Many very smart people (e.g., Warren Buffett, Michael Mauboussin) are recommending William Thorndike’s book The Outsiders. Thorndike’s book describes certain attributes/methods of “top performing” CEOs. (page IX) What does the author mean by a “great” CEO? In short: “return relative to peers and the market” measured by “compound annual return to shareholders during their tenure.” (page IX)
1. The Outsider CEOs are “positive deviants… deeply iconoclastic” (page 3)- The way I interpret this “positive deviancy” is that they understand this fundamental truth: it is mathematically impossible to beat the market if you *are* the market. The author makes this point by including this quotation from John Templeton: “It is impossible to produce superior performance unless you do something different.” Being right doesn’t lead to superior performance if the consensus forecast is also right. To beat the market, your views and actions must be non-consensus and you must be right. Thorndike points out that the Outsider CEOs are committed to “thinking for themselves” (page 9) and avoid consultants and advisers like the plague. They “focus on key assumptions and did not believe in overly detailed spreadsheets” (page 200)
2. The Outsider CEOs are “masters of “capital allocation- the process of deciding how to deploy the firm’s resources” … capital allocation is investment, and as a result all CEOs are both capital allocators and investors.” (page XII) Warren Buffett has established a simple test for use in capital allocation:
“for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” (also page 225)
Determining the right “cost of capital” is a process where Thorndike seems to part ways with Warren Buffett.
For Warren Buffett: “Cost of capital is what could be produced by our second best idea and our best idea has to beat it.” “We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”
In short, Warren Buffett engages in an opportunity cost analysis and ignores what he feels are academic concepts, like “weighted average cost of capital” (WACC).
Warren Buffett starts with a risk free rate that he has decided is the 30 year US Treasury. He only buys companies that he feels have essentially no risk and yet are trading at a 25% or greater discount to “intrinsic value”, which gives him a “margin of safety.” Warren Buffett does not dial up a ‘hurdle rate’ to reflect risk and uncertainty. He instead requires a “margin of safety” to protect himself against his own potential mistakes. Margin of safety is like a safe driving distance on the freeway, it eliminates the need to predict what the other driver ahead of you will do. You react instead of trying to predict.
Thorndike uses a 20% hurdle rate on several occasions in the book. He arrives at this hurdle rate in a manner very different from Warren Buffett:
“Hurdle rate should be determined in reference to the set of opportunities available to the company and should generally exceed the blended cost of equity and debt (usually in the mid-teens or higher). (page 218-9)
Thorndike is referring to a weighted average cost of capital (WACC) computation which is the product of a complex formula. What does the WACC formula used by an academic look like?
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
To say that Warren Buffett and Charlie Munger dislike this formula and the process it represents is an understatement. At the 2014 Berkshire meeting Charlie Munger said: “I’ve never heard an intelligent discussion on cost of capital.” John Huber, who attended the 2014 meeting, described the interaction in this way:
“Both Buffett and Munger agreed that the term “cost of capital” is an abstract concept that is often used by CEO’s and CFO’s to justify investments or acquisitions (i.e. “We think this is “accretive” because the returns exceed our “cost of capital”). Buffett said he has sat in on thousands of these types of discussions where “the CEO has no idea what his cost of capital is” and “I don’t have any idea of what his cost of capital is either.” Buffett and Munger had a much better way to view cost of capital that I thought was much simpler. Buffett went on to say that the “deal test is whether $1 we retain produces more than $1 in market value… not ‘cost of capital’”. Classic Munger: “Cost of capital is stupid.” He went on to say that Warren’s test is the best way to view capital allocation and reinvestment opportunities within a business. “It’s simple: We’re right and they’re wrong”. …Buffett said that they are “always thinking in terms of opportunity costs.” Thinking in this manner, rather than some model that can be manipulated in a spreadsheet, is a much more productive way to analyze investment opportunities within a business.”
Specifically regarding “hurdle rates”, the two partners who run Berkshire have said before:
Buffett- “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”
Munger- “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”
Buffett and Munger might have significant problems with the way a 20% hurdle rate is presented by Thorndike in the book, despite the fact that Buffett endorses the book with a blurb and recommended it at the Berkshire annual meeting. They might say: Who has an second best investment alternative of 20% right now? If shareholders are distributed cash through share purchases or dividends, can they really earn 20% as a second best alternative? In his defense, Thorndike is perhaps referring to deals with a lot of risk that must include a substantial risk premium, as explained below.
So given all this discussion regarding the right measure of opportunity cost, what is reasonable right now in 2014? My suggestion circa May 2014 is to use 10% in most “ordinary” deals. To explain, investors can earn maybe 6% (real) in public markets right now over very long periods. For an ordinary deal involving an ordinary company which makes a basic consumer good or service that has been around for many years (e.g., one in which Warren Buffett might get involved) I would add in 400 basis points (4%) right now to reflect the fact that other similar private businesses can be bought with that sort of return and call it done.
What about “dialing up” that 10% cost of capital to reflect higher risk, for example in the technology industry? You can decide to increase the premium over the risk free rate or use a bigger margin of safety, but doing both is tricky since they are achieving the same thing. I say this despite the fact that Warren Buffett says: “You can’t compensate for risk by using a high discount rate.” Risk, uncertainty and ignorance are always present in making an investment, but whether you use a bigger margin of safety or add a bigger premium to the risk free rate seems like a personal choice given that they are two ways to do the same thing. That risk does not go away if you use a higher discount rate is a different issue than what rate is chosen based on opportunity cost. Warren Buffett advocates making no risk bets and having a buffer against mistakes in the form of a margin of safety, but that is not the only way to invest (even though it is a very wise way to invest).
Regarding the right risk premium if one does not take the “no risk plus margin of safety” approach, investing capital in improving a railroad line, is not investing in a new web service, is not providing communications services from a high altitude drone. The risk premium should be different for different investments and that requires judgment, which is one reason why investing is an art and not a science. For railroad improvement investments one might use 10-12% and at the other extreme investments in a communications service provided from high altitude service via high altitude drones might be 20%.
Trying to be very precise about cost of capital using an academic formula for WACC when the right risk premium is a matter of judgment with a large margin for error seems a waste of time and potentially misleading. Common sense is the best policy when it comes to opportunity cost. One of the smartest people I know puts it this way:
“cost of capital is an estimate of opportunity cost. Opportunity cost is the next best thing you can do with your money. In financial markets that are liquid, we generally assume that you can find multiple investments with similar risk and reward profiles. So the idea that is relevant is what I can earn on an alternative investment of similar risk. That is the cost of capital.”
It is worth pointing out that an ordinary investor who does not have the option of buying private companies as a second best alternative if given a divided of buyback proceeds from say Berkshire might have a second best alternative of investing the cash in a low cost portfolio of index funds/ETFS and therefore have a lower opportunity cost.
With public companies, Warren Buffett seems happy with paying 10x pretax earnings for a company that meets his criteria since he probably thinks 15% over the long-term is likely.
Warren Buffett pays more for private companies in part since he gets to manage the cash. On the value of float:
“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.’” (page 178)
Questions get more complex when a company is purchased or an investment is made based on optionality. For example, take the case of an evaluation of the merits of buying a company like YouTube when it was bought by Google or Whatsapp when it was bought by Facebook more recently. These decisions can’t be made by looking at a 15 year history of earnings and the technology involved is changing value in nonlinear ways. Buffett and Munger put that sort of decision in the “too hard pile” but a tech CEO has no such choice. Thorndike does not deal with valuing optionality and I won’t either here (though I have wrote posts regarding optionality here and here).
3. “They have the investor’s mind set.” The Outsider CEOs understand that a share of stock is a proportional share of a business and not just a piece of paper. Investing is done best when it is most businesslike, and vice versa. In other words, the better you are as an investor the better you are in business and vice versa. They are conformable with concentration of assets (avoiding standard diversification dogma). They would rather invest in a few things squarely within their circle of competence than speculate about the behavior of large masses of people.
4. They “emphasize cash flow over reported earnings”… “in all cases” the Outsider CEOs “focus on cash flow” and forgo the “holy grail of reported earnings.” (page 9) Jeff Bezos is a great illustration of this point, who has said:
“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.” “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”
Jeff Bezos is very focused on this “absolute dollar free cash flow metric.” You will see many people talk about Amazon’s focus on “growth” vs. margins, but the right focus is instead absolute dollar fee cash flow. Jeff Bezos spelled out his focus on absolute dollar free cash flow in his 2004 letter to shareholders. He is not about to run his company based on a ratio much beloved by someone outside the company, such as a Wall Street analyst. If you want to see Amazon’s approach to absolute dollar free cash flow generation taken even further, go to China and see Xiaomi and Alibaba up close.
5. They “optimize long term value per share not organizational growth” (page 10) “growth, it turns out, often does not correlate with maximizing shareholder value.” (page 11) Markets inevitably wiggle and simply by waiting out volatility the CEO can generate market outperformance. Morgan Housel writes:
“The reason stocks offer great long-term returns is because they are volatile in the short run. That’s the price you have to pay to earn higher returns than non-volatile assets, like bank CDs. Wharton professor Jeremy Siegel once said, “volatility scares enough people out of the market to generate superior returns for those who stay in.”
6. They resist the “institutional imperative.” (page 6) The primary work of Warren Buffett and Charlie Munger at Berkshire is: (1) capital allocation; (2) selecting and compensating top managers of businesses and (3) selecting the investments which make up the portfolio. The most important task in capital allocation for Warren Buffett and Charlie Munger is to take cash/earnings generated by a company like See’s Candies and deploy it to the very best opportunity at Berkshire.
Part of that capital allocation task is to avoid the “institutional imperative”:
“… rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.” Berkshire Hathaway Letter, 1989
7. “small number of … high probability bets” (page 16). The Outsider CEOs realize that opportunities which are substantially in your favor arise rarely so they are patient, prepared to act quickly and yet very aggressive when it is time. When you have the odds substantially in your favor bet big.
8. The Outsider CEOs don’t predict the future – they instead *wait* for the right conditions to exist and are prepared to act quickly and aggressively when that happens. “I like to steer the boat each day rather than plan way ahead into the future.” (page 53) We have lots of data about the present but zero data about the future.
9. In acquisitions “the benchmark was a double digit after tax return without leverage” (page 30) “when the companies multiples were low relative to private market comparables, Murphy bought back stock.” (page 30)
The Outsider CEOs only buy companies or their own shares at a substantial discount to intrinsic value (i.e., private market value determined on a DCF basis using “owners earnings”).
The Outsider CEOs buy companies and their own company’s shares when markets are fearful and refrain from doing so when markets are greedy. This is straight up Ben Graham-style “Value Investing”. Warren Buffett, for example, will only buy Berkshire shares when certain conditions are met:
“Buffett told shareholders in his annual letter that in order to trigger repurchases, the stock would have to trade for 120 percent of book value or less. (A company’s book value refers to its assets minus liabilities, and not the size of the contract Michael Lewis could fetch for writing about it.) Berkshire is trading at 138 percent of book, or a price-to-book ratio of 1.38. The multiple hasn’t dipped below 1.2 since 2012.”
10. The Outsider CEOs “lead by example.” (page 20) They walk the talk. It is that simple.
11. “Hire well, manage little” (page 191). Pay in companies controlled by Outside CEOs is often above market to get the very best people who are trustworthy. This enables the Outsider CEO to implement a seamless web of deserved trust. Charlie Munger sets the stage on this point simply:
“A lot of people think if you just had more process and more compliance—checks and double- checks and so forth—you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.”… “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.”
12. Outsider CEOs are “master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest most local levels in their organizations.” (page 202) They push down decision-making on everything but capital allocation and choosing and compensating senior executives. They “delegate to the point of anarchy.” (page 24)