The Outsiders - Summary and Key Ideas
The Outsiders is one of the most recommended books among investors. It covers the difficult topic of assessing management and CEOs. The author studied eight outperforming CEOs and their common traits.
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Investors, Instead of Operators
Cash Flow / Against Wall Street
1. Investors, Instead of Operators
Buffett is famous for his saying: Think like an owner, not an investor. This saying can also be reversed. While most CEOs are focused on the operating and managing side of business, the Outsider CEOs are focused on capital allocation and investing for sustainable long-term success.
Let’s define capital allocation so we all know what we’re talking about here. There are five ways to allocate capital differently, and CEOs have to decide what fits their company best.
The 5 Ways of Capital Allocation:
Reinvest in the Company
Paying a Dividend to Shareholders
Paying off existing debt
All of these five ways to allocate capital can make sense. The question is, when do they make sense? And here’s a major difference between Outsider CEOs and the average CEO.
2. Capital Allocation Decisions
2.1 Reinvesting in the company
Reinvesting in the current business makes sense if it is the highest return opportunity. Outsider CEOs are rational and calculate their Return on Invested Capital (ROIC). If the ROIC is higher than what they think they can achieve by investing elsewhere or allocating capital differently, this is the way to go.
Double down on the current business and operations.
2.2 Acquire Companies
If the current operations are not generating the returns the CEO aims for, acquiring other companies can make sense. Once again, it’s about rational over emotion.
There’s a well-known agency problem called “Empire Building.” Empire building describes the attempt to increase the size of your company to gain more power and influence at the cost of returns and profits.
Outsider CEOs only make acquisitions when the acquired business can achieve higher returns and profits than they could without it.
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2.3 Paying a Dividend to Shareholders
While many shareholders like receiving dividends, Outsider CEOs are not known for paying them. Dividends rarely are the best investment for companies. They cannot be used for growing profits, and they come with the problem of double taxation since they’re first taxed on a corporate level (corporate tax on earnings) and then on a personal level (capital gain tax).
2.4 Paying Off Existing Debt
In some cases, it can make sense to pay off debt. However, this is only the case if debt levels are too high compared to the projected profits and the ability to pay interest.
Outsider CEOs primarily use debt to avoid taxes (Interest Tax Shield) and refinance it when it is due. That way, they never really pay off the debt. They use it for as long as it helps the business.
2.5 Share Repurchases
Share repurchases have two sides. They can be a great tool if done right but destroy value when done wrong.
Outsider CEOs buy back shares when the stock price is low/below fair value. This way, it is value-adding. And while this should make sense to everybody, the typical CEO does the opposite. Most share buybacks happen at historic highs.
Investors and CEOs are hyped for the future, and the announcement of buying back shares pushes the stock. In the end, however, capital allocated to buy overpriced stock is a bad investment. (Instead, a good use of a high stock price is buying other businesses and paying with the overpriced stock).
One of the companies I hold in my Portfolio is actually run by one of the CEOs, John C. Malone, mentioned in “The Outsiders.” And the company’s main value driver is to buy back shares at a massive discount right now.
Here’s the analysis:
To get access to all my Company Research, Deep Dives, Products, and Portfolio, become a paid subscriber. With the compounding of research published, the price will also rise (slowly). Existing subscribers, of course, always pay the price they subscribed for.
So, if you want to learn more, now is always the best time to subscribe ;)
3. Concentrated Bets
Another characteristic that Outsider CEOs and many famous value investors have in common are large and concentrated bets. While diversification is primarily a concept of stock market investing, many CEOs follow the same logic.
They make the same mistake, or better, they have the same wrong incentives as institutional investors and many portfolio managers on Wall Street.
The keyword: Career Risk
Nobody will get fired for mediocre performance or investing in the big names of the S&P 500 and Nasdaq. That’s why investing in line with the big indexes is safe for portfolio managers.
While deviating from the norm is necessary for outperformance, it comes with the risk of underperformance and, thus, the risk of losing your job.
The same goes for many CEOs. Making a few small bets that won’t move the needle in any direction is the safe way to stay where you are.
Outsider CEOs don’t think that way. They want to maximize profits, and if they find a good opportunity, they will go for it. Of course, a good opportunity is one that not only maximizes profits but also presents limited downside risk. Once again, the same principle as in investing.
4. Management Practices
Despite capital allocation, Outsider CEOs also differentiate themselves by the way they manage their companies.
4.1 Killing Bureaucracy
Why is Berkshire, as one of the biggest conglomerates and companies in the world, not drowning in bureaucracy and inefficiencies?
Because Buffett always prioritized a decentralized company structure. He often tells stories of the CEOs running companies for Berkshire. Buffett himself is rarely involved in those companies’ business. He trusts the management in place and wants them to do the job to the best of their abilities.
He minimizes the layers between Berkshire and the companies under its umbrella. There are only a few dozen managers, although the companies have tens and hundreds of thousands of employees.
4.2 Cash Flow is King / Wall Street is Irrelevant
The average CEO wants to beat Wall Street’s estimates quarter after quarter. This forces them into a cycle of short-term thinking and decision-making.
Outsider CEOs don’t care about the quarterly earnings reports that Wall Street wants to see. They are focused on producing sustainable cash flow and the company’s long-term success.
Throughout this article, you already got some insights into the personality of the Outsider CEOs. Here’s a short summary:
5.1 Low Ego but High Self-Confidence
Outsider CEOs don’t care about Empire Building or their public perception. Simultaneously, they are confident enough to make decisions that deviate from the norm and expose them to criticism and failure.
5.2 Analytical and Rational
Most Outsiders came from the analytical side rather than the business side of things and were new to the job. This gave them a completely different view on the questions, and they weren’t trapped in the business school and MBA thinking.
5.3 Honest and Understated
Outsider CEOs aren’t the typical charismatic and camera-savvy people who are great at communicating (or twisting facts). There’s a good book on assessing management called “Investing Between the Lines,” by L. J. Rittenhouse.
With Outsider CEOs, you don’t have to read between the lines. They communicate messages clearly and honestly.
Once again, thanks to Shortform for sponsoring today’s episode of The All-in-One Newsletter!
By the way, if you want to learn more about the Outsider CEOs and their individual stories, that book is also featured on Shortform!
Have a great Sunday, and see you in the next episode! (To all Paid Members, the Flow Trader Research Article is finished and scheduled for Wednesday!)