MI360: The Outsiders w/ Shawn O'Malley

0:00You're listening to TIP. For starters, I think the book is very relevant to any stock investor, obviously looking to identify the traits of companies with high likelihood of outperforming the market. I know some people want to hedge management risk by finding businesses so good that anyone can run them. But there's also, in my opinion, something to be said about looking for companies with shareholder focused management. I think that's just going to make everything a lot easier in the long run when you have management that's working in your favor and not against you. And after reading it, or hopefully even after just listening to this episode, you should have some idea of the type of CEO you should be attracted to as an investor and which ones instead raise red flags for you.

1:01radically rational blueprint for success. You'll learn how CEOs operate like stock investors, why capital allocation is unintuitive for most company leaders, what factors lead to poor capital allocation, how to identify leaders that will be extraordinary capital allocators, how you can apply the lessons in the outsiders to your own investing, and a whole lot more. William Thorndike is founder and a managing director of Housatonic Partners, which is a private equity firm. He's a graduate of Harvard College and the Stanford Graduate School of business. What stood out the most to me in our conversation is the importance of not following the herd and doing a zig when everyone else is zagging.

1:38As John Templeton said, it is impossible to produce superior performance unless you do something different. Without further delay, let's dive into today's episode with Sean O'Malley and learn about the reasons these eight unconventional CEOs delivered extraordinary performance and returns.

1:59Celebrating 10 years, you are listening to Millennial Investing by the Investors Podcast Network. Since 2014, we interviewed successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation. Now for your host, Patrick Donley.

2:25Hey, everybody. Welcome to the Millennial Investing Podcast. I'm your host today, Patrick Donnelly. And joining me once again is my friend and colleague, Sean O'Malley. Sean, welcome to the show. Hey, it's great to be back on. We are in our third of a four-part series. Our first two episodes that we did together, we focused on learning from two of history's best-known stock investors. We talked about Warren Buffett and his mentor, Benjamin Graham. But after recently reading The Outsiders by William Thorndike. You are back once again to tell us about great investors, but from the perspective of CEOs.

2:58So Sean, I wanted to hear your thoughts on what ways CEOs are like stock investors. It's a great question, Patrick. And thanks again for having me back on to talk about some of our favorite books. The Outsiders is a really special one. When people imagine stock investors, I think that can mean different things. They probably think of Wall Street traders or hedge funds or financial advisors, but they probably don't think of CEOs as being investors. And obviously, some like Warren Buffett have stood out in that way for their investing prowess. But if you ask someone on the street, what does a CEO look like and what is their job generally, they probably say things like to manage the company or decide corporate strategy, hire and fire people, or provide leadership and inspiration, or maybe you have no idea what CEOs do and you just think they're overpaid.

3:48And that's what this book, Outsiders, is really about, exploring the commonalities between the best CEOs of the last six decades. It's a must read for many value investors since it was first published in 2012, partly because Warren Buffett himself has recommended it. And Thorndike in the book goes through these eight different case studies from his research on what makes a successful CEO, with the crucial insight being that it's a CEO's job ultimately to be a capital allocator. And so there's this question of what does that mean to be a capital allocator? And what they have to do is decide how to invest the company's capital into new projects or expanding business units, and also how to allocate human capital where people's talents or efforts are best spent.

4:35So CEOs have two core responsibilities. The first one is this most common perception of what CEOs are in charge of, and that is ensuring the operations of the company run smoothly. And the second one is what's more often overlooked, and it relates to capital allocation, as I just mentioned, and really determining what to do with the business's cash flows. So the best CEOs are those who have mastered both, but perfecting the latter is a much rarer trait. Why do you think that is? Why is capital allocation so unintuitive to most CEOs? It's the classic principal agent problem. As an owner in the business, you have a certain set of interests, namely that the business is run to generate excellent long-term returns on your equity, but you're probably going to want to hire an executive team to oversee operations for you.

5:23And that's where the problem starts of finding the right people for this job and ensuring that your interests are perfectly aligned, which is just a lot easier said than done. The CEO who you appoint to run the company on your behalf will probably take some pride in running the business, but ultimately they care about enriching themselves and their family and care a whole lot less about making you rich. And they probably want to create as much wealth for themselves as they can while delivering the minimum necessary performance to keep you satisfied so you don't fire them. And the typical solution to this problem is to try to make executives into owners of the company by paying them stock options and ensuring they have some sort of stake in the business.

6:04But that isn't really a perfect solution because that can incentivize short-term thinking still. One example is it can push them to want to push up the stock price to maximize the value of their stock options, especially if they think that they're not going to be there for the long term. Most CEOs aren't in the job for 20 years. And so if you go into it knowing that it's kind of like going into the NFL or being a professional athlete, if you go into it thinking that you might only have two or three years to maximize your earnings from this very privileged position, you're going to do everything you can to boost the value of those stock options and then cash out when you get the chance.

6:42And yeah, that's certainly going to lead them to do things that are not in your best interest as the owner of the business. And that's the principal agent problem in a nutshell. One tangible way to think about this is in CEOs' decisions on paying out dividends. If there aren't attractive ways to reinvest cash that's produced by the company's operations, the CEO is supposed to pay out that cash to shareholders so they can reinvest it elsewhere and earn better returns. That's just capitalism. But if a CEO's compensation is tied to stock options, like I said, which are tied to the stock's price, ultimately, then the CEO is going to want to retain as much money as possible in the business to bolster the company's market value and therefore the stock price, which isn't as good as it sounds for shareholders.

7:29Yes, a higher stock price today will make some people happy, but if it means plowing cash back into unprofitable business units just for the sake of growth, then over time, you're destroying value for shareholders. And by paying dividends, cash is being taken out of the company's bank accounts, reducing the size of the kingdom that executives rule over. And for anyone to consider, how many people do you know in charge of something that want to be less influential over time, right? It doesn't happen. By paying out dividends, you're voluntarily reducing the size of the kingdom that you oversee. And so if you run an organization, I think you probably just want it to get bigger and bigger because that's what makes you more important and influential in society.

8:11But anyone who's taken a corporate finance 101 class should know that growing a company's operations and revenues doesn't automatically translate to better returns on equity for shareholders. And in fact, growing too aggressively can destroy a business over time. So again, there's some really subtle ways that the interests of the managers of the business can diverge from what's in the shareholders' best interests, which are the people who fundamentally own the company. On top of that, paying stock options to executives is just really dilutive. even though stock options are treated as this magical free currency that can be awarded to attract top CEOs.

8:50In reality, the cost is that existing shareholders see their slice of the ownership pie and the company get trimmed down. It's similar to inflation if you think about it. Stock-based compensation slowly eats away at the value of your investment over time without even you maybe even realizing it by creating more shares and reducing your ownership stake in the business. So there is definitely a principal agent problem at hand here. And it's not that CEOs are inherently unable to think like capital allocators. It's that their compensation structure and the nature of their job generally push them to do things in their own self-interest.

9:27And because most shareholders don't want to be super actively involved with managing every company they invest in, they sort of allow executives to get away with all of this. Beyond the mismatch in incentives that's usually between owners of the business and managers of it. Are there other factors that contribute to poor capital allocation by CEOs? Yeah, the phenomenon of CEOs being bad capital allocators isn't entirely a principal agent problem. Thorndike outlines how the best people for the job of CEO are often not the ones selected. It's sort of like politics. The person who's actually willing to run for office and take on all the associated headaches is probably not the best person for the job, but they're really charming and their egos push them toward the spotlight.

10:11And if you're on the board of a company, you have to select someone for the job. So these politician types usually end up winning out. And the CEO then becomes the person who is the best at representing the company to the media and is probably someone who excelled in one or two more narrowly focused roles within the company, like marketing or sales or product development. And now they're looking at the entire thing from the top down and being asked to make very difficult decisions about how to allocate capital. But obviously, that's not what they're schooled in. These people are not schooled in investing and resource allocation.

10:45So Thorndike uses this metaphor of someone spending a decade perfecting their skills as a musician and climbing up the ladder and at the last rung to climb, instead of being asked to perform at Carnegie Hall, they're asked to become the chairman of the Federal Reserve. And I think that's what happens with the CEO in many cases. We say, oh, well, you are a rock star at running our marketing department. So now can you please be CEO and make capital allocation decisions, even though you've never had any formal training and thinking that way? And I don't want to understate the importance of the skills gap at all.

11:19If you're the CEO for 10 years of a company that retains 10 % of its net worth and earnings each year, you'd have been in charge of allocating 60 % of the company's capital. So not knowing how to think like an investor is a really big problem for a CEO. Let's take a quick break and hear from today's sponsors. Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable. The tricky thing is finding qualified people who are interested and willing to help vet your investment ideas.

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14:27And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. The book talks about the CEO's toolkit for capital allocation with five general options for deploying capital. The first is you can invest in existing operations. Second, you can acquire other businesses. You can issue dividends to shareholders. You can pay down debt. And then finally, you can repurchase shares of the company's own stock. The sources of capital for these decisions are cash generated by the business's operations and funds raised from issuing debt or selling stock. Given that CEOs pretty much all have the same toolkit available and can really only play the hand they're dealt with to the best of their ability, how can we better measure and compare a CEO performance?

15:14It's funny because even though running a business and investing are very quantitative, there isn't some objective and universal metric for grading CEO performance. It's a complicated calculation, but in football, we can use QB ratings to try and objectively compare how players on different teams are performing. And in basketball, you can look at the shooting percentage or in baseball, You can look at a pitcher's ERA to compare performance. And those will all do a pretty good job of telling you how they're doing. Not a perfect job, but pretty good. Even in other professions, there are clearer ways to grade performance.

15:51How many complications does a surgeon have each year? How many cases does a lawyer win? How many cars does a car salesman sell? We have some ways of measuring and comparing performance. But when it comes to CEOs as a society, I think we've just totally failed in agreeing on the right way to evaluate their performance. Or to put it another way, the commonly accepted ways for doing this are deeply flawed. As we've already talked about, growth isn't by definition a good thing for businesses, especially if it's garnered at too steep of a price. We can just look at WeWork from a couple of years ago, right?

16:24Anyone can throw a ton of money and sell a bunch of stock and put that money toward every possible opportunity until they reach some massive scale of operations. But if that foundation isn't built on sound investments, the ground is going to collapse beneath you eventually. So you don't need an MBA to know this stuff. But at the same time, when we think of great CEOs, we have this bias to think of only those at the biggest companies. Being the CEO of Apple is sort of like being on the Yankees. You're a rock star. You're a household name in the corporate world. And then the message to other CEOs is to grow your company as big as possible.

17:01Otherwise, you'll never get that recognition on CNBC or in the media. And as we've already talked about, CEOs are typically the types of people who want that recognition. That's why you take on what is a pretty brutal and consuming job so you can have that notoriety. And if a company grows its revenues by a billion dollars, the business media wants to anoint them as the best CEO of all time. But that's just a nominal number though. A medium size public company that doubles its$1 billion in revenue to$2 billion is going to get very different recognition than a company with$50 billion in sales that grows to$51.

17:38One is just going to get a lot more attention than the other, even though it's actually far more impressive for the medium size company to have done that. And this is basically what Thorndike spends an entire chapter of the book talking about, that we need to adjust for size, the performance of CEOs. It's comparing the GDP of the US and Panama, right? You can't just use nominal numbers. Any meaningful comparison is going to be based on per capita figures. So that's sort of the backdrop for his suggestion that we should grade CEOs based on their track record and growing the per share value of companies' stock over time and contrasting that with the returns offered in the broader market and with their industry peers.

18:21So for shorter periods of time, the flashy CEO or the hot new product will gain a lot of momentum. But over 10 or 20 years, those capital allocation decisions will bear themselves out in the stock price. Either you made intelligent acquisitions, borrowed at the right times, reinvested in the right parts of your company, knew when to pay dividends and when not to, or you didn't. And that's going to show up in your track record of shareholder returns. And what we know from the outsider CEOs, which are these eight great CEOs from the book, is that there's a blueprint for CEO excellence. And a CEO's ability to embrace an investor's mindset is critical to that.

18:58There's this great quote from the book related to this from NFL coach Bill Parcells, who says, you are what your record says you are. And there's another one really good too with John Templeton, who says, success leaves traces. So Thorndike devotes the book to this central question, who are truly the best CEOs in recent history in terms of the returns they created on each dollar invested in the company? And what do they have in common? What traces of success do they leave behind, to quote John Templeton? There's another really great quote in that chapter from Warren Buffett, who definitely knows a thing or two about identifying exceptional CEOs.

19:34He says, it's almost impossible to overpay the truly extraordinary CEO, but the species is rare. I wanted to hear from you a little bit about the traces of success, what those look like, and how we can identify these rare but excellent CEOs? I think you said it best. I'm tempted to say that we can just look at the companies Buffett has invested in and the CEOs he's spoken most highly of, and you're going to find some of those rare breeds. And it's true that several of the eight CEOs Thorndike identifies in this study on outsiders are people that Buffett recognized at the time as being special.

20:10And especially far before others noticed how exceptional they were doing in compounding the value of their companies. One of those great examples is Catherine Graham, who took over the Washington Post and quickly displayed enough of the capital allocation characteristics to attract Warren Buffett as an investor after just a few years. Same with Bill Andrews, who helped turn around General Dynamics in the 1990s. Warren Buffett is sort of the shining example of what an outsider CEO looks like, since he's done better than anyone at taking a dollar invested in Berkshire and compounding it into being worth a whole lot more.

20:45But the seven other CEOs in the book landed on many of the same frameworks and values. And what they all did well was allocate capital. They didn't borrow money to do massive share buybacks at mind-bogglingly high prices, which is sort of all the rage in corporate America today. Nor did they blindly overpay for acquisitions. They didn't issue dividends simply because shareholders like the income, and they certainly weren't worried about fitting in. Instead, these CEOs were deeply humble and practical. People who probably felt uncomfortable about the idea of riding in a corporate private jet or even having one for that matter.

21:18They didn't love the media either. These CEOs spent little time doing interviews or going on TV. Honestly, if the CEO of your company is constantly doing podcasts and TV appearances, that's a red flag. Shouldn't they be focused on running the business, keeping their head down? The outsider CEOs rejected a lot of these more vain pursuits that come with running a company, including giving quarterly guidance to Wall Street. Why waste time trying to predict the future when you could instead spend that time focused on driving the best results possible? Not giving guidance avoids any illusions that business performance will be steadily growing each quarter, which anyone who's ever run a business knows is just not possible, right?

21:58And they also avoided costly consultants and bankers to outsource their thinking to. Instead, they kept really close circles of trusted confidants In their personal lives, they were probably simple and boring, modest people. But in their professional lives, they were bold and unique, intelligent iconoclasts, as Thorndike calls them, which is literally translated from ancient Greek to mean smashers of icons, people who are unapologetically different, not concerned with social etiquette and norms. And that meant having the courage to make the best decisions from a capital allocation standpoint before they are fashionable to do so.

22:35In some cases, that meant buying back stock at extremely discounted prices, even before that had become an acceptable practice on Wall Street, or divesting beloved business units if they were being offered unbeatable prices for them. So they embraced what was a very rewarding combination of knowing how and when to buy low and sell high, to be cliche. The point being, if you do what everyone else is doing as a CEO, you can at best deliver average returns. To truly stand out, you have to zig when others zag. And the Outsiders CEOs did that, beating the broader market average by something like over 20 times over their 10 years and beating out their peers by an average of over seven times in terms of the compounded returns they delivered to shareholders.

23:18It's interesting to think about CEOs needing to zig when others zag because it's something Buffett has talked about at length throughout his career. He's got an expression for it, which he calls the institutional imperative, which is this powerful and visible force pushing CEOs to not do anything too bold, to not rock the boat. It kind of brings everyone towards this kind of status quo, mediocrity, and stagnation. In some ways, what defined the outsider CEOs the most was their ability to resist this institutional imperative. How do you think they were able to do that? The institutional imperative idea resonates because we've all been a part of organizations where bureaucracy and groupthink get in the way of common sense.

23:59It's not really surprising then that although we all fantasize about what we would do differently at the top, when we get there, we find it more comfortable to do what is already accepted. Even if it isn't working very well, nobody wants to be the one who goes out on a limb and just gets things totally wrong. So what I think is special about the outsiders is that there's normally this divide between the people who can run businesses and the people who invest in businesses. And they very much bridge that divide. It's a lot easier to resist the pressures of the institutional imperative when you see yourself as not just someone running the business, but an owner tasked with allocating its resources.

24:37To me, that's just a completely different mindset. Your thinking shifts from how can I not lose my job to what should I do that will be best for the owners of this business, including myself. The key being that as a CEO, you see yourself as an owner and then an employee, not the other way around. And another theme among the outsider CEOs is that they were in lean, decentralized organizations. There's no bureaucratic bloat and no layers of advisors or middle managers who would force that kind of stagnation over time. In each case, the managers of their subsidiary businesses were given a ton of discretion to run things as they saw fit, meaning much of the operational decisions were delegated while the outsider CEOs maintained strict capital allocation decisions from the top down.

25:23These CEOs never compromised their independent thinking on capital allocation, even though they knew how to delegate effectively in almost every other area. As a result, their corporate headquarters would typically be very small, with most of the workforce instead being on the ground, manning the businesses. The most extreme example is, of course, Warren Buffett's Berkshire Hathaway, which is less than 30 employees at corporate headquarters, which oversees something like over 300 ,000 employees. and having this blend of loose control over operations while having tight control over capital allocation decisions has clearly worked pretty well for these CEOs in hedging against the so-called institutional imperative.