Henry Singleton, the co-founder and former CEO of Teledyne, has “the best operating and capital deployment record in American business”,” according to Warren Buffett. And yet he did not have an MBA or indeed any educational background in business (he got his Bachelor’s, Master’s and Ph.D. degrees from Electrical Engineering from MIT).
But he does fit an intriguing pattern.
Singleton is featured, along with seven other CEOs in a book that was the subject of a series of posts by one of my favorite bloggers, The Brooklyn Investor last year: The Outsiders by William Thorndike. The book profiles these eight who have delivered some of the highest long term compounded returns to their shareholders during the last few decades.
So what, why does it matter if some CEO returns a few percent more in annualized returns?
Imagine you have invested a million dollars each in two different stocks: company A compounds your money at an average of 8% per year (the likely long term market average) whereas company C compounds your money at, say, 15% per year. After 10 years stock A would have slightly more than doubled your one million (to $2.2 million). Not too bad. But your investment in stock C would have quadrupled to $4 million during the same time. Now imagine holding both companies for 10 more years. At that point, your initial $1 million in company A would be worth $4.7 million whereas the same investment in company C would have compounded to $16 million, even though it compounds only a few percent more every year!
Even better, if that initial million was invested in one of the eight “outsider” companies, it would have compounded at roughly 20% per year so that twenty years later it would be worth an astonishing 38 million dollars. The gap between these companies widens with every passing year – to paraphrase Buffett, time is a friend of a good compounder.
It seems really worth the while to “crack the code” for what makes a company a great compounder – that returns, say, 15% or better for a decade or two – versus an average company that returns 8% or so.
The Outsiders book contains some intriguing clues on this topic. It is the result of a research project that screened the records of thousands of CEOs. After conducting well over a thousand in-person interviews, it details eight “best of the best” – outlier CEOs who managed to compound their company’s stocks at truly astonishing rates (I have lightly edited The Brooklyn Investor’s handy list):
- Tom Murphy (Capital Cities): 19.9% per year over 29 years (vs. 10.1% for S&P 500)
- Henry Singleton (Teledyne): 20.3% per year over 27 years (vs. 8.0% for S&P 500)
- Bill Anders (General Dynamics): 23.3% per year over 17 years (vs. 8.9% for S&P 500)
- John Malone (TCI Cable): 30.3% per year over 25 years (vs. 14.3% for S&P 500)
- Katharine Graham (Washington Post): 22.3% per year over 22 years (vs. 7.4% for S&P 500)
- Bill Stiritz (Ralston Purina): 20.0% per year over 19 years (vs. 14.7% for S&P 500)
- Dick Smith (General Cinema): 16.1% per year over 43 years (vs. 9.0% for S&P 500)
- Warren Buffett (Berkshire Hathaway): 20.7% per year over 46 years (vs. 9.3% for S&P 500).
Not surprisingly, Buffett is present in the list, but many of the other seven are not familiar names, even though they all have delivered similarly fantastic returns.
Only one of these other seven (besides Buffett) had the expected MBA whereas four had highly technical backgrounds (beside the electrical engineer Singleton, a second an advanced degree in Nuclear Engineering, a third is an electrical engineer with a Ph.D. in Operations Research from Johns Hopkins, and a fourth graduated as an engineer from Harvard). None of these four had any formal business education, and had to learn the CEO’s job from a clean slate. Most of them are described as being introverted, “lacking charisma,” and preferred to avoid the media limelight, although this might well be completely irrelevant to their performance.
While the book does a good job of describing these eight CEOs, I am not entirely convinced with its attempt to explain why they succeeded like they did. The following are some of the common patterns across these CEOs.
In view of their technical backgrounds, a surprising pattern across the Outsider CEOs is that they all chose to view their job primarily as a portfolio manager of their various operating assets, focusing on capital allocation as opposed to running the operations of their company.
Of course, every CEO has to fulfill both essential functions – operating the company as well as allocating the capital generated from operations. It seems most CEOs are neither too interested in nor very good at the capital allocation process. Yet, since excess cash-flow has to be dealt with, one way or another, the majority of a company’s productive resources will soon enough be the result of a CEO’s capital allocation decisions. Default decisions will soon lead to mediocre cash flows in the future, and the compounding rate will rapidly reduce. Perhaps this is why the best compounders are those CEOs who excel at this vital but oft-neglected function.
Most Outsider CEOs had a trusted “right hand” person as their operations chief (often as COO or President) and completely delegated the operational aspects of their job.
This approach allowed the CEOs the time and energy to focus on what they did best, which was capital allocation. Many also structured their company’s operations into independent, self-contained operating units, with only a bare-bones staff at the corporate level. They all preferred to push operating decisions down to the lowest, most local levels in their organizations. Perhaps this unusual pattern of decentralized operations and centralized capital allocation allowed these CEOs to more dispassionately view their operating assets as portfolio constituents, and spin-off or sell the operating units as and when the opportunity presented itself, thus concentrating capital around their most efficient, highest-returning units.
All Outsider CEOs have been unusually proactive in shrinking their company’s assets –people and as well as capital – and returned excess capital to their shareholders rather than invest it in mediocre units.
It is quite rare for a CEO to sell a division or business without pressure; most are “empire builders” who would rather prefer to grow their employee base and revenues. However, since the various operating units of any company usually have varying returns, the overall return can easily get dragged down by its inefficient units as the company gets bigger. Thus it makes sense that only the radically rational CEOs who (1) carefully focused on identifying their best operating units, (2) pared down to concentrate capital on these outperformers, and (3) returned the excess capital, were be able to compile the best returns over time.
The Outsiders seem to have the temperament to embrace rather than avoid volatility.
Their cash-flows were often “lumpy” over the short term as a result of taking infrequent but bold capital actions. They tended to focus on the long term growth of cash flow per share rather than managing short-term quarterly earnings expectations to please the street analysts.
They were willing to buy their stock back aggressively (as much as 90% in Singleton’s case!) when they thought it to be significantly undervalued.
Such buybacks can create tremendous returns but only when the shares are indeed undervalued. Notice that these “Outsider” CEOs are “insiders” as far as their own company’s prospects are concerned! Since Mr. Market is prone to irrational fits of optimism and pessimism, a market-savvy CEO can create a lot of value by suitably buying his own company’s shares back when they are under-priced, and using the company’s over-priced shares to buy other businesses. The usual oscillation of stock prices around earnings provides any CEO the opportunity to increase their compounding rate much faster than their underlying operational growth. However, Outsiders may well be some of the very few that possess the capital allocation skills and temperament required to actually benefit from this price pendulum.
I am less sure of what to make of the readiness of most Outsiders to use high levels of leverage.
They all had unusually strong operating cash-flows enabling them to carry debt. And it allowed them to avoid diluting their outstanding shares when they needed more capital (to buy a company or to invest in growth). Even Buffett, who eschews debt in its explicit form, benefits from the inherent leverage presented by using the negative cost of float enjoyed by his insurance units. Debt may well have boosted the returns of the Outsiders beyond their intrinsic operating rate of returns. That they were able to do so for decades suggests that this may not have been as risky as it sounds. However, the possibility remains that they just got lucky and we are looking at the survivors.
Finally, the self-reported pattern of Outsider CEOs being opportunistic as opposed to strategic. I don’t know exactly what to make of this characterization. Perhaps it should be framed as a contrast between an adaptive vs. central planning styles.
As Jim Barksdale, the former COO of FedEx and CEO of Netscape is fond of saying:
“In a fight between a bear and an alligator, it is the terrain which determines who wins.”
The aphorism neatly captures the Achilles heel of long-term strategic planning: the terrain often changes with time, making any top-down plan likely to stumble. After all, Darwinian evolution is such a successful “designer” of species precisely because it is adaptive, without any grand plan or strategy. The “best-fit” progeny amongst the many produced by an individual organism simply gets an edge in proliferating its genes. After a series of such opportunistic choices, each successful species occupies a finely-tuned niche in its ecology. Similarly, in the context of an economy, an operating unit of a business may have to make many unexpected adaptations before it finds a successful niche (its “moat”). Such non-linearly contingent outcomes would be virtually impossible to arrive at by the usual corporate strategic planning process. Maybe the Outsider approach of viewing their various operating units as a portfolio manager allows them to more objectively select the better “fits” in a given economic terrain, trading away the others in order to concentrate capital around the more successful units. This opportunistic approach may well be superior in quickly finding and developing moated business niches, leading to a powerful chain of economic compounding.
No wonder Dr. Singleton who was a winner of the Putman prize in mathematics, and a near-master level chess player, and, presumably, as capable of strategizing as anyone on the planet, remarks:
“I like to steer the boat each day rather than plan ahead way into the future … we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted … So my idea is to stay flexible.”
He used this “flexibility” to buy or sell more than 130 companies for Teledyne, opportunistically using its high-priced stock. And then when the market for such conglomerate collapsed, he turned around and bought back his own now under-priced stock massively – he bought back 90% of it! These shrewd capital allocation moves allowed him to compound his company’s stock at 20.3% per year for 27 years so that each dollar invested in Teledyne turned into 160 dollars in 27 years!
Singleton basically pioneered these type of capital decisions – they were highly unusual at that time, and still are for the most part. Of course he had an unusual board to back him up. Board member Claude Shannon of MIT is one of the two ” gods” of the digital age (the other being Alan Turing): he was the first to actually quantity the very idea of information (“bits” was his invention). Another legend on Teledyne’s board was Arthur Rock, the VC behind Intel and Apple! Imagine those board discussions…
To be sure, the book does not cover ineffable visionaries like Steve Jobs; perhaps there is no template that fits such one-of-a-kind geniuses; or perhaps his record does not hold up quite so well after mixing in his initial tenure at Apple which was decidedly mixed (compounded averages are diminished rather easily by even a few bad years).
Of course we may be looking at survivor and selection biases often lurking in such history-based records. The high levels of leverage are a clear red flag that luck may well have played a huge role in these outliers: the risk they took did not materialize even though it could have, so the survivor-ship bias really does matter.
It also bothers me that Buffett does not quite fit the “Outsider” mold in some ways. For example, he has almost never “shrunk” by divesting operations (with the notable exception of the original mill), and never really bought back Berkshire’s stock (although his publicly stated willingness to buy shares back below 1.2x book value may have done the job for him).
Nevertheless, if you enjoy reading about fundamental investing or interesting business models, I recommend this well-written and thought provoking book.
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