We Study Billionaires - The Investor’s Podcast Network - TIP555: Lessons from the World's Greatest Capital Allocators

Starting point is 00:00:00 You're listening to TIP. Hey, everyone, welcome to the Investors podcast. I'm your host, Clay Fink. On today's episode, I'll be doing a review of one of Warren Buffett's very favorite investment books called The Outsiders by William Thorndyke, Jr. This book explains how the world's greatest capital allocators delivered exceptional returns to shareholders during their tenures as CEO. The book outlines a number of different CEOs, but this episode focuses on Henry Singleton from

Starting point is 00:00:29 Teledyne, Catherine Graham from The Washington Post, and TIP's favorite Warren Buffett from Berkshire Hathaway. Exceptional capital allocators are very rare, and I've found it helpful to read a book like this to understand what excellent capital allocation looks like so I can hopefully identify it myself when I see it in managers of today's public companies. Without further delay, I hope you enjoy today's episode covering William Thorndyke Jr.'s book, The Outsiders. You are listening to The Investors Podcast, where we study the financial markets and read the books

Starting point is 00:01:07 that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. So as I mentioned at the top, The Outsiders is one of Warren Buffett's very favorite books, and it's always interesting to study successful companies and successful CEOs, so I figured it would be great to cover this book on the show. This book was written by William Thorndyke Jr., and it was published all the way back in 2012. On the cover, there's this quote from Warren Buffett that states that this is an outstanding book about CEOs who excelled at capital allocation. So it's a great book to read if you want to learn about CEOs and managers who are exceptional at their job and deliver really strong returns for their companies.

Starting point is 00:01:57 In the preface of the book, it says that the way to evaluate a CEO's greatness is to look at three things. First is the annual return to shareholders during their tenure. Second is their return relative to the peers in their industry. And third is their return relative to the overall markets such as something like the S&P 500. You can't just look at one of these items individually because there may be some funky things happening where maybe a company has a huge tailwind in the industry they're in and they're trailing their peers or maybe the CEO just operated during a period where stocks in general did really well. For example, if a gold miner sees the price of gold double in a year, even if the business

Starting point is 00:02:38 is poorly run, then odds are that the return to shareholders is still going to be pretty good, but it might not be good relative to a lot of other gold miners. Now, in the preface, one of the first CEOs they dive into is Henry Singleton, who founded a conglomerate called Teledyne in 1960. This guy was just a total genius as he was a world-class mathematician, and he enjoyed playing chess blindfolded. During World War II, he also developed a degossing technology that allowed allied ships to avoid radar detection, and in the 1950s, he created an inertial guidance system that is still in use in most military and commercial aircraft today.

Starting point is 00:03:19 Singleton was a very unconventional CEO during that period, as he aggressively repurchased shares when it was very unconventional to do so. he avoided dividends due to their tax and efficiency, and he emphasized cash flow over reported earnings and ran a famously decentralized organization, which is a theme we're going to see over and over again here. For almost 30 years that Singleton was CEO, shares of Teledyne compounded at 20.4% per year. One dollar invested in the company in 1963 grew to $180 by 1990 when he retired as chairman. Had you invested in the peer group, your dollar would only be worth $27, and if you invested in the S&P 500, it would only be worth 15. So we outperform the index by over 12 times when looking at the dollar figures here.

Starting point is 00:04:08 Like any great CEO, Singleton was a world-class capital allocator. He knew how to take a firm's resources to earn the best possible return for shareholders. To understand what makes a great capital allocator, we need to understand what successful capital allocation really means and how it's achieved. At the end of the day, CEOs need to do two things really well. They need to be able to run their operations efficiently and take the cash that's generated from operations and redeploy it in some way. Most CEOs focus on managing their operations, but oftentimes they neglect proper redeployment of the capital that's generated. Now, there's five things that a CEO can do with the capital that's generated by the company. They can invest in existing operations, they can

Starting point is 00:04:56 acquire other businesses. They can issue dividends, pay down debt, or repurchase shares of their company. Now, another list here, there are three ways a company can raise money. They can use internal cash flow, they can issue debt, or they can issue equity. This is essentially a toolkit for CEOs that they can use to try and deliver returns to shareholders. Long-term returns for shareholders are largely driven by how the CEO decides to manage the operations and then deploy the cash flow and then use these tools at their disposal. And despite capital allocation being so important for shareholder returns, it's largely ignored by business schools according to Thorndyke here. Buffett stated that, quote, the head of many companies are not skilled in capital

Starting point is 00:05:44 allocation. Their inadequacy is not surprising. Most bosses rise to the top, because they've excelled in an area such as marketing, production, engineering, etc. Once they've become CEOs, they now must make capital allocation decisions. It's a critical job that they may have never tackled and is not easily mastered. To stretch the point, it's as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead to be named Chairman of the Federal Reserve, end quote. Now, Singleton specifically delivered returns to shareholders primarily by doing two things. Teledyne made selective acquisitions, and then they conducted a series of large share repurchases.

Starting point is 00:06:29 Singleton was restrained in issuing shares. He made frequent use of debt and didn't pay a dividend until the late 1980s. He did all of this while the majority of his peers in the industry did the mirror opposite. The trouble with these unconventional CEOs is that they're so rare. It reminds me of how so few stocks end up outperforming over the long run. There was a study that looked at individual stock returns from 1926 to 2016, and it found that just 4% of companies accounted for all of the excess returns of the stock market above the U.S. Treasury rate.

Starting point is 00:07:04 That's one out of 20 companies, roughly, that generate the majority of the returns in the stock market. Thorndyke points out in his book that the real winners were really in many different industries, but they seemed to operate in a parallel universe and operated under a similar worldview. The outsider CEOs understood that capital allocation was a CEO's most important job, that what counts in the long run is the increase in per share value, not the overall growth or the size of the company, that cash flow, not reported earnings is important and creates value, that decentralized organizations release the entrepreneurial spirit and keep costs lower,

Starting point is 00:07:42 that independent thinking is essential to long-term success, interactions with the media and Wall Street is really a waste of time, and they knew that sometimes the best investment you can make is in repurchasing your shares and also that you should be patient in making acquisitions. Oftentimes the CEOs that were the outsiders usually lived far away from Wall Street and away from the noise, and that helped them act more unconventionally because they were outside of that eco-chamber of Wall Street. Thorndyke also found that these CEOs tended to be frugal, humble, analytical, and understated by the public.

Starting point is 00:08:19 They were family people and they weren't afraid to take time off to attend family events and their children's events, and it was really the opposite of the charismatic CEO that a lot of people imagine when they think of a successful CEO and a successful company. Both Thorndyke and Buffett believed that CEOs that exhibited these traits were extremely rare. In the intro, Thorndyke explains that most CEOs are like hedgehogs. They know one thing, and they know that one thing really well. The benefits of this is that they have strong expertise, they're specialized, and they're focused on that one area. But the outsider CEOs outlined in the book know many different things, and they're referenced in the book as foxes. Foxes are able to connect the dots between different fields, and they're able to innovate. They're more open to

Starting point is 00:09:07 trying new approaches to doing things, even if they're unconventional. Most CEOs fall prey to what Buffett calls the institutional imperative. We're just sticking to what other CEOs do so they can keep their job and prevent themselves from looking foolish relative to their peers. Outsider CEOs thought like owners. When their stock was cheap, they would go out and buy back shares. When their stock was expensive, they would consider issuing shares to make value accretive acquisitions with careful consideration. The 1970s were brutal times for the stock market with things like high inflation and many other headwinds. While times were uncertain and tough, outsider CEOs were implementing significant share repurchase programs or large acquisitions.

Starting point is 00:09:53 While all other CEOs were fearful, outsider CEOs were greedy looking for ways to allocate capital effectively. Since outsider CEOs were more like foxes, they typically entered their respective industries from the outside and with a fresh and new perspective, and they were always ready to innovate. Coming from the outside end, helped prevent them from falling for what Buffett called the institutional imperative. Wall Street wants CEOs to optimize quarterly earnings or net income, which most CEOs give into to try and optimize their share price in the short term. Then it's the outsider CEOs that put their focus on maximizing long-term shareholder value in maximizing long-term free cash flow.

Starting point is 00:10:35 Next, I wanted to dive into a few of the companies that are discussed in the book as examples of outsider CEOs. There are nine chapters in the book discussing eight or so different CEOs, and for this episode, I wanted to dive into just three of them for case studies. I'm particularly interested in diving more into the conglomerate that makes acquisitions, which was the case of Henry Singleton and Teledyne covered in Chapter 2. Buffett stated that, quote, Henry Singleton has the best operating and capital deployment record in American business.

Starting point is 00:11:07 And if one took the top 100 business school graduates and made a composite of their triumphs, their record would not be as good as Singleton's, end quote. Throughout much of the 1900s, most companies were expected to pay out a percentage of their profits as a dividend. And Singleton was adamant about dividends being tax inefficient because the company is taxed on their income and then shareholders would be taxed again on those debt. dividends. But not paying out dividends wasn't the only thing that Singleton did that was unconventional. He would adapt his capital allocation practices as the market conditions changed.

Starting point is 00:11:41 His approach differed significantly from most other companies. Thus, he achieved returns that were much different as well. In 1960, Singleton started Teledyne at 43 years old after he realized that he wasn't going to be CEO of Lytton, which was a firm he was previously working at at that time. I'm going to butcher this name. His colleague George Kempel. Metzky, who also worked at Lytton, started the company with them, and they started out by acquiring three small electronics companies and then quickly went public in 1961. Conglomerates like Teledyne can be a tough business model because if you have a lot of unrelated business units, then this might create inefficiencies that are less productive than if the

Starting point is 00:12:21 business units were all separate and standalone. But back in the 1960s, conglomerates enjoyed high valuations and high PE ratios, and this made it attractive for someone like Singleton to come in and make acquisitions that were value accretive. I was quite surprised to read that they were trading at high multiples because today it seems that many conglomerates trade at what's known as a conglomerate discount. A company like Berkshire Hathaway, for example, tends to trade slightly below the sum of their parts. So between 1961 and 1969, Singleton purchased 130 companies in a wide variety of different industries. The book states that all but two of these companies were acquired by Teledyne using pricey shares of stock so they issued equity to make

Starting point is 00:13:04 the acquisitions. So it was essentially like an arbitrage opportunity where Singleton, as he sold shares that he thought was high, and then he used the proceeds to buy companies that he thought were cheap. He focused on companies that were market leaders, they were profitable and growing, and oftentimes in niche markets. Singleton never paid more than 12 times earnings, intended to pay very low multiples while shares of Teledyne ranged from around a 20 to 50 times earnings. In 1967, Teledyne made their largest acquisition to date as Singleton acquired Vasco medals for $43 million and elevated Vasco's president George Roberts to be the president of Teledyne. This freed up Singleton to be totally focused on strategic and capital allocation decisions

Starting point is 00:13:49 and removed him from the operations of the business. In the middle of 1969, Teledyne's stock price started a fall, and the prices of acquisitions were starting to rise. So Singleton adapted by discontinuing his acquisition strategy because it was no longer attractive. And from that point on, Teledyne never made another material acquisition and never issued another share of stock. Then it shows this table of the company's financials from 1961 to 1971. Over that first 10 years as a public company, earnings per share grew by 64 times from 13 cents up to $8.55 and then sales grew by over $244 times from $4.5 million to $1.1 billion. As I mentioned earlier, part of Teledyne success was driven by that decentralized business

Starting point is 00:14:41 structure and it broke the company into its smallest parts. Teledyne pushed accountability and managerial responsibility as far down in the organization as possible. With over 40,000 employees, there were fewer than 50 people within the headquarters, and there wasn't a human resource, investor relations, or business development departments. Thorndyke writes, ironically, the most successful conglomerate of the era was actually the least conglomerate-like in its operations, end quote. Bureaucracy was essentially removed from Teledyne, and the incentives were set up in such a way that if managers did their job well, they would be compensated accordingly, and if they didn't, then they would move on and go to another company.

Starting point is 00:15:25 The business director attracted high performers who were great at what they did, and it detracted the masters of political games within organizations that really don't add value to shareholders. Now that the acquisition engine had turned off for Teledyne, their attention turned to the existing operations with the focus on optimizing free cash flow. They were paying out bonuses to managers based on the cash generated by each business unit. Singleton once told the Financial World magazine that, quote, 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, end quote. As they shifted more focus to internal operations, margins improved

Starting point is 00:16:11 and working capital was dramatically reduced for Teledyne. This generated significant cash flow in the process. Throughout the 1970s and 1980s, the return on assets averaged over 20%. Charlie Munger described these results as miles higher than anybody else. By early 1972, Teledyne had accumulated a pile of cash, and Singleton decided that the best use of that cash was to repurchase shares because he believed that they were too cheap. From then on, Teledyne went on an unprecedented share repurchasing spree by buying over 90% of outstanding shares and overturned long-held Wall Street beliefs. Thorndyke writes,

Starting point is 00:16:54 To say Singleton was a pioneer in the field of share repurchases is to dramatically understate the case. It is perhaps more accurate to describe him as the Babe Ruth of repurchasees, the towering Olympian figure from the early history of this branch of corporate finance. Prior to the early 1970s, stock buybacks were uncommon and controversial. The conventional wisdom was that repurchases signaled a lack of internal investment opportunity, and they were thus regarded by Wall Street as a sign of weakness, end quote. Munger has even said that no one has ever bought back shares as aggressively as Singleton did. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:21:34 That's Shopify. by.com slash WSB. All right. Back to the show. Singleton believed that buying stock at attractive prices was analogous to coiling a spring that at some point in the future would surge forward to realize full value, generating exceptional returns in the process. Singleton saw the power of share repurchases.

Starting point is 00:21:58 So whenever an investment opportunity was presented to him, he would consider whether the capital was better allocated towards the investment or by simply buying back more shares. Singleton knew very well that he only wanted to conduct share repurchases when the prices of those shares were attractively priced. And he was brilliant at doing so as his share repurchases achieved a 42% kegher for shareholders, according to Thorndyke. Great capital allocators are good at assessing where value is to be found. Singleton's average PE when he issued shares was around 25. And the average PE when he repurchased shares or bought them back was 8. So he was selling shares at 25 and buying them at 8 for the multiple. Singleton also helped

Starting point is 00:22:43 manage the insurance subsidiary stock portfolios during the mid-1970s, and he took advantage of attractive prices by increasing the total equity allocation from 10% in 1975 to 77% in 1981. Over 70% of that equity portfolio was concentrated in just five companies that he knew really well, And 25% of the portfolio was in the company he previously worked out, which is Lytton Industries. In turn, the book value of Teledyne's insurance operations increased by eight times from 1975 to 1985. By 1986, Singleton had turned Teledyne's focus to a conglomeration as he believed that there was a time to conglomerate and a time to deconglomerate.

Starting point is 00:23:29 Through the use of spinouts, Teledyne was able to simplify their overall operations while also unlocking value. That year in 1986, he spun out a company called Arkanaut, the company's workers' comp insurer, and in 1990 they spun out their largest insurance operation. And then in 1991, Singleton retired as chairman, and then he turned his attention to his extensive cattle ranching operations, and during his tenure from 1963 through 1990, as I mentioned, he delivered a kegger of 20.4% for shareholders, relative to just 8% for the S&B 500 and 11.6% for his peer companies.

Starting point is 00:24:07 Another great lesson to be learned by Singleton was that he was well aware that we definitely want to allocate capital effectively, but we also want to allocate our time effectively as well. He didn't assign any day-to-day responsibilities to himself, and he gave himself the freedom to do whatever he felt was in the best interest of Teledyne. He recognized the value in remaining flexible, as his demands for his time can change really quickly, and this allowed him to jump on new opportunities when they were presented, and he knew that these opportunities were really unpredictable. He never had a five- or 10-year master plan. He would just show up to work and steer the ship in the direction he felt was best at the time.

Starting point is 00:24:44 He also spent practically no time talking to the press or Wall Street analysts because he believed that it was an inefficient use of his time, which again was really unconventional. When the market would zig, he would zag, typically doing the opposite of what was popular, among other CEOs. In 1997, two years before he passed, when Singleton was asked about the large number of share repurchases happening, he said that if everyone is doing them, then there must be something wrong with them. Then Thorndyke lays out all these reasons why Singleton is so much like Warren Buffett. And since our audience tends to be more Buffett fanatics, I thought it would be great if we also covered Catherine Graham in this episode, who comes from the Washington Post.

Starting point is 00:25:26 Buffett actually started accumulating shares in the Washington Post in 1973, and he owned shares in the company until it got bought out by Jeff Bezos in 2014. Catherine Graham's husband, Philip Graham, became the CEO of the Washington Post in 1946. Philip ran the company really well until he unexpectedly took his own life in 1963, and this forced Catherine to take the role as CEO. Thorndyke writes, it is impossible to overstate Graham's unpreparedness for this position. At age 46, she was the mother of four and hadn't been regularly employed since the birth of her first child nearly 20 years

Starting point is 00:26:06 before then. With Phil's unexpected death, she suddenly found herself the only female CEO of a Fortune 500-sized company. This is just an incredible story. During Catherine Graham's tenure as CEO, she delivered a 22.3% return from 1971 through 1993, and then the S&P 500 delivered 7.4%, and then the peer group returned 12.4%. When Catherine first began her tenure with the company, she inherited a company that had grown significantly under Phil's leadership, and it owned a portfolio of media assets, including the Post itself, Newsweek magazine, and three television stations in Florida and Texas. In 1971, Graham took the company public so that she could raise capital for acquisitions. And Graham really helped the company grow as they took on these controversial stories regarding

Starting point is 00:26:59 the Vietnam War and investigations into the 1972 Republican campaign, and it established the Washington Post as the only journalistic peer to the New York Times. Then 1974 came around, and Buffett became a business mentor to Graham, and she invited Buffett to join the board of the company. In 1975, the company faced massive strikes from the union. The strikers even set fire to the printing facility, and Graham decided to fight the strike and managed to miss only one day of publication, and she got the paper out for 139 consecutive days prior to the union accepting concessions.

Starting point is 00:27:35 This success was a really critical point in Graham's career as CEO. Around this time, Graham also made the unconventional decision to buy back significant portions of their stock. This is similar to Singleton's line of thinking, as she repurchased almost 40% of the company's shares at rock bottom prices, which I'm sure Buffett was very happy to see at the time as he was a shareholder himself. None of the other newspapers followed her lead of repurchasing shares. By 1981, the post-long-term rival, The Washington Star, seized publication.

Starting point is 00:28:08 In this left Graham was their lean post-drike cost structure as the Monopoly Daily newspaper in the nation's capital, Washington, D.C. But the company was still operating with thin margins relative to their peers, which was resolved with the hire of Dick Simmons as C.O., which underscores the importance of hiring the right people after four previous C.O.S. couldn't get the job done. With Simmons now on board, the company's newspaper and television margins almost doubled, resulting in a surge in profitability. Throughout the 1980s, prices of newspaper companies skyrocketed, in great. Graham, for the most part, sat on the sidelines on acquisitions as competitors went on a buying frenzy.

Starting point is 00:28:50 When the time was right, though, Buffett did introduce Graham to the team at Capital Cities, which she acquired for $350 million in 1986. In the early 1990s, a recession hit which hurt Graham's peer companies, while she was well positioned to heavily reinvest back into their business. And then when Graham stepped down as chairman in 1993, the company was by far the most diversified amongst its newspaper peers, with over half its revenue and profits coming from non-print sources. As I share these success stories of Singleton and Graham, I'm reminded that there is no simple formula to success in business and in capital allocation. The market conditions are continually

Starting point is 00:29:30 changing, and CEOs need to have the foresight to recognize the environment that they're in and think independently and then make independent decisions rather than simply doing what everyone else is doing. Like many great capital allocators, Graham, for example, recognize the importance of having a strong balance sheet, but also not being too stubborn to never take on debt. Sometimes it's very advantageous and attractive to take on some levels of debt, such as when interest rates are abnormally low, or when a deal comes along that's so attractive that it can easily be used to pay down the debt in almost any feasible scenario and still deliver a really a good return for investors. Buffett being Graham's mentor would help guide Graham in her own journey,

Starting point is 00:30:13 especially with regards to acquisitions. In another key theme I found with these outsider CEOs is leading with an approach of sharing their thoughts rather than telling someone directly what they should be doing. If Graham approached Buffett regarding a deal, Buffett wouldn't tell her to do it or not to do it. He would maybe give his opinion on whether he would do it or not, and then the variables he would consider in making his decision. There's something about having someone think about all the variables themselves in owning their decision rather than just simply telling them what to do. It encourages a culture of independent thinking and having ownership over your own decisions, rather than always defaulting to the authority and outsourcing your thinking. In addition to being

Starting point is 00:30:57 an exceptional capital allocator, what also shouldn't be overlooked for Graham was her ability to attract and retain top talent to help lift the newspaper to the top of their field. In order to have an organization with decentralized decision-making, you need to have high-quality talent that can make the right decisions. Then there's a bit here written in the book chatting about the fall of the newspaper industry, which was a business that Buffett regarded as having a really strong moat and really strong competitive advantages. A number of businesses in the book can serve as great reminders for us that truly durable moats are really difficult to come by. In what might look like a durable mode today, maybe nothing of the sort

Starting point is 00:31:38 in 10 or 20 years time. I almost feel that I can't cover this book on famous capital allocators without telling the story of Warren Buffett, who is covered in Chapter 8. Buffett has famously said that he is a better businessman because he's an investor, and he's a better investor because he's a businessman. Berkshire Hathaway was a hundred-year-old textile company located in New Bedford, Massachusetts. Buffett executed a hostile takeover to take control of the company after an extended proxy fight. From an outsider's perspective, this was a pretty unlikely takeover as Buffett was 35 years old, he lived in Omaha, Nebraska, and he ran a small investment partnership out of his office. Buffett even had zero prior management experience. Now, Buffett had developed a close relationship

Starting point is 00:32:26 was the Chase family, who was one of the families who had owned Berkshire Hathaway for generations, and unconventionally, Buffett took over the company without using any debt at all. Buffett being the cigar butt-style investor, he was at this time, was primarily attracted to the company because it was cheap relative to its book value. Berkshire's market cap when Buffett took it over was only $18 million at the time, and the textile mill was anything but a great business. It was in a brutally competitive industry and had a weak market position at that time, too. Starting from an $18 million failing textile mill, Berkshire Hathaway today is worth over $700 billion,

Starting point is 00:33:06 which is over a 38,000 times increase in their market cap since 1965. Thorndyke writes, measured by the long-term stock performance, the formerly crew-cut Nebraska is simply on another planet from all other CEOs, end quote. Going back even further to look at Buffett's history, I did two consecutive episodes covering his whole history and story back on episodes 482 and 484 if you'd like to hear his whole story. But after working for Benjamin Graham and Graham shutting down his investment firm, Buffett moved back to Omaha to eventually start his own investment partnership.

Starting point is 00:33:42 And in the 13 years of operation, he beat the S&P 500 every single year without using any leverage and he primarily used Benjamin Graham's cigar but value investing approach. Early on in Buffett's career, two of the high-quality businesses he first invested in that strayed away from Graham's approach of Deep Value Investing were American Express and Disney in the mid-1960s. In 1969, Buffett had full control of Berkshire Hathaway and he shut down his investment partnership because he wasn't finding any great opportunities in the market anymore. And Thorndyke points out that this happens to be the same year that Henry Singleton from

Starting point is 00:34:19 Teledyne stopped making acquisitions. Buffett, however, kept ownership of Berkshire Hathaway to use as an investment vehicle for himself and the shareholders. Immediately after purchasing Berkshire, Buffett hired Ken Chase to be CEO, and under the first three years of Chase's leadership, the company actually generated $14 million in cash as inventories were reduced and Chase sold off excess plants and equipment. They also happened to experience a rare burst in profitability as well, and then a lot of that $14 million in cash was used to purchase National Indemnity, the insurer, out of Omaha. As many of the listeners know, Buffett loved that national indemnity had float that could be invested before claims were paid out to the insureds. Once the 1970s hit and we entered the 1980s, conventional wisdom was that inflation was here to stay,

Starting point is 00:35:09 and the place to invest was gold in commodities rather than stocks. That was just the hot investment at the time in what was working. As Howard Marks taught us in his most recent interview, when people hop on a trend, they tend to take things too far. People just piled into the hot and popular trade of hard assets and they left stocks completely unloved and undervalued, which we know that Buffett definitely took advantage of. Rather than hopping on the bandwagon of hard assets, Buffett and Munger came to a different conclusion on where to best allocate their capital. His contrarian insight was that companies with low capital needs and the ability to raise prices were actually best positioned to win the battle

Starting point is 00:35:48 against inflation. Thorndyke explained that Buffett then went on to purchase consumer brands and media property businesses with dominant market positions or strong brand names. Along with this investment criteria, Buffett also shifted towards longer holding periods, allowing long-term pre-tax compounding of his investments. The longer capital gains taxes were deferred, the more the force of compounding could boost the value of Berkshire. By the end of the 1970s, Buffett had collected large stakes in wonderful companies, including Seas Candy, Buffalo News, and positions in public companies such as the Washington Post, Geico, and General Foods.

Starting point is 00:36:25 Then throughout the 1980s, Buffett purchased a number of wholly owned companies. And then prior to the 1987 crash, Buffett had sold out of all of his stocks in his insurance company portfolio except for three core positions, which included Capital Cities, Geico, and the Washington Post. Then in 1989, Buffett announced the largest investment in Berkshire's history, which was equal to one-fourth of Berkshire's total book value. And this was the investment in Coca-Cola. Over the years to come, Buffett continued to focus on what worked so well. This was purchasing wonderful businesses, whether that be in the public equity markets

Starting point is 00:37:01 or purchasing wholly owned businesses. Another common theme you'll find with Buffett and many of these other outsider CEOs is that they invest very opportunistically. When the overall market is fearful, you'll find Buffett taking action, whether that be in the inflationary 1970s, the late 1980s after the Black Monday crash, or after 9-11 in the early 2000s. Oftentimes, he would go years of making no major purchases. And during the mid-2000s, Buffett largely sat on the sidelines as markets essentially became pretty euphoric. Once the great financial crisis struck, Buffett entered one of the most active periods of his investment career as Berkshire purchased the United States

Starting point is 00:37:43 largest railroad Burlington Northern Santa Fe in early 2010 for $34 billion. At the time the book was published, which again was 2012, Buffett delivered a 20.7% annual return from 1965 through 2011, while the S&P 500 delivered 9.3%. If you ever need a reminder of just how powerful compounding can be, just take a look at Berkshire's track record. Not that any of us can be like Buffett or anything, but because it shows how investing successfully for a long period of time leads to truly amazing results. One dollar invested with Buffett when he took over Berkshire Hathaway would be worth $6,265 after 45 years. And that equivalent amount invested in the S&P 500 would be worth $62, which I'm assuming doesn't have dividends reinvested.

Starting point is 00:38:34 I'm not 100% sure. I'm just going off the book here. These stellar results were derived from three key things by Buffett. Capital generation, capital allocation, and management of operations. Charlie Munger has said that the secret to Berkshire's long-term success has been its ability to generate funds at 3% and invest those funds at 13%. And they were able to do this consistently, and it's been an underappreciated contributor to their remarkable success, according to Thorndyke. Rather than investing with capital that was financed with equity or debt, Buffett largely preferred to invest with capital that was generated within the business. The flywheel Berkshire had was that they owned businesses that generated great profits,

Starting point is 00:39:18 and those profits would then be used to purchase great businesses at fair prices in order to generate more profits and go out and rents and repeat. Insurance was the keystone to Berkshire's growth over the years by a wide margin, and Buffett's purchase of national indemnity was absolutely necessary to achieve what they did, as even Buffett himself would call the moment of purchasing National Indemnity a watershed moment. He explained that, quote, Flo is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid,

Starting point is 00:39:51 an interval that sometimes extends over many years. During that time, the insurer invests the money, end quote. Buffett was also very strategic in how national indemnity operated. While most insurance companies emphasized growth in pre-exempties, premium volume sold to policyholders, National Indemnity prioritized profitable underwriting, which essentially means selling policies that offer an attractive risk-reward profile for national indemnity. And they also prioritized generating more flow that could then be invested. This approach led to more volatility in the results, but it was very profitable underwriting

Starting point is 00:40:26 results, as some years they would write a lot of business, and some years they would write very little. For example, in 1984, Berkshire's largest property and casualty company wrote $62 million in premiums. Two years later, premium volumes grew sixfold to $366 million issued. And by 1989, they had fallen back to $98 million and didn't return back to the $100 million level in premiums issued for another 12 years. So again, with writing insurance business, he was also very opportunistic. And he only doubled down and bet big when the odds were overwhelmingly. in his favor. As longtime TIP listeners know, Buffett believes that the key to long-term investing success is temperament and a willingness to be fearful when others are greedy and greedy when others are

Starting point is 00:41:12 fearful. This sort of management of an insurance business would be forbidden for other insurers because they want consistent results and consistent growth. While Buffett once stated that, Charlie and I have always preferred a lumpy 15% return to a smooth 12% return. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:44:46 slash income. This is a paid advertisement. All right. Back to the show. Berkshire's strategy with insurance was extremely successful as float grew enormously. In 1970, it was $237 million, and then in 2011 it was $70 billion. As Thorndyke puts it, this growth in their float was rocket fuel for Berkshire's phenomenal results. As I mentioned the flywheel earlier, the profits from wholly owned businesses also helped propel Berkshire forward. In 1990, pre-tax earnings from wholly owned companies were $102 million. and by 2000, that increased in $918 million. This comes out to a 24% kegher.

Starting point is 00:45:28 By 2011, wholly owned businesses accounted for $6.9 billion in pre-tax profits. Next, Thorndyth turns his attention to the capital allocation decisions made at Berkshire. While the operations are largely decentralized, capital allocation decisions were largely centralized. Whenever a company is purchased by Berkshire, the cash flow generated by the businesses, got sent to Buffett. Thorndyke states that this mix of loose and tight delegation and hierarchy was present at all the other outsider companies, but generally not to Berkshire's extreme degree, end quote.

Starting point is 00:46:04 In that quote, Buffett already an extraordinarily successful investor came to Berkshire uniquely prepared for allocating capital. Most CEOs are limited by prior experience to investment opportunities within their own industries, their hedgehogs. Buffett, in contrast, by virtue of his prior experience, evaluating investments in a wide variety of securities and industries

Starting point is 00:46:27 was a classic fox and had the advantage of choosing from a much wider menu of allocation options, including the purchase of private companies and publicly traded securities. Simply put, the more investment options a CEO has, the more likely they are to make high return decisions. And this broader palette has translated into a significant competitive advantage for Berkshire, end quote. With the exception of recent years after Thorndyke's book was written, Buffett practically never paid a dividend or repurchased significant amounts of stock. In fact, Buffett was the only CEO outlined in the book who did not buy back significant amounts of his company's shares. And this goes to show just how great he was at finding opportunities elsewhere. This, of course, changed as Buffett started

Starting point is 00:47:13 to dabble with buybacks in 2019, and he has since accelerated his buyback program, as his cash pile has continued to grow and his opportunity set has shrunk due to how much cash he has. Buffett cared so much about Berkshire shareholders that he truly treated them like partners, and he didn't want to buy out existing shareholders if he felt like they were getting a bad deal. He loved when a public equity holding that he owned repurchase shares, but felt a special culture at Berkshire due to that culture of treating shareholders like partners. From the very beginning, Buffett made exceptional capital allocation decisions. He originally purchased a textile mill, which was a business that was generating very low returns on capital, and that was invested into the business,

Starting point is 00:47:58 which was a business that was generating really low returns on capital. But because Buffett avoided reinvesting in that low return business and instead invested in businesses that generated high returns, Berkshire came out way ahead than all of the other textile businesses. From 1965 to In 1985, Berkshire compounded at 27% annually, while Burlington Industries, which was the world's largest textile business, compounded at a measly rate of 0.6% on average per year. Buffett could have decided he could transform the textile business and try and differentiate himself, but at the end of the day, it was largely a commodity business that generates low returns on capital. Rather than investing into a business like this, Buffett wound down and sold off

Starting point is 00:48:43 operations, as any great capital allocator would do. Once Berkshire finally closed their textile operations for good in 1985, he stated, quote, 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, end quote. Then Thorndyke touches on how Buffett approached investing in public equities, which again, he had an absolutely exceptional track record with. His portfolio management strategy is very much worse. studying as the world's greatest investor, because you can buy great businesses or great stocks,

Starting point is 00:49:18 but if you don't manage your portfolio properly, you may still end up with subpar returns. Buffett's portfolio strategy had two main characteristics. First is that he was highly concentrated into his best names, and second is that he had extremely long holding periods. Both of these are very unconventional and very, very important. One big reason for concentrating his portfolio is because the truly great ideal is are rare. And he repeatedly told students that their investing results would improve if at the beginning of their career, they were handed a 20-hole punch card representing the total number of investments they can make in their investing lifetimes. Looking at Berkshire's portfolio today,

Starting point is 00:49:59 he still stands by this approach of concentration. For just the stock portfolio on his 13F filing, Apple consists of almost 39% of it, and his top five holdings alone consists of 75% of the overall portfolio in his 13F. and this doesn't include international holdings or the wholly owned businesses. Related to the long holding periods piece, Thorndyke states that Buffett held many of his top positions for over 20 years. This compares to the average holding period of less than one year for the typical mutual fund. And then turning to Buffett's strategy with wholly owned businesses, he offers a highly differentiated option for sellers of private businesses. selling one's company to Berkshire allows them to achieve liquidity while continuing to run their

Starting point is 00:50:43 business without receiving calls from Wall Street, asking questions, or receiving scrutiny. When a business sold to Berkshire, they would never hear from Buffett unless they called him to ask him for advice or seek capital for their businesses. Buffett lets the operators run their businesses how they see fit, and he'll hold the company forever. And in private equity companies, which are Berkshire's competition, they promise a high level of investor involvement, and they typically only hold for around five years. Rather than participating in auctions for companies, Buffett simply says to give him a call and name your price. He doesn't do negotiations on valuation, and he promises to give an answer in typically five minutes or

Starting point is 00:51:23 less. This sort of approach forces sellers to move quickly to a reasonable or low price and ensures that his time is not wasted. Surprisingly, Buffett typically arrives at a deal in a matter of a few days. He never visits the operation facilities and rarely meets management before deciding on an acquisition. Tom Murphy from Capital Cities said that Capital Cities was one of the biggest investments Berkshire has ever made, and it only took 15 minutes to talk through the deal and agree on the terms. Buffett also spends no time communicating with Wall Street, such as communicating with analysts or whatnot. He estimates that the average CEO spends 20% of their time communicating with Wall Street, which he largely considers a waste of time. With regards to actually making the capital

Starting point is 00:52:09 allocation decisions, Buffett and Munger made all of them themselves at the time of this book, but we know today that Greg Abel does get to make some decisions himself that aren't significantly major purchases. During this year's 2023 meeting, Buffett even said that Greg understands capital allocation as well as he does. Buffett knows that eventually his time is going to come up as CEO, so he started to delegate those decisions to Greg Abel before he takes his place as the CEO. Buffett understands better than anyone that the number one job of a CEO is capital allocation. So he structured Berkshire in a way that optimizes for that. Berkshire took the idea of decentralization to the extreme.

Starting point is 00:52:50 According to Thorndyke, and again, this book was published back in 2012, Berkshire had over 270,000 employees, but there were only 23 individuals at the corporate headquarters in Omaha. There was none of this extra fluff at the headquarters that Buffett thought was totally unnecessary. And his approach to bringing on managers was to hire well and manage little. Thorndyke explains that this extreme form of decentralization increases the overall efficiency of the organization by reducing overhead and releasing the entrepreneurial spirit. Then, as all the listeners know, Buffett also writes very unconventional annual letters that look and read much different than other letters, and he seeks to attract

Starting point is 00:53:32 investors who think very long-term like he does. He wants long-term relationships with managers, with his businesses, and his shareholders. Thorndyke then closes out this chapter stating, To Buffett and Munger, there is a compelling, zen-like logic in choosing to associate with the best in an avoiding unnecessary change. Not only is it a path to exceptional economic returns, it is a more balanced way to lead a life. And among the many lessons they have to teach, the power of these long-term relationships may be the most important. End quote.

Starting point is 00:54:06 And then the final chapter of the book is titled Radical Rationality, and this sort of wraps everything together from all the CEOs he studied, and he pulls in the common themes from all these outsiders. There are a couple of quotes here that I absolutely love at the start of the chapter. The first is by Ben Graham. You are right, not because others agree with you, but because your facts and reasoning are sound. And then the second quote from William Durechowitz,

Starting point is 00:54:30 what makes him a leader is precisely that he is able to think things through for himself, end quote. Then Thorndyke expands on this idea that I think is so important. When I was first starting out with investing, I really emphasized that the company is in a growing market and their top line revenues are going up. But as I've learned more and more about investing, what is actually more important than growth is capital allocation.

Starting point is 00:54:54 He uses the example of a company called prepaid legal services. The company had really strong growth in the 1980s and 90s, but management recognized that that growth was not likely to continue into the 2000s. And they recognized that investments in trying to grow weren't going to yield high returns for investors. Starting in late 1999, the CEO realized that the market was maturing and he began to put more focus on optimizing free cash flows than returning value back to shareholders through share repurchases. Despite the company's business being flat in the 2000s, their stock actually

Starting point is 00:55:29 increased by 4x, and it vastly outperformed the overall market in their industry peers during that time period, and the company actually bought back over 50% of their shares. So again, this is a great reminder that great capital allocation is much, much, much more important than being in a growing market. This story really reminds me of Home Depot as well over the past 10 or 15 years. Over the past decade, for example, Home Depot's stock has vastly outperform the market. But since 2011, their store counts are practically flat. This is because management took a very similar approach to capital allocation as prepaid legal services.

Starting point is 00:56:07 They optimize free cash flows and bought back significant amounts of stock. In 2010, Home Depot had 1.6 billion shares outstanding, and as of recording, they have just over $1 billion, so that's a 39% decline in the stock. their shares outstanding over that period. Good capital allocation really all just comes down to a math problem and running the numbers. Every investment generates some sort of return. Great capital allocators use conservative assumptions in estimating what those returns are going to be, and they focus on a few key assumptions rather than using some complex, very complex model. This framework for understanding capital allocation and why it's so important, I feel has helped me

Starting point is 00:56:48 so much as an investor. When you see a management team with a really strong track record of allocating capital effectively and then delivering strong returns to investors, I can't help but invest alongside them. And practically, I think of it as a partnership, even if a company is trading at what others would call an expensive valuation. The point that Gottem Bade made in his book, The Joy of the Compounding also comes to mind that the holy grail of long-term value investing is finding a company that can consistent consistently reinvest a lot of capital at high rates of return.

Starting point is 00:57:23 When you find that type of company and you have a long holding period, oftentimes the price paid does not matter as much as getting the business in the management right. Great capital allocators also focus intensely on maximizing per share value, rather than just simply growing the company's overall value through maneuvers like overpaying for acquisitions or investing in projects that provide a really low return. Sherry purchases, for example, can be very value accretive if done at attractive prices, but Sherry purchases themselves don't grow the company's overall value like an acquisition might do. Another interesting characteristic is that outsider CEOs are essentially the polar opposite

Starting point is 00:58:04 of the charismatic CEO that you see in the press all the time. Outsider CEOs are very private. They focus on their business rather than spending time with their investor relations. then they don't look for the spotlight. They just let their stock and business returns speak for themselves. These outsider CEOs understood the numbers behind their investments, and generally they were just much better than average at distinguishing a good investment from a bad one. When there was nothing but bad investments available to them, they had the temperament to be patient and wait for good opportunities to come back around as they always eventually did.

Starting point is 00:58:40 Exceptional capital allocation is just as much about avoiding bad investments as it is ensuring you're making good investments. I also can't help but think of all the companies out there today that are just buying back shares at any price and they just continuously buy back shares, whether their stock is trading at an attractive price or a high price, they just continually keep doing it. And then finally, all outsider CEOs had a very long-term time horizon and they viewed everything from a lens of maximizing long-term shareholder value and being comfortable with the fact that quarter-to-quarter results were going to be bumpy and probably volatile.

Starting point is 00:59:17 And Thorndyke makes a point that outsider CEOs were an extremely talented group, but the main advantage they had relative to their peers was one of temperament and not intellect. The topic of capital allocations seems so basic that it's amazing that exceptional capital allocators that can do it over a really long time seem so rare in today's world because they are. Due to what Buffett calls the institutional imperative, many CEOs either don't fully understand capital allocation and end up defaulting to how the typical CEO would act, whether that be appealing to Wall Street, overpaying for acquisitions, or continuously making decisions that don't offer a high return on their capital. All right, that wraps up today's episode. As you can probably

Starting point is 01:00:01 tell, I really cannot overstate the importance of capital allocation when assessing a business to invest in. Again, that quote from Godin Bade comes to mind on the holy grail of value investing that I mentioned earlier. All right, that's it for today's episode. Thanks a lot for tuning in. I hope to see you again next week. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network.

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We Study Billionaires - The Investor’s Podcast Network - TIP555: Lessons from the World's Greatest Capital Allocators

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