(Image: Zen Buddha Silence by Marilyn Barbone.)
May 28, 2017
William Thorndike is the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Harvard Business Review Press, 2012). It’s an excellent book profiling eight CEOs who compounded shareholder value at extraordinary rates over decades.
Through this book, value investors can improve their understanding of how to identify CEOs who maximize long-term returns to shareholders. Also, investors can become better businesspeople, while businesspeople can become better investors.
I am a better investor because I am a businessman and a better businessman because I am an investor. – Warren Buffett
Thorndike explains that you only need three things to evaluate CEO performance:
- the compound annual return to shareholders during his or her tenure
- the return over the same period for peer companies
- the return over the same period for the broader market (usually measured by the S&P 500)
Thorndike notes that 20 percent returns is one thing during a huge bull market – like 1982 to 1999. It’s quite another thing if it occurs during a period when the overall market is flat – like 1966 to 1982 – and when there are several bear markets.
Moreover, many industries will go out of favor periodically. That’s why it’s important to compare the company’s performance to peers.
Thorndike mentions Henry Singleton as the quintessential outsider CEO. Long before it was popular to repurchase stock, Singleton repurchased over 90% of Teledyne’s stock. Also, he emphasized cash flow over earnings. He never split the stock. He didn’t give quarterly guidance. He almost never spoke with analysts or journalists. And he ran a radically decentralized organization. Thorndike:
If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180. That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500. Remarkably, Singleton outperformed the index by over twelve times. (pages xi-xii)
Thorndike observes that rational capital allocation was the key to Singleton’s success. Thorndike writes:
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. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders. (page xiii)
Warren Buffett has noted that most CEOs reach the top due to their skill in marketing, production, engineering, administration, or even institutional politics. Thus most CEOs have not been prepared to allocate capital.
Thorndike also points out that the outsider CEOs were iconoclastic, independent thinkers. But the outsider CEOs, while differing noticeably from industry norms, ended up being similar to one another. Thorndike says that the outsider CEOs understood the following principles:
- Capital allocation is a CEO’s most important job.
- What counts in the long run is the increase in per share value, not overall growth or size.
- Cash flow, not reported earnings, is what determines long-term value.
- Decentralized organizations release entrepreneurial energy and keep both costs and ‘rancor’ down.
- Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
- Sometimes the best investment opportunity is your own stock.
- With acquisitions, patience is a virtual… as is occasional boldness.
Here are the sections in the blog post:
- Tom Murphy and Capital Cities Broadcasting
- Henry Singleton and Teledyne
- Bill Anders and General Dynamics
- John Malone and TCI
- Katharine Graham and The Washington Post Company
- Bill Stiritz and Ralston Purina
- Dick Smith and General Cinema
- Warren Buffett and Berkshire Hathaway
- Radical Rationality
Only two of the eight outsider CEOs had MBAs. And, writes Thorndike, they did not attract or seek the spotlight:
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 plans, 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. Ben Franklin would have liked these guys. (page 3)
Thorndike describes how the outsider CEOs were iconoclasts:
Like Singleton, these CEOs consistently made very different decisions than their peers did. They were not, however, blindly contrarian. Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions. (page 4)
Thorndike compares the outsider CEOs to Billy Beane as described by Michael Lewis in Moneyball. Beane’s team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job. Beane had discovered new – and unorthodox – metrics that were more correlated with team winning percentage.
Thorndike mentions a famous essay about Leo Tolstoy written by Isaiah Berlin. Berlin distinguishes between a “fox” who knows many things and a “hedgehog” who knows one thing extremely well. Thorndike continues:
Foxes… 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 ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results. (page 5)
TOM MURPHY AND CAPITAL CITIES BROADCASTING
When Murphy became CEO of Capital Cities in 1966, CBS’ market capitalization was sixteen times than that of Capital Cities. Thirty years later, Capital Cities was three times as valuable as CBS. Warren Buffett has said that in 1966, it was like a rowboat (Capital Cities) against QE2 (CBS) in a trans-Atlantic race. And the rowboat won decisively!
Bill Paley, who ran CBS, used the enormous cash flow from its network and broadcast operations and undertook an aggressive acquisition program of companies in entirely unrelated fields. Paley simply tried to make CBS larger without paying attention to the return on invested capital (ROIC).
Without a sufficiently high ROIC, growth destroys shareholder value instead of creating it. But, like Paley, many business leaders at the time sought growth for its own sake. Even if growth destroys value (due to low ROIC), it does make the business larger, bringing greater benefits to the executives.
Murphy’s goal, on the other hand, was to make his company as valuable as possible. This meant maximizing profitability and ROIC:
…Murphy’s goal was to make his company more valuable… Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well. Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS’s rival broadcast network ABC. (page 15)
Burke excelled in operations, while Murphy excelled in making acquisitions. Together, they were a great team – unmatched, according to Warren Buffett. Burke said his ‘job was to create free cash flow and Murphy’s was to spend it.’
During the mid-1970s, there was an extended bear market. Murphy aggressively repurchased shares, mostly at single-digit price-to-earnings (P/E) multiples.
Thorndike writes that in January 1986, Murphy bought the ABC Network and its related broadcasting assets for $3.5 billion with financing from his friend Warren Buffett. Thorndike comments:
Burke and Murphy wasted little time in implementing Capital Cities’ lean, decentralized approach – immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed. They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan…
In the nine years after the transaction, revenues and cash flows grew significantly in every major ABC business line, including the TV stations, the publishing assets, and ESPN. Even the network, which had been in last place at the time of the acquisition, was ranked number one in prime time ratings and was more profitable than either CBS or NBC. (page 20)
In 1993, Burke retired. And in 1995, Murphy, at Buffett’s suggestion, met with Michael Eisner, the CEO of Disney. Over a few days, Murphy sold Capital Cities/ABC to Disney for $19 billion, which was 13.5 times cash flow and 28 times net income. Thorndike:
He left behind an ecstatic group of shareholders – if you had invested a dollar with Tom Murphy as he became CEO in 1966, that dollar would have been worth $204 by the time he sold the company to Disney. That’s a remarkable 19.9 percent internal rate of return over twenty-nine years, significantly outpacing the 10.1 percent return for the S&P 500 and 13.2 percent return for an index of leading media companies over the same period. (page 21)
Thorndike points out the decentralization was one the keys to success for Capital Cities. There was 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 had almost no staff. There were no vice presidents in marketing, strategic planning, or human resources. There was no corporate counsel and no public relations department. The environment was ideal for entrepreneurial managers. Costs were minimized at every level.
Burke developed an extremely detailed annual budgeting process for every operation. Managers had to present operating and capital budgets for the coming year, and Burke (and his CFO, Ron Doerfler) went through the budgets line-by-line:
The budget sessions were not perfunctory and almost always produced material changes. Particular attention was paid to capital expenditures and expenses. Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as ‘a form of report card.’ Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate. (page 25)
High margins resulted not only from cost minimization, but also from Murphy and Burke’s focus on revenue growth and advertising market share. They invested in their properties to ensure leadership in local markets.
When it came to acquisitions, Murphy was very patient and disciplined. His benchmark ‘was a double-digit after-tax return over ten years without leverage.’ Murphy never won an auction as a result of his discipline. Murphy also had a unique negotiating style.
Murphy thought that, in the best transactions, everyone comes away happy. He believed in ‘leaving something on the table’ for the seller. Murphy would often ask the seller what they thought the property was worth. If Murphy thought the offer was fair, he would take it. If he thought the offer was high, he would counter with his best price. If the seller rejected his counter-offer, Murphy would walk away. He thought this approach saved time and avoided unnecessary friction.
Thorndike concludes his discussion of Capital Cities:
Although the focus here is on quantifiable business performance, it is worth noting that Murphy built a universally admired company at Capital Cities with an exceptionally strong culture and esprit de corps (at least two different groups of executives still hold regular reunions). (page 34)
HENRY SINGLETON AND TELEDYNE
Singleton earned bachelor’s, master’s, and PhD degrees in electrical engineering from MIT. He programmed the first student computer at MIT. He won the Putnam Medal as the top mathematics student in the country in 1939. And he was 100 points away from being a chess grandmaster.
Singleton worked as a research engineer at North American Aviation and Hughes Aircraft in 1950. Tex Thornton recruited him to Litton Industries in the late 1950s, where Singleton invented an inertial guidance system – still in use – for commercial and military aircraft. By the end of the decade, Singleton had grown Litton’s Electronic Systems Group to be the company’s largest division with over $80 million in revenue.
Once he realized he wouldn’t succeed Thornton as CEO, Singleton left Litton and founded Teledyne with his colleague George Kozmetzky. After acquiring three small electronics companies, Teledyne successfully bid for a large naval contract. Teledyne became a public company in 1961.
In the 1960’s, conglomerates had high price-to-earnings (P/E) ratios and were able to use their stock to buy operating companies at relatively low multiples. Singleton took full advantage of this arbitrage opportunity. From 1961 to 1969, he purchased 130 companies in industries from aviation electronics to specialty metals and insurance. Thorndike elaborates:
Singleton’s approach to acquisitions, however, differed from that of other conglomerateurs. He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets… 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. (page 41)
In mid-1969, Teledyne was trading at a lower multiple, while acquisition prices were increasing. So Singleton completely stopped acquiring companies.
Singleton ran a highly decentralized company. Singleton also did not report earnings, but instead focused on free cash flow (FCF) – what Buffett calls owner earnings. The value of any business is all future FCF discounted back to the present.
FCF = net income + DDA – capex
(There are also adjustments to FCF based on changes in working capital. DDA is depreciation, depletion, and amortization.)
At Teledyne, bonus compensation for all business unit managers was based on the maximization of free cash flow. Singleton – along with his roommate from the Naval Academy, George Roberts – worked to improve margins and significantly reduce working capital. Return on assets at Teledyne was greater than 20 percent in the 1970s and 1980s. Charlie Munger calls these results from Teledyne ‘miles higher than anybody else… utterly ridiculous.’ This high profitability generated a great deal of excess cash, which was sent to Singleton to allocate.
Starting in 1972, Singleton started buying back Teledyne stock because it was cheap. During the next twelve years, Singleton repurchased over 90 percent of Teledyne’s stock. Keep in mind that in the early 1970s, stock buybacks were seen as a lack of investment opportunity. But Singleton realized buybacks were far more tax-efficient than dividends. And buybacks done when the stock is noticeably cheap create much value. Whenever the returns from a buyback seemed higher than any alternative use of cash, Singleton repurchased shares. Singleton spent $2.5 billion on buybacks – an unbelievable amount at the time – at an average P/E multiple of 8. (When Teledyne issued shares, the average P/E multiple was 25.)
In the insurance portfolios, Singleton invested 77 percent in equities, concentrated on just a few stocks. His investments were in companies he knew well that had P/E ratios at or near record lows.
In 1986, Singleton started going in the opposite direction: deconglomerating instead of conglomerating. He was a pioneer of spinning off various divisions. And in 1987, Singleton announced the first dividend.
From 1963 to 1990, when Singleton stepped down as chairman, Teledyne produced 20.4 percent compound annual returns versus 8.0 percent for the S&P 500 and 11.6 percent for other major conglomerates. A dollar invested with Singleton in 1963 would have been worth $180.94 by 1990, nearly ninefold outperformance versus his peers and more than twelvefold outperformance versus the S&P 500.
BILL ANDERS AND GENERAL DYNAMICS
In 1989, the Berlin Wall came down and the U.S. defense industry’s business model had to be significantly downsized. The policy of Soviet containment had become obsolete almost overnight.
General Dynamics had a long history selling major weapons to the Pentagon, including the B-29 bomber, the F-16 fighter plane, submarines, and land vehicles (such as tanks). The company had diversified into missiles and space systems, as well as nondefense business including Cessna commercial planes.
When Bill Anders took over General Dynamics in January 1991, the company had $600 million in debt and negative cash flow. Revenues were $10 billion, but the market capitalization was just $1 billion. Many thought the company was headed into bankruptcy. It was a turnaround situation.
Anders graduated from the Naval Academy in 1955 with an electrical engineering degree. He was an airforce fighter pilot during the Cold War. In 1963 he earned a master’s degree in nuclear engineering and was chosen to join NASA’s elite astronaut corps. Thorndike writes:
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. (pages 61-62)
Anders was a major general when he left NASA. He was made the first chairman of the Nuclear Regulatory Commission. Then he served as ambassador to Norway. After that, he worked at General Electric and was trained in their management approach. In 1984, Anders was hired to run the commercial operations of Textron Corporation. He was not impressed with the mediocre businesses and the bureaucratic culture. In 1989, he was invited to join General Dynamics as vice-chairman for a year before becoming CEO.
Anders realized that the defense industry had a great deal of excess capacity after the end of the Cold War. Following Welch’s approach, Anders concluded that General Dynamics should only be in businesses where it was number one or two. General Dynamics would stick to businesses it knew well. And it would exit businesses that didn’t meet these criteria.
Anders also wanted to change the culture. Instead of an engineering focus on ‘larger, faster, more lethal’ weapons, Anders wanted a focus on metrics such as return on equity (ROE). Anders concluded that maximizing shareholder returns should be the primary business goal. To help streamline operations, Anders hired Jim Mellor as president and COO. In the first half of 1991, Anders and Mellor replaced twenty-one of the top twenty-five executives.
Anders then proceeded to generate $5 billion in cash through the sales of noncore businesses and by a significant improvement in operations. Anders and Mellor created a culture focused on maximizing shareholder returns. Anders sold most of General Dynamics’ businesses. He also sought to grow the company’s largest business units through acquisition.
When Anders went to acquire Lockheed’s smaller fighter plane division, he met with a surprise: Lockheed’s CEO made a high counteroffer for General Dynamics’ F-16 business. Because the fighter plane division was a core business for General Dynamics – not to mention that Anders was a fighter pilot and still loved to fly – this was a crucial moment for Anders. He agreed to sell the business on the spot for a very high price of $1.5 billion. Anders’ decision was rational in the context of maximizing shareholder returns.
With the cash pile growing, Anders next decided not to make additional acquisitions, but to return cash to shareholders. First he declared three special dividends – which, because they were deemed ‘return of capital,’ were not subject to capital gains or ordinary income taxes. Next, Anders announced an enormous $1 billion tender offer for 30 percent of the company’s stock.
A dollar invested when Anders took the helm would have been worth $30 seventeen years later. That same dollar would have been worth $17 if invested in an index of peer companies and $6 if invested in the S&P. (page 75)
JOHN MALONE AND TCI
While at McKinsey, John Malone came to realize how attractive the cable television business was. Revenues were very predictable. Taxes were low. And the industry was growing very fast. Malone decided to build a career in cable.
Malone’s father was a research engineer and his mother a former teacher. Malone graduated from Yale with degrees in economics and electrical engineering. Then Malone earned master’s and PhD degrees in operations research from Johns Hopkins.
Malone’s first job was at Bell Labs, the research arm of AT&T. After a couple of years, he moved to McKinsey Consulting. In 1970, a client, General Instrument, offered Malone the chance to run its cable television equipment division. He jumped at the opportunity.
After a couple of years, Malone was sought by two of the largest cable companies, Warner Communications and Tele-Communications Inc. (TCI). Malone chose TCI. Although the salary would be 60 percent lower, he would get more equity at TCI. Also, he and his wife preferred Denver to Manhattan.
The industry had excellent tax characteristics:
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. (page 86)
Just after Malone took over as CEO of TCI in 1973, the 1973-1974 bear market left TCI in a dangerous position. The company was on the edge of bankruptcy due to its very high debt levels. Malone spent the next few years meeting with bankers and lenders to keep the company out of bankruptcy. Also during this time, Malone instituted new discipline in operations, which resulted in a frugal, entrepreneurial culture. Headquarters was austere. Executives stayed together in motels while on the road.
Malone depended on COO J. C. Sparkman to oversee operations, while Malone focused on capital allocation. TCI ended up having the highest margins in the industry as a result. They earned a reputation for underpromising and overdelivering.
In 1977, the balance sheet was in much better shape. Malone had learned that the key to creating value in cable television was financial leverage and leverage with suppliers (especially programmers). Both types of leverage improved as the company became larger. Malone had unwavering commitment to increasing the company’s size.
The largest cost in a cable television system is fees paid to programmers (HBO, MTV, ESPN, etc.). Larger cable operators can negotiate lower programming costs per subscriber. The more subscribers the cable company has, the lower its programming cost per subscriber. This led to a virtuous cycle:
if you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on… no one else at the time pursued scale remotely as aggressively as Malone and TCI. (page 90)
Malone also focused on minimizing reported earnings (and thus taxes). At the time, this was highly unconventional since most companies focused on earnings per share. TCI gained an important competitive advantage by minimizing earnings and taxes. Terms like EBITDA were introduced by Malone.
Between 1973 and 1989, the company made 482 acquisitions. The key was to maximize the number of subscribers. (When TCI’s stock dropped, Malone repurchased shares.)
By the late 1970s and early 1980s, after the introduction of satellite-delivered channels such as HBO and MTV, cable television went from primarily rural customers to a new focus on urban markets. The bidding for urban franchises quickly overheated. Malone avoided the expensive urban franchise wars, and stayed focused on acquiring less expensive rural and suburban subscribers. Thorndike:
When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost. (page 93)
Malone also established various joint ventures, which led to a number of cable companies in which TCI held a minority stake. Over time, Malone created a great deal of value for TCI by investing in young, talented entrepreneurs.
From 1973 to 1998, TCI shareholders enjoyed a compound annual return of 30.3 percent, compared to 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500. A dollar invested in TCI at the beginning was worth over $900 by mid-1998. The same dollar was worth $180 if invested in other publicly traded cable companies and $22 if invested in the S&P 500.
Malone never used spreadsheets. He looked for no-brainers that could be understood with simple math. Malone also delayed capital expenditures, generally until the economic viability of the investment had been proved. When it came to acquisitions – of which there were many – Malone would only pay five times cash flow.
KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY
Katharine Graham was the daughter of financier Eugene Meyer. In 1940, she married Philip Graham, a brilliant lawyer. Meyer hired Philip Graham to run The Washington Post Company in 1946. He did an excellent job until his tragic suicide in 1963.
Katharine was unexpectedly thrust into the CEO role. At age forty-six, she had virtually no preparation for this role and she was naturally shy. But she ended up doing an amazing job. From 1971 to 1993, the compound annual return to shareholders was 22.3 percent versus 12.4 percent for peers and 7.4 percent for the S&P 500. A dollar invested in the IPO was worth $89 by the time she retired, versus $5 for the S&P and $14 for her peer group. These are remarkable margins of outperformance.
After a few years of settling into the new role, she began to take charge. In 1967, she replaced longtime editor in chief Russ Wiggins with the brash Ben Bradlee, who was forty-four years old.
In 1971, she took the company public to raise capital for acquisitions. This was what the board had recommended. At the same time, the newspaper encountered the Pentagon Papers crisis. The company was going to publish a highly controversial (and negative) internal Pentagon opinion of the war in Vietnam that a court had barred the New York Times from publishing. The Nixon administration threatened to challenge the company’s broadcast licenses if it published the report:
Such a challenge would have scuttled the stock offering and threatened one of the company’s primary profit centers. Graham, faced with unclear legal advice, had to make the decision entirely on her own. She decided to go ahead and print the story, and the Post’s editorial reputation was made. The Nixon administration did not challenge the TV licenses, and the offering, which raised $16 million, was a success. (page 112)
In 1972, with Graham’s full support, the paper began in-depth investigations into the Republican campaign lapses that would eventually become the Watergate scandal. Bradlee and two young investigative reporters, Carl Bernstein and Bob Woodward, led the coverage of Watergate, which culminated with Nixon’s resignation in the summer of 1974. This led to a Pulitzer for the Post – one of an astonishing eighteen during Bradlee’s editorship – and established the paper as the only peer of the New York Times. All during the investigation, the Nixon administration threatened Graham and the Post. Graham firmly ignored them.
In 1974, an unknown investor eventually bought 13 percent of the paper’s shares. The board advised Graham not to meet with him. Graham ignored the advice and met the investor, whose name was Warren Buffett. Buffett quickly became Graham’s business mentor.
In 1975, the paper faced a huge strike led by the pressmen’s union. Graham, after consulting Buffett and the board, decided to fight the strike. Graham, Bradlee, and a very small crew managed to get the paper published for 139 consecutive days. Then the pressmen finally agreed to concessions. These concessions led to significantly improved profitability for the paper. It was also the first time a major city paper had broken a strike.
Also on advice from Buffett, Graham began aggressively buying back stock. Over the next few years, she repurchased nearly 40 percent of the company’s stock at very low prices (relative to intrinsic value). No other major papers did so.
In 1981, the Post’s rival, the Washington Star, ceased publication. This allowed the Post to significantly increase circulation. At the same time, Graham hired Dick Simmons as COO. Simmons successfully lowered costs and improved profits. Simmons also emphasized bonus compensation based on performance relative to peer newspapers.
In the early 1980s, the Post spent years not acquiring any companies, even though other major newspapers were making more deals than ever. Graham was criticized, but stuck to her financial discipline. In 1983, however, after extensive research, the Post bought cellular telephone businesses in six major markets. In 1984, the Post acquired the Stanley Kaplan test prep business. And in 1986, the paper bought Capital Cities’ cable television assets for $350 million. All of these acquisitions would prove valuable for the Post in the future.
In 1988, Graham sold the paper’s telephone assets for $197 million, a very high return on investment. Thorndike continues:
During the recession of the early 1990s, when her overleveraged peers were forced to the sidelines, the company became uncharacteristically acquisitive, taking advantage of dramatically lower prices to opportunistically purchase cable television systems, underperforming TV stations, and a few education businesses.
When Kay Graham stepped down as chairman in 1993, the Post Company was by far the most diversified among its major newspaper peers, earning almost half its revenues and profits from non-print sources. This diversification would position the company for further outperformance under her son Donald’s leadership. (page 116)
BILL STIRITZ AND RALSTON PURINA
Bill Stiritz was at Ralston seventeen years before becoming CEO at age forty-seven.
This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent. When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries. (page 131)
Stiritz attended the University of Arkansas for a year but then joined the navy for four years. While in the navy, he developed his poker skills enough so that poker eventually would pay for his college tuition. Stiritz completed his undergraduate degree at Northwestern, majoring in business. (In his mid-thirties, he got a master’s degree in European history from Saint Louis University.)
Stiritz first worked at the Pillsbury Company as a field rep putting cereal on store shelves. He was promoted to product manager and he learned about consumer packaged goods (CPG) marketing. Wanting to understand advertising and media better, he started working two years later at the Gardner Advertising agency in St. Louis. He focused on quantitative approaches to marketing such as the new Nielsen ratings service, which gave a detailed view of market share as a function of promotional spending.
In 1964, Stiritz joined Ralston Purina in the grocery products division (pet food and cereals). He became general manager of the division in 1971. While Stiritz was there, operating profits increased fiftyfold due to new product introductions and line extensions. Thorndike:
Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry. For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament. (page 132)
On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company. He fully appreciated the exceptionally attractive economics of the company’s portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements. He immediately began to remove the underpinnings of his predecessor’s strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns. (page 132)
After a number of divestitures, Ralston was a pure branded products company. In the early 1980s, Stiritz began repurchasing stock aggressively. No other major branded products company was repurchasing stock at that time.
Stiritz then bought Continental Baking, the maker of Twinkies and Wonder Bread. He expanded distribution, cut costs, introduced new products, and increased cash flow materially, creating much value for shareholders.
Then in 1986, Stiritz bought the Energizer Battery division from Union Carbide for $1.5 billion. The business had been a neglected operation at Union Carbide. Stiritz thought it was undermanaged and also part of a growing duopoly market.
By the late 1980s, almost 90 percent of Ralston’s revenues were from consumer packaged goods. Pretax profit margins increased from 9 to 15 percent. ROE went from 15 to 37 percent. Since the share base was reduced by aggressive buybacks, earnings and cash flow per share increased dramatically. Stiritz continued making very careful acquisitions and divestitures, with each decision based on an in-depth analysis of potential returns for shareholders.
Stiritz also began spinning off some businesses he thought were not receiving the attention they deserved – either internally or from Wall Street. Spin-offs not only can highlight the value of certain business units. Spin-offs also allow the deferral of capital gains taxes.
Finally, Stiritz sold Ralston itself to Nestle for $10.4 billion, or fourteen times cash flow. This successfully concluded Stiritz’ career at Ralston. A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later. The compound return was 20.0 percent versus 17.7 percent for peers and 14.7 percent for the S&P 500.
Stiritz didn’t like the false precision of detailed financial models. Instead, he focused only on the few key variables that mattered, including growth and competitive dynamics. When Ralston bought Energizer, Stiritz and his protégé Pat Mulcahy, along with a small group, took a look at Energizer’s books and then wrote down a simple, back of the envelope LBO model. That was it.
Since selling Ralston, Stiritz has energetically managed an investment partnership made up primarily of his own capital.
DICK SMITH AND GENERAL CINEMA
In 1922, Phillip Smith borrowed money from friends and family, and opened a theater in Boston’s North End. Over the next forty years, Smith built a successful chain of theaters. In 1961, Phillip Smith took the company public to raise capital. But in 1962, Smith passed away. His son, Dick Smith, took over as CEO. He was thirty-seven years old.
Dick Smith demonstrated a high degree of patience in using the company’s cash flow to diversify away from the maturing drive-in movie business.
Smith would alternate long periods of inactivity with the occasional very large transaction. During his tenure, he would make three significant acquisitions (one in the late 1960s, one in the mid-1980s, and one in the early 1990s) in unrelated businesses: soft drink bottling (American Beverage Company), retailing (Carter Hawley Hale), and publishing (Harcourt Brace Jovanovich). This series of transactions transformed the regional drive-in company into an enormously successful consumer conglomerate. (page 150)
Dick Smith later sold businesses that he had earlier acquired. His timing was extraordinarily good, with one sale in the late 1980s, one in 2003, and one in 2006. Thorndike writes:
This according-like pattern of expansion and contraction, of diversification and divestiture, was highly unusual (although similar in some ways to Henry Singleton’s at Teledyne) and paid enormous benefits for General Cinema’s shareholders. (page 151)
Smith graduated from Harvard with an engineering degree in 1946. He worked as a naval engineer during World War II. After the war, he didn’t want an MBA. He wanted to join the family business. In 1956, Dick Smith’s father made him a full partner.
Dick Smith recognized before most others that suburban theaters were benefitting from strong demographic trends. This led him to develop two new practices.
First, it had been assumed that theater owners should own the underlying land. But Smith realized that a theater in the right location could fairly quickly generate predictable cash flow. So he pioneered lease financing for new theaters, which significantly reduced the upfront investment.
Second, he added more screens to each theater, thereby attracting more people, who in turn bought more high-margin concessions.
Throughout the 1960s and into the early 1970s, General Cinema was getting very high returns on its investment in new theaters. But Smith realized that such growth was not likely to continue indefinitely. He started searching for new businesses with better long-term prospects.
In 1968, Smith acquired the American Beverage Company (ABC), the largest, independent Pepsi bottler in the country. Smith knew about the beverage business based on his experience with theater concessions. Smith paid five times cash flow and it was a very large acquisition for General Cinema at the time. Thorndike notes:
Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands. Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends. He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second- and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a smaller number of large independents). Because Pepsi was the number two brand, its franchises often traded at lower valuations than Coke’s. (pages 152-153)
ABC was a platform company – other companies could be added easily and efficiently. Smith could buy new franchises at seemingly high multiples of the seller’s cash flow and then quickly reduce the effective price through reducing expenses, minimizing taxes, and improving marketing. So Smith acquired other franchises.
Due to constant efforts to reduce costs by Smith and his team, ABC had industry-leading margins. Soon thereafter, ABC invested $20 million to launch Sunkist. In 1984, Smith sold Sunkist to Canada Dry for $87 million.
Smith sought another large business to purchase. He made a number of smaller acquisitions in the broadcast media business. But his price discipline prevented him from buying very much.
Eventually General Cinema bought Carter Hawley Hale (CHH), a retail conglomerate with several department store and specialty retail chains. Woody Ives, General Cinema’s CFO, was able to negotiate attractive terms:
Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH…
Eventually General Cinema would exchange its 40 percent ownership in CHH shares for a controlling 60 percent stake in the company’s specialty retail division, whose primary asset was the Neiman Marcus chain. The long-term returns on the company’s CHH investment were an extraordinary 51.2 percent. The CHH transaction moved General Cinema decisively into retailing, a new business whose attractive growth prospects were not correlated with either the beverage or the theater businesses. (page 156)
In the late 1980s, Smith noticed that a newly energetic Coke was attacking Pepsi in local markets. At the same time, beverage franchises were selling for much higher prices as their good economics were more widely recognized. So Smith sold the bottling business in 1989 to Pepsi for a record price. After the sale, General Cinema was sitting on $1 billion in cash. Smith started looking for another diversifying acquisition.
It didn’t take him long to find one. In 1991, after a tortuous eighteen-month process, Smith made his largest and last acquisition, buying publisher Harcourt Brace Jovanovich (HBJ) in a complex auction process and assembling General Cinema’s final third leg. HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm. Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich. In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders. (page 157)
General Cinema management concluded, after examining the business, that HBJ would fit their acquisition criteria. Moreover, General Cinema managers thought HBJ’s complex balance sheet would probably deter other buyers. Thorndike writes:
After extensive negotiations with the company’s many debt holders, Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time – an enormous bet. This price equaled a multiple of six times cash flow for HBJ’s core publishing assets, an attractive price relative to comparable transactions (Smith would eventually sell those businesses for eleven times cash flow). (page 158)
Following the HBJ acquisition in 1991, General Cinema spun off its mature theater business into a separate publicly traded entity, GC Companies (GCC), allowing management to focus its attention on the larger retail and publishing businesses. Smith and his management team proceeded to operate both the retail and the publishing businesses over the next decade. In 2003, Smith sold the HBJ publishing assets to Reed Elsevier, and in 2006 he sold Neiman Marcus, the last vestige of the General Cinema portfolio, to a consortium of private equity buyers. Both transactions set valuation records within their industries, capping an extraordinary run for Smith and General Cinema shareholders. (page 158)
From 1962 to 1991, Smith had generated 16.1 percent compound annual return versus 9 percent for the S&P 500 and 9.8 percent for GE. A dollar invested with Dick Smith in 1962 would be worth $684 by 1991. The same dollar would $43 if invested in the S&P and $60 if invested in GE.
WARREN BUFFETT AND BERKSHIRE HATHAWAY
Buffett was first attracted to the old textile mill Berkshire Hathaway because its price was cheap compared to book value. Thorndike tells the story:
At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization. From this undistinguished start, unprecedented returns followed; and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs. These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares. Buffett bought his first share of Berkshire for $7; today it trades for over $120,000 share. (page 168) [Late December 2016 Update: $248,000 a share now.]
Buffett was born in 1930 in Omaha, Nebraska. His grandfather ran a well-known local grocery store. His father was a stockbroker in downtown Omaha and later a congressman. Starting at age six, Buffett started various entrepreneurial ventures. He would buy a 6-pack of Coke for 25 cents and resell each one for 5 cents. He later had several paper routes and then pinball machines, too. Buffett attended Wharton, but didn’t feel he could learn much. So he returned to Omaha and graduated from the University of Nebraska at age 20.
He’d always been interested in the stock market. But it wasn’t until he was nineteen that he discovered The Intelligent Investor, by Benjamin Graham. Buffett immediately realized that value investing – as explained simply by Graham – was the key to making money in the stock market.
Buffett was rejected by Harvard Business School, which was a blessing in that Buffett attended Columbia University where Graham was teaching. Buffett was the star in Graham’s class, getting the only A+ Graham ever gave in more than twenty years of teaching. Others in that particular course said the class was often like a conversation between Graham and Buffett.
Buffett graduated from Columbia in 1952. He applied to work for Graham, but Graham turned him down. At the time, Jewish analysts were having a hard time finding work on Wall Street, so Graham only hired Jewish people. Buffett returned to Omaha and worked as a stockbroker.
One idea Buffett had tried to pitch while he was a stockbroker was GEICO. He realized that GEICO had a sustainable competitive advantage: a permanently lower cost structure because GEICO sold car insurance direct, without agents or branches. Buffett had trouble convincing clients to buy GEICO, but he himself loaded up in his own account.
Meanwhile, Buffett regularly mailed investment ideas to Graham. After a couple of years, in 1954, Graham hired Buffett.
In 1956, Graham dissolved the partnership to focus on other interests. Buffett returned to Omaha and launched a small investment partnership with $105,000 under management. Buffett himself was worth $140,000 at the time (over $1 million today).
Over the next thirteen years, Buffett crushed the market averages. Early on, he was applying Graham’s methods by buying stocks that were cheap relative to net asset value. But in the mid-1960s, Buffett made two large investments – in American Express and Disney – that were based more on normalized earnings than net asset value. This was the beginning of a transition Buffett made from buying statistically cheap cigar butts to buying higher quality companies.
- Buffett referred to deep value opportunities – stocks bought far below net asset value – as cigar butts. Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.” Such a cigar butt is disgusting, but that one puff is “all profit.”
Buffett started acquiring shares in Berkshire Hathaway – a cigar butt – in 1965. In the late 1960s, Buffett was having trouble finding cheap stocks, so he closed down the Buffett partnership.
After getting control of Berkshire Hathaway, Buffett put in a new CEO, Ken Chace. The company generated $14 million in cash as Chace reduced inventories and sold excess plants and equipment. Buffett used most of this cash to acquire National Indemnity, a niche insurance company. Buffett invested National Indemnity’s float quite well, buying other businesses like the Omaha Sun, a weekly newspaper, and a bank in Rockford, Illinois.
During this period, Buffett met Charlie Munger, another Omaha native who was then a brilliant lawyer in Los Angeles. Buffett convinced Munger to run his own investment partnership, which he did with excellent results. Later on, Munger became vice-chairman at Berkshire Hathaway.
Partly by reading the works of Phil Fisher, but more from Munger’s influence, Buffett realized that a wonderful company at a fair price was better than a fair company at a wonderful price. A wonderful company would have a sustainably high ROIC, which meant that its intrinsic value would compound over time. In order to estimate intrinsic value, Buffett now relied more on discounted FCF and private market value, rather than a conservative estimate of liquidation value, which Graham had preferred.
In the 1970s, Buffett and Munger invested in See’s Candies and the Buffalo News. And they bought large stock positions in the Washington Post, GEICO, and General Foods.
In the first half of the 1980s, Buffett bought the Nebraska Furniture Mart for $60 million and Scott Fetzer, a conglomerate of niche industrial businesses, for $315 million. In 1986, Buffett invested $500 million helping his friend Tom Murphy, CEO of Capital Cities, acquire ABC.
Buffett then made no public market investments for several years. Finally in 1989, Buffett announced that he invested $1.02 billion, a quarter of Berkshire’s investment portfolio, in Coca-Cola, paying five times book value and fifteen times earnings. The return on this investment over the ensuing decade was 10x.
Also in the late 1980s, Buffett invested in convertible preferred securities in Salomon Brothers, Gillette, US Airways, and Champion Industries. The dividends were tax-advantaged, and he could convert to common stock if the companies did well.
In 1991, Salomon Brothers was in a major scandal based on fixing prices in government Treasury bill auctions. Buffett ended up as interim CEO for nine months. Buffett told Salomon employees:
Lose money for the firm and I will be understanding. Lose even a shred of reputation for the firm, and I will be ruthless.
In 1996, Salomon was sold to Sandy Weill’s Travelers Corporation for $9 billion, which was a large return on investment for Berkshire.
In the early 1990s, Buffett invested – with large positions – in Wells Fargo (1990), General Dynamics (1992), and American Express (1994). In 1996, Berkshire acquired the half of GEICO it didn’t own. Berkshire also purchased the reinsurer General Re in 1998 for $22 billion in Berkshire stock.
In the late 1990s and early 2000s, Buffett bought a string of private companies, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes. He also invested in the electric utility industry through MidAmerican Energy. In 2006, Berkshire announced its first international acquisition, a $5 billion investment in Iscar, an Israeli manufacturer of cutting tools and blades.
In early 2010, Berkshire purchased the nation’s largest railroad, the Burlington Northern Santa Fe, for $34.2 billion.
From June 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company’s shares increased at a compound rate of 20.7 percent compared to 9.3 percent for the S&P 500. A dollar invested in Berkshire was worth $6,265 forty-five years later. The same dollar invested in the S&P 500 was worth $62.
The Nuts and Bolts
Having learned from Murphy, Buffett and Munger created Berkshire to be radically decentralized. Business managers are given total autonomy over everything except large capital allocation decisions. Buffett makes the capital allocation decisions, and Buffett is an even better investor than Henry Singleton.
Another key to Berkshire’s success is that the insurance and reinsurance operations are profitable over time, and meanwhile Buffett invests most of the float. Effectively, the float has an extremely low cost (occasionally negative) because the insurance and reinsurance operations are profitable. Buffett always reminds Berkshire shareholders that hiring Ajit Jain to run reinsurance was one of the best investments ever for Berkshire.
As mentioned, Buffett is in charge of capital allocation. He is arguably the best investor ever based on the longevity of his phenomenal track record.
Buffett and Munger have always believed in concentrated portfolios. It makes sense to take very large positions in your best ideas. Buffett invested 40 percent of the Buffett partnership in American Express after the salad oil scandal in 1963. In 1989, Buffett invested 25 percent of the Berkshire portfolio – $1.02 billion – in Coca-Cola.
Buffett and Munger still have a very concentrated portfolio. But sheer size requires them to have more positions than before. It also means that they can no longer look at most companies, which are too small to move the needle.
Buffett and Munger also believe in holding their positions for decades. Over time, this saves a great deal of money by minimizing taxes and transaction costs.
Buffett’s approach to investor relations is also unique and homegrown. Buffett estimates that 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. (page 192)
… The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship. (page 193)
RADICAL RATIONALITY: THE OUTSIDER’S MINDSET
You’re neither right nor wrong because the crowd disagrees with you; you’re right because your data and reasoning are right. – Ben Graham
Thorndike sums up the outsider’s mindset:
- Always Do the Math
- The Denominator Matters
- A Feisty Independence
- Charisma is Overrated
- A Crocodile-Like Temperament That Mixes Patience with Occasional Bold Action
- The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
- A Long-Term Perspective
Always Do the Math
The outsider CEOs always focus on the ROIC for any potential investment. They do the analysis themselves just using the key variables and without using a financial model. Outsider CEOs realize that it’s the assumptions about the key variables that really matter.
The Denominator Matters
The outsider CEOs focus on maximizing value per share. Thus, the focus is not only on maximizing the numerator – the value – but also on minimizing the denominator – the number of shares. Outsider CEOs opportunistically repurchase shares when the shares are cheap. And they are careful when they finance investment projects.
A Feisty Independence
The outsider CEOs all ran very decentralized organizations. They gave people responsibility for their respective operations. But outsider CEOs kept control over capital allocation decisions. And when they did make decisions, outsider CEOs didn’t seek others’ opinions. Instead, they liked to gather all the information, and then think and decide with as much independence and rationality as possible.
Charisma Is Overrated
The outsider CEOs tended to be humble and unpromotional. They tried to spend the absolute minimum amount of time interacting with Wall Street. Outsider CEOs did not offer quarterly guidance and they did not participate in Wall Street conferences.
A Crocodile-Like Temperament That Mixes Patience With Occasional Bold Action
The outsider CEOs were willing to wait very long periods of time for the right opportunity to emerge.
Like Katharine Graham, many of them created enormous shareholder value by simply avoiding overpriced ‘strategic’ acquisitions, staying on the sidelines during periods of acquisition feeding frenzy. (page 203)
On the rare occasions when there was something to do, the outsider CEOs acted boldly and aggressively. Tom Murphy made an acquisition of a company (ABC) larger than the one he managed (Capital Cities). Henry Singleton repeatedly repurchased huge amounts of stock at cheap prices, eventually buying back over 90 percent of Teledyne’s shares.
The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
The total value that any company creates over time is the cumulative difference between ROIC and the cost of capital. The outsider CEOs made every capital allocation decision in order to maximize ROIC over time, thereby maximizing long-term shareholder value.
These CEOs knew precisely what they were looking for, and so did their employees. They didn’t overanalyze or overmodel, and they didn’t look to outside consultants or bankers to confirm their thinking – they pounced. (page 204)
A Long-Term Perspective
The outsider CEOs would make investments in their business as long as they thought that it would contribute to maximizing long-term ROIC and long-term shareholder value. The outsiders were always willing to take short-term pain for long-term gain:
they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income. (page 207)
Thorndike notes that the advantage the outsider CEOs had was temperament, not intellect (although they were all extremely intelligent). They understood that what mattered was rationality and patience.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.