The Name is Buffett, Warren Buffett

"CEOs need to learn the art of capital allocation"

William Thorndike on the importance of capital allocation by CEOs

Published 11 years ago on Jun 08, 2013 12 minutes Read

In the competitive and challenging landscape of private equity, William Thorndike, founding partner of Housatonic Partners, has managed to create a niche for himself. Thorndike’s firm has made over 60 investments in private companies and kept generating decent returns for investors. So, it’s not surprising that assets under management have grown from $5 million in 1994, when the fund was set up, to around $1 billion currently. Housatonic focuses on growth buyouts and recapitalisation of profitable, middle-market service businesses with highly recurring revenue. But, more importantly, it seeks to invest in and build companies through the close cooperation of experienced and entrepreneurial managers. That approach also led Thorndike to author a book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.

The book takes a look at eight individualistic CEOs, including Buffett, whose firms’ average returns outperformed the S&P 500 by a factor of 20. In other words, an investment of $10,000 in any of their companies, on average, would have been worth over $1.5 million 25 years later. Thorndike, however, believes that what differentiates Buffett from 98% of CEOs is his exceptional understanding of capital allocation — a trait difficult to emulate for most CEOs.

You have an analogy: Hedgehogs and foxes. How did that come about?

It is from an essay by a British intellectual, Isaiah Berlin. The basic concept of the essay is about writers, but it also applies to business people. They are divided into two camps, hedgehogs and foxes. Hedgehog knows one thing but knows it very well — that is, more of an intense specialist. In contrast, the fox knows many things but lacks a deep sense of understanding. There is a common view that successful CEOs tend to be hedgehogs as they tend to focus and specialise and carve out a niche for their businesses. I think there is some truth in that. But the Outsider pattern is quite different. Such CEOs tend to be young and often new to their fields or industries, but bring with them fresh perspectives. Part of the thesis here is that such CEOs take unconventional iconoclastic paths owing to their exposure to other fields. This foxiness allows them to take a look at their businesses with fresh eyes and arrive at a differentiated approach, particularly around capital allocation. In that sense, Buffett would be a classic fox because he began as an investor, an unconventional background for a CEO in the mid-1960s when he assumed control of Berkshire Hathaway. But he had exposure at that time to several industries and businesses. So, when he took over Berkshire he then had a much broader range of capital allocation opportunities than just investing in textiles, which was a terrible business. So he was able to take the cash generated by the business and deploy it in other, more productive areas.

In the chapter on Buffett, it comes across that when Berkshire Hathaway changed hands it wasn’t exactly a friendly one with a CEO who didn’t quite agree to meet Buffett. But then, most of Buffett’s investment decisions have been made without meeting managements.

I think that was a unique circumstance. While Buffett was interested in changing the way the business was run and exploring whether it made sense to assume control, the incumbent 70-year-old CEO felt threatened. So, Buffett reached out to the two families who owned the majority of the stock and ended up developing a very positive relationship with the families who later agreed with Buffett that they needed a new CEO. So it wasn’t exactly a hostile meeting. He had the support of the majority of the shareholders, only the CEO didn’t get along. But Buffett’s initial investment decision wasn’t driven by his view of the management but by the discount from tangible book value.

Could you elaborate on Buffett’s thought process when he mentions that being the CEO has made him a better investor and vice versa?

The comment relates almost entirely to the concept of capital allocation. It’s unusual for pure investors to become CEOs. Though they are not cut out for operations, they are qualified for capital allocation. But this is the reverse for 98% of CEOs, who come up through operating trajectories and don’t know much about capital allocation. Buffett came uniquely suited to capital allocation with an exceptional mind. He was trained to look for the highest probability-adjusted return opportunities. He brought that mindset from day one to Berkshire and that made him a very effective CEO. But he also realised his limitations in operations and didn’t try to tamper with them.

Early on, he set up a corporate structure that allowed him to focus on where he thought he had an edge and kept him away from where he thought he wouldn’t be helpful. I think the part of him being a CEO and that making him a better investor is very interesting. If you look at some of the early investments made at Berkshire, See’s Candies would be the best example of this, and also a weekly newspaper he bought in Omaha. The investment in See’s Candies helped him understand what the true competitive barriers were for consumer branded products. The more he saw of See’s Candies’ ability to raise prices, he realised how valuable those businesses were. That helped him invest in General Foods and Coca-Cola with a greater degree of confidence, which he would otherwise not have had, had he not owned and run See’s Candies privately.

But Buffett never ‘ran’ See’s Candies himself and had hired a CEO.

Though he hired a CEO he was much more involved than he had ever been with any of his public investments. He was instrumental in the price increases — which is a predominant insight. They tried to grow See’s Candies, but found it hard to move it outside of California. But due to the power of its brand, it has been consistently raising prices every year by 4-5%. Through the last 39 years the company has sent $1.65 billion in free cash to Omaha on an original investment of $25 million. Even if Buffett had paid twice the price it would have still been attractive. Now, that understanding of the value of cash generated through price increases has helped him invest in General Foods and Coca-Cola. Similarly, when he bought the weekly newspaper, it wasn’t actually a great business. He then followed it up by buying The Washington Post stock from public markets and then taking over Buffalo News privately. He constantly adopted insights from one sphere and applied it in another.

 So do those attributes make Buffett a role model for a typical CEO?

I think that is a fair question. I intentionally steered the book away from technology geniuses because what they have done is not replicable. You can’t just become like Steve Jobs. He is a genius and so is Buffett. To me one of the key elements in the book was connecting Buffett to a broader group of CEOs. He did some of those uniquely well and you can’t expect to duplicate them. But the core principles that each one of the eight CEOs have followed in different fields at different points during a cycle are highly replicable. You can’t say to a CEO, “With your excess cash flow you need to be a stock picker of Buffett’s talent.” That is not realistic. That piece of what Buffett is, is only unique to him. The simple framework is that CEOs need to do two things to be successful. One, they have to optimise their profitability and, two, they need to figure out what to do with the profits. CEOs are generally wired for the first task but not for the second. Within the second aspect there are only five things you can do: pay dividend, buy back stock, pay down debt, do an acquisition, and invest in your existing assets. But Buffett added a sixth one to that, which is to invest in the stock market. Because of his background he had this other unique option that gave him a broader palette to paint from. 

But that is because Berkshire offered him a platform to invest in the markets. But if Starbucks were to invest money in stocks, the CEO will be damned. Shareholders will not like that and shouldn’t like that. But what does make sense selectively for CEOs is to buy back their stock when it’s cheap. In that they are uniquely qualified to make the determination on when the stock is attractively priced. No one in the world other than the CEO and his core team is able to better project future earnings and determine when that stream of cash flow is cheap. They need to take advantage of that. But outside of that, they can’t go too wide in terms of finding capital allocation options that make sense, whereas someone like Buffett and Eddie Lampert of Sears Holdings could do that. But then, fewer than 1% of CEOs will have that sort of a background.

Buffett is a votary of companies that pay out large dividends but he himself doesn’t do that. Right now they have too much cash and they don’t know how to deploy it. He always felt and continues to feel he can earn an attractive enough return on the retained earnings.

He is also sensitive to the tax effect. There is a phenomenon of double taxation: one at the corporate level and another at the individual level. Dividends are tax inefficient and always have been. But Buffett does a couple of things that are motivated by rational behaviour relative to taxes. One is to have long holding periods. One of the benefits of a long holding period is that you never have to pay capital gains tax. 

The analogy that Charlie Munger uses is: it is like getting a long-term loan from the government that helps you compound over time. It ends up being very valuable and adds a couple of points to the after-tax compound over long periods. But he is not as aggressive in tax avoidance and tax planning as CEOs such as John Malone [TCI] and some others are. But he does understand the economic impact of those decisions.

For a CEO who is in a business that is perhaps on a secular decline or facing some serious challenges, is the option really to get out of that business and move on to other things and diversify? 

It is really hard to get into something else. Buffett is uniquely positioned to do that because of being first an investor and then a CEO. He had a portfolio of businesses to choose from, but a small business owner does not have that option. If a small business owner is faced with a situation, the key thing is rationality. You have to be realistic and rational about your competitive position and have to figure out what it means to own the business going forward, how the cashflow will look like and trading that against selling it to a competitor or shutting the business down. Even though the options aren’t great, it is the same process. You need to sit down with a piece of paper and look at economic returns and then conclude which is the best path for you and your shareholders. That thought process is applicable whether it is a high growth situation or a difficult, declining situation.

Buffett has always been a proponent of shareholder capitalism. Of late, across the globe, there is a huge clamour for stakeholder capitalism, triple bottomline approach and so forth. Is this marking a new paradigm in terms of objectives that you lay out for a CEO?

The metric that I used to select the eight CEOs is based on shareholder returns. So that is the primary performance measure for those CEOs in my view. However, to be successful in generating shareholder returns over 20 years, this is for long-tenure CEOs, it is a requirement that you have loyal customers and loyal employees. You can’t play for the short term in either of those two areas if you want to build long-term value. All the eight CEOs [mentioned in the book] had an extremely loyal employee base. Very few workers were unionised, even the small percentage of union workers were loyal, and there was also no churn in the top ranks. If your view is long enough, all stakeholders have to be taken care of. To my mind, it’s a false choice to say who are your important stakeholders.

Honestly, without customers, there is no business. There are great examples here of some of the most frugal CEOs making these seemingly non-economic short-term decisions to protect their customer experiences and make sure their customers are loyal. Capital Cities’ ABC, which owned TV stations and newspapers, made a much larger investment than it needed to build a colour printing press way back in the 1980s because they felt by doing so ABC would have solidified its dominant position. But in doing so, they penalised near-term earnings. John Malone [of TCI] was an incredibly rational guy. Once it became clear that satellite competition was real he ploughed enormous capital into developing set-top boxes, which was a dramatic near-term sacrifice of earnings but it maintained the company’s long term subscriber base. 

Munger says unlike operations, which are decentralised, capital allocation is very centralised. Do you think this could present its own problems [for Berkshire] in the absence of Buffett and Munger? Also, did you assess succession planning of CEOs in the book?

For the first part, every CEO had a decentralised operation structure. Their aggressively decentralised structures left people in the industry scratching their heads as they couldn’t believe that so few people sat around in the corporate headquarters. That was a common model. However, all of them took the profitability from business units and repatriated it to the corporate office. Then the CEO and a very small team made the allocations. The business units could apply for that capital but they had to make a business case. It had to be based on returns and data. All of them had the same decentralised operations and centralised allocation. 

In terms of succession planning, it varied by company. If you look across the eight companies, a number of them were sold. The endpoint for the returns calculation is either the retirement of the CEO or the sale of the business. Of the eight companies featured, not all ended up being sold. General Dynamics was an exception in the book — it had three CEOs over 17 years and there was a clear succession plan in the place. When the CEO left, it was not just his successor who was identified but his successor’s successor was also identified. He was thinking down the road. 

Buffett has the succession plan absolutely nailed but he is not talking about it. People have been talking about this for 15 years. He is going to break it into two parts. For the investing and capital allocation part, Buffett is very happy with the two young managers that he has brought on board. On the operations side, it is not going to be a dark horse candidate. It is going to be one of the three or four who are on the shortlist now. I don’t doubt that he will make a good decision there.

Despite being so unconventional, what is it that has made Buffett such a huge success and what are the takeaways for other CEOs?

I think the primary reason for his success is that he is uniquely excellent in capital allocation. The second aspect is that, having recognised the fact that he is not good at operations, he put this in the hands of people who are motivated to do the job well and had a track record of doing it well. In terms of his time management, he is a genius, given his sense of discipline. He doesn’t take any time out to talk to investors except at annual meetings, unlike the average public company CEO who spends quite a bit of time with Wall Street analysts. He wants to be disciplined about allowing time for himself to read reports and not get embroiled in things where he can’t be very effective. 

So, Buffett is spending a lot of his time on the important, non-urgent bucket. That is the toughest quadrant for a CEO to be in, but also where the most value can be added. You have to be objective and rational and say I like sales and not making financial statements. You need to realise that and structure your organisation so that you can be empowered in that role. But you also need to have competent people to delegate to in the other areas.