Masterspeak 2015

"In good times, people make errors of commission and in difficult times, errors of omission"

William Thorndike, founder, Housatonic Partners whose book, The Outsiders, is a must-read for investors 

Published 8 years ago on Sep 04, 2015 11 minutes Read

There is great romance, history and mythology in how PE firms or hedge funds get christened. Bridgewater, Carlyle, Blackstone, BlackRock, Pershing Square, Cerberus, Appaloosa and Kynikos are a few that come to mind. William Thorndike has named his PE firm after a great river — Housatonic. A graduate of Harvard College and Stanford School of Business, Thorndike set up Housatonic Partners in 1994 after his stint with T Rowe Price and Walker and Co, where he was named to the board of directors.

Apart from his professional success in building a billion dollar firm, what really catapulted him to cult status was his book The Outsiders. An idea that started off for Thorndike as a presentation for an annual conference eventually grew into a full-fledged book, which now is a must-read in the investing community. Warren Buffett recommended it in his annual letter to shareholders as “an outstanding book about CEOs who excelled in capital allocation.” From his office at Prudential Tower, Thorndike enjoys a 360° view of Boston and this hawk-eye vision is at play when he scans midsize companies for his firm to invest in. Right now of which he is not finding many.

If one were to assess The Outsiders today, would they be able to deliver the same kind of performance in the current environment? Today we have interest rates at zero, information moves a lot faster and arbitrage gets taken care of in a couple of minutes.

I would think they would have similar levels of outperformance relative to their peer groups measured over longer time periods in the current market environment. In support of that I think there are a number of current CEOs with similar characteristics and an analytical rational approach who are having similar success today. Two of the CEOs mentioned in The Outsiders, Warren Buffett and John Malone, are still active and continue to have excellent results. During the late 2008 early 2009 credit crisis, most CEOs were inactive for understandable reasons.

They were nervous, hoarding cash, healing balance sheets, avoiding leverage and were waiting to see how the macro situation unfolded. But that wasn’t how Buffett and Malone acted. For each of them, that 9-18 month period of time starting with the fall of the Lehman Brothers was one of the most active periods in their careers. They were aggressively allocating capital to buying companies, repurchasing shares and making all sorts of proactive decisions. 

Capital allocation is about investing money in businesses that will give maximum return. While in theory, it sounds simple, why is it that CEOs find it so challenging? In fact, during good times, managements tend to commit bigger capital allocation errors. It is not a complex idea that you should allocate capital where the probability adjusted return is the highest but there are often factors that actually complicate implementation. I think in good times people tend to make errors of commission and in difficult times they tend to make errors of omission, i.e. miss opportunities.

If you look at overall stock repurchase data for corporate America, stock repurchases in the US at the overall aggregate level for the S&P 500 are almost a perfect contra indicator for the broader market. So, if 2014 set the record for capital deployed for stock repurchases, it broke the prior record which was set in the last quarter of 2007, the prior market peak. The lowest period for stock repurchase activity was in the first and second quarter of 2009. Corporate America tends to deploy capital for stock repurchases at the worst possible time. 

The typical way in which a company implements a stock repurchase is, the board authorises an amount of capital, usually a fairly small amount of capital as a percentage of the market capitalisation or enterprise value. That capital is deployed for stock repurchase and the company implements it by buying equal amounts on a quarterly basis until the authorisation has been fulfilled. That historically has produced very poor returns. That is in stark contrast to how the outperforming CEOs in The Outsiders implemented their buybacks.

They made larger bets when their stock was in their view attractively priced, trading at a low multiple relative to their assessment of value. To them, a buyback was just another investment alternative and when returns were attractive, they would actively do it and when they weren’t, they wouldn’t. All the eight CEOs were analytically oriented and were comfortable doing the basic math. Occasionally, they would have enough conviction around a capital allocation project, be it an acquisition or stock repurchase, and when they would do it, they would do it in size and scale. 

What part of capital allocation do you think CEOs get wrong most of the time? 

I think acquisitions are an area — at least in corporate America — where CEOs do not have a distinguished record. There is a natural tendency on the part of CEOs to grow their businesses and that quest isn’t always economically rational from the perspective of optimising per share value. We often see CEOs making investments (on acquisitions or internal projects) that are growth oriented but don’t end up generating compelling returns for shareholders. At times, there is pressure from Wall Street to do things and that can be hard to ignore. In the US, there is a lot of pressure to deliver quarter on quarter returns to shareholders.

There are two ways that Wall Street is emphasizing for that to be done. One is to pay dividends and the other is to buy back stock. Corporate America continues to have a sizeable cash balance after the crisis and it is easy for managements to make decisions that aren’t very rational in every case. So a lot of them are leaping on the bandwagon and are paying dividends and repurchasing shares. But I don’t think they are doing either of those in a very profitable fashion. To me the metric that really matters is not earnings per share although that is certainly relevant. To me, what matters is compound growth in per share value over a five to 10 year time period.

An astute investor-CEO like Warren Buffett is an exception but does being a great investor help in any way to be an effective CEO? 

No, that is not the case. While an investing background is clearly helpful, each of the outsider CEOs had deep-expertise COOs for effective oversight of operations, particularly with internal budgeting processes, critical in companies with decentralised organisational structures. All eight were first-time CEOs and the presence of these No. 2s freed them to spend their time thinking about capital allocation and longer term projects. So, it is not automatic that an investor would be successful as a CEO and a capital allocator. An investor background can be helpful but only if it is married to a strong COO and they work hard to create the right culture.

Apart from being extremely efficient capital allocators, are there other strikingly common qualities among The Outsiders?

They were efficient capital allocators and there were specific decisions that flowed from that. For instance, they focused on minimising taxes, tended to not pay dividend and overtime bought back a lot of stock or made the occasional large acquisition. They were proponents of a highly decentralised organisational structure. There were very few people at corporate headquarters and responsibility and authority was distributed out to local business unit managers. They created a self-selective culture of frugality and rationality. Personality-wise you would not use adjectives like charismatic or visionary or strategic to describe them. Instead you would use adjectives like frugal, pragmatic, flexible, rational or analytical. They did not relish the outward facing part of the CEO role.

They did not speak at Wall Street conferences and Chambers of Commerce events and would have never gone to Davos. They were low-key and that was not their scene. They spent as little time as possible on investor relations; they did not view that as a good use of their own time. A typical CEO in the US spends 20% of his time on investor relations and these guys spent a fraction of that. They were very strategic about allocating their own time as they were about capital and other resources.

How much of a role did luck play in the outperformance delivered by The Outsiders?

Certainly, luck is a factor in any business. Every company in the book and every company generally needs luck, so all of these CEOs benefitted from events over time. I don’t think on balance any of these companies were lucky. You need to look at a long time period of 10-20 years in order to eliminate the role of luck as a onetime event in the overall record. At different points of time did they get breaks… sure and did they get breaks that went the other way… yes. I don’t think they had any more luck than others in their industry.

It might have been lucky for the entire cable TV industry that Ronald Reagan during his administration decided to roll back cable regulation dramatically. All the companies were able to raise rates but it didn’t specifically benefit TCI versus the peers. It didn’t explain the outperformance. I think they did a better job than their peers of capitalising on opportunities created by luck.

You have a checklist at the end of the book which is pretty much a do’s list for CEOs. Is there a don’ts list for CEOs?

Like Carl Jacobi, Charlie Munger stresses, “Invert. Always invert.” I think you can invert here and arrive at the don’ts list. The things that you should avoid doing would be, don’t sell stock at a low multiple. Don’t over leverage your business. Don’t make acquisitions that don’t have very compelling returns. Don’t make acquisitions with mediocre returns unless you are highly confident in your assumptions. Don’t repurchase shares unless you are confident that the returns are attractive. Be very careful paying dividends because they are tax inefficient and it is a hard decision to reverse during tough times. Don’t build a lavish corporate headquarters and have a large central corporate office bureaucracy. This is just a partial don’ts list.

The A-list

The New A-list

What metrics should you look for to identify an outsider-like CEO at an early stage?

Early on, I think you can tell a lot by the way a CEO is discussing and describing their business. After about five years, you can evaluate them on their actions. Until that period, you have to look at qualitative signals like the vocabulary they use. Are they talking about free cash flows? Do they use metrics on per share basis? How often are they reducing core metrics down to the per share level versus talking about them at an aggregate level? All that can be very revealing. 

Who do you think are the new set of CEOs who could figure in a potential sequel of your book or The New Outsiders, if we may call them?

In the US, there are a number of CEOs who currently exemplify these traits. They would include Nick Howley who runs a company called TransDigm, the Rales brothers: Mitch and Steve at Danaher and Colfax. There is a wonderful home building company called NVR. There is Mark Leonard in Canada with Constellation Software. There is a group of insurance companies — Fairfax and Markel would be good examples of that. There is a finance company called Credit Acceptance doing some very interesting things. There is a reinsurance company called Arch Re. There is an interesting utility called Calpine. So it is a wide variety of companies that are following a similar sort of approach in the US with excellent results.

In your book, The Outsiders, Teledyne was a favourite. Is there a favourite in your new list?

Teledyne was a favourite because Henry Singleton was a personally fascinating figure. I enjoyed all of them just to be clear but that would be a close contest. Is there a favourite now? I don’t have one; I think there are a whole range of interesting ones. There is Mike Pearson at Valeant Pharma who does some interesting things. I am continually hearing of new ones and I had the good fortune to interact with a number of those CEOs since The Outsiders came out. I hope that by implementing a similar approach, they will grow over time.

What were the lessons from the book for you? 

It certainly has been very helpful to me in private equity investing and personal investing in the public markets. As a private equity firm, we invest in midsize companies. The lessons for me were that it reinforced a number of things for my firm including focusing on certain types of business that structurally generate high amounts of free cash flows and on businesses that have low capital intensity. If you are a good capital allocator, you need to have free cash flow to allocate. Hence, we focus on businesses that are predictable generators of free cash. We like a combination of hunger and talent and specifically back talented younger CEOs in the 35 to 45 age bracket. Along with general management exposure, they have a prior history of P&L success but are getting their first opportunity to earn a little equity. 

We tend to own businesses for a longer time, compared to other PE firms. Six to seven years is our average holding period. Then, we systematically try to repurchase shares from other PE investors in our investee companies over time. So, it is a combination of those things that the book is helpful in reinforcing. 

What has your portfolio approach been in the current market?

In our portfolio now, we are doing more selling than buying because of where prices are. We are finding it harder at the moment to deploy capital into new investments given where valuations are. The headline for us would be that we are pretty meaningful net sellers at the moment.

*Note: This interview was conducted in June 2015. Mike Pearson was replaced by Joseph Papa at Valeant Pharma in May 2016.