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Managing Equity Portfolios – Part 2 – Analysis – Chief Executive Officer as Chief Investment Officer

“Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.  Once they become CEOs, they face new responsibilities.  They now must make capital allocation decisions, a critical job that they may have never tackled and that 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.”
–       Warren Buffett – Letter to Berkshire Hathaway Shareholders, 1987

Shortly after initiating coverage of my first company as a sell-side equity research analyst, I attended a client dinner with the company’s management team.  Over the course of the meal, the CFO pulled me aside to ask my opinion of a recently announced share repurchase program.  The situation was unique, as the company had only recently gone public, presumably to raise needed funds for investment, and here they were a year later, admitting they had no other opportunities for investment in their business, save for buying back their own shares.

The question raised by this CFO is one we hear frequently from both investors and from senior executives at the companies we interact with:  “What do I do with my capital?” This is amongst the most pressing and frankly career-defining choices that a senior executive team for a company can wrestle with.

As Warren Buffett noted in his 1987 letter to shareholders, at a firm which retains 10% of its earnings, over a 10 year period, the CEO will be responsible for allocating almost 2/3rds of the total capital at work in the business.  We would argue that a 10% retention rate is quite low for most businesses, so the stakes are even higher. So for those who think CEOs are not investors, think again.

I recently finished reading The Outsiders by William Thorndike, a tremendous book which profiles 8 CEOs who generated extraordinary financial results during their tenure of leadership. Thorndike summarizes the common attributes of the 8 executives he profiles. “Each ran a highly decentralized organization; made at least 1 very large acquisition, developed unusual, cash flow-based metrics, and bought back a significant amount of stock [when it traded at a low price vs. intrinsic value].”

All 8 of the CEOs profiled exceeded the returns of Jack Welch during his 20-year tenure as Chairman and CEO of General Electric (1981-2001).  Welch is generally regarded as one of the all-time great CEOs in modern business history.

Compare Welch’s results to those of Henry Singleton (one of the profiled CEOs), who ran Teledyne from 1963-1990.  Over that period of time, Singleton delivered an annual return of 20.4%, beating the S&P 500 return by over 12 times.  Welch, while no slouch, benefited from a secular bull market for most of his tenure, and only outperformed the S&P 3.3x.

A few facts about Singleton / Teledyne:

  • Singleton eventually repurchased 90% of Teledyne’s shares outstanding
  • He avoided paying dividends, choosing instead to reinvest in his higher-return businesses
  • Company had very little interaction with Wall Street analysts and did not give short-term earnings guidance

As long-term, value-focused investors, assessing the capital allocation skills of a corporate management team is amongst the most important factors we review for each potential investment opportunity. While the CEOs profiled in The Outsiders followed similar playbooks and generated similar results, the bigger questions in our mind are 1) ‘What were the thought processes that led to these actions/results?’ and 2) ‘Are these identifiable in an ex ante fashion?’

While each CEO made pointed and direct choices about how best to allocate the capital generated by their respective enterprises, we would argue there are 4 key “tools” that support successful capital allocation.

First, these managers had a strong capital tracking discipline in place.  While finance theory and business schools teach managers to only invest in projects where the IRR (returns) exceeds the WACC (cost of capital), we often wonder how many managers actually track the returns of their projects on a 1-year, 5-year, 10-year basis?

The first step to allocating capital well is having the systems and processes in place to measure the effectiveness of capital allocation. Just as public market investors have regular updates on the performance of their portfolio, we would argue that companies should rigorously review and assess the returns generated from their investments. The natural temptation in business is to always be moving forward, to fight the next fire, to chase the next deal, launch the next product, etc. The task of retrospection must always be viewed in light of Santayana’s wise maxim, “Those who cannot remember the past are condemned to repeat it.”

The difficulty with making any decision is that the “future self” has a hard time recalling what the “past self” was thinking at the time the decision was made. Witness the natural justification behavior we all engage in after a large Thanksgiving meal. Companies must protect themselves from this natural behavior in order to accurately assess the success or failure of their prior decision making.

One way to overcome this difficulty is through the use of written analyses and writing down specific reasons for decision making. This allows us to retro-actively review how/when/why we made a particular decision.

Secondly, managers must have a strong understanding of the reinvestment characteristics of their business.  A CEO is faced with two primary decisions regarding capital allocation, to either add more capital to the business or to return capital to shareholders. The choice between each must be driven by a sober assessment of the industry dynamics in which they participate.

Those who work in a single industry, and especially those who have never left that industry, run the very real risk of having blinders on with regards to the characteristics of their own industry. All the reinvestment in the world is going to be hard pressed to generate incremental value in highly competitive industries with little strategic differentiation.  We see this constantly in capital intensive, cyclical industries where companies add capacity at the top of the cycle – take for example the cement or gypsum wallboard industries here in the U.S.  In these industries, management’s consistently overestimate the likely future profitability of their industry, and destroy shareholder value by over-investing at the peak of the cycle.

As Figure 1 highlights below, companies consistently generate large amounts of goodwill impairment. Recall goodwill in its simplest form is the difference between the price paid for an acquisition and the value of the acquired assets. This capital destruction represents the failure of management teams to accurately assess the reinvestment characteristics of their own industry, which skews them into overpaying for deals.

Figure 1. Goodwill Impairments, U.S. Companies ($ Billions)
Source: Duff and Phelps

As an aside, management compensation is generally tied to median compensation levels of other management teams at “peer group” set of companies. With such an incentive structure, it is not surprising that management teams choose the “reinvest” option, which grows a bigger company and therefore a more highly compensated “peer group” set, even if the reinvestment occurs at less attractive rates of return.

Thirdly, these CEOs sized their balance sheets and debt profiles conservatively and appropriately to their business model.  There is a level of debt appropriate to each business model, and it is largely a function of the return characteristics of the business, the volatility of the cash flow stream, and the cyclicality of the industry in which it participates.  By running at appropriate leverage (debt / EBITDA or cashflow) levels, the company is protected from the vagaries of the marketplace, and never finds itself in a position of being forced to raise capital. Just like a loan shark, the institutional credit market takes its pound of flesh when capital is least available and is most needed.

We are not anti-debt by any means.  Many businesses run quite well with higher levels of leverage, but they must take into account the items mentioned above.  John Malone, CEO of Tele-Communications, Inc. (TCI) is a perfect example of this.  Over the course of his roll-up strategy in the cable industry, he operated TCI near 5x of leverage, which was sensible given the stability of the cash flow stream – i.e. How many of you canceled your cable subscription during the economic crisis? QED.

We knew several companies in the recreational vehicle (RV) industry that were over-leveraged heading into the 2008 economic crash.  Operating a low margin, low barrier to entry, highly cyclical consumer discretionary company with a lot of leverage is a recipe for disaster in our view.  As soon as consumers pulled back on RV purchases, the ultimate consumer discretionary item, the cash flow streams of these businesses dissolved. After all, Nascar drivers aside, no one ever really needs an RV.

Contrast this with the appropriately leveraged business which is able to use periodic market crises to be buy assets when they are cheap.

Finally, they knew the value of their own stock.  Too many public company CEOs and CFOs do not know how to sensibly value their own company.  You see this with management teams that repurchase shares when the company’s stock is making new highs, but are suspiciously inactive when shares are hitting new lows (whereas ideally their actions would be the reverse).

The value of a business is simply what a sensible buyer is willing to pay for the stream of cash flows your business can be expected to generate.  How do you discern this value?  Why not pick up the phone and talk with some of your long-term investors and deep dive into how they think about valuing their business?  This is not the time to quibble about valuation multiples or models, but a time to understand what a rational, long-term holder is willing to pay.

So are these factors identifiable ex ante? These items are like the giant squid in our view. The giant squid is one of the largest living organisms in the world. Males of the species can grow to estimated lengths of more than 40 feet. While scientists had seen dead squid washed up on beaches, it was not until the past several years that they were able to film a living squid in the wild.

Like scientists observing a dead squid who can only make reasonable estimations about how the creature behaves in the wild, so too, investors have the entrails of capital allocation through which to make estimations about the future. The company’s historical record of capital allocation and returns are a reasonable place to start. Management’s candor in shareholder letters and in meetings with investors can provide other tell-tale clues. Proxy filings and employment contracts provide an open look at the behaviors management is being incentivized to engage in. The end result one believes is a reasonable estimation of capital allocation attitudes and approach for a given company.

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