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The Outsiders by William Thorndike

7-17-2019

 

The Outsiders is one of the greatest influence to the thought that active investing can be consistently replicated throughout time. In the book, Thorndike demonstrates that by using the ownership in the stock, an adroit manager can add additional return to operating results. Pragmatists and the general purpose reader can enjoy the read, filled with quantitative logic and terrific anecdotes. The below is not in any conventional format and though direct quotes are observed, much of the context could be lost. 

Opening

Discussing the iconoclasm of the 8 ‘outsider’ investors: 

“The residents of Singletonville, however, represent a refreshing rejoinder to this stereotype. All were first-time CEOs, most with very little prior management experience. Not one came to the job from a high-profile position, and all but one were new to their industries and companies. Only two had MBAs. As a group, they did not attract or seek the spotlight. Rather, they labored in relative obscurity and were generally appreciated by only a handful of sophisticated investors and aficionados.

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness. They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate planes, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press. They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them. Ben Franklin would have liked these guys.

This group of happily married, middle-aged men (and one woman) led seemingly unexciting, balanced, quietly philanthropic lives, yet in their business lives they were neither conventional nor complacent. They were positive deviants, and they were deeply iconoclastic.

 

The word iconoclast is derived from Greek and means “smasher of icons.” The word has evolved to have the more general meaning of someone who is determinedly different, proudly eccentric.

Warren Buffett looked back on his first twenty-five years as a CEO and concluded that the most important and surprising lesson from his career to date was the discovery of a mysterious force, the corporate equivalent of teenage peer pressure, that impelled CEOs to imitate the actions of their peers. He dubbed this powerful force the institutional imperative and noted that it was nearly ubiquitous, warning that effective CEOs needed to find some way to tune it out.

Each ran a highly decentralized organization; made at least one very large acquisition; developed unusual, cash flow–based metrics; and bought back a significant amount of stock. None paid meaningful dividends or provided Wall Street guidance. All received the same combination of derision, wonder, and skepticism from their peers and the business press. All also enjoyed eye-popping, credulity-straining performance over very long tenures (twenty-plus years on average).

 

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 longterm 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.

 

As a result, the outsiders (who often had complicated balance sheets, active acquisition programs, and high debt levels) believed the key to long-term value creation was to optimize free cash flow, and this emphasis on cash informed all aspects of how they ran their companies—from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems.

This single-minded cash focus was the foundation of their iconoclasm, and it invariably led to a laser-like focus on a few select variables that shaped each firm’s strategy, usually in entirely different directions from those of industry peers. For Henry Singleton in the 1970s and 1980s, it was stock buybacks; for John Malone, it was the relentless pursuit of cable subscribers; for Bill Anders, it was divesting noncore businesses; for Warren Buffett, it was the generation and deployment of insurance float.

This pragmatic focus on cash and an accompanying spirit of proud iconoclasm (with just a hint of asperity) was exemplified by Henry Singleton, in a rare 1979 interview with Forbes magazine: “After we acquired a number of businesses, we reflected on business. Our conclusion was that the key was cash flow. . . . Our attitude toward cash generation and asset management came out of our own thinking.” He added (as though he needed to), “It is not copied.”

My aside: As an investor, you’d rather BUY IN to businesses with huge cash flows and treat them like your own businesses. This is preferred to having to go out and figure out how to create your own cash flow.

 

Capital Cities

 

By the time Murphy sold his company to Disney thirty years later, however, Capital Cities was three times as valuable as CBS. In other words, the rowboat had won. Decisively.

So, how did the seemingly insurmountable gap between these two companies get closed? The answer lies in fundamentally different management approaches. CBS spent much of the 1960s and 1970s taking the enormous cash flow generated by its network and broadcast operations and funding an aggressive acquisition program that led it into entirely new fields, including the purchase of a toy business and the New York Yankees baseball team. CBS issued stock to fund some of these acquisitions, built a landmark office building in midtown Manhattan at enormous expense, developed a corporate structure with forty-two presidents and vice presidents

As Murphy put it succinctly in an interview with Forbes, “We just kept opportunistically buying assets, intelligently leveraging the company, improving operations and then we’d . . . take a bite of something else.”3 What’s interesting, however, is that his peers at other media companies didn’t follow this path. Rather, they tended, like CBS, to follow fashion and diversify into unrelated businesses, build large corporate staffs, and overpay for marquee media properties.

Capital Cities under Murphy was an extremely successful example of what we would now call a roll-up. In a typical roll-up, a company acquires a series of businesses, attempts to improve operations, and then keeps acquiring, benefiting over time from scale advantages and best management practices.

As Murphy told me, “The business of business is a lot of little decisions every day mixed up with a few big decisions.”

My aside: These investors thought that revenues of the holding company are wtd averages of the subsidiaries. If you own 1% of a company earning 100 M, your holding company has $1 M Revenue.

 

As Burke told me, “Our relationship was built on a foundation of mutual respect. I had an appetite for and a willingness to do things that Murphy was not interested in doing.” Burke believed his “job was to create the free cash flow and Murphy’s was to spend it.”

Once in the CEO seat, it did not take Murphy long to make his mark. In 1967, he bought KTRK, the Houston ABC affiliate, for $22 million—the largest acquisition in broadcast history up to that time. In 1968, Murphy bought Fairchild Communications, a leading publisher of trade magazines, for $42 million. And in 1970, he made his largest purchase yet with the acquisition of broadcaster Triangle Communications from Walter Annenberg for $120 million. After the Triangle transaction, Capital Cities owned five VHF TV stations, the maximum then allowed by the FCC.

My aside: Cash Flow allows well managed firms to buy during downturns. CF + good MGMT = Defensive Earnings

In 1984, the FCC relaxed its station ownership rules, and in January 1986, Murphy, in his masterstroke, bought the ABC Network and its related broadcasting assets (including major-market TV stations in New York, Chicago, and Los Angeles) for nearly $3.5 billion with financing from his friend Warren Buffett.

The ABC deal was the largest non–oil and gas transaction in business history to that point and an enormous bet-the-company transaction for Murphy, representing over 100 percent of Capital Cities’ enterprise value.

In 1961, after he took over as general manager at WTEN, Burke began sending weekly memos to Murphy as he had been trained to do at General Foods. After several months of receiving no response, he stopped sending them, realizing his time was better spent on local operations than on reporting to headquarters. As Burke said in describing his early years in Albany, “Murphy delegates to the point of anarchy.”

Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as “a form of report card.” Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.

“The system in place corrupts you with so much autonomy and authority that you can’t imagine leaving.”

In the area of capital allocation, Murphy’s approach was highly differentiated from his peers. He eschewed diversification, paid de minimis dividends, rarely issued stock, made active use of leverage, regularly repurchased shares, and between long periods of inactivity, made the occasional very large acquisition.

After closing an acquisition, Murphy actively deployed free cash flow to reduce debt levels, and these loans were typically paid down ahead of schedule.

And when he had conviction, Murphy was prepared to act aggressively. Under his leadership, Capital Cities was extremely acquisitive, three separate times doing the largest deal in the history of the broadcast industry, culminating in the massive ABC transaction.

Murphy was a master at prospecting for deals. He was known for his sense of humor and for his honesty and integrity. Unlike other media company CEOs, he stayed out of the public eye (although this became more difficult after the ABC acquisition). These traits helped him as he prospected for potential acquisitions. Murphy knew what he wanted to buy, and he spent years developing relationships with the owners of desirable properties. This reputation helped him enormously when he approached Goldenson about buying ABC in 1984 (in his typical self-deprecating style, Murphy began his pitch with “Leonard, please don’t throw me out the window, but I’d like to buy your company.”)

He would often ask the seller what they thought their property was worth, and if he thought their offer was fair he’d take it (as he did when Annenberg told him the Triangle stations were worth ten times pretax profits). If he thought their proposal was high, he would counter with his best price, and if the seller rejected his offer, Murphy would walk away. He believed this straightforward approach saved time and avoided unnecessary acrimony.

My aside: If a firm has great cash flow but is doing a poor job with earning on it, it is a takeover target. It’s like finding a great property in a good neighborhood that isn’t producing an appropriate NOI

Cash Flow -[defined as EBITDA, or earnings before interest, taxes, depreciation, and amortization]

Teledyne

Singleton left Litton in 1960 after it became clear to him that he would not succeed Thornton as CEO. He was forty-three years old. His colleague, George Kozmetzky, who ran Litton’s Electronic Components Group, left with him, and together, in July 1960, they founded Teledyne. They started by acquiring three small electronics companies, and using this base, they successfully bid for a large naval contract. Teledyne became a public company in 1961 at the dawn of the conglomerate era.

During this heady period, there was significantly less competition for acquisitions than today (private equity firms did not yet exist), and the price to buy control of an operating company (measured by its P/E ratio) was often materially less than the multiple the acquirer traded for in the stock market, providing a compelling logic for acquisitions.

Singleton took full advantage of this extended arbitrage opportunity to develop a diversified portfolio of businesses, and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to specialty metals and insurance. All but two of these companies were acquired using Teledyne’s pricey stock.

In mid-1969, with the multiple on his stock falling and acquisition prices rising, he abruptly dismissed his acquisition team. Singleton, as a disciplined buyer, realized that with a lower P/E ratio, the currency of his stock was no longer attractive for acquisitions. From this point on, the company never made another material purchase and never issued another share of stock.

Earnings per share grew from 0.13 to 8.55 USD

Sales from 4.5 to 1,101.9

Net income from 0.1 to 32.3

Debt outstanding from 5.1 to 151

Shares outstanding from 0.4 to 6.6

In contrast to peers like Thornton and Harold Geneen at ITT, Singleton and Roberts eschewed the then trendy concepts of “integration” and “synergy” and instead emphasized extreme decentralization, breaking the company into its smallest component parts and driving accountability and managerial responsibility as far down into the organization as possible. At headquarters, there were fewer than fifty people in a company with over forty thousand total employees

He and his CFO, Jerry Jerome, devised a unique metric that they termed the Teledyne return, which by averaging cash flow and net income for each business unit, emphasized cash generation and became the basis for bonus compensation for all business unit general managers. As he once told Financial World magazine, “If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.”

In early 1972, with his cash balance growing and acquisition multiples still high, Singleton placed a call from a midtown Manhattan phone booth to one of his board members, the legendary venture capitalist Arthur Rock (who would later back both Apple and Intel). Singleton began: “Arthur, I’ve been thinking about it and our stock is simply too cheap. I think we can earn a better return buying our shares at these levels than by doing almost anything else. I’d like to announce a tender—what do you think?” Rock reflected a moment and said, “I like it.”

These repurchases were very large bets for Teledyne, ranging in size from 4 percent to an unbelievable 66 percent of the company’s book value at the time they were announced. In all, Singleton spent an incredible $2.5 billion on the buybacks.

Table 2-2 puts this achievement in perspective. From 1971 to 1984, Singleton bought back huge chunks of Teledyne’s stock at low P/Es while revenues and net income continued to grow, resulting in an astonishing fortyfold increase in earnings per share.

 

Sales went from 1109.9 to 3494.3

Net Income from 32.3 to 260.7

Earnings per share from 8.55 to 353.34

Shares Outstanding from 6.6 to 0.9

Debt went from 151 to 1072.7

In the mid-1970s, Singleton finally had an opportunity to act on this lifelong fascination when he assumed direct responsibility for investing the stock portfolios at Teledyne’s insurance subsidiaries during a severe bear market with P/E ratios at their lowest levels since the Depression. In the area of portfolio management, as with acquisitions, operations, and repurchases, Singleton developed an idiosyncratic approach with excellent results.

In a significant contrarian move, he aggressively reallocated the assets in these insurance portfolios, increasing the total equity allocation from 10 percent in 1975 to a remarkable 77 percent by 1981. Singleton’s approach to implementing this dramatic portfolio shift was even more unusual. He invested over 70 percent of the combined equity portfolios in just five companies, with an incredible 25 percent allocated to one company (his former employer, Litton Industries). This extraordinary portfolio concentration (a typical mutual fund owns over one hundred stocks) caused consternation on Wall Street, where many observers thought Singleton was preparing for a new round of acquisitions.

His top holdings were invariably companies he knew well (including smaller conglomerates like Curtiss-Wright and large energy and insurance companies like Texaco and Aetna), whose P/E ratios were at or near record lows at the time of his investment. As Charlie Munger said of Singleton’s investment approach, “Like Warren and me, he was comfortable with concentration and bought only a few things that he understood well.”6

As with his repurchases of Teledyne stock, Singleton’s returns in these insurance portfolios were excellent. A proxy for these returns can be seen in figure 2-1, which shows the approximately eightfold growth in book value at Teledyne’s insurance subsidiaries from 1975 through 1985, when Singleton began the process of dismantling his company.

Singleton was a pioneer in the use of spin-offs, which he believed would both simplify succession issues at Teledyne (by reducing the company’s complexity) and unlock the full value of the company’s large insurance operations for shareholders. In the words of longtime board member Fayez Sarofim, Singleton believed “there was a time to conglomerate and a time to deconglomerate.”7 The time for deconglomeration finally arrived in 1986 with the debut spin-off of Argonaut, the company’s worker’s compensation insurer.

He returned, however, in 1996 to personally negotiate the merger of Teledyne’s remaining manufacturing operations with Allegheny Industries and fend off a hostile takeover bid by raider Bennett LeBow. In these negotiations, according to Bill Rutledge, Teledyne’s president at the time, Singleton focused exclusively on getting the best possible price, ignoring other peripheral issues such as management titles and board composition.8 Again, the outcome was a favorable one for Teledyne share holders: a 30 percent premium to the company’s prior trading price.

My aside: Teledyne became a conglomerate to boost stock price in 1960’s. Bought back shares when depression hit in the 70’s. Invested in Equities with Float in the late 70’s. Spun off companies in the mid-80s at highs.

Singleton’s 1980 share buyback provides an excellent example of his capital allocation acumen. In May of that year, with Teledyne’s P/E multiple near an all-time low, Singleton initiated the company’s largest tender yet, which was oversubscribed by threefold. Singleton decided to buy all the tendered shares (over 20 percent of shares outstanding), and given the company’s strong free cash flow and a recent drop in interest rates, financed the entire repurchase with fixed-rate debt.

After the repurchase, interest rates rose sharply, and the price of the newly issued bonds fell. Singleton did not believe interest rates were likely to continue to rise, so he initiated a buyback of the bonds. He retired the bonds, however, with cash from the company’s pension fund, which was not taxed on investment gains.

As a result of this complex series of transactions, Teledyne successfully financed a large stock repurchase with inexpensive debt, the pension fund realized sizable tax-free gains on its bond purchase when interest rates subsequently fell, and, oh yes . . . the stock appreciated enormously (a ten-year compound return of over 40 percent).

 

The CEO as investor. Both Buffett and Singleton designed organizations that allowed them to focus on capital allocation, not operations. 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 investments 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 unit 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).

Significant CEO ownership. Both Singleton and Buffett had significant ownership stakes in their companies (13 percent for Singleton and 30-plus percent for Buffet). They thought like owners because they were owners.

Insurance subsidiaries. Both Singleton and Buffett recognized the potential to invest insurance company “float” to create shareholder value, and for both companies, insurance was the largest and most important business.

The restaurant analogy. Phil Fisher, a famous investor, once compared companies to restaurants—over time through a combination of policies and decisions (analogous to cuisine, prices, and ambiance), they self-select for a certain clientele. By this standard, both Buffett and Singleton intentionally ran highly unusual restaurants that over time attracted like-minded, long-term-oriented customer/shareholders.

 

General Dynamics

 

In other words, this was a turnaround. Companies in financial distress often hire restructuring “consultants” who helicopter in, slash costs, negotiate with lenders and suppliers, and look to sell the company as quickly as possible before moving on to the next assignment. These hired guns tend to ignore longer-term considerations like culture, capital investment, and organizational structure, focusing instead on short-term cash needs.

Anders outlined his strategy in his initial annual and quarterly reports and proceeded to aggressively implement it.

This strategy rested on three key tenets:

1. Anders, borrowing a page from his former GE colleague Welch, believed General Dynamics should only be in businesses where it had the number one or number two market position. (This was strikingly similar to the Powell Doctrine of the same era, which called for the United States to only enter military conflicts that it could win decisively.)

2. The company would exit commodity businesses where returns were unacceptably low.

3. It would stick to businesses it knew well. Specifically, it would be wary of commercial businesses—long an elusive, holy grail–like source of new profits for defense companies.

The Anders years (only three in total) can be divided into two basic phases: the generating of cash and its deployment. In each phase, the company’s approach was highly idiosyncratic.

Let’s start with cash generation. When Anders and Mellor began to implement their plan, General Dynamics was overleveraged and had negative cash flow. Over the ensuing three years, the company would generate $5 billion of cash. There were two basic sources of this astonishing influx: a remarkable tightening of operations and the sale of businesses deemed noncore by Anders’s strategic framework.

Specifically, as longtime executive Ray Lewis says, “Cash return on capital became the key metric within the company and was always on our minds.”3 This was a first for the entire industry, which had historically had a myopic focus on revenue growth and new product development.

In the first two years of their regime, Anders and Mellor reduced overall head count by nearly 60 percent (and corporate staff by 80 percent), relocated corporate headquarters from St. Louis to northern Virginia, instituted a formal capital approval process, and dramatically reduced investment in working capital. As Mellor said, “For the first couple of years we didn’t need to spend anything, we could simply run off the prior years’ buildup of inventories and capital expenditures.”5

These moves produced a tsunami of cash—a remarkable $2.5 billion—and the company quickly became the unquestioned leader among its peers in return on assets, a position it holds to this day.

After making early progress on the sales front, he turned his attention to acquisition, and the military aircraft unit, the company’s largest business, was a logical place to start. On top of the economic logic of growing this sizable business unit, Anders, a former fighter pilot and an aviation buff, loved it. So when Lockheed’s CEO surprised him by offering $1.5 billion, a mind-bogglingly high price for the division, Anders was faced with a moment of truth.

What he did is very revealing—he agreed to sell the business on the spot without hesitation (although not without some regret). Anders made the rational business decision, the one that was consistent with growing per share value, even though it shrank his company to less than half its former size and robbed him of his favorite perk as CEO: the opportunity to fly the company’s cutting-edge jets.

Collectively, these divestitures generated an additional $2.5 billion in cash and left General Dynamics with two businesses in which it held dominant market positions: tanks and submarines.

As the cash from asset sales and improved operations poured in, Anders shifted his focus to capital allocation. With prices high, he chose not to make additional acquisitions. Instead, he decided to return the majority of the company’s cash to shareholders.

First, Kapnick initiated a series of three special dividends to shareholders totaling just under 50 percent of the company’s equity value. Because of the large percentage of General Dynamics’ overall business that had been divested by Anders, these dividends were deemed “return of capital” and were, remarkably, subject to neither capital gains nor ordinary income taxes. As a next step, Anders and Kapnick announced a gigantic $1 billion tender to repurchase 30 percent of the company’s shares

This abrupt series of dramatic actions stunned Wall Street and led to a meteoric rise in General Dynamics’ stock price. It also attracted Warren Buffett’s attention. Buffett saw that under Anders’s leadership, the company was divesting assets and focusing on an innovative, shareholder-friendly capital allocation strategy, and in 1992 he bought 16 percent of General Dynamics’ stock at an average price of $72 per share. Remarkably, he also gave Anders, whom he had only met once, the proxy to vote Berkshire’s shares, a position that aided Anders in implementing his strategy.

Chabraja set ambitious goals for himself when he became CEO. Specifically, he wanted to quadruple the company’s stock price over his first ten years as CEO (a 15 percent compound rate of return).

Chabraja looked coolly at the company’s prospects for the next ten years and concluded that he could get about two-thirds of the way there through market growth and improved operating margins. The rest would need to come from acquisitions, a notable departure from Anders’s strategic framework.

Chabraja’s approach to acquisitions was distinctive, focusing initially on small purchases around existing business lines, a new capital allocation focus for the company. As he said, “Our strategy has been to aggressively pursue targets directly related to our core businesses . . . broadening our product line into adjacent spaces.”8 In his first year, he bought twelve small companies.

The crowning achievement of the Chabraja era, however, was the massive 1999 acquisition of Gulfstream, the world’s largest commercial jet manufacturer. This purchase was a $5 billion, bet-the-company transaction, equal to a remarkable 56 percent of General Dynamics’ enterprise value.

Anders would have preferred to establish a traditional stock option program but was told by the board that shareholders, disgruntled by the stock’s weak performance in the years prior to his arrival, would not approve one. Anders, however, wanted to align managers with shareholders, and developed a compensation plan that rewarded managers for sustained improvements in stock price.

The problem with this plan was that almost immediately after its implementation, the stock price moved quickly upward as Wall Street began to understand the effect of Anders’s unusual moves, resulting in very early and large bonus payments to management.

So what do you do with a high-priced stock? Use it to acquire a premium asset in a related field at a lower multiple and benefit from the arbitrage.”11 As Ray Lewis summarized, “Nick sold shares equaling one-third of the company to acquire a business that provided half of our consolidated operating cash flow.”

 TCI

By 1970, John Malone had been at McKinsey long enough to know an attractive industry when he saw one, and the more Malone learned about the cable television business, the more he liked it. Three things in particular caught his attention: the highly predictable, utility-like revenues; the favorable tax characteristics; and the fact that it was growing like a weed.

His two academic fields, engineering and operations, were highly quantitative and shared a focus on optimization, on minimizing “noise” and maximizing “output.” Indeed, Malone’s entire future career can be thought of as an extended exercise in hyperefficient value engineering, in maximizing output in the form of shareholder value and minimizing noise from other sources, including taxes, overhead, and regulations.

After earning his PhD, Malone took a job at Bell Labs, the highly prestigious research arm of AT&T. There, he focused on studying optimal strategies in monopoly markets. After extensive financial modeling, he concluded that AT&T should increase its debt level and aggressively reduce its equity base through share repurchases. This unorthodox advice was graciously received by AT&T’s board (and promptly ignored).

After a couple of years, Malone concluded that AT&T’s bureaucratic culture was not for him

In 1970, when one of those clients, General Instrument, offered him the opportunity to run Jerrold, its rapidly growing cable television equipment division, he leapt at the opportunity. He was twenty-nine years old.

At Jerrold, 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

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows.

TCI went public in 1970 and, by 1973 when Malone joined, had become the fourth-largest cable company in the country, with six hundred thousand subscribers. Its debt at that time was equal to an astonishing seventeen times revenues.

TCI, however, with its new, thirty-two-year-old CEO, was burdened with significantly more debt than any of its peers and teetered on the edge of bankruptcy. “Lower than whale dung [sic],” is Malone’s typically blunt assessment of his starting point at TCI.1

Malone had been dealt a tough hand, and he and Magness spent the next several years keeping the lenders at bay and the company out of bankruptcy. They met constantly with bankers. At one point in a particularly tense lender meeting, Malone threw his keys on the conference room table and walked out of the room, saying, “If you want the systems, they’re yours.” The panicked bankers eventually relented and agreed to amend the terms on TCI’s loans.

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 his balance sheet stabilized, Malone was finally able 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 the 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 and 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 expenses) is the fees paid to programmers (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.

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.

My aside: Buy businesses of customers to get more leverage with vendors, creating more cash flow, reducing lending costs and finally allowing more business buying.

“Ignoring EPS gave TCI an important early competitive advantage versus other public companies.”

Between 1973 and 1989, the company closed 482 acquisitions, an average of one every other week. To Malone, a subscriber was a subscriber was a subscriber. As longtime investor Rick Reiss said, “In the pursuit of scale, he was willing to look at beachfront property even if it was near a toxic waste dump,” and over the years, he bought systems from sellers as diverse as the Teamsters and Lady Bird Johnson.

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 1991, he spun off TCI’s minority interests in programming assets into a new entity, Liberty Media, in which he ended up owning a significant personal stake. This was the first in a series of tracking stocks that Malone created, including TCI Ventures (for Teleport, Sprint/PCS, and other noncable assets) and TCI International (for TCI’s ownership in miscellaneous foreign cable assets).

Malone was a pioneer in the use of spin-offs and tracking stocks, which he believed accomplished two important objectives: (1) increased transparency, allowing investors to value parts of the company that had previously been obscured by TCI’s byzantine structure, and (2) increased separation between TCI’s core cable business and other related interests (particularly programming) that might attract regulatory scrutiny. Malone started with the spin-off of the Western Tele-Communications microwave business in 1981, and by the time of the sale to AT&T, the company had spun off a remarkable fourteen different entities to shareholders.

He had been correct about their return potential—in 1997, Teleport was sold to AT&T for an astounding $11 billion, a twenty-eight-fold return on investment. In 1998, the Sprint/PCS joint venture was sold to Sprint Corporation for $9 billion in Sprint stock, and in 1999, General Instrument was sold to Motorola for $11 billion.

Characteristically, he handled the negotiations himself, often facing a sizable crowd of AT&T lawyers, bankers, and accountants across the table.

As talks between the two companies unfolded, Malone proved to be as adept at selling as he had been at acquiring. As Rick Reiss said, “He turned the board of AT&T upside down, shook every nickel from their pockets, and returned them to their board seats.”7 The financial terms—twelve times EBITDA, $2,600 per subscriber—were extraordinary and, remarkably, the company received no discount for its patchwork quilt of decrepit rural systems. Not surprisingly, Malone, ever watchful of unnecessary taxes, structured the transaction as a stock deal, allowing his investors to defer capital gains taxes.

He believed financial leverage had two important attributes: it magnified financial returns, and it helped shelter TCI’s cash flow from taxes through the deductibility of interest payments. Malone targeted a ratio of five times debt to EBITDA and maintained it throughout most of the 1980s and 1990s.

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. “We want to sell some of our systems . . . at 10 times cash flow to buy back our stock at 7 times.”

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. When he sold assets, he almost always sold for stock (the reason that, to this day, Liberty has large holdings of News Corp., Time Warner, Sprint, and Motorola stock) or sheltered gains through accumulated NOLs, and he made constant use of the latest tax strategies. As Dennis Leibowitz said, “TCI hardly ever disposed of an asset unless there was a tax angle to it.”10 No other cable company devoted remotely as much time and attention to this area as TCI.

He never paid dividends (or even considered them) and rarely paid down debt. He was parsimonious with capital expenditures, aggressive in regard to acquisitions, and opportunistic with stock repurchases.

Until the advent of satellite competition in the mid-1990s, Malone saw no quantifiable benefit to improving his cable infrastructure unless it resulted in new revenues.

He bought more companies than anybody else—in fact, he bought more companies than his three or four largest competitors combined.

only purchase companies if the price translated into a maximum multiple of five times cash flow after the easily quantifiable benefits from programming discounts and overhead elimination had been realized. This analysis could be done on a single sheet of paper

In contrast, TCI repurchased over 40 percent of its shares during Malone’s tenure.

“We are evaluating all alternatives in order to buy our equity at current prices to arbitrage the differential between its current multiple and the private market value.”13 These buybacks provided a useful benchmark in evaluating other capital allocation options, including acquisitions. As Malone said to Wargo in 1981, “With our stock in the low twenties . . . purchasing it looks more attractive than buying private systems.”

My aside: Private valuations and Public Valuations often differ. Value your enterprise as a private company. If the public will pay more than this intrinsic value, sell it for private businesses! If public will offer you a price lower than intrinsic, buyback shares.

No CEO has ever used joint ventures as actively, or created as much value for his shareholders through them, as John Malone. Malone realized early on that he could leverage the company’s scale into equity interests in programmers and other cable companies, and that these interests could add significant value for shareholders, with very little incremental investment. At the time of the sale to AT&T, the company had forty-one separate partnership interests, and much of TCI’s long-term return is attributable to these cable and noncable joint ventures.

Because of these polyglot joint ventures, TCI was notoriously hard to analyze and often sold at a discount to its cable peers.

Many early employees (supposedly including Malone’s longtime secretary) became millionaires, and this culture bred tremendous loyalty—in Malone’s first sixteen years at the helm, not a single senior executive left the company.

TCI’s operations were remarkably decentralized, and as late as 1995, when Sparkman retired, the company had only seventeen employees at corporate in a company with 12 million subscribers. As Malone put it with characteristic directness, “We don’t believe in staff. Staff are people who second-guess people.”

There is no reason for Human resources if you hire people properly in the beginning. White collar jobs need little oversight.

Washington Post

It was at this time, coached by Buffett, owner of 13% of WPO, that Graham made another unconventional decision and began aggressively buying her own stock, something very few people (outside of Henry Singleton and Tom Murphy) were even thinking about at the time. Over the next several years, she would repurchase almost 40 percent of the company’s shares at rock-bottom prices. Significantly, none of her peers at other major newspaper companies followed her lead.

In 1981, two significant events occurred. First, the Post’s longtime rival, the Washington Star, after years of declining circulation, finally ceased publication. This left the Post, with its lean, poststrike cost structure, as the monopoly daily newspaper in the nation’s capital, which led to a dramatic increase in circulation and profitability that continued throughout the decade.

In 1984, she acquired the Stanley Kaplan test preparation business, establishing a toehold in the education market. Finally, in 1986, Graham, thanks to a timely introduction by Buffett, made her largest acquisition ever: the purchase of Capital Cities’ cable television assets for $350 million. Each of these businesses would prove enormously important for the Post Company in the years ahead.

My aside: Buffett was SELF DEALING. He owned almost all of capital cities, and owned 13% of WPO and arranged this deal to benefit both firms.

 

Graham was generally reticent about using debt, and during her tenure, the Post consistently maintained the most conservative balance sheet among its peers. Graham raised significant debt only a few times during her tenure, most notably to finance the 1986 purchase of the Capital Cities cable systems. The Post’s strong cash flow, however, allowed the bulk of this debt load to be paid down in less than three years.

All capital expenditure decisions were submitted to a rigorous approval process, which required attractive returns on invested capital. As Alan Spoon summarized it, “The system was totally federalized, with all excess cash sent to corporate. Managers had to make the case for all capital projects. The key question was, ‘Where’s the next dollar best applied?’ And the company was rigorous and skeptical in answering that question.”

“Acquisitions needed to earn a minimum 11 percent cash return without leverage over a ten-year holding period.” Again, this seemingly simple test proved a very effective filter, and as Might says, “Very few deals passed through this screen. The company’s whole acquisition ethos was to wait for just the right deal.”

This is Buffett – only invest where at least a 11% CAGR is over 10 years.

Buffett’s style, however, was not directive, according to longtime board member and Cravath, Swaine partner George Gillespie: “He would never say, ‘Don’t do that,’ but something more subtle, along the lines of, ‘I probably wouldn’t do that for these reasons, but I’ll support whatever you decide.’

Taking advantage of dramatically reduced prices, the Post opportunistically purchased a series of rural cable systems, several underperforming television stations in Texas, and a number of education businesses, all of which proved to be extremely accretive to shareholders.

As we’ve seen, stock repurchases were another major capital allocation outlet for Graham. Once Buffett explained the compelling math of repurchases, she initiated a buyback program and pursued it with vigor. Graham would add enormous value for her shareholders by buying in a massive amount of stock (almost 40 percent eventually), most of it purchased during the 1970s and early 1980s at single-digit P/E multiples.

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 the repurchase program in 1984. Donald Graham reckons this high-priced McKinsey wisdom cost Post shareholders hundreds of millions of dollars of value

 

General Cinema 

 

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).

Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands. Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends. 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

My aside: Buy companies and sell assets to third parties while leasing them back to yourself.

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.

…the idea being to make a sizable minority investment, take a seat on the board, and work with management to improve operations and increase value. In the first half of the 1980s, Smith was involved with three of these investment-with-involvement attempts: Columbia Pictures, Heublein, and Cadbury Schweppes. In the case of the latter two, the incumbent management team viewed the General Cinema investment with suspicion or outright hostility. As a result, no board seats were offered, and Smith sold each of the positions within one to two years of the initial purchase.

Ives had an initially cool reaction to Gleacher’s description, but as he listened, he sensed 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 (Patriots’ 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.

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 advantaged debt, plus we got a conversion option

HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm. Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich. In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders.

This series of moves kept Maxwell at bay but left the company with an unsustainable debt load.

Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time—an enormous bet. This price equaled a multiple of six times cash flow for HBJ’s core publishing assets

When I met with Smith in his office, he showed me the 1962 annual report, his first as CEO, in which he refers repeatedly to cash earnings (defined as net earnings plus depreciation) as the key metric in evaluating company performance, not net income. This may well be the first use in American business parlance of that now standard term. As longtime General Cinema CFO Woody Ives said, “Our focus was always on cash,”

 

Berkshire Hathaway

 

A pivotal investment in Buffett’s shift in investment focus from “cigar butts” to “franchises” was the acquisition in 1972 of See’s Candies. Buffett and Munger bought See’s for $25 million. At the time, the company had $7 million in tangible book value and $4.2 million in pretax profits, so they were paying a seemingly exorbitant multiple of over three times book value (but only six times pretax income). See’s was expensive by Graham’s standards, and he would never have touched it. Buffett and Munger, however, saw a beloved brand with excellent returns on capital and untapped pricing power, and they immediately installed a new CEO, Chuck Huggins, to take advantage of this opportunity.

See’s has experienced relatively little unit growth since it was acquired, but due to the power of its brand, it has been able to consistently raise prices, resulting in an extraordinary 32 percent compound return on Berkshire’s investment over its first twenty-seven years. (After 1999, See’s results were no longer reported separately.)

During the last thirty-nine years, the company has sent $1.65 billion in free cash to Omaha on an original investment of $25 million. This cash has been redeployed with great skill by Buffett, and See’s has been a critical building block in Berkshire’s success. (Interestingly, purchase price played a relatively minor role in generating these returns: had Buffett and Munger paid twice the price, the return would still have been a very attractive 21 percent.)

In the late 1980s, Buffett made a handful of investments in convertible preferred securities in publicly traded companies, including Salomon Brothers, Gillette, US Airways, and Champion Industries. The dividends from these securities were tax advantaged, providing Berkshire with an attractive yield and the potential for upside (via the ability to convert to common stock) if the companies performed well.

During this period, Buffett was also active in a variety of investing areas outside of traditional equity markets. In 2003, he made a large ($7 billion) and very lucrative bet on junk bonds, then enormously out of favor. In 2003 and 2004, he made a significant ($20 billion) currency bet against the dollar, and in 2006, he announced Berkshire’s first international acquisition: the $5 billion purchase of Istar, a leading manufacturer of cutting tools and blades based in Israel that has prospered under Berkshire’s ownership.

Several years of inactivity followed, interrupted by the financial crisis in the wake of the Lehman Brothers bankruptcy, after which Buffett entered one of the most active investing periods of his career. This stretch of activity reached its climax with Berkshire’s purchase of the nation’s largest railroad, the Burlington Northern Santa Fe, in early 2010 at a total valuation of $34.2 billion.

Charlie Munger has said that the secret to Berkshire’s longterm 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.1 Remarkably, Buffett has almost entirely eschewed debt and equity issuances—virtually all of Berkshire’s investment capital has been generated internally.

This approach, wildly different from most other insurance companies, relied on a willingness to avoid underwriting insurance when pricing was low, even if short-term profitability might suffer, and, conversely, a propensity to write extraordinarily large amounts of business when prices were attractive.

This approach led to lumpy, but highly profitable, underwriting results. As an example, in 1984, Berkshire’s largest property and casualty (P&C) insurer, National Indemnity, wrote $62.2 million in premiums. Two years later, premium volumes grew an extraordinary sixfold to $366.2 million. By 1989, they had fallen back 73 percent to $98.4 million and did not return to the $100 million level for twelve years. Three years later, in 2004, the company wrote over $600 million in premiums. Over this period, National Indemnity averaged an annual underwriting profit of 6.5 percent as a percentage of premiums. In contrast, over the same period, the typical property and casualty insurer averaged a loss of 7 percent.

Our cost of float is determined by our underwriting loss or profit. In those years when we have had an underwriting profit, our cost of float has been negative. In effect, we have been paid for holding money.

We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the unequaled financial strength of our insurance companies.

My aside: Not only did BRK gain on the value of its investments, but also from the ‘underwriting profit’; a multiplicative effect on total returns.

 

As he summarized in the 1993 annual report, “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”

Buffett’s pattern of investment at Berkshire has been similar to the pattern of underwriting at his insurance subsidiaries, with long periods of inactivity interspersed with occasional large investments. The top five positions in Berkshire’s portfolio have typically accounted for a remarkable 60–80 percent of total value. This compares with 10–20 percent for the typical mutual fund portfolio. On at least four occasions, Buffett invested over 15 percent of Berkshire’s book value in a single stock, and he once had 40 percent of the Buffett Partnership invested in American Express.

He has held his current top five stock positions (with the exception of IBM, which was purchased in 2011) for over twenty years on average. This compares with an average holding period of less than one year for the typical mutual fund.

Buffett uses the analogy of a pro-am golf event to describe these investment opportunities, which arise when a company with an excellent “franchise-type” business invests in other businesses with lower returns: “Even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.”b When, however, Buffett sees that a new management team is removing the amateurs from the foursome and returning focus to the company’s core businesses, he pays close attention, as the preceding table demonstrates.

Buffett never participates in auctions. As David Sokol, the (now former) CEO of MidAmerican Energy and NetJets, told me, “We simply don’t get swept away by the excitement of bidding.”9 Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer “usually in five minutes or less.”10 This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.

Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition.

He believes these splits are purely cosmetic and likens the process to dividing a pizza into eight versus four slices, with no change in calories or asset value delivered. Avoiding stock splits is yet another filter, helping Berkshire to self-select for longterm owners. In 1996, he reluctantly agreed to create a lower-priced class of B shares, which traded at one-thirtieth of the A shares and were the second-highest-priced issue on the NYSE. (In connection with the Burlington Northern deal in early 2010, Buffett agreed to split the B shares a further 50:1 to accommodate the railroad’s smaller investors.)

He believes directors should have exposure to the consequences of poor decisions (Berkshire does not carry insurance for its directors) and should not be reliant on the income from board fees, which are minimal at Berkshire.

In addition to thinking independently, they were comfortable acting with a minimum of input from outside advisers. There is something out of High Noon in John Malone showing up solo to face a phalanx of AT&T corporate development staff, lawyers, and accountants; or Bill Stiritz showing up alone with a yellow legal pad for due diligence on a potential multibillion-dollar transaction; or Warren Buffett making a decision on a potential acquisition for Berkshire in a single day without ever visiting the company.

 

Conclusion:

 

So, here we go with some rules:

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 determined 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.

Comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.

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 and that 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 under-performing business units if they are no longer capable of generating acceptable returns.

 

 

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