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Management, Management, Management: How to Tell Between Those You Can Invest In & Those You Can’t

Growth Investing, Strategies

Written by:

Alvin Chow

The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by [Thorndike, William]

Warren Buffett called this book, “An outstanding book about CEOs who excelled at capital allocation.”

The Outsiders is about unusual CEOs who are very good capital allocators.

Most CEOs are good in operations but not skilled in allocating capital. They usually defer that to the CFOs but the author argued it is best done by the CEO.

Hence watching how the management handles capital can provide clues of how good they are.

Just note that personally I feel the author sensationalised the abilities of the CEOs and there is definitely a strong dose of survivorship bias.

Beyond the exaggerations, however, is still an important message on capital allocation.

Here are the notes I have taken from the book.

CEO Henry Earl Singleton of Teledyne

 Henry Singleton was honoured for establishing the Singleton Research Fellowship at the City of Hope Pilot Medical Center in 1970. He received the Outstanding Achievement Award in Business Management from the University of Southern California in 1972. His citation for membership in the National Academy of Engineering in 1979 read: “For his contributions to lightweight inertial navigation systems and his leadership in the creation of a major technological corporation.” 
While an undergraduate student at MIT, he was named a Putnam Fellow after his three-man team won the William Lowell Putnam Intercollegiate Mathematics Competition in 1939. Warren Buffett, one of the wealthiest men in the world, is quoted as saying that “Henry Singleton of Teledyne has the best operating and capital deployment record in American business.”

CEOs need to do two things well to be successful:

  1. run their operations efficiently
  2. deploy the cash generated by those operations.

Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important. Singleton, in contrast, gave most of his attention to the latter task.

CEOs have five essential choices for deploying capital.

  1. investing in existing operations
  2. acquiring other businesses
  3. issuing dividends
  4. paying down debt, or,
  5. repurchasing stock.

CEOs have three alternatives for raising it – tapping internal cash flow, issuing debt, or raising equity.

There are no courses on capital allocation at the top business schools.

As Warren Buffett has observed, very few CEOs come prepared for this critical task:
The heads of many companies are not skilled in capital allocation.

Their inadequacy is not surprising.

Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes, institutional politics. Once they become CEOs, they now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.

To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead, to be named Chairman of the Federal Reserve.

Our outsider CEOs also shared an interesting set of personal characteristics:

  1. They were generally frugal (often legendarily so) and humble, analytical, and understated.
  2. They were devoted to their families, often leaving the office early to attend school events.
  3. They did not typically relish the outward-facing part of the CEO role.
  4. They did not give chamber of commerce speeches, and they did not attend Davos.
  5. They rarely appeared on the covers of business publications and did not write books of management advice.
  6. They were not cheerleaders or marketers or backslappers, and they did not exude charisma.

They were very different from high-profile CEOs such as Steve Jobs or Sam Walton or Herb Kelleher of Southwest Airlines or Mark Zuckerberg.

These geniuses are the Isaac Newtons of business, struck apple-like by enormously powerful ideas that they proceed to execute with maniacal focus and determination.

Their situations and circumstances, however, are not remotely similar (nor are the lessons from their careers remotely transferable) to those of the vast majority of business executives.

An Intelligent Iconoclasm

Isaiah Berlin, in a famous essay about Leo Tolstoy, introduced the instructive contrast between the “fox,” who knows many things, and the “hedgehog,” who knows one thing but knows it very well.

Most CEOs are hedgehogs—they grow up in an industry and by the time they are tapped for the top role, have come to know it thoroughly. There are many positive attributes associated with hedgehogs, including expertise, specialization, and focus.

Foxes, however, also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes.

They had familiarity with other companies and industries and disciplines, and this range of expertise translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results.

These CEOs thought more like investors than managers.

Fundamentally, they had confidence in their own analytical skills, and on the rare occasions when they saw compelling discrepancies between value and price, they were prepared to act boldly.

When their stock was cheap, they bought it (often in large quantities), and when it was expensive, they used it to buy other companies or to raise inexpensive capital to fund future growth.

If they couldn’t identify compelling projects, they were comfortable waiting, sometimes for very long periods of time (an entire decade in the case of General Cinema’s Dick Smith). Over the long term, this systematic, methodical blend of low buying and high selling produced exceptional returns for shareholders.

At the core of their shared worldview was the belief that the primary goal for any CEO was to optimize long-term value per share, not organizational growth.

This may seem like an obvious objective; however, in American business, there is a deeply ingrained urge to get bigger versus optimising long term share value.

Larger companies get more attention in the press; the executives of those companies tend to earn higher salaries and are more likely to be asked to join prestigious boards and clubs. As a result, it is very rare to see a company proactively shrink itself. And yet virtually all of these CEOs shrank their share bases significantly through repurchases.

Most also shrank their operations through asset sales or spin-offs, and they were not shy about selling (or closing) underperforming divisions. Growth, it turns out, often doesn’t correlate with maximizing shareholder value.

A Perpetual Motion Machine for Returns – Tom Murphy and Capital Cities Broadcasting

Typically, a company acquires a series of businesses, attempts to improve operations, and then keeps acquiring, benefiting over time from scale advantages and best management practices.

This concept came into vogue in the mid- to late 1990s and flamed out in the early 2000s as many of the leading companies collapsed under the burden of too much debt. These companies typically failed because they acquired too rapidly and underestimated the difficulty and importance of integrating acquisitions and improving operations.

Murphy’s approach to the roll-up was different. He moved slowly, developed real operational expertise, and focused on a small number of large acquisitions that he knew to be high-probability bets. Under Murphy, Capital Cities combined excellence in both operations and capital allocation to an unusual degree.

Burke, the Chief Operating Officer tangent to Murphy being Chief Executive Officer believed his job was to “create the free cash flow and Murphy’s was to spend it.”

He exemplifies the central role played in this book by exceptionally strong COOs whose close oversight of operations allowed their CEO partners to focus on longer-term strategic and capital allocation issues.

There are two basic types of resources that any CEO needs to allocate:

  • financial
  • human.

The outsider CEOs shared an unconventional approach, one that emphasized flat organizations and lean corporate staffs.

The hallmark of the company’s culture—extraordinary autonomy for operating managers—was stated succinctly in a single paragraph on the inside cover of every Capital Cities annual report: “Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs. All decisions are made at the local level. . . . We expect our managers . . . to be forever cost-conscious and to recognize and exploit sales potential.”

Headquarters staff was anorexic, and its primary purpose was to support the general managers of operating units.

There were no vice presidents in functional areas like marketing, strategic planning, or human resources; no corporate counsel and no public relations department (Murphy’s secretary fielded all calls from the media).

Frugality was also central to the ethos.

Murphy and Burke realized early on that while you couldn’t control your revenues at a TV station, you could control your costs. They believed that the best defence against the revenue lumpiness inherent in advertising-supported businesses was a constant vigilance on costs, which became deeply embedded in the company’s culture.

The two primary sources of capital for Capital Cities were internal operating cash flow and debt.

As can be seen, the company produced consistently high, industry-leading levels of operating cash flow, providing Murphy with a reliable source of capital to allocate to acquisitions, buybacks, debt repayment, and other investment options.

Murphy also frequently used debt to fund acquisitions, once summarizing his approach as “always, we’ve . . . taken the assets once we’ve paid them off and leveraged them again to buy other assets.”

After closing an acquisition, Murphy actively deployed free cash flow to reduce debt levels, and these loans were typically paid down ahead of schedule. The bulk of the ABC debt was retired within three years of the transaction. Interestingly, Murphy never borrowed money to fund a share repurchase, preferring to utilize leverage for the purchase of operating businesses.

Other than the sale of stock to Berkshire Hathaway to help finance the ABC acquisition, the company did not issue new stock over the twenty years prior to the Disney sale, and over this period total shares outstanding shrank by 47% as a result of repeated repurchases.

According to recent studies, somewhere around two-thirds of all acquisitions actually destroy value for shareholders.

And when he had conviction, Murphy was prepared to act aggressively. Under his leadership, Capital Cities was extremely acquisitive, three separate times doing the largest deal in the history of the broadcast industry, culminating in the massive ABC transaction. Over this time period, the company was also involved with several of the largest newspaper acquisitions in the country, as well as transactions in the radio, cable TV, and magazine publishing industries.

Murphy was willing to wait a long time for an attractive acquisition. He once said, “I get paid not just to make deals, but to make good deals.”

When he saw something that he liked, however, Murphy was prepared to make a very large bet, and much of the value created during his nearly thirty-year tenure as CEO was the result of a handful of large acquisition decisions, each of which produced excellent long-term returns.

These acquisitions each represented 25% or more of the company’s market capitalization at the time they were made.

Murphy knew what he wanted to buy, and he spent years developing relationships with the owners of desirable properties. He never participated in a hostile takeover situation, and every major transaction that the company completed was sourced via direct contact with sellers

Murphy’s benchmark was a double-digit after-tax return over ten years without leverage. As a result of this pricing discipline, he never prevailed in an auction, although he participated in many. Murphy’s auction bids consistently ended up at only 60 to 70% of the eventual transaction price.

Murphy had an unusual negotiating style. He believed in “leaving something on the table” for the seller and said that in the best transactions, everyone came away happy.

Murphy was also disciplined in rejection offers – someone once told him The Triangle stations were worth ten times pretax profits. If he thought their proposal was high, he would counter with his best price, and if the seller rejected his offer, Murphy would walk away.

Share repurchases were another important outlet for Murphy, providing him with an important capital allocation benchmark, and he made frequent use of them over the years.

When the company’s multiple was low relative to private market comparables, Murphy bought back stock.

Over the years, Murphy devoted over $1.8 billion to buybacks, mostly at single-digit multiples of cash flow. Collectively, these repurchases represented a very large bet for the company, second in size only to the ABC transaction, and they generated excellent returns for shareholders, with a cumulative compound return of 22.4% over nineteen years.

As Murphy says today, “I only wished I’d bought more.”

The media world is littered with Capital Cities alums. The company’s culture and operating model were widely admired, and in addition to Sias at Chronicle, former company executives have occupied top management slots at a dizzying variety of media companies, starting with Disney itself (now run by Bob Iger). Capital Cities alums have also held executive positions at LIN Broadcasting (CEO), Pulitzer (CEO), Hearst (CFO), and E. W. Scripps (head of newspaper operations), among others. Dan Burke’s son, Steve, formerly COO of Comcast, is now the CEO of NBCUniversal.

A contemporary analogue for Capital Cities can be found in Transdigm, a little-known, publicly-traded aerospace components manufacturer.

An Unconventional Conglomerateur: Henry Singleton and Teledyne

Singleton ran a notoriously decentralized operation; avoided interacting with Wall Street analysts; didn’t split his stock; and repurchased his shares as no one else ever has, before or since.

Singleton took full advantage of this extended arbitrage opportunity to develop a diversified portfolio of businesses, and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to speciality metals and insurance.

All but two of these companies were acquired using Teledyne’s pricey stock.

He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets.

As Jack Hamilton, who ran Teledyne’s speciality metals division, summarized his business to me, “We specialized in high-margin products that were sold by the ounce, not the ton.”

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 high P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.

Singleton became the first of the conglomerateurs to stop acquiring. In mid-1969, with the multiple on his stock falling and acquisition prices rising, he abruptly dismissed his acquisition team.

Singleton, as a disciplined buyer, realized that with a lower P/E ratio, the currency of his stock was no longer attractive for acquisitions. From this point on, the company never made another material purchase and never issued another share of stock.

Singleton and Roberts eschewed the then trendy concepts of “integration” and “synergy” and instead emphasized extreme decentralization, breaking the company into its smallest component parts and driving accountability and managerial responsibility as far down into the organization as possible.

At headquarters, there were fewer than fifty people in a company with over forty thousand total employees and no human resource, investor relations, or business development departments.

Ironically, the most successful conglomerate of the era was actually the least conglomerate-like in its operations.

Singleton eschewed reported earnings, the key metric on Wall Street at the time, running his company instead to optimize free cash flow. He and his CFO, Jerry Jerome, devised a unique metric that they termed the Teledyne return, which by averaging cash flow and net income for each business unit, emphasized cash generation and became the basis for bonus compensation for all business unit general managers.

This influx of cash was sent to headquarters to be allocated by Singleton.

Prior to the early 1970s, stock buybacks were uncommon and controversial.

The conventional wisdom was that repurchases signalled 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% of Teledyne’s outstanding shares. As Munger says, “No one has ever bought in shares as aggressively.”

The average price-to-earnings ratio for Teledyne’s stock issuances was over 25; in contrast, the average multiple for his repurchases was under 8.

Singleton was a pioneer in the use of spin-offs, which he believed would both simplify succession issues at Teledyne (by reducing the company’s complexity) and unlock the full value of the company’s large insurance operations for shareholders. In the words of longtime board member Fayez Sarofim, Singleton believed “there was a time to conglomerate and a time to de-conglomerate.”

One of the most important decisions any CEO makes is how he spends his time—specifically, how much time he spends in three essential areas: management of operations, capital allocation, and investor relations.

Board members included Claude Shannon, Singleton’s MIT classmate and the father of information theory; Arthur Rock, the legendary venture capitalist; and Fayez Sarofim, the billionaire Houston-based fund manager.

Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market.

This approach is careful, conservative, and, not coincidentally, unlikely to have any meaningful impact on long-term share values. Let’s call this cautious, methodical approach the “straw.”

The other approach, the one favoured by the CEOs in this book and pioneered by Singleton, is quite a bit bolder.

This approach features less frequent and much larger repurchases timed to coincide with low stock prices—typically made within very short periods of time, often via tender offers, and occasionally funded with debt.

  • The CEO as an investor. Both Buffett and Singleton designed organizations that allowed them to focus on capital allocation, not operations. Both viewed themselves primarily as investors, not managers.
  • Decentralized operations, centralized investment decisions. Both ran highly decentralized organizations with very few employees at corporate and few, if any, intervening layers between operating companies and top management. Both made all major capital allocation decisions for their companies.
  • Investment philosophy. Both Buffett and Singleton focused their investments in industries they knew well, and were comfortable with concentrated portfolios of public securities.
    Insurance subsidiaries. Both Singleton and Buffett recognized the potential to invest insurance company “float” to create shareholder value, and for both companies, insurance was the largest and most important business.

The Turnaround: Bill Anders and General Dynamics

William Alison Anders, is a retired United States Air Force Major general, former electrical engineer, nuclear engineer, NASA astronaut, and businessman. In December 1968, as a crew member of Apollo 8, he was one of the first three people to leave low Earth orbit and travel to the Moon.

Bill Anders assumed the helm at General Dynamics in January 1991, at the depth of the early 1990s, post–Gulf War bear market.

Anders was definitely not your garden-variety CEO.

He had had a remarkably distinguished, if unconventional, career before he joined General Dynamics, graduating with an electrical engineering degree from the Naval Academy in 1955 and serving as an air force fighter pilot during the Cold War.

He earned an advanced degree in nuclear engineering in 1963 and was one of only fourteen men chosen from a pool of thousands to join NASA’s elite astronaut corps.

As the lunar module pilot on the 1968 Apollo 8 mission, Anders took the now-iconic Earthrise photograph, which eventually appeared on the covers of Time, Life, and American Photography.

The defence industry had significant excess capacity following the end of the Cold War. As a result, Anders believed industry players needed to move aggressively to either shrink their businesses or grow through acquisition. In this new environment, there would be consolidators and consolidatees, and companies needed to figure out quickly which camp they belonged in.

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James Mellor is currently the Chairman of USEC Inc. (a global energy company) and previously served as their Chairman and Chief Executive Officer. He retired as Chairman and Chief Executive Officer of General Dynamics Corporation in 1997. Previous to that he had served as President and CEO and as President and COO of the company. He joined General Dynamics as Executive Vice President and a member of their Board of Directors in October, 1981. Mr. Mellor graduated from the University of Michigan in 1952 with a Bachelor of Science degree in Electrical Engineering and Mathematics. He was awarded a Master of Science degree from the same University in 1953. He is presently on the Board of Directors of USEC Inc., the Scripps Research Institute, and Materia, Inc. He previously served on the boards of Pinkerton, Inc., Computer Sciences Corporation, Kerr Manufacturing, Inc., IDT, Inc., Net-2-Phone, Inc., Bergen Brunswick Corporation, Inc., Howmet, Inc. and as Chairman of AmerisourceBergen Corporation. He is presently on the Board of Trustees of the University of California- Irvine, the National Museum of American History and the National Endowment for the Humanities.

In operations, Anders and Mellor found a legacy of massive overinvestment in inventory, capital equipment, and research and development. Together, they moved quickly to wring the excesses out of the system.

When they visited an F-16 factory, they looked around and counted huge numbers of expensive F-16 canopies (the clear glass covering for the cockpit) in a facility that made one plane a week—Mellor’s new rule: a two-canopy maximum. They found duplicate pieces of expensive and underutilized machinery in adjacent tank plants—Mellor combined the facilities. More generally, they discovered that plant managers carried far too much inventory and hadn’t been calculating return on investment in their requests for additional capital.

Cash return on capital became the key metric within the company and was always on our minds.” This was a first for the entire industry, which had historically had a myopic focus on revenue growth and new product development.

Anders and Mellor insisted the company bid on projects only when returns were compelling and the probability of winning was high.

Anders and Mellor reduced overall headcount by nearly 60% (and corporate staff by 80%), relocated corporate headquarters from St. Louis to northern Virginia, instituted a formal capital approval process, and dramatically reduced investment in working capital.

As Mellor said, “For the first couple of years we didn’t need to spend anything, we could simply run off the prior years’ buildup of inventories and capital expenditures.”

In the first two years, after taking the reins as CEO, Anders sold the majority of General Dynamics’ businesses, including its IT division, the Cessna aircraft business, and the missiles and electronics businesses.

Anders had a very clear and specific strategic vision that called not only for selling weaker divisions but for building up to larger ones.

After making early progress on the sales front, he turned his attention to Acquisition, and the military aircraft unit, the company’s largest business, was a logical place to start.

On top of the economic logic of growing this sizable business unit, Anders, a former fighter pilot and an aviation buff, loved it. So when Lockheed’s CEO surprised him by offering $1.5 billion, a mind-bogglingly high price for the division, Anders was faced with a moment of truth.

What he did is very revealing—he agreed to sell the business on the spot without hesitation (although not without some regret).

Anders made the rational business decision, the one that was consistent with growing per-share value, even though it shrank his company to less than half its former size and robbed him of his favourite perk as CEO: the opportunity to fly the company’s cutting-edge jets.

This single decision underscores a key point across the CEOs in this book: as a group, they were, at their core, rational and pragmatic, agnostic and clear-eyed. They did not have ideology. When offered the right price, Anders might not have sold his mother, but he didn’t hesitate to sell his favorite business unit.

It is very, very rare to see a public company systematically shrink itself; as Anders summarized it to me, “Most CEOs grade themselves on size and growth . . . very few really focus on shareholder returns.”

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Buffett saw that under Anders’s leadership, the company was divesting assets and focusing on an innovative, shareholder-friendly capital allocation strategy, and in 1992 he bought 16% of General Dynamics’ stock at an average price of $72 per share. Remarkably, he also gave Anders, whom he had only met once, the proxy to vote Berkshire’s shares, a position that aided Anders in implementing his strategy.

Buffett sold his shares on Anders’s departure for an excellent return, a decision, however, he regrets today.

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Nicholas D. Chabraja (pronounced cha-brah-ya)

Chabraja’s approach to acquisitions was distinctive, focusing initially on small purchases around existing business lines, a new capital allocation focus for the company. As he said, “Our strategy has been to aggressively pursue targets directly related to our core businesses . . . broadening our product line into adjacent spaces.”

In his first year, he bought twelve small companies. Ray Lewis described this approach as “just a piece at a time in markets we understood well.”

There would be only two people between the CEO and the head of any profit centre, whereas before there had been four.

All human relations, legal, and accounting personnel at headquarters were eliminated or pushed down into the operating divisions, and there was a conscious effort to keep staff involved in the divisions to a minimum, to prevent headquarters from “screwing around with operating people,” as Chabraja says.

Operating managers were held responsible—in Chabraja’s words, “severely accountable”—for hitting their budgets and were left alone if they did so.

Value Creation in a Fast-Moving Stream: John Malone and TCI

Malone’s arrival, however, the industry was blindsided by new regulations, and the market for cable stocks cooled, forcing the company to pull its offering and leaving it with an unsustainable debt position.

The sudden evaporation of liquidity that resulted from the 1973–1974 Arab oil embargo left the entire industry in a precarious position. TCI, however, with its new, thirty-two-year-old CEO, was burdened with significantly more debt than any of its peers and teetered on the edge of bankruptcy. “Lower than whale dung,” is Malone’s typically blunt assessment of his starting point at TCI.

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JC Sparkman

Malone saw himself as an investor and capital allocator, delegating responsibility for day-to-day operations to Sparkman, his longtime lieutenant, who managed the company’s far-flung operations through a rigorous budgeting process. Managers were expected to hit their cash flow budget, and these targets were enforced with almost military discipline by Sparkman, a former air force officer.

Managers in the field had a high degree of autonomy, as long as they hit their numbers. System managers who missed monthly budgets were frequently visited by the itinerant COO, and underperformers were quickly weeded out.

He told longtime TCI investor David Wargo in 1982, “The key to future profitability and success in the cable business will be the ability to control programming costs through the leverage of size.”

In a cable television system, the largest category of cost (40% of total operating expenses) is the fees paid to programmers (HBO, MTV, ESPN, etc.). Larger cable operators are able to negotiate lower programming costs per subscriber, and the more subscribers a cable company has, the lower its programming cost (and the higher its cash flow) per subscriber. These discounts continue to grow with size, providing powerful scale advantages for the largest players.

To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.

The Widow Takes the Helm: Katharine Graham and The Washington Post Company

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With her board, she subjected all potential transactions to a rigorous, analytical test. As Tom Might summarized it, “Acquisitions needed to earn a minimum 11 percent cash return without leverage over a ten-year holding period.”

Again, this seemingly simple test proved a very effective filter, and as Might says, “Very few deals passed through this screen. The company’s whole acquisition ethos was to wait for just the right deal.

In the early 1980s, the management consulting firm McKinsey advised the company to halt its buyback program. Graham followed McKinsey’s advice for a little over two years, before, with Buffett’s help, coming to her senses and resuming the repurchase program in 1984.

Donald Graham reckons this high-priced McKinsey wisdom cost Post shareholders hundreds of millions of dollars of value, calling it the “most expensive consulting assignment ever!

A Public Leveraged Buy-Out: Bill Stiritz and Ralston Purina

It did not escape Stiritz’s attention that pruning unrelated businesses might make the company’s core pet food brands more attractive to a strategic acquirer, and in 2001 the company was approached by Nestlé.

After extensive negotiations (which Stiritz characteristically handled himself), the Swiss giant agreed to pay a record price for Ralston: $10.4 billion, equal to an extraordinary multiple of fourteen times cash flow. This transaction was the capstone of Stiritz’s tenure at Ralston.

He believed that businesses with predictable cash flows should employ debt to enhance shareholder returns, and he made active use of leverage to finance stock repurchases and acquisitions, including his two largest, Energizer and Continental. Ralston consistently maintained an industry-high average debt–to–cash flow ratio during his tenure.

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He would eventually repurchase a phenomenal 60% of Ralston’s shares, second only to Henry Singleton among the CEOs in this book, and he would earn very attractive returns on these buybacks, averaging a long-term internal rate of return of 13%.

He was, however, a very frugal buyer, preferring opportunistic open-market purchases to larger tenders that might raise the stock price prematurely. These purchases were consistently made when P/E multiples were at cyclical low points.

When the opportunity to buy Energizer came up, a small group of us met at 1:00 PM and got the seller’s books. We performed a back of the envelope LBO model, met again at 4:00 PM and decided to bid $1.4 billion. Simple as that. We knew what we needed to focus on. No massive studies and no bankers.”

Again, Stiritz’s approach (similar to those of Tom Murphy, John Malone, Katharine Graham, and others) featured a single sheet of paper and an intense focus on key assumptions, not a forty-page set of projections.

Optimizing the Family Firm: Dick Smith and General Cinema

The three primary sources of cash during Smith’s long tenure were operating cash flow, long-term debt, and proceeds from the occasional large asset sale.

The movie theatre business is characterized by exceptional cash flow characteristics due to its negative working capital needs (customers pay in advance, while the movie studios are paid ninety days in arrears for their films) and low capital requirements (once a theatre is built, very little investment is required to maintain it).

These attractive economics had a powerful effect on Dick Smith’s business worldview, and from a very early point in the company’s history, he focused on maximizing cash flow, not traditional earnings per share (EPS).

Smith disdained equity offerings.

In fact, he almost entirely avoided issuing equity from the time of the company’s IPO until issuing a microscopic number of shares in 1991 to facilitate favourable tax treatment for the HBJ transaction. As he said to me, “We never issued any stock. I was like a feudal lord, holding onto the ancestral land!

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The company did, however, make strategic use of debt to fund acquisitions. Its two largest purchases, Carter Hawley Hale and Harcourt Brace Jovanovich, were entirely debt-financed.

As a result, from the mid-1980s on, the company consistently maintained debt-to-cash flow ratios of at least three times, leveraging equity returns and helping minimize taxes.

Smith deployed the cash provided by these various sources into three principal outlets: (1) acquisitions, (2) stock repurchases, and (3) capital expenditures.

The company paid minimal dividends and was notable for its willingness to hold large cash balances while waiting for attractive investment opportunities to emerge.

Smith’s acquisitions shared several common characteristics.

  • They were market leaders with solid growth prospects and respected brand names.
  • They were also typically opportunistic transactions whose circumstances deterred other potential buyers—in the case of Carter Hawley Hale, no other buyer could have moved as quickly to counter The Limited’s takeover bid; in the case of HBJ, no other purchaser was willing to spend the time to unravel the complex capital structure and negotiate with the manifold layers of debt holders.
  • They were also very large bets relative to the company’s size, ranging from 22% to a remarkable 62% of the company’s enterprise value at the time they were made.

The Investor as CEO: Warren Buffett and Berkshire Hathaway

Buffett and Munger bought See’s Candies for $25 million.

At the time, the company had $7 million in tangible book value and $4.2 million in pretax profits, so they were paying a seemingly exorbitant multiple of over three times book value (but only six times pretax income).

See’s was expensive by Graham’s standards, and he would never have touched it. Buffett and Munger, however, saw a beloved brand with excellent returns on capital and untapped pricing power, and they immediately installed a new CEO, Chuck Huggins, to take advantage of this opportunity.

See’s has experienced relatively little unit growth since it was acquired, but due to the power of its brand, it has been able to consistently raise prices, resulting in an extraordinary 32% compound return on Berkshire’s investment over its first twenty-seven years. (After 1999, See’s results were no longer reported separately.)

During the last thirty-nine years, the company has sent $1.65 billion in free cash to Omaha on an original investment of $25 million.

By 1987, in advance of the October market crash, Buffett had sold all of the stocks in his insurance company portfolios, except for his three core positions. After the Capital Cities transaction, he did not make another public market investment until 1989, when he announced that he had made the largest investment in Berkshire’s history: investing an amount equal to one-quarter of Berkshire’s book value in the Coca-Cola Company, purchasing 7% of its shares.

In the late 1990s and early 2000s, Buffett was an opportunistic buyer of private companies, many of them in industries out of favour after the September 11 terrorist attacks, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes.

He also made a series of significant investments in the electric utility industry through MidAmerican Energy, a joint venture with his Omaha friend Walter Scott, the former CEO of Kiewit Construction.

During this period, Buffett was also active in a variety of investing areas outside of traditional equity markets.

In 2003, he made a large ($7 billion) and very lucrative bet on junk bonds, then enormously out of favour.

In 2003 and 2004, he made a significant ($20 billion) currency bet against the dollar, and in 2006, he announced Berkshire’s first international acquisition: the $5 billion purchase of Istar, a leading manufacturer of cutting tools and blades based in Israel that has prospered under Berkshire’s ownership.

Buffett’s exceptional results derived from an idiosyncratic approach in three critical and interrelated areas: capital generation, capital allocation, and management of operations.

Charlie Munger has said that the secret to Berkshire’s long-term success has been its ability to generate funds at 3% and invest the company’s primary source of capital that has been floated from its insurance subsidiaries, although very significant cash has also been provided by wholly-owned subsidiaries and by the occasional sale of investments. Buffett has in effect created a capital “flywheel” at Berkshire, with funds from these sources being used to acquire full or partial interests in other cash-generating businesses whose earnings in turn fund other investments, and so on.

Buffett evolved an idiosyncratic strategy for his insurance operations that emphasized profitable underwriting and float generation over revenue growth.

This approach, wildly different from most other insurance companies, relied on a willingness to avoid underwriting insurance when pricing was low, even if short-term profitability might suffer, and, conversely, a propensity to write extraordinarily large amounts of business when prices were attractive.

This approach led to lumpy, but highly profitable, underwriting results.

As an example, in 1984, Berkshire’s largest property and casualty (P&C) insurer, National Indemnity, wrote $62.2 million in premiums.

Two years later, premium volumes grew an extraordinary sixfold to $366.2 million. By 1989, they had fallen back 73% to $98.4 million and did not return to the $100 million levels for twelve years.

Three years later, in 2004, the company wrote over $600 million in premiums. Over this period, National Indemnity averaged an annual underwriting profit of 6.5% as a percentage of premiums. In contrast, over the same period, the typical property and casualty insurer averaged a loss of 7%.

Whenever Buffett buys a company, he takes immediate control of the cash flow, insisting that excess cash be sent to Omaha for allocation. As Charlie Munger points out, “Unlike operations (which are very decentralized), capital allocation at Berkshire is highly centralized.”

Two investors with the same investment philosophy but different approaches to portfolio management will produce dramatically different results.

Despite his historic advocacy of stock repurchases, Buffett (with the exception of a few small, early buybacks) is the only CEO in this book who did not buy back significant amounts of his company’s stock.

Despite admiring and encouraging the repurchases of other CEOs, he has felt buybacks were counter to Berkshire’s unique, partnership-like culture and could potentially tamper with the bonds of trust built up over many years of honest, forthright communications and outstanding returns.

Timing investments to coincide with significant management or strategy changes. Buffett uses the analogy of a pro-am golf event to describe these investment opportunities, which arise when a company with an excellent “franchise-type” business invests in other businesses with lower returns: “Even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.”

When, however, Buffett sees that a new management team is removing the amateurs from the foursome and returning focus to the company’s core businesses, he pays close attention.

Buffett never participates in auctions.

As David Sokol, the (now former) CEO of MidAmerican Energy and NetJets, told me, “We simply don’t get swept away by the excitement of bidding.”

Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer “usually in five minutes or less.” This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.

Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of the first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition.

In a company with over 270,000 employees, there are only 23 at corporate headquarters in Omaha. There are no regular budget meetings for Berkshire companies. The CEOs who run Berkshire’s subsidiary companies simply never hear from Buffett unless they call for advice or seek capital for their businesses. He summarizes this approach to management as “hire well, manage little” and believes this extreme form of decentralization increases the overall efficiency of the organization by reducing overhead and releasing entrepreneurial energy.

Buffett estimates the average CEO spends 20 percent of his time communicating with Wall Street. In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance. He prefers to communicate with his investors through detailed annual reports and meetings, both of which are unique.

Buffett has famously eschewed splitting Berkshire’s A shares, which currently trade at over $120,000, more than fifty times the price of the next-highest issue on the New York Stock Exchange (NYSE). He believes these splits are purely cosmetic and likens the process to divide a pizza into eight versus four slices, with no change in calories or asset value delivered.

Avoiding stock splits is yet another filter, helping Berkshire to self-select for long term owners. In 1996, he reluctantly agreed to create a lower-priced class of B shares, which traded at one-thirtieth of the A shares and were the second-highest-priced issue on the NYSE. (In connection with the Burlington Northern deal in early 2010, Buffett agreed to split the B shares a further 50:1 to accommodate the railroad’s smaller investors.)

Buffett believes that the best boards are composed of relatively small groups (Berkshire has twelve directors) of experienced business people with large ownership stakes. (He requires that all directors have significant personal capital invested in Berkshire’s stock.)

He believes directors should have exposure to the consequences of poor decisions (Berkshire does not carry insurance for its directors) and should not be reliant on the income from board fees, which are minimal at Berkshire.

Radical Rationality: The Outsider’s Mind-Set

The outsider CEOs always started by asking what the return was.

Every investment project generates a return, and the math is really just fifth-grade arithmetic, but these CEOs did it consistently, used conservative assumptions, and only went forward with projects that offered compelling returns.

They focused on the key assumptions, did not believe in overly detailed spreadsheets, and performed the analysis themselves, not relying on subordinates or advisers.

The outsider CEOs believed that the value of financial projections was determined by the quality of the assumptions, not by the number of pages in the presentation, and many developed succinct, single-page analytical templates that focused employees on key variables.

These executives were capital surgeons, consistently directing available capital toward the most efficient, highest-returning projects.

Over long periods of time, this discipline had an enormous impact on shareholder value through the steady accretion of value-enhancing decisions and (equally important) the avoidance of value-destroying ones.

This unorthodox mindset, in itself, proved to be a substantial and sustainable competitive advantage for their companies. It provided the equivalent of polarized lenses, allowing the outsider CEOs to cut through the glare of peer activity and conventional wisdom to see the core economic reality and make decisions accordingly.

Epilogue – An Example and a Checklist for investors to keep in mind

The Outsider’s Checklist

  1. The allocation process should be CEO led, not delegated to finance or business development personnel.
  2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes). Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the mid-teens or higher).
  3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions. Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low returns.
  4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark. While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.
  5. Focus on after-tax returns, and run all transactions by tax counsel.
  6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.
  7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?)
  8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.
  9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax-inefficient.
  10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.

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