteristics).
You can imagine what would happen to the rate of return if the price increase could not be consistently passed to the consumer. You can also see the effects of low working capital and capital expenditures. Imagine how the math would look if it cost $700,000 annually to maintain the bridge. Consumer brands and media holdings were fundamental to the CEOs’ success. Profitably underwriting insurance was arguably the most important for Berkshire and Teledyne. (low capital needs and ability to increase prices, with industry leading margins).
Buffett chose to shut down Berkshire Hathaway (BRK.A)(BRK.B) in 1985 around the same time he said famously, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to become more productive than energy devoted to patching leaks.” He decided, luckily for Berkshire, to make no further investments in Berkshire around 1965 and to deploy the capital elsewhere. Luckily for shareholders, Buffett achieved rates of return (on the stock price) north of 25%, while the largest textile company, Burlington Industries, chose the opposite path and invested heavily in new factory and equipment. Burlington Industries fared far worse, earning an annual rate of return of 0.6%, or as Robert Frost said, “The road not taken has made all the difference.”
High Valued Acquisitions When Compared to Enterprise Value
There are numerous examples of the various CEOs continually making larger bets (purchases) throughout their careers, at times, the largest acquisitions in their respective industries. Concentration was the name of the game for these iconoclastic CEOs, causally allowing dry powder to pile up over years for the sake of future triumphs and rationality, hunting elephants in the safari of capitalism on their own accord. At one point, 40% of the book value of Berkshire was made up of American Express common shares, and another example is the Burlington Northern Santa Fe acquisition in 2011 for a total over $34 billion (the largest of Buffett’s career).
Patient, Disciplined, Contrarian
These CEOs had no problem allowing cash to build up on the balance sheet in times of optimism, when no attractive acquisitions were available. Acquisitions were sporadic in nature, much like an accordion, expanding through acquisition and contracting through operational efficiencies and divestures. They were intelligent and rationale thinkers exploiting the temperament of others, buying when others were fearful. Long periods of inactivity combined with long-term holding periods were some of the variables of success, as characterized by Buffett’s top five holdings, which he has held for over 20 years (and continues to hold).
Impressive Allocation of Human Capital, Management of Operations & Size of Corporate Staff (Adhocracy)
The culture of the firms have/had decentralized operations but a centralized capital allocation process managed by the CEO. All the firms had no problem ignoring Wall Street earnings guidance and investor relations functions above the required minimum. (A non-conventional metric that may be of use is corporate staff to total employee ratio.)
All the CEOs on the list continually expanded their network of people, hiring the absolute best for the job and eliminating the weak links, looking for higher levels of productivity, although rarely were CEOs replaced after an acquisition was made of an existing company, but rather kept in place with incentives realigned. These skills can be more difficult to quantify beforehand as they’re classified as “soft,” although past performance may be an indication of future actions.
Acquisitions Were Incredibly Cheap, Divestures Were Above Fair Value, Taxes Were Always Minimized
Numerous examples through all of the CEOs’ careers provide insight into their thinking process as well as the value they were willing to pay at the time for the business. More often than not, purchases were made at 4x to 8x cash flow while divestures or entire business sales took place at about 9x to 16x cash flow. Teledyne is a great example of using common shares as currency. When Mr. Singleton believed the company share price to exceed the intrinsic value he was eager to spend, eventually making over 130 acquisitions.
The CEOs in this book were ruthless when it came to divesting or shutting down existing underperforming businesses for the sake of rational capital allocation. Minimizing taxes was probably one of the most important factors in all of the CEOs’ decisions to allocate capital, as after-tax returns were what was important to them. They used strategies ranging from acquisitions and divestures in stock instead of cash, buying back shares instead of paying dividends, leveraging the capital base to pay interest instead of taxes, and minimizing reported earnings before taxes through conservative accounting. As John Malone once said, “It is better to pay interest than taxes.”
Unique Financial Engineering, Opportunistic Temperament and an Extreme Focus on OCF
Financial engineering, when the opportunity was prime, enabled the CEOs and their shareholders to prosper (Because of the ability to exploit others’ weak temperament). A lot of the financial engineering that was used was to shelter taxes, minimizing the government’s take. They did not care for reported net income, nor did they care for growing revenues at the sake of profitability, (margins) instead giving a laser-like focus to cash earnings and operating cash flow the business was able to produce.
Used Common Shares as Currency When They Were Overpriced, Bought Shares Back When They Were Under-Valued, Combined with Low or No Dividends Paid
This should not be a surprise to most disciples of any of these legendary CEOs. During the few times when they believed their company market price to exceed intrinsic value they opportunistically acquired businesses using shares as currency (with an added benefit of capital gains tax deferral) when they were priced at a discount.
Henry Singleton is a great example of how ruthlessly a CEO can and will buy back common shares when there are large discrepancies between market price and intrinsic value. Singleton eventually bought back about 90% of the outstanding shares over his tenure at Teledyne. Dividends paid were avoided for the simple reasoning they are taxed twice, once on the corporate side and again when the investor receives them. All the CEOs saw early on that buying back shares was a much more efficient and effective way to return capital to shareholders.
“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” – Warren Buffett
Further Reading:
Five Must Reads Recommended By Warren Buffett
Henry Singleton: Teledyne Case Study of Capital Allocation
Outlier Allocators 