I first heard of the book “The Outsiders” in Berkshire Hathaway’s 2012 letter to shareholders. And who is going to ignore a book that Buffett calls “outstanding!”?
The book goes in detail on 8 different CEOs who excelled at creating exceptional long term returns for shareholders. In fact, the average returns of these companies’ shares outperformed the S&P 500 by a factor of 20 – every $10,000 invested in these companies was worth $1.5 million 25 years later.
What’s their secret? And how can we use those lessons to find today’s great CEOs?
The book makes the point that the reason these companies were so successful was because of the ability of the CEOs to allocate their company’s capital into the areas that produced the highest returns.
Sure it’s nice to have a CEO who is charismatic, a great communicator or maybe even one who enjoys a celebrity type status. But what really matters to shareholders? Returns.
And a CEO who is a master capital allocator will ensure that shareholder money is put to the best use, and generates the best returns possible. Capital Allocation done right over decades creates a huge compounding effect – as shown in this book – and compounding wealth for its shareholders.
The CEO’s job is to allocate the company’s two forms of capital, for the sake of this article we are going to refer to these as a company’s “Financial Capital” and “Human Capital”, and take a look at how these 8 outstanding CEOs allocated their capital to produce superior returns.
First lets look at the much easier to define and measure Financial Capital.
Financial Capital Allocation
This is how a company’s CEO spends the company’s money.
Focus on Cash Flow – Not Reported Earnings
The first common theme evident throughout the book is nearly all of these CEOs focused on one thing above all else – Cash Flow. Even at the expense of reportable earnings, these CEOs wanted their businesses to generate cash.
For example, in the chapter on John Malone and his company, TCI, Thorndike says:
“…Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. 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.”
And Henry Singleton, CEO of Teledyne said:
“If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.”
Finding Companies Focused on Cash Flow
What does this mean for finding your next investment? Instead of evaluating a company based on a ratio using net earnings (such as P/E ratio), look instead at the price of a company based on the cash it generates. Use a metric like Free Cash Flow (FCF) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) instead, because a CEO focused on cash flow will sacrifice a “good” P/E value in favor of high free cash flow. Combine a company that produces tons of cash with a CEO who allocates that cash wisely (which we will learn to measure in the next few steps) and you may be well on your way to an excellent long term ride.
Read more: “How much is too much to pay for a great business” – Where we explore one company with a P/E of 66…but as we have seen, P/E doesn’t tell the whole story. Look and see how much cash they generate!
Screening based on Price/FCF, Price/EBITDA will find companies that are cheap relative to the cash they generate.
This screening will give you a list of companies to start with. For those that want to play along, here is the start of my list, which we will whittle down as we go through this article. There are too many on this list right now, wait for the next step and we can start to get some solid companies to look into. So don’t write them all down yet, but here is the list of companies (it ended up being 95 total) that; 1) have a price/fcf ratio of 10 or less, 2) are not banks and 3) do not trade over the counter (OTC or “pink sheets”).
(click to enlarge)
Now to narrow that list down:
The Buffett Test – An Evaluation of a CEO’s Allocation Ability
So you found a company that generates a lot of cash. Now you need to find a CEO that has a proven record of investing that cash wisely, to get (or keep) the “snowball” of compounding growth rolling.
One quick test is what has become known as the “Buffett Test”.
The appendix of The Outsiders defines the “Buffett Test” as:
“…a simple test of capital allocation ability. Has a CEO created at least a dollar of value for every dollar of retained earnings over the course of his venture?”
This Buffett Test is discussed further by Buffett in his “Berkshire Hathaway Owner’s Manual”, originally in 1983 he wrote:
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”
But this was updated later to also include:
“I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.
When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.
The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If
these tests are met, retaining earnings has made sense.”
So, each of these definitions reads a little bit different to me. Let’s look at each of them:
First, The Outsider’s definition. If we assume that “value” equates to shareholder equity (or book value), then we simply take the change in shareholder equity over the CEOs tenure and divide it by the change in retained earnings. The Book says that Buffett himself has achieved a Buffett ratio of 2.3 over his tenure (meaning that every dollar in retained earnings has created 2.3 dollars in shareholder equity).
How did they get this?
The book was published when Berkshire Hathaway had released its 2007 annual report. So start with 2007 numbers: Retained earnings were $120,733,000,000 and Shareholder Equity was $273,160,000,000. Berkshire’s numbers for 1965 were Shareholder Equity of $22,139,000 and retained earnings somewhere around -$10,000,000.
Which comes out to 2.26, remember any value over 1 “passes” this test. Obviously, the higher the better though.
In Buffett’s definition from his owners manual, he seems to recommend using the companies market cap instead of shareholder equity (Which seems strange to me, coming from a guy who says the market can be inefficient and misprice stocks, and that investors should not worry too much about the share price – which is why I like the first definition better – But no one asked me!)
So, as of October 1964 there were 1,134,776 shares of Berkshire outstanding and was around $18 when Buffett took control, for a market cap of $20,425,968. In 2007 Berkshire had 1,548,000 shares outstanding with a price around $118,000 per share, for a market cap of $182,664,000,000.
Using the retained earnings numbers from the example above we get:
Which gives us 1.50, another passing grade (is there any surprise?)
How many names can we eliminate from our original screen by requiring a “Buffett test ratio” of 1 or greater? My Screener is limited to 7 years of data, so these companies are all screened for their Buffett Test over the last 7 years, using the shareholder equity definition above.
By eliminating all of the names with a Buffett Test of less than 1, we are left with 46 companies left:
46 is still a few too many for me to start pulling up years and years worth of annual reports, 10-ks and conference call transcripts. In order to whittle the list down further, lets look and see some other qualities of great CEOs described in The Outsiders.
Without a doubt, one of the most prominent themes I found in this book is the magnitude of share buybacks between these CEOs. Kathrine Graham of the Washington Post Company (Ticker: WPO) bought back over 40% of the company’s shares outstanding during her tenure, Capital Cities repurchased 47% of shares outstanding, TCI repurchased 40%, and Ralston Purina repurchased 60%!
New to the idea of share buybacks? Here’s a quick example:
Consider 2 similar companies with the exact same earnings. The only thing different about them is the number of shares outstanding:
Since one company has half the number of shares outstanding, its EPS (Earnings per Share) is twice as high. And since the companies are very similar (same industry, same growth expectations, etc) they should trade at a similar multiple, or P/E ratio. Since the company with less shares outstanding has twice the EPS to report, based on EPS and P/E ratio alone, company 2 can justify a share price that is twice that of company 1.
There are other benefits too, repurchased shares do not get paid dividends, which may save the company some money and reducing the number of shares outstanding boosts the ownership percentage of the company.
The book gives an example of Buffett’s original purchases of Washington Post stock. Buffett eventually accumulated an ownership stake of 13% of the company, but over time as Graham repurchased the company’s shares, Buffett’s ownership stake in the company would rise to 22%, as the number of shares outstanding decreased.
Of course, share buybacks can actually take away value from the shareholders if the company is buying back shares at a high price.
In Buffett’s 2012 letter to shareholders he said:
“The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the SUREST way to use funds intelligently: It’s hard to go wrong when you are buying dollar bills for 80 cents or less. We explained our criteria for repurchases in last years report and, if the opportunity presents itself, we will buy large quantities of our stock. We originally said we would not pay more than 110% of book value, but that proved unrealistic. Therefore, we increased the limit to 120% in December when a large block become available at 116%.
But never forget: In repurchase decisions, price is all-important. Value is DESTORYED when purchases are made above intrinsic value.”
So how do we search for companies that have bought back their shares? Thankfully, the number of shares outstanding for a company is listed on its balance sheet, and therefore searchable and screenable.
There is a term “Buyback Yield” that represents the percentage of a company’s shares that were repurchased. If a company bought back half its number of shares outstanding, it would have a buyback yield of 50%. Here is the definition provided by my stock screener:
“A stock’s buyback yield is determined by comparing the average shares outstanding of a fiscal period with the average shares outstanding of another fiscal period. The Buyback Yield for the latest fiscal year (Y1) compares the average shares outstanding for the latest fiscal year (Y1) to the average shares outstanding one year ago (Y2). If a stock has 90 million average shares outstanding in Y1 and had 100 million average shares outstanding in Y2, the buyback yield would be 10%. Conversely, if a stock has 100 million average shares outstanding in Y1 and had 90 million average shares outstanding in Y2, it would have a buyback yield of -11%. We then take the simple averages of a company’s buyback yields over the last three, five and seven years. Note that the signs are reversed, so that a positive buyback yield indicates the average number of shares outstanding declining while a negative number indicates the average number of shares outstanding is increasing.”
So we subject an additional screening criteria for our now 46 companies. Now I want to see only the companies that have a positive average buyback yield of the last 7 years.
Down to just 11 names now from our original pool of hundreds. Now I feel like this is a manageable list to start delving into some financial statements, listen to some comments from management, read annual reports, etc.
So we have a set of companies that exhibit some basic Fundamental qualities of the Outsider CEO companies.
But what about our other aspect of capital allocation – Human Capital – how these companies manage their people.
Human Capital Allocation
How a company manages and allocates its personnel can be as important as how it manages its money.
What are some characteristics of great CEOs?
One common trait is a decentralized structure of the company.
The entire publishing operation at Capital Cities (which ran 6 daily newspapers, several magazine groups and some several weekly shoppers) was run by 3 people at headquarters – including an administrative assistant!
In fact, on the inside cover of every Capital Cities annual report read:
“Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them responsibility and authority they need to perform their jobs. All decisions are made at the local level.”
Berkshire Hathaway is one famous example of a company with a decentralized structure. The company has 75 subsidiaries, and employs more than 300,000 people. How many do you think make up Berkshire’s headquarters?
25 (including Buffett).
Why is this important? It means Warren Buffett is not calling the shots for a company in Cleaveland, Ohio from his chair in Omaha, Nebraska. Buffett has the confidence in his management to run the company themselves, he just allocates their capital.
Other “Outsider” companies: Teledyne – had an HQ of less than 50 people and TCI – which had an HQ of 17 people.
Finding companies with this type of structure is no easy task. The only way I have found it is by reading through annual reports. You could try a screen by looking at low SG&A costs (selling, general and administrative – as listed on a company’s income statement) per revenue, but at this point in the research, I like to get my nose into annual reports.
For example, one company I am in the middle of researching right now:
Which leads us to our next quality (also highlighted by the company above):
This entrepreneurial culture is in part, forced by a company with a decentralized structure. As they are forced to manage their business without help from corporate.
But there are other key works to keep a look out for as you read through a company’s reports:
Incentives – such as with stock options. This keeps managers and shareholders interests aligned. If the primary source for a managers pay is to have the company’s stock price appreciate – then he will more than likely act in ways that also benefit shareholders as well.
You can find companies that have the incentives in place by looking at insider ownership (how many shares certain managers own – which is listed in a company’s annual report) or at manager and executive pay (as noted in a proxy report). Are executives and managers getting a high salary, but own little to no stock? That may be a big red flag.
Or are the manager’s getting meager salary, but a fair amount of stock options that will only be worthwhile if the company’s share price appreciates? Now you can be certain management and shareholders are on the same page.
Incentives could also mean bonuses based on performance, which one could argue is not as promising as stock, but at least performance bonuses will keep employees hungry to perform. For example Teledyne typically offered bonuses of up to 100% of salary!
Now we have a much better picture on how great companies in the past have been run and managed, and an idea on how to search for today’s companies that will hopefully become great companies tomorrow.
What is surprising to me is how “basic” this seems. Companies shouldn’t have waste by supporting massive corporate headquarters, companies should keep their managers and shareholders interests aligned, companies should spend their money wisely and not waste it by overpaying on acquisitions or the latest and greatest technology.
It takes a special kind of CEO to sacrifice the fame and celebrity status that could come with an elaborate corporate headquarters (see Facebook or Apple’s new headquarters, or “campuses” as they call them), higher than expected earnings numbers or headline grabbing acquisitions.
But it’s not easy to find a rational, pragmatic person these days, let alone one running a public company.
Thankfully with the help of William Thorndike’s book – we start to realize what is important, what creates LONG TERM shareholder value, what to avoid and how to identify great management.
Honestly this book is one of my top reads so far this year. Before writing up this article I just read through it for the third time to get all the information out I missed the first couple times. It’s an easy read, and one of the most educational resources I have found in a long time. Don’t miss out! Used copies on amazon are about $8 as I write this – worth every penny!
Also used in this article is Berkshire Hathaway Letters to Shareholders, which can be found online here: http://www.berkshirehathaway.com/letters/letters.html
Or, if you want the collection in book form (and letters from 1965 to 1976 which are NOT available on Berkshire’s website) – Look here!