The Outsiders - William N. Thorndike, Jr.

"An outstanding book about CEOs who excelled at capital allocation." - Warren Buffett

These managerial standouts, the ones profiled in this book, ran companies in both growing and declining markets, in industries as diverse as manufacturing, media, defense, consumer products, and financial services. Their companies ranged widely in terms of size and maturity. None had hot, easily repeatable retail concepts or intellectual property advantages versus their peers, and yet they hugely outperformed them.

They seemed to operate in a parallel universe, one defined by devotion to a shared set of principles, a worldview, which gave them citizenship in a tiny intellectual village. Call it Singleton-ville, a very select group of men and women who understood, among other things, that:

-Capital allocation is a CEO's most important job.

-What counts in the long run is the increase in per share value, not overall growth or size.

-cash flow, not reported earnings, is what determines long-term value.

-Decentralized organizations release entrepreneurial energy and keep both costs and “rancor” down.

-Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc,) can be distracting and time-consuming.

-Sometimes the best investment opportunity is your own stock.

-"With acquisitions, patience is a virtue... as is occasional boldness.

The outsider CEOs had neither the charisma of Walton and Kelleher nor the marketing or technical genius of Jobs or Zuckerberg. In fact, their circumstances were a lot like those of the typical American business executive. Their returns, however, were anything but quotidian. As figures P-l and P-2 show, on average they outperformed the S&P 509 by over twenty times and their peers by over seven times-and our focus will be on looking at how those returns were achieved.

CHAPTER 1 A Perpetual Motion Machine for Returns

The hallmark of the company’s culture-extraordinary autonomy for operating managers—was stated succinctly in a single paragraph on the inside cover of every Capital Cities annual report: "Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs. All decisions are at the local level.... We expect our managers... to be forever cost conscious and recognize and exploit sales potential.”

Headquarters staff was anorexic, and it’s primary purpose was to support the general managers of operating units. There were no Vice Presidents I’m functional areas like marketing, strategic, planning, or Human Resources; no corporate counsel and no public relations department (Murphy's secretary fielded all calls from the media). In the Capital Cities culture, the publishers and station managers had the power and prestige internally, and they almost never heard from New York if they were hitting their numbers. It was an environment that selected for and promoted independent, entrepreneurial general mangers. The company's guiding human resource philosophy, repeated ad infinitum by Murphy, was to "hire the best people you can and leave them alone." As Burke told me, the company's extreme decentralized approach "kept both costs and rancor down.”

CHAPTER 2 An Unconventional Conglomerateur Henry Singleton and Teledyne

Buffett and Singleton: Separated at Birth?

Many of the distinctive tenets of Warren Buffett’s unique approach to managing Berkshire Hathaway were first employed by Singleton at Teledyne. In fact, Singleton can be seen as a sort of proto-Buffett, and there are uncanny similarities between these virtuoso CEOs, as the following list demonstrates.

- The CEO as investor. Both Buffett and Singleton designed organizations that allowed them to focus on capital allocation, not operation. Both viewed themselves primarily as investors, not managers.

- Decentralized operations, centralized investment decisions. Both ran highly decentralized organizations with very few employees at corporate and few, if any, intervening layers between operating companies and top management. Both made all major capital allocation decisions for their companies.

-Investment philosophy. Both Buffett and Singleton focused their investment in industries they knew well, and were comfortable with concentrated portfolios of public securities.

-Approach to investor relations. Neither offered quarterly guidance to analysts or attended conferences. Both provided informative annual reports with detailed business information.

-Dividends. Teledyne, alone among conglomerates, didn’t pay a dividend for its first twenty-six years. Berkshire has never paid a dividend.

-Stock splits, Teledyne was the highest-priced issue on the NYSE for much of the 1970s and 1980s. Buffett has never split Berkshire's A shares (which now trade at over $120,000 a share).

CHAPTER 4 Value Creation in a Fast-Moving Stream John Malone and TCI

Malone actively cultivated relationships with the major cable companies, and after two years he was simultaneously courted by two of the largest operators: Steve Ross of Warner Communications and Bob Magness of Tele-Communications Inc. (TCI). Despite a salary that was 60 percent lower than Ross's offer, he chose TCI because Magness offered him a larger equity opportunity and because his wife preferred the relative calm of Denver to the frenetic pace of Manhattan.

The Edifice Complex

There is an apparent inverse correlation between the construction of elaborate new headquarter building and investor returns. As an example, over the last ten years, three media companies—The New York Times Company, IAC, and Time Warner—have all constructed elaborate, Taj Mahal-like headquarters towers in midtown Manhattan at great expense. Over that period, none of these companies has made significant share repurchases or had market-beating returns. In contrast, not one of the outsider CEOs built lavish headquarters.

By 1977, TCI had finally grown to the point that it was able to entice a consortium of insurance companies to replace the banks with lower-cost debt. with lower-cost debt. With his balance sheet stabilized, Malone waslmaSyTble to go on the offensive and implement his strategy for TCI, which was highly unconventional and stemmed from a central strategic insight that had been germinating since he joined company.

Malone, the engineer and optimizer, realized early on that the key to creating value in the cable television business was to maximize both financial leverage and leverage with suppliers, particularly programmers, and that the key to both kinds of leverage was size. This was a simple and deceptively powerful insight, and Malone pursued it with single-minded tenacity. As he told longtime TCI investor David Wargo in 1982, " The key to future profitability success in the cable business will be the ability to control programming costs through the leverage of size.

In a cable television system, the largest category of cost (40 percent of total operating (HBO, MTV, ESPN, etc.). Larger cable operators are able to negotiate lower programming costs per subscriber, and the more subscribers a cable company has, the lower its programming cost (and the higher its cash flow) per subscriber. These discounts continue to grow with size, providing powerful scale advantages for the largest players.

Thus, the largest player with the lowest programming costs would have a sustainable advantage in making new acquisitions versus smaller players-they would be able to pay more for a cable company and still earn the same or better returns, thereby creating a virtuous cycle of scale that went something like this: if you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on ad infinitum. The logic and power of this feedback loop now seems obvious, but no one else at the time pursued scale remotely as aggressively as Malone and TCI.

Related to this central idea was 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 acquisition with pretax cash flow.

It's hard to overstate the unconventionality of this approach. At the time, Wall Street evaluated companies on EPS. Period. For a long time, Malone was alone in this approach within the cable industry; other large cable companies initially ran their companies for EPS, only later switching over to a cash flow focus (Comcast finally switched in the mid-1980s) once they realized the difficulty of showing EPS while growing a cable business. As longtime cable analyst Dennis Leibowitz told me, "Ignoring EPS gave TCI an important early competitive advantage versus other public companies.”

While this strategy now seems obvious and was eventually copied by Malone's public peers, at the time, Wall Street did not know what to make of it. In lieu of ePS, Malone emphasized cash flow to lenders and investors, and in the process, invented a new vocabulary, one that today’s managers and investors take for granted. Terms and concepts such as EBITDA (earnings before merest, 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.

Malone's creativity further evidenced itself in a wave of joint ventures in the late 1970s and early 1980s in which he partnered with promising young programmers and cable entrepreneurs. A partial list of these partners reads like a cable Hall of fame roster, including such names as Ted Turner, John Sie, John Hendricks, and Bob Johnson. In putting these partnerships together, Malone was in effect an extremely creative venture capitalist who actively sought young, talented entrepreneurs and provided them with access to TCI's scale advantages (its subscribers and programming discounts) in return for minority stakes in their businesses. In this way, he generated enormous returns for his shareholders. When he saw an entrepreneur or an idea that he liked, he was prepared to act quickly.

Beginning in 1979, when he famously wrote Bob Johnson, the founder of Black Entertainment Television (BET), a $500,000 check at the end of their first meeting, Malone began to actively pursue ownership stakes in programming entities, offering in rea potent combination of start-up capital and access to TCI's millions of households. Malone led a consortium of cable companies in the bailout of Ted Turner's Turner Broadcasting System (whose channels included CNN and The Cartoon Network) when it flirted with bankruptcy in 1987; and by the end of the 1980s, TCI's programming portfolio would include Discovery, Encore, QVC, and BET in addition to the Turner channels. He was now a significant owner of both cable systems and cable programming.

The Nuts and Bolts

As Malone sought to achieve scale by growing his subscriber base, three primary sources of capital were available to him in addition to TCIs robust operating cash flow: debt, equity, and asset sales. His use of each of these resources was distinctive.

Malone pioneered the active use of debt in the cable industry. He believed financial leverage had two important attributes: it magnified financial returns, and it helped shelter TCl's cash flow from taxes through the deductibility of interest payments.

Malone targeted a ratio of five times debt to EBITA and maintained it throughout most of the 1980s and 1990s.

Malone occasionally and opportunistically sold assets. Malone carefully managed the company’s supply of net operating losses (NOLs), accumulated over years of depreciation and interest deductions, which allowed him to sell assets without paying taxes.

Another key source of capital at the company was taxes not paid. As we've seen, tax minimization was a central component of Malone's strategy at TCI, and he took Magness's historical approach to taxes to an entirely new level. Malone abhorred taxes; 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. The internal tax team met monthly to determine optimal tax strategies, with meetings chaired by Malone himself.

CHAPTER 5 The Widow Takes the Helm Katharine Graham and The Washington Post Company

In 1971, on the advice of her board, she file d to take the company public in order to raise capital for acquisitions. Within a week of the offering, the newspaper became embroiled in the Pentagon Paper crisis, which presented an opportunity to publish a highly controversial (and negative) internal Pentagon assessment of the war in Vietnam that a court had barred the New York Times from publishing. The Nixon administration, fearing a fresh wave of negative publicity on the war, threatened to challenge the company’s broadcast licenses if it published the report. Such a challenge would have scuttled the stock offering and threatened one of the company's primary profit centers. Graham, faced unclear legal advice, had to make the decision entirely on her own. She decided to go ahead and print the story, and the Post’s editorial reputation was made. Nixon administration not challenge the TV licenses, and the offering, which raised $16 million, was a success.

Ironically, in the early 1980s, the management consulting firm McKinsey advised the company to halt its buyback program. Graham followed McKinsey's advice for a little over two years, before, with Buffett's help, coming to her senses and resuming repurchase program in 1984. Donald Graham reckons this high-priced McKinsey wisdom cost Post shareholders hundreds of millions of dollars of value, calling it the "most expensive consulting assignment ever!”

Chapter 6 A Public LBO Bill Stints and Ralston Purina

He would eventually repurchase a phenomenons 60 percent of Ralston’s shares, second only to Henry Singleton among CEOs in this book, and he would earn very attractive returns on these buybacks, averaging a long-term internal rate of return of 13 percent.

He was, however, a very frugal buyer, preferring opportunistic open-market purchases to larger tenders that might raise the stock price prematurely.

Stiritz believed buyback returns represented a handy benchmark for other internal capital investment decisions, particularly acquisitions. As his longtime lieutenant, Pat Mulcahy, said, "The hurdle we always used for investment decisions was the share repurchase return. If an acquisition, with some certainty, could beat that return, it was worth doing.”

He preferred companies that had been under managed by prior owners; and, not coincidentally, his two largest acquisitions, Continental Baking and Energizer, were both small, neglected divisions within giant conglomerates.

Stiritz focused on sourcing acquisitions through direct contact with sellers, avoiding competitive auctions whenever possible.

Stiritz believed that Ralston should only pursue opportunities that presented compelling returns under conservative assumptions, and he sustained the false precision of detailed financial models, focusing instead on a handful of key variables:

- market growth

- competition

- potential operating improvements, and, as always,

- cash generation.

As he told me, “I really only cared about the key assumptions going into the model. First, I want to know about the underlying trends in the market: it’s growth and competitive dynamics.”

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 critical prerequisite for a CEO and the key to independent thinking: “without it, chief executives are that the mercy of their bankers and CFOs.”

His counsel was simple: “Leadership is analysis.”

Chapter 7 Optimizing the family firm Dick Smith and General Cinema

The transformational acquisition for Smith was the 1986 purchase of the Ohio-based American Beverage Company (ABC), the largest, independent Pepsi bottler in the country. Smith was familiar with the beverage business through his involvement with theater concessions, and when he learned that ABC might be for sale, he moved quickly. The deal as negotiated by Smith was both compelling (an attractive price of five times cash flow) and very large, equaling over 20 percent of the company’s enterprise value (EV) at the time. Smith leveraged his real estate expertise to creatively finance the purchase via a sale/leaseback of ABC’s manufacturing facilities (he is still justifiably proud of this coup).

He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second-and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a small number of large independents). Because Pepsi was the number two brand, it’s franchises often traded at lower valuation than Coke’s.

In buying ABC, Smith acquired a legitimate platform company-one that other companies could be added to easily and efficiently. As ABC developed scale advantages, Smith realized he could purchase new franchises at seemingly high multiples of the seller’s cash flow and immediately reduce the effective price through expense reduction,tax savvy, and marketing expertise. Acting on this insight, Smith aggressively acquired other franchises, including American Pepsi in 1973, Pepsi Cola Bottling Company in 1977, and the Washington, DC, franchise in 1977.

Gleacher was calling about Carter Hawley Hale (CHH), a publicy traded retail conglomerate that owned several department store and specialty retail chains. Leslie Wexner, the CEO of The Limited, had recently made a hostile takeover bid for CHH, and Gleacher had been hired to find a "white knight," a friendly investor who could buy a significant percentage of the stock and thwart a takeover.

Ives had an initially cool reaction to Gleacher's description, but as he listened, he sense a potentially significant opportunity. The timing was almost impossibly tight (they would need to respond by the following Tuesday), and Ives realized that any buyer who could perform to this unforgiving timetable would have enormous leverage in negotiating a transaction. Ives got off the phone and spoke to Dick Smith and the other top members of the management team. By 5 p.m. they were on a plane to CHH's corporate headquarters in Los Angeles.

They spent the weekend in intensive due diligence and negotiations and emerged Sunday evening with an agreement. On Monday (Patriots4 Day, a bank holiday in Boston) they hastily assembled a syndicate of three banks to finance the transaction, and by Thursday, a week and a day after Gleacher's initial call, the deal had closed. Smith and his management team had so refined their acquisition criteria and process that they were able to perform to this extraordinary timetable. Very few publicly traded firms could have moved so quickly on such a large transaction.

The CHH investment is an excellent example of Smith's opportunism and his willingness to make sizable bets when circumstances warranted. The transaction was both very large (equal to over 40 percent of GC’s enterprise value) and very complex. It was also very attractive. Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH. As Ives summarized to me, "At the end of the day, we borrowed money at 6-7 percent fully tax-deductible while earning 10 percent on tax advantages debt, plus we got a conversion option (which eventually allowed us to peel off the Neiman Marcus Group) and the option to buy Waldenbooks."2 Hot a bad weekend's work.

The Nuts and Bolts

Smith evolved a distinctive approach to managing General Cinema's operations. He ran the company in close collaboration with a coterie of three top executives: chief financial offer Woody Ives, chief operating officer Bob Tarr, and Corporate Counsel Sam Frankenstein. He officially designated this group the Office of the Chairman, or the OOC. The OOC net weekly, and Smith actively encouraged debate among his top executives.

Smith was even willing to be outvoted by the other OOC members. "He gave me permission to publicly disagree with him in front of the Board. Very few CEOs would have done that.”

General Cinema operated with a very lean corporate staff. The company had its corporate headquarters next to one of its theaters in the rear of a nondescript shopping mall in Chestnut Hill, Massachusetts.

Compensation for top executives was, in Smith’s words, “competitive but not extraordinary.” However, the company did offer equity to key managers through options and a generous stock purchase program in which the company matched employee investment up to a stated maximum level. The net effect of these initiatives, according to Woody Ives, was that the executive team “felt like owners... we were all shareholders and behaved as such.”

CHAPTER 8 The Investor as CEO Warren Buffett and Berkshire Hathaway

Immediately after buying control of Berkshire, Buffett installed a new CEO, Ken Chance. In the first three years under Chance’s leadership, the company generated $14 million of cash as Chance reduced inventories and sold off excess plants and equipment, and the business experienced a (rare) cyclical burst of profitability. The lion’s share of this capital was used to acquire National Indemnity, a niche insurance company that generated prodigious amounts of cash in the form of float, premium income generated in advance of losses and expenses. Buffet invested this float very effectively, buying both publicly traded securities and wholly owned businesses, including Omaha Dun, a weekly newspaper in Omaha, and a bank in Rockford, Illinois.

His contrarian insight was that companies with low capital needs and the ability to raise prices were actually best positioned to resist inflation’s corrosive effects.

This led him to invest in consumer brands and media properties-businesses with "franchises," dominant market positions, or brand names. Along with this shift in investment criteria came an important shift to longer holding periods, which allowed for long-term pretax compounding of investment values.

It is hard to overstate the significance of this change. Buffet was switching 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 relief now on discounted cash flows and private market values instead of Graham’s beloved net working capital calculation. It was not unlike Bob Dylan’s controversial and roughly contemporaneous switch from acoustic to electric guitar.

The Nuts and Bolts

Buffett’s exceptional results derived from an idiosyncratic approach in three critical and interrelated areas: 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 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.

The company's primary source of capital has been flit from its insurance subsidiaries, although very significant cash has also been provided by wholly owned subsidiaries and by the occasional sale of investments. Buffet has in effect created a capital “flywheel” at Berkshire, with funds from these sources being used to acquire full or partial interests in other cash-generating businesses whose earnings in turn fund other investments, and so on.

As Charlie Munger has said about Berkshire's approach to acquisitions, "We don't try to do acquisitions, we wait for no-brainers."

In a company with over 270,000 employees there are only 23 at corporate headquarters in Omaha. There are no regular budget meetings for Berkshire companies. 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.

The Outsider's Checklist

1. The allocation process should be CEO led, not delegated to finance or business development personnel.

2. Start by determining the hurdle rate- the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).

Comment: Hurdle rates should be determine in reference to the set of opportunities available to the company and should generally exceed the blended cost of equity and debt capital (usually in the midteens or higher).

3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions.

Comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic-it is often corporate code for low returns.

4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.

5. Focus on after-tax returns, and run all transactions by tax counsel.

6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.

7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees-how does this compare to your peer group?)

8. Retain capital in the business only if you have confidence you can generate returns over time that are above Your hurdle rate.

9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse dividends can be tax inefficient.

10. "When prices are extremely high, it's OK to consider selling businesses or stock. It's also OK to close underperforming business units if they are no longer capable of generating acceptable returns.