Buffett’s 50th Anniversary letter was a fascinating read, as expected. I have now read every single annual letter he has written, including from his partnership days pre-Berkshire, and still find something new and valuable in each new letter! This time, Buffett’s (as well as Munger’s) comments on conglomerates — both their features and their bugs — clarified some thoughts that have been lingering in my mind ever since I wrote last year about the amazing returns generated by of eight other CEOs, besides Buffett, with an unusual management style that is characterized by:

Highly decentralized portfolio of autonomous operating units combined with a CEO focus on the centralized allocation of capital.

The following is an updated version of my thinking on this topic.

Buffett, along with seven others, are profiled in an interesting book, The Outsiders by William Thorndike, about CEOs who have delivered the highest long term compounded returns to their shareholders in the last half century or so.

Written with the help and advice of Charlie Munger, the book is the result of a research project that screened the records of thousands of CEOs and conducted over a thousand in-person interviews. The author then selects and describes eight “best of the best” – CEOs who compounded their company’s stocks at truly astonishing rates when compared to the market over the same interval.

Not surprisingly, Buffett is present in the list, as well as his protege Katharine Graham, but many of the other names are not that well-known, even though they all have delivered similarly fantastic returns:

• Warren Buffett (Berkshire): 21.6% per year over 50 years (vs. 9.9% for S&P 500).
• John Malone (TCI Cable): 30.3% per year over 25 years (vs. 14.3%).
• Henry Singleton (Teledyne): 20.3% per year over 27 years (vs. 8.0%).
• Tom Murphy (Capital Cities): 19.9% per year over 29 years (vs. 10.1%).
• Katharine Graham (Washington Post): 22.3% per year over 22 years (vs. 7.4%).
• Bill Anders (General Dynamics): 23.3% per year over 17 years (vs. 8.9%).
• Bill Stiritz (Ralston Purina): 20.0% per year over 19 years (vs. 14.7%).
• Dick Smith (General Cinema): 16.1% per year over 43 years (vs. 9.0%).

It seems clear from these results that it may be worth exploring the question: Do these CEOs share some kind of common pattern that might explain their off-the-charts performance?

Let us begin by zooming in on one of these CEOs, to get a flavor of their background and style.

Buffett has described Henry Singleton, the co-founder and former CEO of Teledyne, as having the “best operating and capital deployment record in American business.”  

Yet Singleton did not have any formal background in business; he was, instead, an electrical engineer by training, with a Bachelor’s, Master’s, and Doctoral degrees from MIT.

During Singleton’s tenure as CEO, Teledyne’s board members included Prof. Claude Shannon of MIT (considered the father of information theory, and one of the seminal figures of our digital age) and Arthur Rock, the legendary VC who funded Intel and Apple, among others!  Imagine being a fly on the wall during those board discussions!

It turns out that Singleton was not the only Outsider CEO with an technical background — four of the eight had technical backgrounds,  including a nuclear engineer and a Ph.D. in Operations Research (John Malone, some of whose moves I have described a previous post). In fact, only one of these other seven besides Buffett had the expected MBA. Most of CEOs are also described in the book as being introverted in style, preferring to avoid the media limelight.

In view of their technical backgrounds, the most surprising pattern shared by the Outsider CEOs is that, like Buffett, they all chose to view their job primarily as a portfolio manager of their various operating units, focusing on capital allocation as opposed to actually 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. Poor allocations will, therefore,  soon lead to mediocre cash flows in the future, reducing the rate at which the company compounds the capital invested in it. Perhaps this is why the best performers are exactly those CEOs who excel at this vital but oft-neglected function.

Most Outsider CEOs had a trusted “right hand” person as their operations head (e.g., COO or President) and they completely delegated the operational aspects of their job to him.

This allowed the CEOs the time and energy to focus on what they did best, which was capital allocation. Many, like Buffett, chose to structure their company 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 – when this was the right thing to do, returning excess capital to their shareholders rather than expand into mediocre business.

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 most radically rational CEOs who (1) carefully focused on identifying their best operating units, (2) pared down to concentrate capital on these outperforming units, and (3) returned any excess capital left over, were be able to compile the best returns over time.

Most of the Outsider CEOs seem to be very comfortable with volatility of earnings, and did not bother to smoothen them in any way.

Their cash-flows were often “lumpy” over the short term as a result of taking infrequent but bold capital actions. They all tended to focus on the long term growth of cash flow per share rather than managing short-term quarterly earnings expectations to please the analysts.

They were also willing to buy their stock back aggressively (as much as 90% in Singleton’s case!) when they thought it to be significantly undervalued.

There is catch, however. Such buybacks can create tremendous returns only when the shares are indeed undervalued compared to the company’s intrinsic value. As Buffett observes in his latest letter: “Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value. (In our view, that is an essential criterion for repurchases that is often ignored by other managements.)”

Notice that all “outsider” CEOs, including Buffett, are “insiders” as far as their own company’s prospects are concerned! And since Mr. Market is prone to irrational fits of optimism and pessimism, a valuation-sensitive CEO can take advantage 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 their company’s intrinsic value thus provides such CEOs the opportunity to increase their compounding rate much faster than their underlying operational growth.

Outsiders may well be those few CEOs who understand valuation as well as have the temperament required to actually benefit from the price pendulum.

Most Outsiders were quite comfortable with high levels of leverage from time to time.

They all enjoyed unusually strong operating cash-flows which enabled them to carry debt. This 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 publicly eschews debt in its explicit form, hugely benefits from the implicit leverage (estimated by a recent study as 1.6x) created by the negative cost of float created by his insurance units.

Debt leverage may well have boosted the returns of the Outsiders beyond their intrinsic operating rate of returns. However, the fact that they were able to do so for decades suggests that this may not have been as risky as it sounds (e.g., Buffett minimizes leverage risk by demanding an ultra-conservative underwriting discipline so that the debt is virtually “free”).

It is also possible, though, that these particular eight just got lucky, and that we are looking at the survivors.

Finally, many of the Outsider CEOs self-report being opportunistic as opposed to strategic.

I think this should be understood as a contrast between an adaptive vs. central planning styles. As Jim Barksdale, the former COO of FedEx and CEO of Netscape has said: “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 changes with time, making any top-down plan likely to be suboptimal. It is worth remembering that Darwinian evolution is such a successful “designer” of species precisely because it is adaptive, without any grand 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.

Dr. Singleton, for example, a winner of the national Putnam prize in mathematics, and a master-level chess player, was presumably as capable of being strategic as anyone on the planet; he nevertheless said: “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 kind of “flexibility” to buy or sell more than 130 (!) companies for Teledyne, opportunistically using its high-priced stock. And later, 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 valuation-sensitive capital allocation moves allowed him to compound his company’s stock at 20.3% per year over 27 years; each $1 invested in Teledyne turned into $160!

Singleton basically pioneered these type of capital decisions – they were highly unusual at that time, and still are for the most part. It probably required unconventional thinkers like Shannon and Rock on his board to back him up!

And brings me to the lingering doubts I had mentioned in the beginning: the history of conglomerates during the 1960s has been notorious for its “ponzi” aspects. As George Soros noted in his book The Alchemy of Finance, the boom in conglomerates was followed by a massive bust.

Buffett discusses how the conglomerate ponzi scheme was worked in his latest letter:

“The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate’s stock
to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied “pooling” accounting to the acquisition, which – with not a dime’s worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. They next explained to investors that this sort of talent justified the maintenance, or even the
enhancement, of the acquirer’s p/e multiple. And, finally, they promised to endlessly repeat this procedure and thereby create ever-increasing per-share earnings.”

He then explains how this kind of financial engineering came to its inglorious end:

“Since the per-share earnings gains of an expanding conglomerate came from exploiting p/e differences, its CEO had to search for businesses selling at low multiples of earnings. These, of course, were characteristically mediocre businesses with poor long-term prospects. This incentive to bottom-fish usually led to a conglomerate’s collection of underlying businesses becoming more and more junky… Eventually, however, the clock struck twelve, and everything turned to pumpkins and mice.”

But Buffett then goes on and explains how the judicious use of the conglomerate structure allows him to allocate capital in a way that is more efficient that the market:

“One of the heralded virtues of capitalism is that it efficiently allocates funds. The argument is that markets will direct investment to promising businesses and deny it to those destined to wither. That is true: With all its excesses, market-driven allocation of capital is usually far superior to any alternative.

Nevertheless, there are often obstacles to the rational movement of capital … A CEO with capital employed in a declining operation seldom elects to massively redeploy that capital into unrelated activities. A move of that kind would usually require that long-time associates be fired and mistakes be admitted. Moreover, it’s unlikely that CEO would be the manager you would wish to handle the redeployment job even if he or she was inclined to undertake it.

At the shareholder level, taxes and frictional costs weigh heavily on individual investors when they attempt to reallocate capital among businesses and industries. Even tax-free institutional investors face major costs as they move capital because they usually need intermediaries to do this job. A lot of mouths with expensive tastes then clamor to be fed – among them investment bankers, accountants, consultants, lawyers and such capital-reallocators as leveraged buyout operators. Money-shufflers don’t come cheap.

In contrast, a conglomerate such as Berkshire is perfectly positioned to allocate capital rationally and at minimal cost … At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to
pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.”

…

I want to end with some caveats:

• The Outsides book does not really cover hands-on 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 not so great (and compounded average returns are spoiled rather easily by even a few bad years).
• After all is said and done, there remains the possibility that we may be looking at survivor and selection biases often lurking in such history-based records. The high levels of leverage is a clear red flag that luck may well have played a huge role in some of these outliers: the risk they took did not materialize even though it could have, so the survivor-ship bias really does matter.

Having said that, it is hard not be impressed by the power of a pattern — decentralized operations combined with centralized capital allocation in the hands of a CEO who understands valuation — that is capable 20% type annualized returns over decades!

 

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Full Disclosure: As of the time of writing this post, I am long Liberty Global (LBTYA), whose largest holder is John Malone, one of the eight Outsider CEOs. I am not connected with William Thorndike or the Outsiders book in any way.

This post is not meant to be and should not be construed as investment advice of any sort. Investing is extremely difficult, the risk of permanent loss is high, and past results are meaningless in the future.