Radical Rationality - Outsider Management
In 2012 William Thorndike set out to uncover the secrets of the best CEOs in modern industry. He identified eight CEOs who stood head-and-shoulders above the rest. Their stocks outperformed the S&P 500 by an astounding 20x and their peer group by over 7x.
Thorndike refers to these executives as “The Outsiders” and they consist of:
These CEOs thought and acted unusually. Thorndike's book, The Outsiders, explains what each did. Though each operated in a different industry and period in time, five common threads tied their successes together:
1. Capital allocation is the CEO's most important job;
2. What counts in the long run is per share value, not overall growth or size;
3. Cash flow, not reported earnings, is what drives long-term shareholder value;
4. Operate a decentralized organization; and
5. Be patient and swing hard when you receive a fat pitch.
The Outsiders is one of my favorite books and one I’d recommend to anyone interested in investing or business. A full blog could be dedicated to each CEO and business, so here I’ll briefly review each Outsider trait with some examples. Hopefully, these takeaways can not only be applied to investing but to any business setting when evaluating a company’s leadership.
Capital Allocation as the CEO’s Most Important Job
CEOs have two important functions – running their business and allocating capital (i.e. investing). Nearly all leadership books focus on running the business, which is of course important. However, it is capital allocation that has the biggest long-term impact on shareholders.
Operating a business is a skill that usually comes naturally to CEOs, as they have typically risen through some functional area (marketing, engineering, administration, etc.). But, as Buffett has noted, most CEOs come unprepared for the job of allocating their businesses cash flows.
“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…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.”
To hammer home the point, Buffett asks shareholders to consider a CEO whose company retains 10 percent of net worth each year (not a significant percentage in most cases). After a decade the CEO will have been responsible for deploying 60 percent of all the capital at work in the business.
The Outsiders largely took a contrarian view and understood that their most important task was to effectively allocate capital. It’s not clear why they all came to this conclusion, but maybe it has something to do with each of them being a first-time CEO.
CEOs have five choices when allocating capital; invest in existing operations, acquire other businesses, pay dividends, pay down debt, or repurchase stock. The divergence in how Outsider CEOs allocated capital is stark compared to their peers.
Take Henry Singleton of Teledyne for example. While industry peers all employed a mirror image strategy – they issued shares to make several acquisitions, paid dividends, avoided share repurchases, and used minimal debt – Singleton pursued the exact opposite approach. He issued few shares, undertook a series of large repurchases, utilized debt for selective large acquisitions, and didn’t pay a dividend for years. Under this approach Singleton outperformed his peers by ninefold and the S&P by more than twelvefold.
Per Share Value is What Matters Most
Each Outsider CEO emphasized per share results, which is what ultimately matters to shareholders over the long-term. None of the CEOs pursued the popular Wall Street growth at any cost mentality. Almost all the CEOs repurchased substantial amounts of shares over their tenure – more than 30% in all cases except Buffett – which was a rarity during the time period. They understood that the best investment was sometimes their own stock, which created huge tailwinds for per share results.
Taking it to the extreme, Bill Anders employed a “shrink to grow” approach at General Dynamics. In 1990 General Dynamics was on the brink of bankruptcy and had revenue of $10B and a market cap of just $1B. Anders assumed the CEO role and decided the company would only occupy markets where they had a #1 or #2 position, and exit all other businesses. Anders shrunk the business by selling underperforming units, generating huge sums of cash which he used to buyback over 30% of the undervalued shares and pay dividends. What was left was a leaner business with leading positions in its industries.
Despite initially shrinking the absolute size of the business dramatically, per share results flourished. A dollar invested when Anders took over was worth $30 seventeen years later compared to $17 if invested in peers and $6 if invested in the S&P 500.
Focus on Cash
In addition to the focus on per share value, the Outsiders emphasized cash flow over reported earnings. GAAP accounting is inherently subjective and can be massaged to meet analyst expectations. Cash on the other hand, doesn’t lie. Cash is what can be invested to earn returns for or distributed to shareholders. Measuring the business on a cash basis proved wise, and unconventional, for the Outsiders. Each CEO maintained an obsessive focus on a key cash flow metric that was idiosyncratic for their industry – cash flow margins for Tom Murphy, Cash ROI for Bill Anders, Cash IRR for Katharine Graham – and so on.
John Malone embodied this when building the cable empire TCI. By sheltering his cash from taxes by using debt to build new systems and aggressively depreciating the costs of construction, Malone almost never showed net income despite extremely healthy cash flows.
Operate a Decentralized Structure
Allowing decisions to be made at the lowest appropriate level of an organization enables an owner-mindset to permeate a company. The Outsiders avoided micromanagement and empowered their leaders to run their business units without heavy corporate oversight. This approach resulted in emotionally invested employees that ran their portion of the business like it was their own. Each of the businesses operated a lean corporate staff which boosted profitability while encouraging the right behavior from managers and executives.
Buffett has championed this approach for decades. Berkshire Hathaway employed around 270,000 people at the time the Outsiders was written and operated with a corporate headquarters of 23 (I’m not missing a zero). Under Jack Welch GE employed around 400,000 people and maintained a headquarters staff of many thousands of employees, much more the norm for large conglomerates.
Swing Aggressively at Fat Pitches
A flexible, independent-minded, and opportunistic approach to bold action was a constant among the Outsiders. Each CEO made an acquisition that was 25% or more of their market cap. Many of the CEOs conducted 30%+ tender offers to buyback a large amount of stock quickly when they perceived it to be undervalued. Other times they didn’t do much of anything for several years as there wasn’t anything particularly attractive to do. This also usually went against the grain of how peers were behaving. As Howard Marks’ says, to outperform “you have to be different, and you have to be right” – the Outsiders were both.
Like all good investors, the Outsiders opportunistically took meaningful action when it became obvious to do so – a fat pitch as Buffett would say. Whether running a multi-billion-dollar company or a $15,000 portfolio, investors would be well served to follow a similar approach.
Takeaway
In summary, each CEO simply behaved a like long-term business owner and ignored short term results in favor of maximizing long term per share value of their businesses. Thorndike described them as behaving “radically rationale” – something far less common than one would think, especially on Wall Street.
It’s important to note that there was no strict formula for success for the Outsiders. It does not always make sense to repurchase your own stock, or to make acquisitions when others are not, or to avoid dividends. These outcomes were the output of logical thinking to maximize long term value given their present situation. Thorndike summed it up near the end of his book:
“As a group, these CEOs faced the inherent uncertainty of the business world with a patient, rational, pragmatic opportunism, not a detailed set of strategic plans”.
We're always on the lookout for modern day Outsiders. We think we're found some in the likes of NVR, AutoZone, and Berkshire Hathaway. Outside of our portfolio, examples might include Verisign, TransDigm, and Constellation Software. Beyond studying Outsiders, we try to embody their lessons and rationality when making our own investment decisions.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.