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The Outsiders

Recently, I finished reading 'the Outsiders' by William Thorndike. I think it's a very insightful book about what makes a CEO exceptional. In this blog post, I will share and explain what a great CEO does and where one should look to spot whether a CEO is likely to deliver great shareholder returns or not.


First, we will answer the question of why it's important to understand and recognize the traits and activities of exceptional managers.

In investing, management plays a large role in the performance of a company, and because a company's performance is tightly connected with shareholders' return, a CEO can have a lot of impact on whether an investment will turn out well or not. Therefore, it's crucial to understand and being able to recognize the traits of exceptional managers and distinguish them from mediocre and bad managers.


The goal of a CEO

Now, we should clarify the goal of a CEO and how a manager's performance should be measured. The goal of a CEO is to maximize a company's per-share value. You might ask: "Well... why isn't growth or the size of a company not more important?" Let me explain.


Imagine you are running a software company.

Would you rather run company A with $1 billion in revenues and $10 million in earnings, or would you prefer to have a company B with $100 million in sales and $40 million income? Of course, you would prefer the company with the most earnings; company B, and therefore is company B also more valuable. (If we assume that both companies' earnings don't change.)


That was about size. Now, let's have a look at growth. Let's say that your business, company B, has a cost of capital of 10%. It could choose to reinvest all its earnings back into the company at a return on investment (ROI) of 8%, or I could reinvest only a quarter of its earnings but at a ROI of 15%.


In the first scenario, the company would grow by 3.2% ($103.2 million vs. $100 million) and in the second scenario, the business would grow by 1.5% ($101.5 million vs. $100 million). Which scenario do you prefer? One or two? I would choose scenario two.


"Well... why is that?" is what you might ask.

The reason is simple: in the first scenario the return on investment (8%) is lower than the cost of capital (10%) and therefore 2% of the money gets destroyed. In the second scenario, the ROI (15%) is higher than the cost of capital and therefore the investment creates additional income for the company. So, this company could use that other 75% of earnings better to buy back shares, acquire another company or pay out a dividend (which I will talk about later in this post) than investing in the business's operations.


Then we also compare the returns a CEO has delivered to the returns of the broader market, the S&P 500, over the same period and to his market peers over the same period, to determine whether he did a great job or not.


The activities for outperformance

Now, we are going to talk about what a CEO, in general, needs to do to reach its goal (maximize a company's per-share value). There are two activities where he/she should focus on: (1) capital allocation - what is the best way to deploy the cash generated by the business? - and (2) operations efficiency - how to extract as much cash as possible from current operations.


First, we are going to look at capital allocation. Here, the goal is to achieve the highest return on investment possible. This can be done through investing the company's earnings in one or several of these four districts: (1) merger & acquisition, (2) expanding operations, (3) share buybacks, and (4) paying out a dividend.

For example, when we choose to invest 100 dollars to acquire a company and get $10 in return each year after the investment or invest the money to expand operations and receive $20 per year after the investment. We would choose the second case, of course. And this investment would give us a ROI of 20%.


The question that probably has come to your mind is "how does one know which one should be chosen". Well... that's a difficult question. A manager should be constantly on the outlook for investment with the highest ROI possible. Therefore, he should constantly (1) be analyzing potential companies to take over or where his company could merge with, (2) have a very excellent understanding of the companies current operations and market opportunities (for expanding operations), and (3) know what his own company is worth, to be able to compare it with the current share price and maybe buy his own shares back.


Thereafter, he needs to be able to estimate the expected risk and return associated with the opportunities out of the previously mentioned districts. And act on the opportunity that is most promising given the estimated risk/return.


This all sounds quite easy to execute but it's always easier said than done. Some issues that occur when trying to make good investments:

  1. Great opportunities aren't always available to the CEO. The interesting companies the CEO understands and will add value to his firm are often not available at the favorable price one wants to buy them. Sometimes (dependent on the company) the CEO is not able to invest in operations or investing in operations will not give favorable returns. Being able to buy the company's own stock at attractive prices is also often not possible, because stock prices aren't often below intrinsic value. Then one could pay out a dividend, as the last option. When paying back the earned money to investors you first need to pay extra taxes and then hope that they could earn a return of 15% or higher (below 15% is just not attractive for most investors). This is quite hard to do and therefore it's often better for a CEO to wait for one or two years to deploy the cash at sound returns himself. Therefore should a CEO be patient and prepared to find the best opportunity possible.

  2. It could be quite difficult for a manager to estimate and judge with some accuracy whether an opportunity will have nice returns or not.

  3. Wall Street analysts like dividends for example but, as said earlier, for greater shareholder returns it's better to invest in one of the other opportunities. So, it's quite tempting for some CEOs to pay a dividend to get a higher stock price in the short run.

  4. Peer pressure is also something where a lot of CEOs suffer from. This plays a bigger role on the highest level in corporations than you might think. When, for example, one CEO expands his operations in one region, others will follow and therefore the opportunity will vanish because of the increased competition.


Then we land at operational efficiency. I believe that there are three key elements for getting as much money out of operations as possible:

  • Having a cost-conscious culture.

How much money you take out of a business depends on sales and subtracting all costs. Capital allocation could be seen as the art of increasing sales and the operations determine how much money will be left. By getting your personnel to think about cost-cutting where possible, the small contributions of their cost-cutting behavior will add up and have a large impact on what number is left on the last line.

  • Hiring the best people you can.

This might sound quite obvious but is really important. A company needs to make working for them very attractive for very smart and capable people. This can be done by building a hard-working culture, setting up nice bonuses, and have great challenges ready for them.

  • Last but not least is having as few people working for your firm as possible and giving your personnel as much authority and responsibility they need.

Having as few people working for your firm as possible (without letting your personnel overwork too much) is best for a company because you prevent a company from getting a lot of supervisors who need to report to another one who is above them etc. This will prevent the remaining managers from doing work that isn't going to contribute to the core operations. Having a lot of supervisors/managers would also restrict the responsibility and authority individual workers need to have to do the best work they can and from being creative.


One of the outsiders

Now I will pick one exceptional CEO from the seven outsiders mentioned in the book. We will look at what this manager has accomplished and what his plan of attack was.


The outsider we are going to look at is Murphy, who was the CEO of Capital Cities Broadcasting. Capital Cities was just a small broadcasting/media company and had to go against the dominant and giant CBS. But by the time Murphy sold his company to Disney, Capital Cities was worth three times as much as CBS.


So how come that this company dwarfed CBS in valuation?

I'll tell you, it's the difference in managing.

The management of CBS started to shift their focus away from the industry where they were so dominant. They started acquiring all kinds of companies that weren't related to their core business. They even bought the New York Yankees! This diversification is called "diworsification". Why? Because they bought a lot of different businesses they knew little about, most of the operations of those businesses began to deteriorate, as a result, and therefore the profits of those firms came down.


On the contrary, Murphy's tactic was different. He focused on relevant industries, he understood, with attractive economic characteristics. Then he used leverage to buy occasional large properties, improve operations, pay down debt, and repeat. After some time Capital Cities benefitted from economies of scale while CBS and other competitors build large corporate staffs, and overpay for marquee media properties.


Again, on the contrary, Murphy liked to have as little staff as possible because he believed if you hire the best people you can and give them the responsibility and authority they need, operations will improve drastically and the company will thrive.


This all resulted in massive outperformance of Capital Cities shares compared to their competitors in the media. As a result, $1 invested with Capital Cities when Murphy became CEO in 1966, became $204 29 years later. That's a remarkable 19.9 percent annual return. $1 dollar invested in the S&P 500 and other media companies over the same period would have become $16 and $36.



Where to search for

For searching through management and trying to grasp whether management has characteristics of returning good, great, or even exceptional returns it would help if we understand some of the traits outstanding CEOs have in common.


One of these traits is that all of these outsiders had fresh eyes to business and the industry. When having fresh eyes, one is likely to question current operations and current ways of dealing with things, whether those actions look or feel suboptimal. Mostly, managers already operating in those businesses and/or industries have a traditional way of doing things and are likely to continue doing the same thing as always and as everyone else. Well... you don't get above-average returns with operating the same way as everyone does.

Therefore being new in an industry could allow you to do things differently and may lay roots for outperformance.


Another thing that has a lot to do with the first trait is: a deep-seated commitment to rationality. Being new in an industry and doing things better, not only differently, requires rationality. With rationality, one needs to try to think long-term, and have the capability to think on second-level (about the effects of the effects of your actions). This could give you the edge you need to outperform.


Most exceptional managers' companies also have little or no debt, or debt is used in a conservative way to acquire other companies. These CEOs do tend to hold a lot of stock in the company when running it. This is known as "skin in the game". For a man having a significant amount of stock in his company suggests that whatever returns you get from investing in this company, the same returns are what they get. And, of course, every manager wants to make nearly as much money as possible.



Thanks for reading!

I hope I've disclosed some useful information on how CEOs operate, what needs to be done for outperformance, and where to look to spot these exceptional managers.


I would appreciate it if you would leave your thoughts on this little blog post in the comments and if you don't want to miss a post, you can subscribe below.

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