A Book

The Outsiders

BY WILLIAM THORNDIKE, JR

A book that received high praise from Warren Buffett, The Outsiders chronicles the unconventional techniques that led eight CEOs to outperform the S&P 500 by an astounding twenty times.The best CEOs are not managers, but capital allocators. They were not charismatic visionaries who actively managed operations. On the contrary, they decentralized operations and centralized capital allocation. They rarely paid dividends and emphasized cash flows over net revenue. Learn how their approach generated exceptional returns across industries and market conditions.

TOP 20 INSIGHTS



The best way to measure a CEO’s performance is to measure the increase in per-share value during their tenure. Jack Welch of General Motors, widely considered to be an all-time great, outperformed the S&P 500 by a factor of three. However, the Outsider CEOs profiled in this book outperformed the S&P 500 twenty times over.
The two core tasks CEOs have are management of operations and deployment of capital. Most CEOS tend to focus more on operations. However, two equally well-managed companies with different capital allocation strategies will have widely divergent long-term results. Despite its importance, most business schools don’t have courses on capital allocation.
The Outsider CEOs share a worldview, which includes attention to capital allocation and per-share value, as well as emphasis on cash flows over reported earnings, and focus on highly decentralized operations, highly centralized capital allocation, investment in their stock, and discipline and patience when it comes to acquisitions.
The Outsiders shared personal traits like frugality, humility, independence, and an analytical approach. They avoided the media spotlight and interacted little with Wall Street. These CEOs waited for years to identify the right investment opportunity. To increase per-share value, they were even ready to shrink company size and share base.
In the case of Capital Cities, Tom Murphy managed strategy, acquisitions, and capital allocation, while Dan Burke managed operations. Burke’s job was to create the free cash flow, and Murphy’s was to spend it.
Murphy was very acquisitive and made the largest deal in the history of the broadcast industry thrice. Murphy used leverage to fund acquisitions. Burke, with his operations and integration expertise, would quickly improve margins and profitability. Murphy used this cash flow to pay loans ahead of schedule and leveraged these assets again to buy new assets.
Murphy made the largest non-oil and gas transaction in business history when Capital Cities bought the ABC Network for an astounding $3.5 billion in 1986. The deal was worth more than 100% of Capital Cities’ enterprise value. Burke immediately stepped in to improve operations, reduce perks, and sell off excess real estate. Stunningly, most of the ABC debt was paid within three years of acquisition.
Over nearly 40 years and across different market conditions, Singleton of Teledyne outperformed the S&P twelvefold. Teledyne was founded at a time when conglomerates enjoyed high price-to-earnings (P/E) ratios, and the cost of acquisitions was far cheaper. He therefore acquired 130 companies in 9 years and issued stock to raise cheap capital.
Singleton enhanced free cash flow. These cash flows were used to buy back 90% of Teledyne’s outstanding shares. Singleton spent an incredible $2.5 billion on buybacks. From 1971 to 1984, Teledyne witnessed a forty-fold increase in earnings per share.
From 1984 to 1996, Singleton pioneered spinoffs to manage succession and unlock the full value of the company’s insurance operations. He believed it was “time to de-conglomerate.” He successfully spun off Uniturn at a time when it accounted for a      majority of Teledyne’s value.
Singleton did not take any day-to-day responsibilities. Teledyne emphasized extreme decentralization and drove managerial accountability to the lowest levels. For a company of 40,000 people, Teledyne’s headquarters had less than 50 people with no Human Resource, Business Development, or Investor Relations departments.
When Bill Anders took over as CEO of General Dynamics, the company was at a historic low. It was valued at $1 billion when revenues were $10 billion. Over 17 years from Anders’s tenure, the company generated a phenomenal 23.3% compound annual return compared to the 8.9% for the S&P 500.
In 3 years, Anders generated a remarkable $5 billion in cash. General Dynamics got $2.5 billion by reduction of its over-investment in inventory, capital equipment, and R&D and decreased headcount by 60%. In an industry first, Anders sold a majority of General Dynamics’s businesses, including its F16 division, to raise the remaining      amount. Most of this was returned to shareholders.
The F16 sale happened when Anders offered to buy Lockheed’s fighter plane division. Lockheed’s CEO made a counter-offer of $1.5 billion for the F16 division. Anders agreed to sell the business on the spot, even though it shrank the company to half its former size and left it with only its tank and submarine units.
In 1995, General Dynamics acquired Bath Iron Works, one of the largest navy shipbuilders, for $400 million. This decision had high symbolic value as it signaled to the Pentagon that the company was ready to grow again.
When Nick Chabraja became CEO, he wanted to quadruple stock price in ten years. Two-thirds would come from market growth and one-third from acquisitions. Chabraja’s defining move was the purchase of Gulfstream for $5 billion, a deal that was 56% of General Dynamics’s value. The move was widely criticized, but Gulfstream’s revenues have insulated General Dynamics from uncertainties in defense spending.
During Warren Buffett’s tenure of 40 years, Berkshire’s returns outperformed the S&P by over a hundredfold. Buffett’s insurance operations focused on float generation over growth in premiums. This float was deployed to purchase other cash-generating businesses that fund subsequent investments. Berkshire’s float grew from $237 million in 1970 to over $70 billion in 2011.
Berkshire had a highly concentrated portfolio, and investments were held for very long periods. The top five positions accounted for about 60% to 80% of the company’s portfolio and have been held for over 20 years on average. Buffett called this low level of activity as “inactivity bordering on sloth.”
It’s lucrative for companies to sell to Berkshire because it gives freedom from Wall Street scrutiny and near unlimited access to capital. Buffett spent little time on traditional due diligence and handled all deals personally.
Buffett structured Berkshire in such a way that he spent very little time on operations. He kept a blank calendar, did not use a computer at the office, and utilized most of his time to read and think.


SUMMARY



The best metric to measure a CEO’s performance is the increase in a company’s per-share value. By this measure, the legendary Jack Welch of General Motors outperformed the S&P by a factor of three. However, the CEOs profiled in this book exceeded the S&P twenty times over. CEOs have two core tasks: operations management and capital allocation. It’s common to see Business Schools and Wall Street emphasize an obsessive focus on operational efficiency. But what makes the real difference over the long-term is the firm’s capital allocation strategy.


THE OUTSIDER’S WORLDVIEW



The iconoclast CEOs profiled in this book share an outsider’s worldview. The key elements are:
The CEO’s main job is capital allocation
What matters in the long term is the increase in per-share value
Long term value is determined by cash flows not reported earnings
Organizational decentralization improves efficiency and reduces costs
Rely on independent thinking over expert opinion
One of the best investment opportunities is the company’s stock
Patience, with occasional swiftness in deal-making, is the strategy for acquisitionsThe outsiders also shared some personal characteristics, including frugality, humility, independence, and an analytical, understated approach. Almost all of them were first time CEOs. They avoided corporate perks and media spotlight. These CEOs were more investors than managers with high confidence in their analytical skills. They bought their stock when it was cheap and leveraged it to raise cheap capital when it was expensive. They were willing to wait long periods to identify compelling investment or acquisition opportunities. In pursuing per-share value, they were ready even to shrink their company size and share base.


MINNOW SWALLOWS WHALE



“Tom Murphy and Dan Burke were probably the greatest two-person combination in management that the world has ever seen or maybe ever will see.”  -- Warren BuffettWhen Tom Murphy joined Capital Cities in 1966, its market cap was sixteen times smaller than that of CBS. Thirty years later, it was three times more valuable. Murphy’s strategy was to acquire Radio and TV stations, improve operations, pay down debt, and acquire again. It was a rare combination of both operational excellence and capital allocation. In contrast, CBS bought into notions of “diversification” and “synergy,” expanding into unknown new domains and creating highly centralized management structures.


A CLEAR DIVISION OF LABOR



Murphy and Burke had a clear division of labor at Capital Cities: Murphy as CEO, managed strategy, acquisitions, and capital allocation, while Burke as President and COO, managed operations. In his 29-year term, Murphy made  the largest deal in the history of the broadcast industry thrice. To do this, he relied on Burke’s operations and integration expertise. Murphy bought KTRK, an ABC affiliate, for $22 million in 1967. In 1970, he purchased broadcaster Triangle Communication for an astounding $120 million. In the ’70s and early ’80s, Murphy entered the newspaper and cable industries by buying the Forth Worth Telegram and the Kansas City Star and Cablecom, respectively.


THE DEAL OF A LIFETIME



The deal of his life came when Murphy bought the ABC Network for an astounding $3.5 billion in 1986, with financing from Warren Buffett. It was then the largest non-oil and gas transaction in business history, worth more than 100% of Capital Cities enterprise value. Wall Street Journal headlined it “Minnow Swallows Whale.” Within two years, Burke improved ABC’s margins from around 30% to over 50% by implementing a frugal, decentralized approach. Unnecessary perks like private dining rooms were cut, and more than 1500 workers were laid off. Surplus real estate, including the Manhattan headquarters, was sold.In 1995, Murphy sold Capital Cities to Disney for an extraordinary $19 billion, representing 28 times its net income. During his 29 years, Murphy outperformed the S&P by 16.7 times and his peers by four times.


HIRE THE BEST AND LEAVE THEM ALONE



Capital Cities was famously decentralized, with extraordinary managerial autonomy and minimal headquarters staff. Murphy’s HR philosophy was to “hire the best people you can and leave them alone.” Burke had a razor-sharp focus on frugality and economic efficiency. He would do a line-by-line analysis of annual budgets that every manager presented. Apart from these individual annual meetings, managers were left alone.


LEVERAGE, PURCHASE, REPEAT



Murphy avoided diversification, paid very minimal dividends, and rarely issued stock. He used debt to fund acquisitions and used free cash flow to pay loans ahead of schedule. These assets were again leveraged to buy newer assets. Stunningly, the majority of the ABC debt was paid within three years of the acquisition. Though prolific, Murphy was careful in deal-making, waiting years to find the right acquisition. His rule for transactions was a double-digit after-tax return over ten years without leverage.Murphy aggressively repurchased shares, buying close to 50% of shares at over $1.8billion in his career. This was a large bet that generated a compound return of 22.4% over 19 years.


CONGLOMERATE AND DE-CONGLOMERATE



Henry Singleton, an MIT Ph.D. in Electrical Engineering, founded Teledyne in 1960. This was the era of conglomerates, who enjoyed high price-to-earnings(P/E) ratios at a time when the cost of acquiring companies was far lesser in P/E ratio terms. Singleton took advantage of this to buy 130 companies between 1961 and 1969, ranging from aviation electronics to insurance. In 1967, Singleton made George Roberts the President of Teledyne and removed himself from operations to focus on capital allocation.


FOCUS ON CASH FLOW AND REPURCHASE STOCK



In 1969, Teledyne abruptly stopped acquiring and fired its entire acquisition team. Singleton instead focused on improving operations. Rather than optimizing for Wall Street’s preferred benchmark of reported earnings, Singleton took the unconventional approach of improving free cash flow. This cash flow was used to fund the acquisition of new companies. Across the ’70s and ’80s, the company was consistently profitable in a variety of market conditions.From being an issuer of stock in the ’60s, Singleton went on a massive stock repurchasing spree in the ’70s and ’80s, buying back an astonishing 90% of Teledyne’s outstanding shares. This was done at a time when repurchases were highly controversial. Teledyne spent an incredible $2.5 billion on buybacks. From 1971 to 1984, Teledyne witnessed a forty-fold increase in earnings per share.


A TIME TO DE-CONGLOMERATE



From 1984 to 1996, Singleton focused on management succession. He pioneered spinoff’s to manage succession and unlock the full value of the company’s insurance operations. Singleton believed that there was “a time to conglomerate and a time to de-conglomerate.” He successfully spun off Argonaut and Uniturn at a time when the later company accounted for a majority of Teledyne’s value.Singleton retired in 1991 with an extraordinary record. From 1963 to 1990, he delivered a 20.4% compound annual interest rate to shareholders, thus outperforming the S&P twelvefold.


SINGLETON’S TENETS OF MANAGEMENT



Singleton did not reserve any day-to-day responsibilities for himself. He emphasized extreme decentralization, driving managerial accountability to the lowest levels. For a company of 40,000 people, Teledyne’s headquarters had less than 50 people with no human resources, business development, or investor relations departments. Singleton considered investor relations to be a waste of time, famously avoiding Wall Street and not declaring quarterly earnings guidance.


AN IMPROBABLE TURNAROUND AT GENERAL DYNAMICS



When the Berlin Wall came down in 1989, defense stocks crashed. General Dynamics, a company with a stellar history of selling aircraft, ships, and tanks to the Pentagon, had a market cap of just $1 billion when revenues were around $10 billion. Until Anders took over.


THE ANDERS APPROACH



Anders’s turnaround strategy was highly unusual. The defense industry’s excess capacity meant that companies had to either shrink businesses or grow through acquisitions. He wanted General Dynamics to remain in business only where it was number 1 or number 2 by market position. Anders transformed the company’s mindset from building faster, more lethal weapons to emphasizing shareholder value and return on equity.


GENERATING A TSUNAMI OF CASH



In the three years Anders led the company, it generated a remarkable $5 billion in cash. This was from two sources: a sharp tightening of operations and selling off non-core businesses. Anders insisted that the company bid only on projects they had a good chance of winning, and the returns were compelling. The number of bids fell drastically, while the success rate shot up. The overall headcount was cut by 60%. As a result of this, $2.5 billion was freed up.


SHRINKING THE COMPANY



In a first for the industry, Anders sold a majority of General Dynamics’s businesses, including its F16 and the missiles and electronics division. The F16 sale happened unexpectedly. Anders offered to buy Lockheed’s smaller fighter plane division, to which Lockheed’s CEO responded with a counter-offer of $1.5 billion for the F16 division. Anders agreed to sell the business on the spot, even though it shrank his company to half its former size. These moves generated another $2.5 billion in cash and left the company with only its tank and submarine units.Instead of investing the cash, Anders chose to return most of it to shareholders through innovative tax-efficient techniques. This stunned Wall Street and General Dynamics’s stock price rose rapidly. It attracted Warren Buffett’s attention. He bought 16% of the company and gave Anders the proxy to vote Berkshire’s shares.


READY TO GROW AGAIN



Anders retired after naming Mellor as chairman. As CEO, Mellor continued to focus on operations. In 1995, he acquired Bath Iron Works for $400 million. This decision had high symbolic value as it signaled to the Pentagon that the company was ready to grow again. In 1997, Mellor handed the baton to Nick Chabraja, who aimed to quadruple the company stock price within ten years. Two thirds would come from market growth and improving margins. The remaining one-third would have to come from acquisitions. In his first year, Chabraja bought 12 companies. These led General Dynamics into the military information technology market, which became its largest business in 2008. Chabraja’s defining move was the purchase of Gulfstream for $5 billion, a deal that represented 56% of General Dynamics’s enterprise value. The move was widely criticized then, but Gulfstream’s revenues have insulated General Dynamics from the uncertainties in defense spending.Over seventeen and a half years, General Dynamics generated a phenomenal 23.3% compound annual return compared to the 8.9% for the S&P 500. In a defense industry with highly centralized, bureaucratic organizations the trio made an active push for decentralization. When Chabraja left, the company had more employees than during Anders’s time, but only a quarter as many at the headquarters. All three CEOs were committed to stock buybacks, including Anders’s tender in 1992, where 30% of the stock was repurchased.


THE ORACLE OF OMAHA



Warren Buffett bought his first share at Berkshire Hathaway for $7. Today, a stock is worth over $300,000. Buffett’s story best exemplifies the idea of the CEO as an investor.


VALUE INVESTING



Buffett was inspired by Benjamin Graham’s Value Investing approach. Value Investing emphasized buying companies that were trading at significant discounts to net working capital. After two years of working under Graham, Buffett returned to his hometown Omaha and raised an investing partnership of $105,000. Over the next 13 years, he beat the S&P every year without employing leverage. In 1965, he bought Berkshire Hathaway, then a small textile company. Three years of cost-cutting yielded $14 million in cash, which Buffett used to buy National Indemnity, a niche insurance company. This company generated vast amounts of floats, premium income in advance of losses, that Buffett effectively invested in securities and purchasing companies like the Omaha Sun. This acquisition laid the foundation for Berkshire’s extraordinary run.

A SHIFT IN APPROACH



In the ’70s, when fear of inflation was high, Buffett defied the conventional wisdom of investing in hard assets. He instead bought shares of consumer brands and media companies with dominant market positions and franchises and held them for long periods. This was a definite shift in investment strategy from his previous balance-sheet & investment-focused approach to one that emphasized income, brand name, and market share. By the end of the ’80s, Buffett had significant positions in the Washington Post, GEICO, and General Foods. In 1986, he made a massive $500 million investment to help Tom Murphy of Capital Cities acquire ABC. Berkshire now owned 18% of Capital Cities.

BE GREEDY WHEN OTHERS ARE FEARFUL



Anticipating the stock crash of 1987, Buffett sold all stocks in his insurance company portfolios except the three “permanent holdings,” namely Capital Cities, GEICO, and Washington Post. Towards the end of the decade, he made large insurance transactions, buying the remaining half of GEICO for $2.3 billion and purchasing the reinsurer GeneralRe for $22 billion in Berkshire stock. This was the largest transaction in Berkshire’s history. After the Lehman Brothers collapse, when all of corporate America was fearful, Buffett invested a massive $15 billion within 25 days.

CREATING A CAPITAL FLYWHEEL



During his tenure of over 40 years, Berkshire’s returns outperformed the S&P by over a hundredfold. What made this possible? According to Charlie Munger, Berkshire’s long-term success was due to its ability to “generate funds at 3$ and invest them at 13%”. Almost all of Berkshire’s investment capital was generated internally, avoiding debt and leverage.The primary source of capital was float from insurance business complemented by cash from wholly-owned subsidiaries. Buffett’s insurance operations focused on float generation over growth in premium revenue. This float is deployed to purchase other cash-generating businesses that fund subsequent investments. Float from Berkshire’s insurance businesses grew from $237 million in 1970 to over $70 billion in 2011.


INACTIVITY BORDERING ON SLOTH


Berkshire’s investments were highly concentrated and had very long holding periods. The top five positions accounted for about 60% to 80% of the company’s portfolio. Buffett’s top stock positions have been held for over 20 years on average. Buffett calls this low level of activity as “inactivity bordering on sloth.” A sale to Berkshire gives companies freedom from Wall Street scrutiny and near unlimited access to capital. Buffett spends little time on traditional due diligence, including meeting management and inspecting operating facilities. The Capital Cities deal was finalized in less than 15 minutes.CEOs who run the businesses usually don’t hear from Buffett. Buffett consciously designed the company in such a way that he spends as little time on operations as possible. He keeps a blank calendar, does not use a computer at the office, and utilizes most of his time in reading and thinking.Buffett is the ideal example of a CEO as an investor, whose zen-like vision focuses on long-term investments and avoiding the unnecessary financial and human costs of churn. All the outsider CEOs had the approach of a long-term investor, not a highly paid employee. Their edge was because of this temperament, not intellect.