Tuesday, 26 March 2013

Book Review - The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William Thorndike, Jr.

William Thorndike Jr.'s The Outsiders considers eight Hall of Fame CEOs (and, in some cases, the small teams that they worked closely with), the only executives that passed his twin tests: outperforming companies in their peer group, and besting the performance of General Electric's Jack Welch, widely considered one of the finest managers in business history.  Thorndike found that unlike the jet-set, media-savvy, wheeling-and-dealing, larger-than-life Welch, the truly elite eight were modest, private, and humble.  Their most notable qualities, however, were cerebral.  As Bill Stiritz of Ralston Purina put it: "Leadership is analysis" (145).  And all of the featured executives had the independence of mind to turn analysis into action.

Warren Buffett has noted that most CEOs, however exemplary their abilities in areas such as marketing, production or administration, tend to be poor capital allocators.  They're executors, not investors.  However, decisions about what to do with a spare dollar are just as important to the long-term performance of a business as the day-to-day operations.  In terms of specific policies, most of the featured CEOs repurchased shares, but none paid a significant dividend; all focused on one version or another of cash flows, rather than emphasizing earnings; and none provided earnings guidance to analysts - in short, they behaved like investors, rather than operators.  They didn't out-manage Welch; they bested him in the area of capital allocation.

Perhaps Thorndike's greatest achievement in the book is to resurrect the largely forgotten story of Henry Singleton, who Warren Buffett regards as among the greatest capital allocators in the history of business.  No business major, Singleton earned a PhD in electrical engineering, was awarded the Putnam Medal as the best math student in America, and played chess at an almost-grandmaster level.  In 1960, he and a partner founded a small firm, Teledyne, a conglomerate that swallowed a mind-boggling 130 companies in its first decade of existence, using his own firm's high-priced stock as the currency.  While the sheer scale of his shopping spree might suggest an indiscriminate approach to acquisitions, Singleton was in fact a bargain-hunter: he never paid more than 12x earnings.  

Singleton understood that using Teledyne's stock to fund acquisitions made sense only if that stock was fully (or over) priced, and by 1971 he had grown the share count by about 14x.  However, when the conglomerate form fell out of favor on Wall Street, Teledyne's stock swooned, and he correctly reversed course.  Not only did he never again issue a single share of additional stock, he spent the next decade-plus retiring an unheard of 90% of Teledyne's shares.  In part by issuing stock at an average P/E of 25, and buying it at an average of 8, Singleton managed to grow EPS by a world-beating 27% per year for 33 years.
Just as he had earlier retreated by repurchasing shares that had been previously issued, Singleton eventually decided to dismantle the conglomerate that he'd spent his life building.  He spun out several of Teledyne's largest operating companies, and sold what remained to another firm, but only at a full price.  What was it all for?  A 20.4% stock return over nearly three decades, or an 180-to-1 increase. 

John Malone, who has made his eye-popping fortune in the cable and media industries, allocates capital, and leaves operations to a trusted number two, as well as local managers.  For many years as he built his empire, Malone was the only significant cable company CEO to strive for cash flow growth, rather than increases in EPS.  In fact, the now widely used acronym EBITDA was coined by Malone.  (Admittedly, this is not a wholly desirable accomplishment).  Recognizing that scale is a powerful competitive advantage for cable operators, Malone bought smaller competitors at a heated pace, but managed to do so on attractive economic terms.  Not only did size lead to lower costs - and higher cash flows - per subscriber, Malone used it to strike unique deals in which he acquired stakes in up-and-comers such as BET and Discovery in return for access to his imposing subscriber base.  Thorndike argues convincingly that Malone used joint ventures more often and more effectively than any other CEO ever has, perhaps adding a sixth category to the Big Five types of capital allocation.  The scorecard: 30.3% per year from 1973 to 1998, over 900-to-1.

Inevitably, a book about capital-allocating CEOs will include a chapter on Warren Buffett and Charlie Munger.  While the chapter itself covers no new ground, it's an able summary of the twin Oracles of Omaha, and offers a nearly up-to-date performance record: 20.9% over 45 years, or a 6,265-to-1 return.  But Buffett and Munger cannot be bound and contained in a single chapter.  In fact, the book reads a little like an experimental, post-modern literary work, in which the mischievous author (Buffett) writes a book wherein its main character (Thorndike) writes a book about the author (Buffett).  After all, Thorndike, like most investors, almost certainly first heard of Tom Murphy and Dan Burke of Capital Cities and Henry Singleton from Buffett; Kay Graham would not have fared nearly as well as she did without the active, ongoing counsel of Buffett, long the Washington Post's largest shareholder; Buffett invested in General Dynamics well before it became a must-read case study; and most of the books Thorndike cites are about, or have been recommended by, Buffett and Munger. 

Though Buffett, Munger and Singleton are three of the finest, most original minds in the history of business and investing, better capital allocation is possible for most CEOs, regardless of their ability to play chess blindfolded or perform complex calculations in their head.  In fact, the book left this reader frustrated: a few of the case studies offer formulas that are so simple they border on boring.  How difficult can it be, after all, to close or sell poor businesses?  To be sure, not all businesses can be above average, but shareholders as a whole would be meaningfully richer even if CEOs were better at just one simple task: discriminating between paying a dividend and repurchasing cheap shares.  For even a moderately disciplined chief executive, buybacks are a far more attractive option over the long-term, since most stocks are undervalued in the market from time to time.  Thorndike is more optimistic than this reader about the potential uses of leverage: even the uber-talented John Malone nearly succumbed to bankruptcy - largely because of debt that he inherited, but not entirely - and few CEOs will be mistaken for Malone.  

Rather than merely reassembling and reinterpreting publically available material, Thorndike conducted nearly 100 interviews, talks that included many of the (surviving) subjects themselves, as well as people who worked directly with them, adding freshness to the book.  In addition to the stories noted above, he offers analysis of the Dick Smith at General Cinema, and Bill Stiritz at Ralston Purina, case studies unknown even in many business schools.  And for active investors, Thorndike addresses a few potential investments, including Transdigm, Sara Lee, Exxon Mobil and the collection of companies controlled by John Malone.  This fine book ought to be read by most investors; but it's an emphatic must read for all CEOs.

Source: Thorndike, Jr., William.  The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Boston: Harvard Business Review Press, 2012.

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