Book-review: The Outsiders by William Thorndike

Capital allocation is of utmost importance for exceptional long-term shareholder returns, and should be handled by CEOs accordingly! …

For that reason I featured The capital allocation guide for CEOs as a must read in Food for Thought (#11). It is one of the best pieces on the very important topic of Capital Allocation. Its importance for long-term shareholder returns can hardly be overstated.

I watched William Thorndike’s google talk interview some months ago and decided to read his book. The interview pretty much provides the same content/message as the book in a compressed format. But I like good books! They usually offer an incredible return on investment and provide a welcoming setting in contrast to todays fast paced 140 280 character messages)

The book is about eight outstanding CEOs and how they achieved outstanding shareholder returns over their serving term. The refused to behave like their peers (institutional imperative) and they share a handful of traits regarding capital allocation …

An irrelevant note: academically/statistically that might not be useful for investing because he is backward looking / asking what traits did those outstanding CEOs achieve. The correct method would be to look at CEOs ‘before knowing’ the outcome.
– Of course I could be wrong here or miss sth. regarding their methodology and/or one could state that CEOs buying back large quantities of shares without delivering superior returns did not possess the necessary skills.

Capital allocation is to decide how to use capital or cash available to ‘your firm’. You get capital from operations (internal cashflows), from issuing debt or equity, or from divestitures (selling assets). Capital can be used for investing in existing businesses (maintenance or growth investments like machines), buying other companies, pay down debt, paying dividends to shareholders or repurchasing outstanding shares of your own firm – to do that profitably, good CEOs must act like good investors (and know the likely fair value of their companies).

own chart, was an auto suggestion from MS office

Good CEOs and investors focus on long-term value per share and manage their operations/investments according to this goal.

A focus on cashflows (not on wallstreet’s heralded) earnings and EpS is needed for good capital allocation. Further, it helps to understand minimizing payable taxes, or at least deferring tax payments.

Using debt can enhance shareholder returns considerably over the long-term. Equity returns are leveraged and interest expenses are mostly treated with a tax advantage – but at the same time risk increases, accord to my General Risk Framework for Companies. If the business is quite predictable, leverage might be the way to go (for example Malone used considerable leverage building his cable empire)!

Selling of business units at attractive prices can greatly enhance longterm shareholder returns. Often times, the individual units profit from a more focused and flexible management (sometimes with incentives better aligned).

Equity issuance was not used frequently by the eight outstanding CEOs, but at least one used his overpriced stock as an acquisitions currency to buy other (relatively cheaper) companies – again, having a rough estimate of your company’s fair value is important! and should enable you to …

buy back own shares opportunistically in large quantities if available at low prices (relative to fair value). Often they are more tax efficient than paying dividends to shareholders.

Investments in operations need to be thoroughly evaluated for their return character, risks involved and possible optionality. Weighing available investment opportunities against both, a minimum hurdle rate and other projects is essential. Again, CEOs and investors are alike: looking at a watchlist with possible securities with fair value estimates and some overall quality/risk scores attached is very much the same task – it’s both capital allocation!

Buying other companies might be a good option for superior long-term returns, if CEOs act as careful investors (often they do not and are more interested in empire building, increasing their personal stance/celebrity/wage/bonus/quality of dinners and networks). Logically, M&A projects should deliver higher (estimated) returns than internal projects since a CEO has a much better (realistic) view of his own company vs another company. As Damodaran says, the expression strategic acquisition is often business lingo for low-returns and projected/communicated synergies are to be treated with care.

Paying down debt or more generally to increase net cash might be the preferable option if no high-return projects/investments are available at the time.

I hope you enjoyed my book-review of The Outsiders. If you like reading books and want to learn more details than in Thorndike’s interview referenced above, I can strongly recommend the book to you – he performed rigorous research toghether with HBS students for his analysis. Because the topic of capital allocation is so important, I will constantly add new info on the topic on a micro page About Capital Allocation (work in progress) …


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