Friday, March 22, 2013

Book Review: The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

In his most recent annual letter to shareholders, Warren Buffett recommended several books.  I picked up one of his suggestions earlier this month, and thought it was worth a mention.

Written by William Thorndike, The Outsiders goes through a variety of case studies of highly successful companies whose managements excelled at something that is often overlooked when evaluating companies: capital management.

Thorndike points out that managements have little control over how the market values their stock. He notes that former General Electric chairman Jack Welch is usually cited as one of the top CEO's in recent history, yet Welch's reputation was significantly helped by the fact that his tenure coincided with the greatest bull market in American history (1982 - 1999).

When Jack Welch retired in 2000, the shares of GE were valued at a P/E of 50x, which was a premium to the market at that time.  However, Welch's predecessor Reginald Jones had actually produced better per share earnings growth, but because stocks carried such low multiples throughout much of his tenure Jones never achieved the notoriety as Welch did.

Thorndike makes a thorough examination of eight different management teams who excelled at capital management.

Besides Buffett, included in this group were Tom Murphy at Capital Cities Broadcasting; Henry Singleton at Teledyne; Bill Anders at General Dynamics; John Malone at TCI; Katharine Graham at the Washington Post; Bill Stiritz at Ralston Purina; and Dick Smith at General Cinema.

Good capital management is deceptively simple.  Thorndike writes that CEO's really only need to do two things to be successful: "run their operations efficiently and deploy the cash generated by those operations".  The latter can be hugely important in the success or failure of any company, since large and expensive mistakes can be fatal to a company's existence.

The CEO's of the eight companies he profiles were fixated on growing per share value. If their stock was trading at a cheap enough level in the public markets, they would not hesitate to aggressively buy back shares (over the course of his career  Henry Singleton bought back 90% of Teledyne's shares).  They were relentlessly focused on costs, and kept corporate overhead to an absolute minimum.

At the same time, if a business segment offered promise, they would hesitate to invest significant capital.  The book mentions that Tom Murphy of Capital Cities:

...did not simply cut its way to high margins, however. It also emphasized investing in its businesses for long term growth. Murphy and {CFO} Burke realized that the key drivers of profitability in most of their businesses were revenue growth and advertising market share, and were prepared to invest in their properties to ensure leadership in local markets.

Throughout the book Thorndike notes that successful capital allocators are prepared to think in a fashion considerably different than most of their peers, and were often considered outsiders.  Most CEO's focus on earnings per share, but this group focused instead on cash flow:

As a result, the outsiders (who often had complicated balance sheets, active acquisition programs, and high debt levels) believed the key to long-term value creation was to optimize free cash flow, and this emphasis on cash informed all aspects of how they ran their companies - from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems.

Finally, Thorndike describes that the fabulous success that all of his studies achieved had several characteristics in common:

Each ran a highly decentralized organization; made at least one very large acquisition; developed unusual, cash flow-based metric; and bought back a significant amount of stock. None paid meaningful dividends or provided Wall Street guidance.  All received the same combination of derision, wonder and skepticism from their peers and business press. All also enjoyed eye-popping, credulity-straining performance over very long tenures (twenty-plus years on average).

I found this book a terrific read, and well worth any serious investor's time.