The Outsiders

The Outsiders is a collection of portraits of eight unconventional, yet very successful (ex-)CEOs of public companies. With success measured as the creation of shareholder value.

I found this book an interesting read as I didn't know anything about most of the profiled CEOs and their companies. And I liked how it highlighted the importance of capital allocation for the long-term success of businesses. On the other hand I wished that the portraits would have been longer with more details and a more critical tone. I didn't like the author's writing style, it felt too fanboyish and everything the CEOs did was "great"...

My notes

Preface: Singletonville

It's almost impossible to overpay the truly extraordinary CEO... but the species is rare.

Success leaves traces.

It's the increase in a company's per share value, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO's greatness.

In assessing performance, what matters isn't the absolute rate of return but the return relative to peers and the market. You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500).

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations.

Basically, CEOs have five essential choices for deploying capital – investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock – and three alternatives for raising it – tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long-term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.

Introduction

It is impossible to produce superior performance unless you do something different.

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness. They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate planes, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press. They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them.

Most public company CEOs focus on maximizing quarterly reported net income, which is understandable since that is Wall Street's preferred metric. Net income, however, is a bit of a blunt instrument and can be significantly distorted by differences in debt levels, taxes, capital expenditures, and past acquisition history. As a result, the outsiders (who often had complicated balance sheets, active acquisition programs, and high debt levels) believed the key to long-term value creation was to optimize free cash flow, and this emphasis on cash informed all aspects of how they ran their companies – from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems.

Growth, it turns out, often doesn't correlate with maximizing shareholder value.

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

"The goal is not to have the longest train, but to arrive at the station first using the least fuel."

The formula [...] was deceptively simple: focus on industries with attractive economic characteristics, selectively use leverage to buy occasional large properties, improve operations, pay down debt, and repeat.

Capital Cities under Murphy was an extremely successful example of what we would now call a roll-up. In a typical roll-up, 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.

"The business of business is a lot of little decisions every day mixed up with a few big decisions."

There is a fundamental humility to decentralization, an admission that headquarters does not have all the answers and that much of the real value is created by local managers in the field.

The company's guiding human resource philosophy, repeated ad infinitum by Murphy, was to "hire the best people you can and leave them alone".

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 defense against the revenue lumpiness inherent in advertising-supported businesses was a constant vigilance on costs, which became deeply embedded in the company's culture.

Murphy and Burke believed that even the smallest operating decisions, particularly those relating to head count, could have unforeseen long-term costs and needed to be watched constantly.

"I get paid not just to make deals, but to make good deals."

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. He would often ask the seller what they thought their property was worth, and if he thought their offer was fair he'd take it [...]. 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. He believed this straightforward approach saved time and avoided unnecessary acrimony.

An Unconventional Conglomerateur: Henry Singleton and Teledyne

In addition to eschewing dividends, 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.

The conventional wisdom today is that conglomerates are an inefficient form of corporate organization, lacking the agility and focus of "pure play" companies. It was not always so – for most of the 1960s, conglomerates enjoyed lofty price-to-earnings (P/E) ratios and used the currency of their high-priced stock to engage in a prolonged frenzy of acquisition. During this heady period, there was significantly less competition for acquisitions than today (private equity firms did not yet exist), and the price to buy control of an operating company (measured by its P/E ratio) was often materially less than the multiple the acquirer traded for in the stock market, providing a compelling logic for acquisitions.

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 specialty 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.

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.

Great investors (and capital allocators) must be able to both sell high and buy low; 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.

"My only plan is to keep coming to work... I like to steer the boat each day rather than plan ahead way into the future."

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. [...] The other approach, the one [...] 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 Turnaround: Bill Anders and General Dynamics

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 favorite perk as CEO: the opportunity to fly the company's cutting-edge jets.

"Most CEOs grade themselves on size and growth... very few really focus on shareholder returns."

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

His two academic fields, engineering and operations, were highly quantitative and shared a focus on optimization, on minimizing "noise" and maximizing "output". Indeed, Malone's entire future career can be thought of as an extended exercise in hyperefficient value engineering, in maximizing output in the form of shareholder value and minimizing noise from other sources, including taxes, overhead, and regulations.

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows. If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.

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.

Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges.

Using the debt available from the company's new lenders, internal cash flow, and the occasional equity offering, Malone began an extraordinarily active acquisition program. Between 1973 and 1989, the company closed 482 acquisitions, an average of one every other week.

Malone was a pioneer in the use of spin-offs and tracking stocks, which he believed accomplished two important objectives: (1) increased transparency, allowing investors to value parts of the company that had previously been obscured by TCI's byzantine structure, and (2) increased separation between TCI's core cable business and other related interests (particularly programming) that might attract regulatory scrutiny.

Malone abhorred taxes; they offended his libertarian sensibilities, and he applied his engineering mind-set to the problem of minimizing the "leakage" from taxes as he might have minimized signal leakage on an electrical engineering exam. As the company grew its cash flow by twentyfold over Malone's tenure, it never paid significant taxes. In fact, Malone's one extravagance in terms of corporate staff was in-house tax experts.

Malone appreciated how difficult and expensive it was to implement new technologies, and preferred to wait and let his peers prove the economic viability of new services [...].

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

After [Phil Graham's] tragic death, Katharine found herself thrust unexpectedly into the CEO role. It is impossible to overstate Graham's unpreparedness for this position. At age forty-six, she was the mother of four and hadn't been regularly employed since the birth of her first child nearly twenty years before.

[...] during the acquisition frenzy of the 1980s, Graham generally stood aside, passing on numerous newspaper acquisitions, large and small. As her son Donald says today, "The deals not done were very important. Another large newspaper would have been a boat anchor around our necks today."

The decision to welcome Buffett into the fold was a highly independent and unusual one at the time. In the mid-1970s, Buffett was virtually unknown. Again, the choice of a mentor is a critically important decision for any executive, and Graham chose unconventionally and extraordinarily well. As her son Donald has said, "Figuring out this relatively unknown guy was a genius was one of the less celebrated, best moves she ever made."

A Public LBO: Bill Stiritz and Ralston Purina

Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

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 businesses that he felt were mature or underappreciated by Wall Street.

Stiritz was the pioneer among consumer packaged goods CEOs in the use of debt. This was heresy in an industry that had long been characterized by exceptionally conservative financial management. Stiritz, however, saw that the prudent use of leverage could enhance shareholders' returns significantly. 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 [...].

From the outset, Stiritz had been a believer in decentralization, working to reduce layers of corporate bureaucracy and giving responsibility and autonomy for the company's key businesses to a close-knit group of managers. He viewed spin-offs as a further move in this direction, "the ultimate decentralization", providing managers and shareholders with an attractive combination of transparency and autonomy and allowing managers to be compensated more directly on their operating results than was possible in the larger conglomerated structure of the mother company.

Stiritz believed that Ralston should only pursue opportunities that presented compelling returns under conservative assumptions, and he disdained the false precision of detailed financial models, focusing instead on a handful of key variables: market growth, competition, potential operating improvements, and, always, cash generation.

Stiritz was fiercely independent, and actively disdained the advice of outside advisers. He believed that charisma was overrated as a managerial attribute and that analytical skill was a critical prerequisite for a CEO and the key to independent thinking: "Without it, chief executives are at the mercy of their bankers and CFOs."

He was well known for showing up alone to important due diligence meetings or negotiations where the other side of the table was crowded with bankers and lawyers.

Optimizing the Family Firm: Dick Smith and General Cinema

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

The Investor as CEO: Warren Buffett and Berkshire Hathaway

"Being a CEO has made me a better investor, and vice versa."

It is hard to overstate the significance of this change. Buffett was switching at midcareer from a proven, lucrative investment approach that focused on the balance sheet and tangible assets, to an entirely different one that looked to the future and emphasized the income statement and hard-to-quantify assets like brand names and market share. To determine margin of safety, Buffett relied now on discounted cash flows and private market values instead of Graham's beloved net working capital calculation.

Charlie Munger has said that the secret to Berkshire's long-term success has been its ability to "generate funds at 3 percent and invest them at 13 percent", and this consistent ability to create low-cost funds for investment has been an underappreciated contributor to the company's financial success. Remarkably, Buffett has almost entirely eschewed debt and equity issuances – virtually all of Berkshire's investment capital has been generated internally.

In both insurance and investing, Buffett believes the key to long-term success is "temperament", a willingness to be "fearful when others are greedy and greedy when they are fearful".

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".

Most CEOs are limited by prior experience to investment opportunities within their own industry [...]. Buffett, in contrast, by virtue of his prior experience evaluating investments in a wide variety of securities and industries [...] had the advantage of choosing from a much wider menu of allocation options, including the purchase of private companies and publicly traded stocks.

A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets.

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it."

Buffett has created an attractive, highly differentiated option for sellers of large private businesses, one that falls somewhere between an IPO and a private equity sale. A sale to Berkshire is unique in allowing an owner/operator to achieve liquidity while continuing to run the company without interference or Wall Street scrutiny. Buffett offers an environment that is completely free of corporate bureaucracy, with unlimited access to capital for worthwhile projects. This package is highly differentiated from the private equity alternative, which promises a high level of investor involvement and a typical five-year holding period before the next exit event.

Buffett never participates in auctions. [...] 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 came to the CEO role without any relevant operating experience and consciously designed Berkshire to allow him to focus his time on capital allocation, while spending as little time as possible managing operations, where he felt he could add little value. As a result, the touchstone of the Berkshire system is extreme decentralization.

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 spends his time differently than other Fortune 500 CEOs, managing his schedule to avoid unnecessary distractions and preserving uninterrupted time to read (five newspapers daily and countless annual reports) and think.

All of this adds up to something much more powerful than a business or investment strategy. Buffett has developed a worldview that at its core emphasizes the development of long-term relationships with excellent people and businesses and the avoidance of unnecessary turnover, which can interrupt the powerful chain of economic compounding that is the essence of long-term value creation.

Radical Rationality: The Outsider's Mind-Set

You are right not because others agree with you, but because your facts and reasoning are sound.

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 were master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest, most local levels in their organizations. They did not, however, delegate capital allocation decisions.

In addition to thinking independently, they were comfortable acting with a minimum of input from outside advisers.

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 mind-set, in itself, proved to be a substantial and sustainable competitive advantage for their companies.

Although frugal by nature, the outsider CEOs were also willing to invest in their businesses to build long-term value. To do this, they needed to ignore the quarterly earnings treadmill and tune out Wall Street analysts and the cacophony of cable shows [...] with their relentless emphasis on short-term thinking.

They had the perspective of the long-term investor or owner, not the high-paid employee – a very different hat than most CEOs wear to work.