Saturday, August 23, 2014

Book Review of The Outsiders

I finally got around to reading William Thorndike's The Outsiders -- a sure classic that I've added to the "must read" section of my recommended books on investing.

Looking through my Kindle copy of the book, I have 70 highlights and bookmarks, so going through all of them here would be a bit onerous to both read and write.

Instead, I want to focus on the core principles of eight CEOs that Thorndike lays out in the introduction.

With a nod to Buffett's Graham and Doddsville, which analyzes a group of investors who consistently beat the market by following the principles of Benjamin Graham and David Dodd, Thorndike calls his group of CEOs "Singletonville" after former former Teledyne CEO Henry Singleton.

While each CEO was dealt different sets of cards, they all played their hands incredibly well by understanding the following principles and putting them into action:
  • 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 is occasional boldness.
Right away, you'll notice that most CEOs don't embody these principles. In fact, if you invert each principle, you're closer to how most CEOs approach their jobs (with perhaps the exception of the sixth principle).

Even though Buffett's been writing about the importance of management's capital allocation decisions for decades, it's a topic that's been undercovered for much too long.

The reason it has flown under the radar, I believe, is that analyzing management is largely qualitative in nature and doesn't lend itself well to screening tools and Excel spreadsheets.

Measuring management

Indeed, it's generally only after the fact that a CEO's impact can be measured and appreciated. Thorndike writes, for instance, that "You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500)."

The key for investors, of course, is to identify these CEOs before they dramatically outperform the market and their peers.

And here is where understanding the capital allocation processes practiced by the CEOs in Thorndike's book come in handy. If you come across a CEO or management team with an approach that includes some of the principles mentioned above, you might be onto something.

The next step is to read the company's annual reports, understand how executives are incentivized, and reverse engineer management's capital allocation decisions to determine why and how management arrived at its decision to acquire a certain company, divest an asset, or repurchase its stock.

Just because a company may not be led by a member of Singletonville doesn't mean the company isn't worth owning. Elite capital allocators are few and far between; decent-to-good capital allocators, while still rare, are more common. Provided those decent-to-good capital allocators are running a company with durable competitive advantages, that can still be an attractive business to own at the right price.

Finally, the princples outlined by Thorndike in Outsiders can also help you avoid investing behind CEOs that are decidedly poor capital allocators, and ultimately that might be just as important as finding the elite CEOs.

What I've been reading this week

Stay patient, stay focused.


@toddwenning on Twitter

Wednesday, August 20, 2014

Buybacks Aren't Doing Much For Shareholders Right Now

"If everyone is doing (buybacks), there must be something wrong with them." 
- Henry Singleton, former Teledyne CEO (profiled in The Outsiders)

With the exception of 2009, gross buybacks have outpaced dividends paid by U.S. companies each year since 1997. As such, it's absolutely critical that investors -- even dividend investors -- take buybacks into consideration when evaluating companies.

But as Michael Mauboussin points out in a recent study on capital allocation, unlike dividends, which treat all shareholders equally:
In a buyback, selling shareholders benefit at the expense of ongoing shareholders if the stock is overvalued, and ongoing shareholders benefit at the expense of selling shareholders if the stock is undervalued. All shareholders are treated uniformly only if the stock price is at fair value.
In other words, when a company repurchases its shares at a discount to fair value, it's a good use of shareholder capital and ongoing shareholders make out quite well. However, relatively few management teams consistently buyback stock at opportunistic prices.

Indeed, the number of S&P 500 companies repurchasing shares and the amount spent on buybacks tends to follow the market.

While there are undoubtedly some companies making smart and opportunistic buyback decisions today, when the majority of companies are also buying back stock, it's not likely that companies on average are adding much long-term shareholder value with share repurchases.

Jim Chanos, in an interview with Barry Ritholtz, echoed these sentiments:
And when corporations embarked on massive buybacks across all industries and all companies, in effect these CEOs are buying the stock market. So what they’re telling you then, is unequivocally that they think that either they’re happy to earn the stock market rate of return or maybe something hopefully better. Or their rate of return on the margin of any new capital project is much much lower, in fact half or less of what is stated. And that does not bode well for the future of profits, or for the quality of earnings reported as current profits.
Any investor can earn the market rate of return on their own using low-cost index funds. We certainly don't need companies doing it on our behalf. If companies can't find projects (including their own stocks) that generate long-term value, that cash should be returned to shareholders via dividends. Let the shareholders decide how to reinvest the cash as they see fit.

Let me know what you think in the comments below or on Twitter @toddwenning

Stay patient, stay focused.



Friday, August 8, 2014

This is the Opposite of Real Investing

Innovation in finance is designed largely to benefit those who create the complex new products, rather than those who own them. - Jack Bogle 
Earlier this week, I came across an article about "math nerds taking over Wall Street" and thought it must have been republished from 2006 when quantitative strategies were in their heyday

Nope. A few years after the financial crisis broke their old can't-miss algorithims, the quants have returned with a new set of proprietary trading formulas that will work until they don't anymore. 

No one ever said Wall Street had a long memory. 

The article highlights a quantitative software program that "uses historical data and analysis to predict price movements in various assets." 

This line made me think of Buffett's commentary in the 2008 Berkshire letter:
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. (my emphasis)
I don't mean to come down too hard on the quants -- they're clearly bright people and there's apparently demand for what they're doing, but their approach is the complete opposite of what we should be trying to do as investors.

Seeking patterns where none exist. (Pi)
Any time you would spend seeking patterns in the newspaper quotes page or developing automatic trading formulas would be much better spent pursuing another type of formula, like the one Buffett outlined in the 1994 Berkshire letter:
We believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success. 
This simple formula isn't easy to implement, of course, but it beats using a complex formula that is easy to implement.

What do you think? Let me know on Twitter @toddwenning.

What I've been reading this week:
Cartoon of the week:

Stay patient, stay focused.