Podcast Summary
The Power of Contrarian Thinking in Capital Allocation: Successful capital allocators like Henry Singleton, John Malone, Tom Murphy, Catherine Graham, and Warren Buffett were contrarian on topics like dividends, buybacks, acquisitions, and debt.
Key takeaway from this interview with Will Thorndyke is the importance of contrarian thinking in successful capital allocation. Thorndyke, an author and investor, discussed his research on CEOs who were master capital allocators, such as Henry Singleton, John Malone, Tom Murphy, Catherine Graham, and Warren Buffett. These CEOs tended to be contrarian on topics like dividends, buybacks, acquisitions, and the use of debt. In the second part of the conversation, Thorndyke shared his career in private equity, founding and running Housatonic Partners since 1994. He has been an active search fund investor for decades. Despite focusing on public markets in his book, Thorndyke's background in private equity offers valuable insights into the industry. The conversation also touched on the dangers and opportunities in today's private equity market. Will's journey from reading about Buffett in college to founding Housatonic Partners demonstrates the importance of seizing unexpected opportunities and following one's passion for investing.
A deep research project on exceptional CEOs evolves into 'The Outsiders' book: Through rigorous research and analysis, the book identifies successful CEOs who significantly outperformed the broader market by making effective capital allocation decisions
The book "The Outsiders" began as an intensive research project on specific CEOs who produced exceptional results. The project started as a talk at a CEO conference, where the author, William Thorndike, chose to focus on Henry Singleton of Teledyne. To conduct the research, Thorndike recruited talented HBS students to help, leading to a series of deep analytical dives into the companies and interviews with key individuals. Over time, the project evolved into a broader book, revealing a clear pattern of successful capital allocation among these CEOs. The book's appeal lies in its description of capital allocation decisions in a quantitative and fundamental way, which aligns with Thorndike's research focus. The successful CEOs identified in the book significantly outperformed the broader market over extended periods. The research project's success came from the talented students Thorndike encountered at HBS, who contributed their expertise as independent study projects.
Capital allocators disdained dividends for tax reasons: Successful investors prefer tax minimization and retaining earnings over dividends, but companies continue to pay them due to high profits and investor expectations
Successful capital allocators, as highlighted by eight case studies, generally disdained dividends due to their tax inefficiency. These allocators focused on tax minimization and preferred to retain earnings or invest in their businesses rather than paying dividends. In the public markets, dividends have remained popular despite becoming less tax efficient in recent years. It's puzzling why companies continue to pay dividends in a hyper-liquid market where shareholders can sell shares to create their own dividends. However, the popularity of dividends may be due to high corporate profits and the widespread belief in returning capital to shareholders. It's an interesting trend to monitor as tax laws and market conditions evolve.
High dividend yields no longer indicate cheap stocks: Studying a company's capital allocation decisions, such as share buybacks and capex, can predict future performance
High dividend yields no longer indicate low prices or other measures of cheapness in the stock market. This correlation, which used to be significant, is now almost non-existent. Instead, firms that make large, sporadic share repurchases, often timed to coincide with low points in the stock price, have shown to outperform the market. This pattern was exemplified by the late Melvin R. "Bud" Singleton, who famously reversed course from issuing shares during the 1960s to aggressively buying them back in the early 1970s. This shift in capital allocation strategy led to significant gains for Singleton and his company, Teledyne. Additionally, research shows that high rates of capital expenditures (capex) growth can predict poor future returns due to the significant increase in the size of a company's asset base. These insights highlight the importance of studying a company's capital allocation decisions, particularly in regards to share buybacks and capex, as they can provide valuable predictive information.
CEOs with pragmatic approach to CapEx and growth decisions: CEOs in the book were characterized by their disciplined, quantitative, and flexible approach to capital allocation, avoiding undisciplined spending and underperformance in high CapEx growth companies through the use of specific hurdle rates and a focus on opportunity cost.
The CEOs in the book, despite coming from diverse backgrounds and being first-time CEOs, were characterized by their pragmatic, analytical, and flexible approach to capital expenditures (CapEx) and growth decisions. They were not charismatic or visionary strategists, but rather cool, agnostic, and opportunistic leaders. John Malone, the CEO of the largest cable television company for over 25 years, is a prime example of this approach. Malone constantly toggled between organic and inorganic growth opportunities, making decisions based on quantitative analysis and clear decision rules, such as a mid-20s IRR or better for internal organic growth. This disciplined approach to capital allocation helped these CEOs avoid undisciplined spending and underperformance in high CapEx growth companies. The use of specific hurdle rates and a focus on opportunity cost were key elements of their success.
Flexible and Opportunistic Approach to Business Planning: Successful CEOs have a flexible approach to business planning, reacting to the external environment, focusing on analytical rigor, and making occasional large bets for high probability returns, while keeping a robust internal system for accountability.
Effective CEOs have a flexible and opportunistic approach to business planning, contrasting the common practice of broad, long-term strategic planning. They believe in reacting to the external environment and focus on analytical rigor. Regarding acquisitions, the successful CEOs in the study made occasional large bets, aiming for high probability returns and improving margins through cost economies. An exception was John Malone, who constantly acquired to maintain scale advantages in the cable television industry. However, most CEOs avoided frequent acquisitions due to their tendency to follow market cycles and lack of unique value-adding information. Additionally, having a robust internal system for accountability, such as a rigorous annual budgeting process, is crucial to prevent managers from consistently presenting models with unrealistically high returns.
Capital Cities' focus on efficiency led to profitability in TV stations: Capital Cities increased TV station margins from 30% to 50% through headcount reduction and synergies, financing their expansion with debt, a strategy reminiscent of private equity.
Capital Cities' success in increasing margins from 30% to 50% in TV station business was the key to their large bet, which was mostly financed through debt. They achieved this by focusing on headcount reduction and synergies. The TV station business in the 70s and 80s had exceptional economic characteristics, allowing even mediocre operators to be profitable. Capital Cities, known for their efficiency, ran stations lean while investing in on-air content. This story of running a station profitably with minimal investment reminded me of the private equity model, where debt is used to make equity sweat. Most outsider CEOs in the book used leverage actively, believing in the tax benefits it provides. Malone, in particular, ran his cable business with a consistent 4x leverage, while being clear about the risk to equity investors. Despite the risks, they were willing to be more aggressive in their use of debt than their industry peers.
Understanding business and leverage, like John Malone and Dick Smith: Successful CEOs have a clear business understanding and manage leverage wisely. John Malone, with his disciplined acquisition strategy and optimization skills, is a strong contender for long-term investment due to his prudent use of the balance sheet.
Successful CEOs, such as John Malone and Dick Smith, have a clear understanding of their businesses and the appropriate level of leverage they can comfortably support. They were transparent with investors about their leverage levels and adhered to them throughout their tenure. However, the use of leverage is not exclusive to these CEOs. If you were to make a lump sum investment with a 20-year holding period and could pick one outsider CEO and a business, John Malone, known for his disciplined and opportunistic acquisition strategy, would be a strong contender due to his exceptional ability to optimize acquisitions and minimize taxes. Malone's background in operations research and electrical engineering further emphasizes his focus on optimization. Additionally, his prudent and aggressive use of the balance sheet adds to his appeal for a long-term investment.
Successful CEOs prioritize long-term per share price optimization: CEOs like John Malone optimize per share price through share repurchasing and acquisitions, delegate budgeting and IR, and focus on long-term projects with strong COO partnerships and decentralized organizations.
Successful CEOs, like John Malone, understand the importance of optimizing per share price over the long term. Malone's unique expertise in both share repurchasing and acquisitions makes him an ideal candidate for this. If I had to choose a business for Malone, I would suggest a niche insurance company with a strong history of underwriting profitability, flow generation, and a CEO who understands how to allocate those funds effectively. This partnership between the strategic CEO and the operations-focused COO is a common thread among the eight CEOs in the book. These CEOs prioritized the allocation of their time, delegating intensive budgeting processes and investor relations to strong COOs, allowing them to focus on capital allocation and long-term projects. Unconventional approaches to investor relations, such as spending less time with Wall Street and the business press, also freed up valuable time for these CEOs to focus on other areas of growth. Overall, this book highlights the importance of strong partnerships, decentralized organizations, and effective time management for successful CEOs.
Unexpected opportunities from writing a book: Writing a book can lead to new connections and experiences, inspiring intellectual curiosity and personal growth.
Writing a best-selling book unexpectedly opened up new opportunities for the author, leading to interactions with talented investors and interesting CEOs. The experience was personally rewarding and invigorating, and if he had to write another book, he would choose a topic that piqued his intellectual curiosity. The author's high school football coach was an example of an independent thinker who achieved remarkable results, and this experience paralleled his career in private equity, where he specialized in traditional buyouts, recaps, and search funds. The author was an early investor in the search fund model, having been exposed to it at Stanford Business School, where it was pioneered by professor Irv Grossman.
Search Funds: A Unique Source of Deal Flow in Private Equity: Search funds offer high returns with a proprietary pipeline and concentration of alpha in top decile outcomes, but competition is fierce and dispersion of returns has narrowed.
Search funds have been a successful source of deal flow for private equity firms, offering a unique focus on smaller growth buyouts. With a proprietary pipeline and a high concentration of alpha in the top decile or quartile outcomes, search funds have shown mid-thirties IRRs over long holding periods. However, the dispersion of returns has shrunk, indicating that the overall level of returns remains high but the gap between top performers and underperformers has narrowed. Despite this, the number of search funds has grown logarithmically in the last dozen years, making it a dynamic and fascinating area in private equity. My first experience with search funds was with Housatonic Partners, which invested in them actively for the first 8 to 10 years of their existence. One of our most successful investments was in Asurion, a roadside assistance services provider during the nineties era of cellular phones. Today, Asurion is the largest provider of handset insurance in the US and has branched out into other businesses. While the number of searches going on at any given time may seem high, the competition is fierce, and not all investments are successful. The most comprehensive data on search funds can be found on the Stanford Business School website.
Trend towards permanent capital structures like evergreen funds: Sophisticated investors prefer permanent capital structures for tax advantages and long-term investments, with private equity and recapitalizations gaining popularity for long-term partnerships and less intermediary involvement.
There's a growing trend towards permanent capital structures, such as evergreen funds, among sophisticated investors. This category, which can be thought of as "permanent equity," is gaining popularity due to its potential tax advantages and the desire for more stable, long-term investments. While private equity remains a favored asset class for large institutional allocators, there's increased scrutiny on fees and the market is becoming more competitive. Recapitalizations, or minority investments, offer a unique advantage in this environment. By partnering with founders and CEOs, investors can develop long-term relationships and grow businesses over an extended period, often with less involvement from intermediaries. Overall, the private equity landscape is evolving, with a focus on value creation and long-term partnerships.
High valuation multiples and abundant debt fuel real estate market's 'frothiness': Investors seek industries with recurring revenues, growing end markets, and low capital intensity, but even these traits may result in high valuations and slower growth
The current market environment is characterized by high valuation multiples and abundant debt availability, leading to a sense of "frothiness" in the real estate market. This frothiness is driven by both active auction processes and the availability of leverage. Recurring revenues, growing end markets, and businesses that aren't capital intensive are the economic characteristics that investors look for in potential investments. However, even industries with these traits, such as records management and cell towers, have seen maturing markets in the US, resulting in higher multiples and slower growth. The US market's exceptional performance relative to international indexes may contribute to performance chasing and high valuations. The most memorable days in the speaker's career have been deep analytical conversations with CEOs, leading to successful investments, and the early days at Housatonic, where they defined a differentiated niche in private equity.
Quality of investors crucial for investment firm success: Focus on long-term, high net worth investors with proprietary sourcing, longer holding periods, and specific business models. Evaluate businesses with a focus on growing recurring revenue and understand internet economics and margins.
The success of an investment firm depends significantly on the quality of its investors. Long-term, high net worth individuals and institutions who share the firm's focus on proprietary sourcing, longer holding periods, and specific business models are crucial. These investors are not easy to find and are often the unheralded factor in investment firm successes. Another key takeaway from the discussion is the importance of evaluating businesses with a focus on growing recurring revenue and understanding the internet economics and margins. The material used to evaluate opportunities is often rudimentary, but this focused approach allows for a tight screen and quick identification of potential investments. However, it's important to note that not all businesses fit this mold, and there are opportunities in volatile, deep cyclical, highly levered, high growth businesses. It's essential for investors to know their circle of competence and not ignore potential opportunities outside of it, but also recognize the unique challenges those businesses present.
The importance of understanding your strengths and building a strong team: Successful investing requires focusing on areas of expertise and fostering a supportive work environment. Stay true to your investing style and values, but also be open to new ideas through reading and collaboration.
Successful investing requires understanding your strengths and focusing on areas where you have an edge. In the case of Patrick O'Shaughnessy and his investment firm, they found success in the "super high growth bucket," but acknowledged that other investors excel in different areas, such as cyclical and levered investments. A key moment in their firm's history was when the founding partners generously shared economics with Patrick, setting a culture of generosity and collaboration. This anecdote highlights the importance of building a strong team and fostering a supportive work environment. Additionally, Patrick encourages readers to explore new ideas through reading and joining his book club. Overall, the conversation emphasizes the importance of staying true to your investing style and values, while also being open to learning from others.
