Inflation Or Economic Growth: Which One Wins?

Inflation Or Economic Growth: Which One Wins?

Domestic growth continues to be strong. Since our economy is very diverse, growth can be categorized in many ways. Some are growing off the charts (commodities), some are growing at normal rates (consumer staples and consumer discretionaries) and some are continuing to gain market share and be even more irreplaceable than they were before the pandemic (Big-Cap technology). What I am going to try and explain today is inflation- what it really means and although generally thought of as a nasty and undesirable situation, if happening on a gradual basis, it can be a good thing. I will also talk about the Fed and the growth rate of the economy- given the tools that we are most familiar with that the Fed has, it is often difficult to believe that they can raise rates but not cause a recession or a mild slow down. The third and most important point I would like to cover is the financial storm that is brewing outside the US that is being catalyzed by the Russian conflict. 

INFLATION

One key thing that everyone needs to understand is that inflation by itself does not take down markets. What takes down stock prices is slower growth of the economy and lower profitability for the companies themselves. This then translates into consumer habits changing due to these price changes. Consumer behaviors of purchasing change and lifestyles are altered and therefore industries either flourish or consumption slows.

Inflation, as a term, is a political lightning rod. The media will choose to use the CPI (consumer price index) as a measuring stick for current inflation. Current CPI is up 7.9% versus a year ago and is expected to peak somewhere in the 8-9% range- the highest since 1981. The natural inference is that since inflation measures are now at 1981 levels that interest rates should be moving to 1981 levels as well. This is just not true! The politicians blame it on war or COVID, but the simple explanation is that there is just so much cash out there that consumers are able to pay massively elevated prices with the excess cash they have on hand. Three of the easiest components to understand the price changes on are food, gasoline, and used car prices. All consumers at all financial levels can get an emotional feel for these three—whether they are deeply affected or not. What I mean by this is a wealthy person may be able to afford $6.50 per gallon gas prices but are really upset that they have to pay it, and a lower income earner now has difficulty paying for other living expenses when paying this much for gas and is expectedly upset! 

What isn't being discussed is that if food prices go super high, the world just produces more. If gasoline goes too high, producers find somewhere else to get it (Europe coming to the US for natural gas due to Russian embargos) or they change to a different type of fuel. And as for used cars, as soon as there is some level of stabilization in the supply chain, auto inventories should be replenished, and prices should normalize. The Russian / Ukraine conflict, coupled with more waves of the virus, is influencing prices and therefore consumption.  This then diminishes the growth of consumption and a resulting slowdown in GDP. In Barron's this past weekend, there was an article about labor. In the article, it was said that many people are returning to the workforce because they are simply too bored with sitting around all day. Is it this or the fact that the government is no longer paying them to do nothing? Whichever it is, the fact remains that many that dropped out of the workforce during the pandemic are now returning. 

I believe the ultimate indicator of the future course of inflation could be partially determined by the direction of the equity markets. Since equities prices are dependent on the expectation of future earnings, it is no wonder that the S&P 500 has been in a funk since the second half of 2021. Yet inflation measures weren't highly elevated yet even though prices started to decline. Since stock prices are a discounting mechanism where prices "today" reflect what is "expected" 9-12 months forward, it is no wonder that we are experiencing issues in many industries now, yet the price levels of these companies were declining many months ago. Now, as the supply chain begins to get back on course, equity prices are stabilizing and rising before the consumption numbers are even starting to improve. THIS IS AN INCREDIBLY DIFFICULT CONCEPT TO REMEMBER. We are so focused on the here and now, we have trouble considering the concept of time.

FED TIGHTENING

At this point in the cycle, Fed tightening is normal. This is the opposite of March 2020, when the world was within a hair’s breadth of a depression. The Fed injected an unprecedented amount of liquidity into the system and the administration poured tens of trillions of dollars into the so-called "infrastructure" bill. As the economy got back its footing, however, there is no need for additional stimulus.

Even though interest rates will rise today, the system remains very liquid as corporations, institutions, and individuals are still flushed with cash. As interest rates rise, this brings us to the current "fear de jour," the widely feared INVERTED YIELD CURVE. The media will have you believe that the inverted yield curve is when short rates are higher than long rates. The periods they are using to measure this inversion are the 2yr. to the 10yr. or the 5yr. to the 10yr. The reality is that the true measure—the one that is the most accurate at forecasting—is the 13-week T-bill yield to the 30-year Treasury. At this point, this comparison is a long way from inverting yet the 2 to 10 is getting close- perfect fodder for the media. When the 13-week to the 10 year is inverted, caution would then be warranted. Please take a moment and look at the two charts below that show the 2 to 10 relationship:

 

 

The first table is the picture of the 2yr vs the 10yr going back to the 1980s and the period of time before a recession actually occurred. The second one is a true timeline in a picture, of when things got difficult vs. when the inversion occurred. The difference this time, I believe is Jerome Powell. He has been very good at stating his intentions way ahead of time and in so doing allowed financial markets to adjust prior to the action being taken. Remember, he told us back in October & November of last year when he was going to turn off the money spigot and when he was going to begin to raise short rates. This was very good at providing stability in the financial markets. I believe that the non-farm payroll number we are expecting this Friday should give us some additional insights as to the continued velocity of economic growth (or lack thereof) and therefore the need or lack thereof for more drastic interest rate hikes. Powell will be sure to comment on this number as labor, he has stated, is very important to his decisions.

FINANCIAL STORM BREWING IN EUROPE

In the March 19th issue of Barron's, there was an interview with Louis-Vincent Gave, co-founder of Gavekal Research, “A Financial Storm Is Brewing in Europe. Where to Hide.” Gave uses terms like de-globalization and depression, but what is really important is what is happening in Europe due to the escalation in energy and agricultural commodity prices and the fact that Europe has basically run out of ways to mitigate the negative effects of these price hikes. There are many countries in continental Europe that remain in negative interest rate debacles or are close. At the same time, the strongest economy in Europe; Germany, has done something few are familiar with. They have all but done away with their nuclear power generation (which could arguably offer the best energy option by providing large-scale power production without emitting the feared greenhouse gases). Michael Shellenberger wrote emphatically in, "The West's Green Delusions Empowered Putin," written March 1, 2022. According to Shellenberger:

• While Putin expanded Russia's oil production, expanded natural gas production, and then doubled nuclear energy production to allow more exports of its precious gas, Europe, led by Germany, shut down its nuclear power plants, closed gas fields, and refused to develop more through advanced methods like fracking. 
• The numbers tell the story best. In 2016, 30% of the natural gas consumed by the European Union came from Russia. In 2018, that figure jumped to 40%. By 2020, it was nearly 445, and by early 2021, it was nearly 47%. 

Where do all of the commodities of Russia and Ukraine go? See below:

Shellenberger asserts- and it seems credible- that Europe allowed its dependence on imports of energy and other commodities, especially from Russia, to increase so dramatically because it wanted to be more ecologically responsible at home (sound familiar with what the current administration did with drilling in the US the first week of their administration!!!). In addition to limiting their production of oil and gas, some nations (especially Germany) reduced their use of nuclear power generation- which could arguably offer the best energy option by providing large-scale power production without emitting greenhouse gases- in a concession to those who consider nuclear power unsafe. He goes on to say:

• At the turn of the millennium, Germany's electricity was around 30% nuclear. But Germany has been sacking its reliable, inexpensive nuclear plants... By 2020, Germany had reduced its nuclear share from 30% to 11%. Then, on the last day of 2021, Germany shut down half of its remaining six nuclear reactors. The other three are slated for a shutdown at the end of the year. 

The ultimate point is that energy is clearly the biggest commodity component, but with Ukraine being the "Breadbasket of Europe" agricultural commodities are also very important and are in the same turmoil. Above I referenced the interview with Gave in Barron's. Gave was asked, how do you see this potential crisis playing out? He was very succinct at saying that Europe's economic growth will collapse. "Over the next six months, inflation that continues to rise will lead to popular discontent. In the fall, Europe may see a massive surge in immigration, similar to the one that followed the Arab Spring, as the surge in wheat prices will create further political instability in the southern and eastern sides of the Mediterranean. Rising inflation plus surging immigration will boost the vote of the populist parties, which will be visible in the Spanish and Italian elections in 2023. While clouds hang over Europe, I wouldn't be inclined to add risk. You need to see the European situation stabilized." Please make sure that you follow what is going on in Europe. You will begin to hear the term “deglobalization.” 

In closing, the energy situation has emerged due to the US mothballing many of our drilling locations and Germany focusing (shortsightedly) on overly environmental issues, at the expense of global economies. The follow-on is the increased costs due to skyrocketing agriculture prices. Europe, which is still deep in its COVID malaise, is clearly the worst affected. The US has the means and the growth in our domestic economy to rise above these issues. These increases in price levels should cause the level of GDP growth to be tempered and in so doing allow Powell & Co. to not increase rates at a speed that could throw us into a recession. The result is our domestic energy companies should continue to thrive, our domestic agriculture companies should thrive, and our employment picture should remain buoyant and stable. I don't say this to be insensitive to what is unfolding in Europe, but as an investor, I wish to concentrate on where business is doing the best, and this remains stateside. Lastly, remember the picture of what normally happens in the Mid-Term year of a US Presidential cycle. See below. We have experienced a rough patch since the second half of 2021, and we are looking forward to the second half of 2022 and into the Pre-Election year of 2023. Please be invested accordingly. 

 

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Important Disclosures: 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy. 

Investing involves risks including possible loss of principal.

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The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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Ken south, Mar 30, 2022

Source

https://www.tower68.com/blog

The Outsiders

The Outsiders

Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

The Outsiders is a collection of portraits of eight unconventional, yet very successful (ex-)CEOs of public companies. With success measured as the creation of shareholder value.

I found this book an interesting read as I didn't know anything about most of the profiled CEOs and their companies. And I liked how it highlighted the importance of capital allocation for the long-term success of businesses. On the other hand I wished that the portraits would have been longer with more details and a more critical tone. I didn't like the author's writing style, it felt too fanboyish and everything the CEOs did was "great"...

My notes

Preface: Singletonville

It's almost impossible to overpay the truly extraordinary CEO... but the species is rare.

Warren Buffett

Success leaves traces.

John Templeton

It's the increase in a company's per share value, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO's greatness.

In assessing performance, what matters isn't the absolute rate of return but the return relative to peers and the market. You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500).

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations.

Basically, CEOs have five essential choices for deploying capital – investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock – and three alternatives for raising it – tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long-term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.

Introduction

It is impossible to produce superior performance unless you do something different.

John Templeton

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness. They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate planes, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press. They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them.

Most public company CEOs focus on maximizing quarterly reported net income, which is understandable since that is Wall Street's preferred metric. Net income, however, is a bit of a blunt instrument and can be significantly distorted by differences in debt levels, taxes, capital expenditures, and past acquisition history. 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.

Growth, it turns out, often doesn't correlate with maximizing shareholder value.

A Perpetual Motion Machine for Returns: Tom Murphy and Capital Cities Broadcasting

"The goal is not to have the longest train, but to arrive at the station first using the least fuel."

The formula [...] was deceptively simple: focus on industries with attractive economic characteristics, selectively use leverage to buy occasional large properties, improve operations, pay down debt, and repeat.

Capital Cities under Murphy was an extremely successful example of what we would now call a roll-up. In a typical roll-up, a company acquires a series of businesses, attempts to improve operations, and then keeps acquiring, benefiting over time from scale advantages and best management practices.

"The business of business is a lot of little decisions every day mixed up with a few big decisions."

There is a fundamental humility to decentralization, an admission that headquarters does not have all the answers and that much of the real value is created by local managers in the field.

The company's guiding human resource philosophy, repeated ad infinitum by Murphy, was to "hire the best people you can and leave them alone".

Frugality was also central to the ethos. Murphy and Burke realized early on that while you couldn't control your revenues at a TV station, you could control your costs. They believed that the best defense against the revenue lumpiness inherent in advertising-supported businesses was a constant vigilance on costs, which became deeply embedded in the company's culture.

Murphy and Burke believed that even the smallest operating decisions, particularly those relating to head count, could have unforeseen long-term costs and needed to be watched constantly.

"I get paid not just to make deals, but to make good deals."

Murphy had an unusual negotiating style. He believed in "leaving something on the table" for the seller and said that in the best transactions, everyone came away happy. He would often ask the seller what they thought their property was worth, and if he thought their offer was fair he'd take it [...]. If he thought their proposal was high, he would counter with his best price, and if the seller rejected his offer, Murphy would walk away. He believed this straightforward approach saved time and avoided unnecessary acrimony.

An Unconventional Conglomerateur: Henry Singleton and Teledyne

In addition to eschewing dividends, Singleton ran a notoriously decentralized operation; avoided interacting with Wall Street analysts; didn't split his stock; and repurchased his shares as no one else ever has, before or since.

The conventional wisdom today is that conglomerates are an inefficient form of corporate organization, lacking the agility and focus of "pure play" companies. It was not always so – for most of the 1960s, conglomerates enjoyed lofty price-to-earnings (P/E) ratios and used the currency of their high-priced stock to engage in a prolonged frenzy of acquisition. During this heady period, there was significantly less competition for acquisitions than today (private equity firms did not yet exist), and the price to buy control of an operating company (measured by its P/E ratio) was often materially less than the multiple the acquirer traded for in the stock market, providing a compelling logic for acquisitions.

Singleton took full advantage of this extended arbitrage opportunity to develop a diversified portfolio of businesses, and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to specialty metals and insurance. All but two of these companies were acquired using Teledyne's pricey stock.

He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets.

In mid-1969, with the multiple on his stock falling and acquisition prices rising, he abruptly dismissed his acquisition team. Singleton, as a disciplined buyer, realized that with a lower P/E ratio, the currency of his stock was no longer attractive for acquisitions. From this point on, the company never made another material purchase and never issued another share of stock.

Great investors (and capital allocators) must be able to both sell high and buy low; the average price-to-earnings ratio for Teledyne's stock issuances was over 25; in contrast, the average multiple for his repurchases was under 8.

"My only plan is to keep coming to work... I like to steer the boat each day rather than plan ahead way into the future."

Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market. This approach is careful, conservative and not coincidentally, unlikely to have any meaningful impact on long-term share values. [...] The other approach, the one [...] pioneered by Singleton, is quite a bit bolder. This approach features less frequent and much larger repurchases timed to coincide with low stock prices – typically made within very short periods of time, often via tender offers, and occasionally funded with debt.

The Turnaround: Bill Anders and General Dynamics

So when Lockheed's CEO surprised him by offering $1.5 billion, a mind-bogglingly high price for the division, Anders was faced with a moment of truth. What he did is very revealing – he agreed to sell the business on the spot without hesitation (although not without some regret). Anders made the rational business decision, the one that was consistent with growing per share value, even though it shrank his company to less than half its former size and robbed him of his favorite perk as CEO: the opportunity to fly the company's cutting-edge jets.

"Most CEOs grade themselves on size and growth... very few really focus on shareholder returns."

Value Creation in a Fast-Moving Stream: John Malone and TCI

His two academic fields, engineering and operations, were highly quantitative and shared a focus on optimization, on minimizing "noise" and maximizing "output". Indeed, Malone's entire future career can be thought of as an extended exercise in hyperefficient value engineering, in maximizing output in the form of shareholder value and minimizing noise from other sources, including taxes, overhead, and regulations.

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows. If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.

To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.

Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges.

Using the debt available from the company's new lenders, internal cash flow, and the occasional equity offering, Malone began an extraordinarily active acquisition program. Between 1973 and 1989, the company closed 482 acquisitions, an average of one every other week.

Malone was a pioneer in the use of spin-offs and tracking stocks, which he believed accomplished two important objectives: (1) increased transparency, allowing investors to value parts of the company that had previously been obscured by TCI's byzantine structure, and (2) increased separation between TCI's core cable business and other related interests (particularly programming) that might attract regulatory scrutiny.

Malone abhorred taxes; they offended his libertarian sensibilities, and he applied his engineering mind-set to the problem of minimizing the "leakage" from taxes as he might have minimized signal leakage on an electrical engineering exam. As the company grew its cash flow by twentyfold over Malone's tenure, it never paid significant taxes. In fact, Malone's one extravagance in terms of corporate staff was in-house tax experts.

Malone appreciated how difficult and expensive it was to implement new technologies, and preferred to wait and let his peers prove the economic viability of new services [...].

The Widow Takes the Helm: Katharine Graham and The Washington Post Company

After [Phil Graham's] tragic death, Katharine found herself thrust unexpectedly into the CEO role. It is impossible to overstate Graham's unpreparedness for this position. At age forty-six, she was the mother of four and hadn't been regularly employed since the birth of her first child nearly twenty years before.

[...] during the acquisition frenzy of the 1980s, Graham generally stood aside, passing on numerous newspaper acquisitions, large and small. As her son Donald says today, "The deals not done were very important. Another large newspaper would have been a boat anchor around our necks today."

The decision to welcome Buffett into the fold was a highly independent and unusual one at the time. In the mid-1970s, Buffett was virtually unknown. Again, the choice of a mentor is a critically important decision for any executive, and Graham chose unconventionally and extraordinarily well. As her son Donald has said, "Figuring out this relatively unknown guy was a genius was one of the less celebrated, best moves she ever made."

A Public LBO: Bill Stiritz and Ralston Purina

Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

Warren Buffett

Stiritz himself likened capital allocation to poker, in which the key skills were an ability to calculate odds, read personalities, and make large bets when the odds were overwhelmingly in your favor. He was an active acquirer who was also comfortable selling or spinning off businesses that he felt were mature or underappreciated by Wall Street.

Stiritz was the pioneer among consumer packaged goods CEOs in the use of debt. This was heresy in an industry that had long been characterized by exceptionally conservative financial management. Stiritz, however, saw that the prudent use of leverage could enhance shareholders' returns significantly. He believed that businesses with predictable cash flows should employ debt to enhance shareholder returns, and he made active use of leverage to finance stock repurchases and acquisitions [...].

From the outset, Stiritz had been a believer in decentralization, working to reduce layers of corporate bureaucracy and giving responsibility and autonomy for the company's key businesses to a close-knit group of managers. He viewed spin-offs as a further move in this direction, "the ultimate decentralization", providing managers and shareholders with an attractive combination of transparency and autonomy and allowing managers to be compensated more directly on their operating results than was possible in the larger conglomerated structure of the mother company.

Stiritz believed that Ralston should only pursue opportunities that presented compelling returns under conservative assumptions, and he disdained the false precision of detailed financial models, focusing instead on a handful of key variables: market growth, competition, potential operating improvements, and, always, cash generation.

Stiritz was fiercely independent, and actively disdained the advice of outside advisers. He believed that charisma was overrated as a managerial attribute and that analytical skill was a critical prerequisite for a CEO and the key to independent thinking: "Without it, chief executives are at the mercy of their bankers and CFOs."

He was well known for showing up alone to important due diligence meetings or negotiations where the other side of the table was crowded with bankers and lawyers.

Optimizing the Family Firm: Dick Smith and General Cinema

The company paid minimal dividends and was notable for its willingness to hold large cash balances while waiting for attractive investment opportunities to emerge.

The Investor as CEO: Warren Buffett and Berkshire Hathaway

"Being a CEO has made me a better investor, and vice versa."

It is hard to overstate the significance of this change. Buffett was switching at midcareer from a proven, lucrative investment approach that focused on the balance sheet and tangible assets, to an entirely different one that looked to the future and emphasized the income statement and hard-to-quantify assets like brand names and market share. To determine margin of safety, Buffett relied now on discounted cash flows and private market values instead of Graham's beloved net working capital calculation.

Charlie Munger has said that the secret to Berkshire's long-term success has been its ability to "generate funds at 3 percent and invest them at 13 percent", and this consistent ability to create low-cost funds for investment has been an underappreciated contributor to the company's financial success. Remarkably, Buffett has almost entirely eschewed debt and equity issuances – virtually all of Berkshire's investment capital has been generated internally.

In both insurance and investing, Buffett believes the key to long-term success is "temperament", a willingness to be "fearful when others are greedy and greedy when they are fearful".

Whenever Buffett buys a company, he takes immediate control of the cash flow, insisting that excess cash be sent to Omaha for allocation. As Charlie Munger points out, "Unlike operations (which are very decentralized), capital allocation at Berkshire is highly centralized".

Most CEOs are limited by prior experience to investment opportunities within their own industry [...]. Buffett, in contrast, by virtue of his prior experience evaluating investments in a wide variety of securities and industries [...] had the advantage of choosing from a much wider menu of allocation options, including the purchase of private companies and publicly traded stocks.

A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets.

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it."

Buffett has created an attractive, highly differentiated option for sellers of large private businesses, one that falls somewhere between an IPO and a private equity sale. A sale to Berkshire is unique in allowing an owner/operator to achieve liquidity while continuing to run the company without interference or Wall Street scrutiny. Buffett offers an environment that is completely free of corporate bureaucracy, with unlimited access to capital for worthwhile projects. This package is highly differentiated from the private equity alternative, which promises a high level of investor involvement and a typical five-year holding period before the next exit event.

Buffett never participates in auctions. [...] Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer "usually in five minutes or less". This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.

Buffett came to the CEO role without any relevant operating experience and consciously designed Berkshire to allow him to focus his time on capital allocation, while spending as little time as possible managing operations, where he felt he could add little value. As a result, the touchstone of the Berkshire system is extreme decentralization.

The CEOs who run Berkshire's subsidiary companies simply never hear from Buffett unless they call for advice or seek capital for their businesses. He summarizes this approach to management as "hire well, manage little" and believes this extreme form of decentralization increases the overall efficiency of the organization by reducing overhead and releasing entrepreneurial energy.

Buffett spends his time differently than other Fortune 500 CEOs, managing his schedule to avoid unnecessary distractions and preserving uninterrupted time to read (five newspapers daily and countless annual reports) and think.

All of this adds up to something much more powerful than a business or investment strategy. Buffett has developed a worldview that at its core emphasizes the development of long-term relationships with excellent people and businesses and the avoidance of unnecessary turnover, which can interrupt the powerful chain of economic compounding that is the essence of long-term value creation.

Radical Rationality: The Outsider's Mind-Set

You are right not because others agree with you, but because your facts and reasoning are sound.

Benjamin Graham

The outsider CEOs always started by asking what the return was. Every investment project generates a return, and the math is really just fifth-grade arithmetic, but these CEOs did it consistently, used conservative assumptions, and only went forward with projects that offered compelling returns. They focused on the key assumptions, did not believe in overly detailed spreadsheets, and performed the analysis themselves, not relying on subordinates or advisers.

The outsider CEOs were master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest, most local levels in their organizations. They did not, however, delegate capital allocation decisions.

In addition to thinking independently, they were comfortable acting with a minimum of input from outside advisers.

These executives were capital surgeons, consistently directing available capital toward the most efficient, highest-returning projects. Over long periods of time, this discipline had an enormous impact on shareholder value through the steady accretion of value-enhancing decisions and (equally important) the avoidance of value-destroying ones. This unorthodox mind-set, in itself, proved to be a substantial and sustainable competitive advantage for their companies.

Although frugal by nature, the outsider CEOs were also willing to invest in their businesses to build long-term value. To do this, they needed to ignore the quarterly earnings treadmill and tune out Wall Street analysts and the cacophony of cable shows [...] with their relentless emphasis on short-term thinking.

They had the perspective of the long-term investor or owner, not the high-paid employee – a very different hat than most CEOs wear to work.

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Source

https://books.danielhofstetter.com/the-outsiders/

William Thorndike – Author of “The Outsiders” – 2 Qualities that Make a Great CEO

William Thorndike – Author of “The Outsiders” – 2 Qualities that Make a Great CEO

I first heard of the book “The Outsiders” in Berkshire Hathaway’s 2012 letter to shareholders. And who is going to ignore a book that Buffett calls “outstanding!”?

The book goes in detail on 8 different CEOs who excelled at creating exceptional long term returns for shareholders. In fact, the average returns of these companies’ shares outperformed the S&P 500 by a factor of 20 – every $10,000 invested in these companies was worth $1.5 million 25 years later.

What’s their secret? And how can we use those lessons to find today’s great CEOs?

The book makes the point that the reason these companies were so successful was because of the ability of the CEOs to allocate their company’s capital into the areas that produced the highest returns.

Capital Allocation

Sure it’s nice to have a CEO who is charismatic, a great communicator or maybe even one who enjoys a celebrity type status. But what really matters to shareholders? Returns.

And a CEO who is a master capital allocator will ensure that shareholder money is put to the best use, and generates the best returns possible. Capital Allocation done right over decades creates a huge compounding effect – as shown in this book – and compounding wealth for its shareholders.

The CEO’s job is to allocate the company’s two forms of capital, for the sake of this article we are going to refer to these as a company’s “Financial Capital” and “Human Capital”, and take a look at how these 8 outstanding CEOs allocated their capital to produce superior returns.

First lets look at the much easier to define and measure Financial Capital.

Financial Capital Allocation

This is how a company’s CEO spends the company’s money.

Focus on Cash Flow – Not Reported Earnings

The first common theme evident throughout the book is nearly all of these CEOs focused on one thing above all else – Cash Flow. Even at the expense of reportable earnings, these CEOs wanted their businesses to generate cash.

For example, in the chapter on John Malone and his company, TCI, Thorndike says:

“…Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to MINIMIZE reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.”

And Henry Singleton, CEO of Teledyne said:

“If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.”

 Finding Companies Focused on Cash Flow

What does this mean for finding your next investment? Instead of evaluating a company based on a ratio using net earnings (such as P/E ratio), look instead at the price of a company based on the cash it generates. Use a metric like Free Cash Flow (FCF) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) instead, because a CEO focused on cash flow will sacrifice a “good” P/E value in favor of high free cash flow. Combine a company that produces tons of cash with a CEO who allocates that cash wisely (which we will learn to measure in the next few steps) and you may be well on your way to an excellent long term ride.

Read more: “How much is too much to pay for a great business” – Where we explore one company with a P/E of 66…but as we have seen, P/E doesn’t tell the whole story. Look and see how much cash they generate!

Screening based on Price/FCF, Price/EBITDA will find companies that are cheap relative to the cash they generate.

This screening will give you a list of companies to start with. For those that want to play along, here is the start of my list, which we will whittle down as we go through this article. There are too many on this list right now, wait for the next step and we can start to get some solid companies to look into. So don’t write them all down yet, but here is the list of companies (it ended up being 95 total) that; 1) have a price/fcf ratio of 10 or less, 2) are not banks and 3) do not trade over the counter (OTC or “pink sheets”).

(click to enlarge)

Now to narrow that list down:

The Buffett Test – An Evaluation of a CEO’s Allocation Ability

So you found a company that generates a lot of cash. Now you need to find a CEO that has a proven record of investing that cash wisely, to get (or keep) the “snowball” of compounding growth rolling.

One quick test is what has become known as the “Buffett Test”.

The appendix of The Outsiders defines the “Buffett Test” as:

“…a simple test of capital allocation ability. Has a CEO created at least a dollar of value for every dollar of retained earnings over the course of his venture?”

This Buffett Test is discussed further by Buffett in his “Berkshire Hathaway Owner’s Manual”, originally in 1983 he wrote:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”

But this was updated later to also include:

“I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.

When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.

The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If

these tests are met, retaining earnings has made sense.”

So, each of these definitions reads a little bit different to me. Let’s look at each of them:

First, The Outsider’s definition. If we assume that “value” equates to shareholder equity (or book value), then we simply take the change in shareholder equity over the CEOs tenure and divide it by the change in retained earnings. The Book says that Buffett himself has achieved a Buffett ratio of 2.3 over his tenure (meaning that every dollar in retained earnings has created 2.3 dollars in shareholder equity).

How did they get this?

The book was published when Berkshire Hathaway had released its 2007 annual report. So start with 2007 numbers: Retained earnings were $120,733,000,000 and Shareholder Equity was $273,160,000,000. Berkshire’s numbers for 1965 were Shareholder Equity of $22,139,000 and retained earnings somewhere around -$10,000,000.

So,

Which comes out to 2.26, remember any value over 1 “passes” this test. Obviously, the higher the better though.

In Buffett’s definition from his owners manual, he seems to recommend using the companies market cap instead of shareholder equity (Which seems strange to me, coming from a guy who says the market can be inefficient and misprice stocks, and that investors should not worry too much about the share price – which is why I like the first definition better – But no one asked me!)

So, as of October 1964 there were 1,134,776 shares of Berkshire outstanding and was around $18 when Buffett took control, for a market cap of $20,425,968. In 2007 Berkshire had 1,548,000 shares outstanding with a price around $118,000 per share, for a market cap of $182,664,000,000.

Using the retained earnings numbers from the example above we get:

Which gives us 1.50, another passing grade (is there any surprise?)

How many names can we eliminate from our original screen by requiring a “Buffett test ratio” of 1 or greater? My Screener is limited to 7 years of data, so these companies are all screened for their Buffett Test over the last 7 years, using the shareholder equity definition above.

By eliminating all of the names with a Buffett Test of less than 1, we are left with 46 companies left:

46 is still a few too many for me to start pulling up years and years worth of annual reports, 10-ks and conference call transcripts. In order to whittle the list down further, lets look and see some other qualities of great CEOs described in The Outsiders.

Buybacks

Without a doubt, one of the most prominent themes I found in this book is the magnitude of share buybacks between these CEOs. Kathrine Graham of the Washington Post Company (Ticker: WPO) bought back over 40% of the company’s shares outstanding during her tenure, Capital Cities repurchased 47% of shares outstanding, TCI repurchased 40%, and Ralston Purina repurchased 60%!

New to the idea of share buybacks? Here’s a quick example:

Consider 2 similar companies with the exact same earnings. The only thing different about them is the number of shares outstanding:

Since one company has half the number of shares outstanding, its EPS (Earnings per Share) is twice as high. And since the companies are very similar (same industry, same growth expectations, etc) they should trade at a similar multiple, or P/E ratio. Since the company with less shares outstanding has twice the EPS to report, based on EPS and P/E ratio alone, company 2 can justify a share price that is twice that of company 1.

There are other benefits too, repurchased shares do not get paid dividends, which may save the company some money and reducing the number of shares outstanding boosts the ownership percentage of the company.

The book gives an example of Buffett’s original purchases of Washington Post stock. Buffett eventually accumulated an ownership stake of 13% of the company, but over time as Graham repurchased the company’s shares, Buffett’s ownership stake in the company would rise to 22%, as the number of shares outstanding decreased.

Of course, share buybacks can actually take away value from the shareholders if the company is buying back shares at a high price.

In Buffett’s 2012 letter to shareholders he said:

“The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the SUREST way to use funds intelligently: It’s hard to go wrong when you are buying dollar bills for 80 cents or less. We explained our criteria for repurchases in last years report and, if the opportunity presents itself, we will buy large quantities of our stock. We originally said we would not pay more than 110% of book value, but that proved unrealistic. Therefore, we increased the limit to 120% in December when a large block become available at 116%.

But never forget: In repurchase decisions, price is all-important. Value is DESTORYED when purchases are made above intrinsic value.”

So how do we search for companies that have bought back their shares? Thankfully, the number of shares outstanding for a company is listed on its balance sheet, and therefore searchable and screenable.

There is a term “Buyback Yield” that represents the percentage of a company’s shares that were repurchased. If a company bought back half its number of shares outstanding, it would have a buyback yield of 50%. Here is the definition provided by my stock screener:

“A stock’s buyback yield is determined by comparing the average shares outstanding of a fiscal period with the average shares outstanding of another fiscal period. The Buyback Yield for the latest fiscal year (Y1) compares the average shares outstanding for the latest fiscal year (Y1) to the average shares outstanding one year ago (Y2). If a stock has 90 million average shares outstanding in Y1 and had 100 million average shares outstanding in Y2, the buyback yield would be 10%. Conversely, if a stock has 100 million average shares outstanding in Y1 and had 90 million average shares outstanding in Y2, it would have a buyback yield of -11%. We then take the simple averages of a company’s buyback yields over the last three, five and seven years. Note that the signs are reversed, so that a positive buyback yield indicates the average number of shares outstanding declining while a negative number indicates the average number of shares outstanding is increasing.”

So we subject an additional screening criteria for our now 46 companies. Now I want to see only the companies that have a positive average buyback yield of the last 7 years.

Down to just 11 names now from our original pool of hundreds. Now I feel like this is a manageable list to start delving into some financial statements, listen to some comments from management, read annual reports, etc.

So we have a set of companies that exhibit some basic Fundamental qualities of the Outsider CEO companies.

But what about our other aspect of capital allocation – Human Capital – how these companies manage their people.

Human Capital Allocation

How a company manages and allocates its personnel can be as important as how it manages its money.

What are some characteristics of great CEOs?

One common trait is a decentralized structure of the company.

The entire publishing operation at Capital Cities (which ran 6 daily newspapers, several magazine groups and some several weekly shoppers) was run by 3 people at headquarters – including an administrative assistant!

In fact, on the inside cover of every Capital Cities annual report read:

“Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them responsibility and authority they need to perform their jobs. All decisions are made at the local level.”

Berkshire Hathaway is one famous example of a company with a decentralized structure. The company has 75 subsidiaries, and employs more than 300,000 people. How many do you think make up Berkshire’s headquarters?

25 (including Buffett).

Why is this important? It means Warren Buffett is not calling the shots for a company in Cleaveland, Ohio from his chair in Omaha, Nebraska. Buffett has the confidence in his management to run the company themselves, he just allocates their capital.

Other “Outsider” companies: Teledyne – had an HQ of less than 50 people and TCI – which had an HQ of 17 people.

Finding companies with this type of structure is no easy task. The only way I have found it is by reading through annual reports. You could try a screen by looking at low SG&A costs (selling, general and administrative – as listed on a company’s income statement) per revenue, but at this point in the research, I like to get my nose into annual reports.

For example, one company I am in the middle of researching right now:

BINGO!

Which leads us to our next quality (also highlighted by the company above):

Entrepreneurial culture

This entrepreneurial culture is in part, forced by a company with a decentralized structure. As they are forced to manage their business without help from corporate.

But there are other key works to keep a look out for as you read through a company’s reports:

Incentives – such as with stock options. This keeps managers and shareholders interests aligned. If the primary source for a managers pay is to have the company’s stock price appreciate – then he will more than likely act in ways that also benefit shareholders as well.

You can find companies that have the incentives in place by looking at insider ownership (how many shares certain managers own – which is listed in a company’s annual report) or at manager and executive pay (as noted in a proxy report). Are executives and managers getting a high salary, but own little to no stock? That may be a big red flag.

Or are the manager’s getting meager salary, but a fair amount of stock options that will only be worthwhile if the company’s share price appreciates? Now you can be certain management and shareholders are on the same page.

Incentives could also mean bonuses based on performance, which one could argue is not as promising as stock, but at least performance bonuses will keep employees hungry to perform. For example Teledyne typically offered bonuses of up to 100% of salary!

Conclusion

Now we have a much better picture on how great companies in the past have been run and managed, and an idea on how to search for today’s companies that will hopefully become great companies tomorrow.

What is surprising to me is how “basic” this seems. Companies shouldn’t have waste by supporting massive corporate headquarters, companies should keep their managers and shareholders interests aligned, companies should spend their money wisely and not waste it by overpaying on acquisitions or the latest and greatest technology.

It takes a special kind of CEO to sacrifice the fame and celebrity status that could come with an elaborate corporate headquarters (see Facebook or Apple’s new headquarters, or “campuses” as they call them), higher than expected earnings numbers or headline grabbing acquisitions.

But it’s not easy to find a rational, pragmatic person these days, let alone one running a public company.

Thankfully with the help of William Thorndike’s book – we start to realize what is important, what creates LONG TERM shareholder value, what to avoid and how to identify great management.

Honestly this book is one of my top reads so far this year. Before writing up this article I just read through it for the third time to get all the information out I missed the first couple times. It’s an easy read, and one of the most educational resources I have found in a long time. Don’t miss out! Used copies on amazon are about $8 as I write this – worth every penny!

Also used in this article is Berkshire Hathaway Letters to Shareholders, which can be found online here: http://www.berkshirehathaway.com/letters/letters.html

Or, if you want the collection in book form (and letters from 1965 to 1976 which are NOT available on Berkshire’s website) – Look here!

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Source

https://www.begintoinvest.com/william-thorndike-author-of-the-outsiders-2-qualities-that-make-a-great-ceo/