The author, a founder of an investment firm, studied companies that outperformed their peers and the larger market over extended periods of time. He ended with eight CEOs and companies with standout performance in the latter half of the 20th century. Looking deeper into their management practices, he found virtually identical patterns to their management style that were unorthodox but directly caused their outsized results. These CEOs and their management practices are the subject of The Outsiders.
The author found uncannily strong patterns among the outsider CEOs that distinguished them from typical CEOs. This concerned three areas:
In all three areas, outsider CEOs departed from common wisdom about how to operate a company and behave as a CEO.
This departure from conventional thinking makes logical sense. By doing the same things as everyone else, you’re restricted to average performance. You need to do unorthodox things to get unorthodox results.
In general, CEOs have to do two things to succeed:
Most CEOs and most management books focus on the former. In contrast, Henry Singleton of Teledyne and the other outsider CEOs in the book focused on the latter. Rather than seeing themselves as company operators, the outsider CEOs saw themselves as investors and capital allocators first and foremost.
Despite the importance of capital allocation, little training is devoted to it. Business schools don’t feature capital allocation in curricula, and CEOs are promoted from functional roles (like product or marketing) without strong experience with investment in the business. Outsider CEOs saw it as their core job.
As a baseline, businesses can deploy cash in five basic ways—invest in the existing business, acquire other businesses, pay dividends to shareholders, pay down debt, or buy back stock. They can also raise money by issuing debt or raising equity. These are all tools in capital allocation, and the specific usage of these tools determines a company’s performance.
How to decide between these options? Universally, outsider CEOs were rational—they calculated the return on each investment project, then made the most profitable choice. They ignored conventional wisdom and what their peers were doing.
Compared to their peers, outsider CEOs tended to allocate capital differently:
Outsider CEOs thought about their companies as investors and made cool, rational decisions based on what provided the best returns. Ego and a desire to build empires were never part of the decision.
In contrast, typical CEOs issued shares to fund costly acquisitions, preferred not to buy back stock or raise debt, and paid dividends frequently. In the conglomerate era, they aggressively acquired companies believing they could improve profits through scale or synergies; this was often a mirage that never materialized. All these activities tend to result in lower performance by the author’s favorite metric—price-per-share.
Note that the optimal choices vary from company to company, from industry to industry, and between different time periods. The point is not to blindly mirror what the outsider CEOs did—it’s to examine all of the tools in your toolkit, and choose the best one based on rational analysis.
Beyond capital allocation decisions, the outsider CEOs ran their businesses in unorthodox ways.
In their management of people and business units, outsider CEOs were relentlessly decentralized. They hired entrepreneurial operators for their business lines and left them alone. They kept a skeleton staff at headquarters, which reduced overhead and anxiety about office politics—the way to get ahead in the company was to outperform in your business unit.
Examples:
In contrast, typical companies tend to bulk up headquarters, featuring layers of vice presidents and MBAs. Not only does this increase overhead, but it also encourages office politics.
Decentralization also came in the form of spin-offs and tracking stocks. Instead of being buried within a large conglomerate, spin-offs gave individual business units more autonomy and better-aligned incentives with management.
To outsider CEOs, cash was vital to the business, since it could be redeployed in their capital allocation strategies. Therefore, outsider CEOs cut operating expenses to a minimum. They avoided typical corporate perks like private cars and airline seats and kept headcount lean and efficient. When they acquired companies, they instilled this lean culture into the new company.
Outsider CEOs resisted focusing on reported earnings, which present a muddled reflection of company performance because of capital expenditures, acquisitions, and other accounting artifacts. Instead, they focused on cash flow and then-innovative metrics like EBITDA (earnings before interest, taxes, depreciation, and amortization). This affected their operations deeply, from how they financed acquisitions to their compensation schemes for employees.
This relentless focus on cash flow also allowed them to avoid counterproductive distractions, such as costly acquisitions for the sake of growth that would later prove unprofitable.
Typical CEOs let their egos get involved in strategic decisions. They enjoy empire building, growing revenue and headcount without concern for profit or long-term outcomes.
In contrast, outsider CEOs focused on shareholder value as their top priority. Having low egos, they didn’t hesitate to shrink the size of the company if it meant better returns to shareholders. For instance, Henry Singleton of Teledyne actively spun out businesses, believing they would independently perform better than under one large umbrella. This reduced the size of Teledyne but improved total shareholder performance.
Outsider CEOs saw investor relations as a waste of time. They spent little time talking to Wall Street and managing expectations. Instead, they preferred to spend their time on the business. Most of the companies were situated outside the financial Northeast, in places like Omaha and Denver, where they would be insulated from the conventional wisdom of Wall Street.
Outsider CEOs outperformed because of how they managed their businesses, not because of idiosyncratic strokes of luck, like intellectual property advantages or groundbreaking new ideas. Other than management, they didn’t have any discernible advantages over their peers, and so their outsized performance can be attributed directly to their management and capital allocation strategies.
In contrast, some high-profile CEOs like Steve Jobs or Mark Zuckerberg had highly unusual circumstances. They had powerful new ideas taking advantage of technology trends, and they executed the ideas relentlessly. These situations are unlike those facing most business managers, and so lessons of a Steve Jobs or Zuckerberg are rarely generalizable to the business community at large.
Among outsider CEOs, there was a pattern of having COOs who focused on day-to-day operations, while the CEO focused on long-term strategy and capital allocation. In essence, the COO generated the free cash flow, and the CEO spent it.
Examples:
Outsider CEOs tended to be strategically flexible, changing company strategy as the circumstances required. Rather than adhering to a preset strategy, outsider CEOs evaluated all possible options at each point in time, then chose the option that was best.
For example, General Dynamics aggressively sold business lines like Cessna during one phase of the company’s turnaround, then decades later reversed course and acquired large businesses like Gulfstream when the environment had changed.
Likewise, at one time, share buybacks might be the best use of cash; in another time, using high-priced stock to buy companies might be preferable.
The outsider CEOs tended to negotiate directly instead of through a layer of advisers.
Examples:
When making capital allocation decisions, outsider CEOs avoided complicated financial models and pages of analysis, which they knew to be imprecise. Instead, they tended to simplify understanding of a business down to a handful of key assumptions—market growth trends, competitive dynamics, and cash flow. This allowed them to make fast decisions when an opportunity appeared.
The outsider CEOs also showed patterns to their personalities that informed how they ran their businesses.
Outsider CEOs preferred to come to their own conclusions instead of following conventional wisdom. They were analytical and rational about their businesses. All were quantitative people, with more having engineering degrees than MBAs.
This independent thinking often led to unorthodox practices, such as buying back shares when none of their peers were, or ignoring traditional measures of value like reported earnings and book value. But even when observers were skeptical, outsider CEOs cared little what others thought. This iconoclast personality allowed them to avoid the peer pressure of imitating other CEOs.
They were also broad thinkers, familiar with a variety of industries and disciplines, which translated into new perspectives and approaches. Using the metaphor of a “hedgehog,” who knows one thing very well, or a “fox,” who knows many things, the outsider CEOs were foxes. For example, Bill Stiritz of Ralston Purina had an unusual blend of marketing acumen and financial astuteness.
The CEOs featured in the book were first-time CEOs, with little management experience. Only two had MBAs. In fact, many were new to their industries. This inexperience might have helped their management, as they were unbound by conventional wisdom and built their practices independently, from first principle.
Outsider CEOs were humble and did not seek the spotlight. They avoided magazine covers and public talks. They weren’t considered charismatic. They were not household names in business, and so few people other than sophisticated investors and company fans know about them. They lived seemingly boring lives and were happily married. They were patient and tolerated waiting long periods of time for compelling opportunities to arise.
Again, this did not mean timidness. When outsider CEOs saw a great opportunity, they acted boldly and decisively.
If you’re asked who the greatest CEO of the last century was, one name might naturally come to mind: Jack Welch. During his 20-year tenure as CEO of GE from 1981 to 2001, GE stock had a compounded annual return of 20.9 percent. $1 invested in GE stock in 1981 would have turned into $48 20 years later.
As a result, Jack Welch has been lionized as the classical power-CEO. He was a famously active manager, diving deep into business units and traveling among GE’s locations. He communicated regularly with Wall Street and focused intently on managing GE’s stock price. He earned a public persona as a charismatic high-performance manager, gracing the covers of business magazines and authoring management books like Winning.
But is Jack Welch really the greatest CEO of the century? According to the author of The Outsiders, no—not even close.
There are two common issues with assessing the performance of CEOs like Jack Welch:
Taking these two points into account, there are CEOs that outperformed Jack Welch by multiples. For example, Henry Singleton of the conglomerate Teledyne operated during a 30-year period when his peers were returning 11% per year. In contrast, Teledyne returned 20.4% in the same period. $1 invested in Teledyne at the beginning of the period (1963) would have returned $180 by 1990, compared to $27 in a basket of conglomerates, or $15 in the S&P 500. Singleton achieved 5-times better performance relative to peers, in a worse time that featured multiple bear markets.
The author investigated CEOs like Henry Singleton who had outlier performance compared to the rest of their industry and the market. He found 8 CEOs whose companies showed remarkable financial performance over the course of decades. Furthermore, he found uncannily strong patterns among the outsider CEOs that distinguished them from typical CEOs. These CEOs and their management practices are the subject of The Outsiders.
Capital Cities Broadcasting was a media company owning television stations, radio stations, and print publications. Outsider CEO Tom Murphy was CEO from 1966 to 1996.
In 1966, the market capitalization of Capital Cities was 6% that of CBS, the dominant media business in the country.
By 1996, when Capital Cities sold to Disney, it had rocketed past CBS and was now worth three times as much as CBS. It had acquired media giant ABC, which was dubbed by the press as akin to a “minnow swallowing a whale.” Relative to CBS, Capital Cities had grown nearly 50 times as much in the same period.
The strategy was simple and repeatable: buy media properties with attractive economics, improve operations to generate more cash, and use the cash to buy more media properties. Capital Cities had a management playbook that made it very effective at increasing revenue and cutting costs at its newly acquired companies. This created a “perpetual motion machine for returns.”
From 1966 to 1996, Capital Cities showed a 19.9% annual return rate, compared to the 10.1% for the S&P 500 and 13.2% return for leading media companies.
$1 invested at the beginning would have been worth $204 by 1996. This outperformed the S&P by 16.7 times, and his peers by almost 4 times.
Tom Murphy served in World War II and graduated from Harvard Business School in 1949. He worked as a product manager in consumer packaged goods for Lever Brothers until 1954, when his father’s friend Frank Smith told him about a TV station in Albany he’d purchased from bankruptcy. With no broadcasting experience, Murphy left to run the station day-to-day, with Smith running the business from downtown New York.
Murphy’s strategy was to improve programming to raise revenue and manage costs to reduce expenses. After a few years of losses, Murphy turned the station into a profitable cash generator. In 1957, they bought a second station in North Carolina, then a third one in Providence, and continuously from then on.
When Smith died in 1966, Murphy became CEO of Capital Cities. Murphy in turn promoted Dan Burke, a Harvard MBA he had hired 5 years earlier, to COO. They had a clean division of labor—Burke would focus on the day-to-day operations, while Murphy was responsible for capital allocations and acquisitions. In essence, Burke generated the free cash flow, and Murphy spent it.
At the time, Capital Cities had revenues of $28 million. Over the next few years, Murphy made large acquisitions.
At the time, the FCC allowed a company to own a maximum of five VHF TV stations, and Capital Cities had reached this maximum. Thus they turned to newspaper publishing, which had a similar business model as broadcasting. Once again, he had an appetite for acquisitions, buying newspapers for values in the high 8-figures in the 1970s. In 1980, he entered cable television by buying Cablecom for $139 million.
During the bear market of the early 1980s, Capital City shares were at single-digit P/E (price to earning) multiples. Murphy aggressively repurchased Capital City shares, eventually buying back close to half of standing shares.
In 1984, the FCC relaxed its maximum station limit, and in 1986 Capital Cities bought the ABC network for $3.5 billion, with financing help from Warren Buffett. As the largest transaction in business history outside of oil and gas, it stunned observers. ABC was bigger than Capital Cities at the time.
But Capital Cities treated ABC no differently than small local stations it had acquired. It cut costs aggressively, including ABC’s plush executive perks; it improved programming, in turn leading to better ratings and revenues. Soon ABC became more profitable than its competitors CBS and NBC.
In 1993, at 65, Burke retired from Capital Cities. Now without a clear successor, Murphy met with Michael Eisner (CEO of Disney) in 1995, who was interested in buying Capital Cities. Murphy negotiated a $19 billion price, which was 28 times net income.
As a prototypical Outsider CEO, Murphy rarely issued stock to fund acquisitions, which would dilute existing shareholders. Instead, he raised debt to fund acquisitions. Since Capital Cities enjoyed industry-leading margins, he would often pay off debt ahead of schedule. Then, with the new profitable asset, he would leverage it to buy other assets. This was a highly repeatable strategy that they employed dozens of times over Murphy’s tenure.
Capital Cities also repurchased $1.8 billion of shares, mostly at single-digit ratios of price to cash flow.
When acquiring companies, Capital Cities focused on businesses it knew it could run well—media businesses that it could buy, make more efficient using its operating playbook, and thus turn into productive assets that could fuel further similar acquisitions. They knew the business model well—advertising-driven revenue with good margins and strong competitive barriers.
In contrast, its peer company CBS engaged in the conventional practice of acquiring unrelated businesses, such as toy businesses and the Yankees baseball team. The conventional thinking was that these acquisitions would lead to diversification, thus avoiding the variability of economic cycles, as well as synergies, where larger companies magically become more profitable through efficiency. However, like many acquisitions by conglomerates of this era, these did not materialize in meaningful synergies or better profits. Often, conglomerates acquired too rapidly and underestimated the difficulty of improving operations to realize cost efficiencies.
When acquiring companies, Murphy prospected carefully for good deals. He had a simple benchmark—the acquisition should have a “double-digit after-tax return over ten years without leverage.”
He was known for being fair. He’d ask the seller what a fair price was, and if he thought it was fair, he’d pay it. If he didn’t, he countered once—if rejected, he walked away. He never engaged in hostile takeovers.
Often, the reputation of Capital Cities preceded him. They were known for being market leaders and fair employers. This lowered the hesitation of potential acquisition targets.
Capital Cities strongly believed that the best decisions were made at the local level. Headquarters gave responsibility and authority to individual publishers and station managers.
As a result, its headquarters was tiny. It saw its role purely as supporting the general managers. There were no vice presidents in functional areas like strategy or marketing and no PR department. This drastically reduced overhead, contributing to Capital Cities having the highest margins in the industry.
In this environment, entrepreneurial general managers thrived. Managers were expected to deliver margins and to outperform their peers. If they met their numbers, they rarely heard from headquarters.
High-performing managers were trusted to take over a newly acquired business or to enter a new industry, even if the manager didn’t have prior experience in the industry.
Businesses that rely on advertising face variability in revenues, often as a result of the larger economic environment. Capital Cities knew that their businesses couldn’t control revenue, but it could control costs. Therefore, they cut wasteful expenditures aggressively, particularly around headcount and perks.
In a famous story, when Murphy first arrived in Albany in 1956, Smith asked him to paint the TV station’s exterior to look better to advertisers. Murphy painted only the two sides facing the road, leaving the other two sides the same.
This spirit carried throughout Murphy’s management. Each year, every general manager prepared detailed budgets for the upcoming year and met with Burke and his CFO at headquarters. Burke would go line-by-line and scrutinize each expense.
When Capital Cities acquired ABC, they immediately cut unnecessary expenses like executive limo service, and they laid off 1500 redundant positions.
Despite their philosophy of lean expenses, Capital Cities made choice investments in quality programming to drive more advertising revenue. They realized that the number one station in local news often ended with a disproportionate share of local ad revenue, and so they invested heavily in news talent and technology to lead local markets. Most of the media properties in Capital Cities were local leaders.
As an example of a Capital Cities transformation, newspaper Kansas City Star was purchased in 1977 for $95 million, with $12.5 million in cash flow and single-digit margins. In 1996, cash flow grew to $68 million and margins grew to 35%.
Teledyne is an industrial conglomerate founded in 1960, currently involved in businesses ranging from aerospace electronics to digital imaging.
Founder Henry Singleton served as CEO from 1960 to 1986, taking it through three phases with very different activities:
From 1963 to 1990, Teledyne showed a 20.4% annual return rate, compared to 11.6% for the S&P 500 and 11.6% for major conglomerates.
$1 invested at the beginning would have been worth $181 by 1990. This outperformed the S&P by 12 times, and his peers by nearly 9 times.
Henry Singleton was born in 1916. He attended MIT for college and received a PhD in electrical engineering. He won first place in the Putnam Math Competition and was nearly a chess grandmaster—clearly a smart guy.
After graduating, he became a research engineer at a series of aviation companies. At Litton Industries, he led a business group that grew to $80 million in revenue and became the company’s largest division.
In 1960, at age 43, he left Litton to co-found Teledyne with a colleague. They began by acquiring three electronics companies and using this platform to win a large naval contract. Within a year, they became a public company.
In this era of conglomerates, companies expanded quickly through acquisitions. Since private equity didn’t yet exist, there was less competition for acquisitions, and acquired companies often traded for lower P/E multiples than their buyers had in public markets. As a result, conglomerates had a virtuous cycle for acquisitions—buying cheap companies raised short-term profits, which increased stock prices, which in turn was used to buy more companies.
Singleton took advantage of these dynamics. In 8 years ending in 1969, he purchased 130 companies in a wide range of industries, including specialty metals and insurance. Most companies were purchased using Teledyne stock.
In 1967, Singleton acquired Vasco Metals and promoted its president (and Singleton’s former roommate at the Naval Academy) George Roberts to president of Teledyne. As with Burke at Capital Cities, Roberts became the operating manager of Teledyne, freeing up Singleton to focus on strategy and capital allocation.
In 1969, Teledyne’s stock began falling in P/E ratio, and acquisition prices began rising. Realizing that Teledyne’s stock would no longer be profitable for acquisitions, he laid off his acquisition team and never made another material acquisition. Instead, they turned their focus to increasing margins at business units. Through the 1970s and 1980s, Teledyne saw remarkably high return on assets of 20% or greater.
This generated remarkable free cash flow, which was used by Singleton in a series of aggressive share repurchases. At the time, the conventional wisdom held that repurchases were done only by weak companies that lacked investment opportunities. But given Teledyne’s low P/E ratio and high acquisition prices, Singleton reasoned that the best use of cash was to repurchase shares. Over 12 years, he bought back a staggering 90% of Teledyne’s shares, becoming a pioneer in share repurchases as a financial strategy. As a result of share repurchases, from 1971 to 1984, Teledyne’s earnings per share grew by 40-fold.
From 1984, Singleton began planning for his succession (he promoted Roberts to CEO in 1986). By this time, Teledyne had begun showing stagnating results. Singleton’s approach here, as usual, was unconventional—he began unpacking the Teledyne conglomerate, spinning off companies to be independent. For example, in 1990, he spun off Unitrin, Teledyne’s largest insurance business and the majority of Teledyne’s company value. He believed disassembling the conglomerate would reduce Teledyne’s complexity, thus reducing succession issues, as well as unlock more value for shareholders.
Finally, in 1987, Singleton paid Teledyne’s first dividend in its 26 years as a public company. The reasoning: stock prices and acquisition prices were at historic highs, while Teledyne’s non-insurance companies were in a slump, and so he reasoned distributing cash flow to shareholders was the best use of money.
Singleton retired in 1991, having realized a 20% compounded annual growth rate over the 30 years as a public company.
Singleton chose his acquired companies deliberately. Like Murphy at Capital Cities, Singleton had a financial benchmark for acquisitions—never paying more than 12 times earnings, and often paying single digit-multiples. In comparison, Teledyne’s stock price ranged from 20 to 50 times earnings, thus making many acquisitions a great deal.
Singleton also chose to focus on companies that were profitable, growing, and in leading market positions. They were often in niche markets. He avoided acquiring struggling turnaround companies, a common target of other conglomerates at the time.
Singleton’s share buybacks were in a class of its own in its level of aggression. Over 12 years, he bought back a staggering 90% of Teledyne’s shares, at one point buying over 20% in a single tender offer. He acted deliberately at opportune times, when Teledyne’s stock price was low; when interest rates were low, he would use debt to buy back stock.
In the era of conglomerates, the idea among many companies was that central headquarters could find large synergies among its subsidiaries. Thus, they employed armies of executives to conduct planning and strategy.
In contrast, Teledyne’s headquarters had fewer than 50 people, while its company employed over 40,000.
They even had a small board, featuring just 6 directors, including Singleton.
Internally, the key metric was the Teledyne return, an average of cash flow and net income. For each business unit, this metric determined the general manager’s bonus compensation. Focusing on this internal metric helped Teledyne achieve best-in-class profitability and cash flow, which fueled their growth.
General Dynamics is an aerospace and defense corporation. After the end of the Cold War, it and many other defense companies faced a large contraction of spending as US national defense priorities shifted. Incoming CEO Bill Anders successfully led a turnaround that made General Dynamics the industry’s profit leader, instilling fundamentals that continue to this day.
From 1991 to 2008, General Dynamics showed a 23.3% annual return rate, compared to 8.9% for the S&P 500 and 17.6% for major conglomerates.
$1 invested at the beginning would have been worth $30 by 2008. This outperformed the S&P by 6.7 times, and its peers by 1.8 times.
In 1989, the Berlin Wall fell, and with it fell the US defense industry’s business model. Accustomed to selling large weapons systems such as missiles and bombers, the defense industry now found its wares obsolete amidst new national priorities. Within 6 months, the price of leading defense companies had fallen 40%.
General Dynamics was one of the worst affected companies. In 1991, it had $10 billion of revenue but negative cash flow, as well as $600 million of debt, and thus had a market capitalization of just $1 billion. That year, Bill Anders joined as CEO.
Anders was an air force fighter pilot and astronaut who held the rank of major general at NASA and was well-respected at the Pentagon. At 45, he left government for the private sector, first for General Electric and then for conglomerate Textron. An independent thinker and blunt communicator, he was a misfit for bureaucratic cultures.
In 1989, he was made an offer to join General Dynamics, first as vice-chairman for one year and then to rise to CEO. He spent the year studying the industry with fresh eyes, where he came upon his strategic insight: during the Cold War, defense companies had become bloated with excess capacity. Now that much of their wares weren’t needed, defense companies had two options: 1) shrink down dramatically to retain margins, or 2) acquire businesses to grow.
In turn, his strategy for General Dynamics had three key ideas:
In his three years as CEO, Anders implemented a rigorous focus on margins and generating more cash:
These moves produced fantastic returns—$2.5 billion in cash, and a market-leading return on assets.
The other major move Anders employed was selling non-core businesses to other defense companies. He found that competitors were willing to pay premium prices to grow their businesses. Within two years, Anders sold the majority of their business lines, including their F-16 fighter plane division to Lockheed for $1.5 billion. This was unprecedented in the defense industry—observers say Anders was only able to do this because of his credibility in Washington as a military veteran. These sales generated another $2.5 billion in cash.
What to do with this extra $5 billion in cash? Anders made two moves:
All of these moves—the generation of billions in cash, and its return to shareholders—made the stock price of General Dynamics shoot up.
After serving as 3 years as CEO, Anders handed the reins to his COO, Jim Mellor.
Mellor continued discipline around operational excellence and selling the last non-core business units.
However, in 1995 he made an uncharacteristic move by buying a navy ship builder for $400 million. After years of the company shrinking, he had kicked off a new era for General Dynamics—one of growth.
After 3 years as CEO, Mellor handed the reins to the company’s general counsel and a key facilitator of Anders’s strategy, Nick Chabraja.
Chabraja set a lofty goal for himself as CEO—grow the stock price by 4-fold in ten years (a 15% annual return). He figured the majority of this could come through market growth and improved operations. The rest had to come through acquisitions.
While this departed from Anders’s actions, the fundamental beliefs were the same—General Dynamics should grow only in core businesses it knew well. Chabraja began with small acquisitions, adding onto its information technology, tank production, and marine divisions.
In 1999, he made his hallmark move, the $5 billion purchase of Gulfstream, the largest commercial jet manufacturer. The acquisition was equal to 56% of the enterprise value of General Dynamics.
Observers criticized the move as departing from Anders’s 3-point strategy from 1991, but Chabraja had a deeper logic—Gulfstream had stagnated in product development. In contrast, General Dynamics had considerable experience in aircraft from its previous days, and this expertise could be used to grow Gulfstream. In turn, Gulfstream would help diversify General Dynamics away from the fluctuations in military defense spending.
In an unusual move for outsider CEOs, Chabraja sold stock to fund the purchase of Gulfstream. However, his logic was that General Dynamics was trading at all-time highs (23 times projected earnings, vs. the recent average of 16). He could sell ⅓ of the company to buy a business that would contribute half of its cash flow—a clear profitable arbitrage.
When Chabraja retired from CEO in 2008, he had more than achieved his goal of quadrupling their stock price. Importantly, the three CEOs left a legacy of fundamental ideals—General Dynamics leads in all its business lines, and it has the industry’s highest return on assets and margins.
Many CEOs let ego drive their strategy, growing revenue and headcount with little concern for profits.
It takes an egoless CEO to actively shrink the company for the sake of shareholder value. In a time when defense companies were scrambling to acquire other businesses to grow, Anders actively shed the majority of the business units at General Dynamics.
These were not easy decisions—a former pilot, he had a special soft spot for the F-16 fighter jet division. But when Lockheed made an offer for the right price, he did it without hesitation.
Outsider CEOs tended to avoid concrete strategic plans, instead preferring flexibility to adjust to the circumstances.
When Anders was actively selling businesses, he had actually intended to grow the fighter jet business through acquisition. He approached Lockheed’s CEO with the intent to buy their business, and was surprised when Lockheed instead countered with a generous offer to buy General Dynamics’s F-16 business. Had Anders been more stubborn about retaining the business, he might have missed this opportunity.
Likewise, a company needs different strategies in different situations. Anders grew the company’s value by aggressively shedding its non-core businesses and shrinking the company through improved operations. Just 6 years later, Chabraja grew the business lines through thoughtful acquisitions, including the massive bet on Gulfstream. Even more notably, he did so by selling stock, a rare move among outsider CEOs but appropriate at the time given that their stock was at an all-time high.
Companies in the defense industry are often run by military veterans, so it’s no surprise that they tend to be hierarchical, centralized, and run from the top-down, just like the military.
However, Anders and his two successors pushed continuously for decentralization. They shrunk headquarters and middle management by over 75% and shifted responsibility downward to the business units. There was active dissuasion of headquarters meddling with operating divisions. As is typical in outsider CEO companies, if the division chiefs hit their budgets, they were left alone.
As part of its decentralization strategy, General Dynamics instituted bonus compensation based on long-term improvements in stock price. This was key to attracting capable talent to the company.
Tele-Communications Inc. (TCI) was a cable television provider founded in 1958. It grew to be the largest cable company in the country, owning both cable providers and content programming. It was acquired by AT&T in 1999 for $43.5 billion in stock and, through a series of transactions, would ultimately become Comcast.
As CEO from 1972 to 1991, John Malone pursued a virtuous cycle strategy—grow subscriber count through acquisitions of cable providers, which would give scale to negotiate lower fees with content providers, which would make acquisitions of cable companies further cheaper.
From 1973 to 1998, Teledyne showed a 30.3% annual return rate, compared to 14.3% for the S&P 500 and 20.4% for public cable companies.
$1 invested at the beginning would have been worth $900 by 1998. This outperformed the S&P by 40 times, and his peers by 5 times.
John Malone was born in 1941 and earned bachelor’s degrees from Yale in economics and electrical engineering, as well as graduate degrees in operations research from Johns Hopkins. He worked at Bell Labs, studying financial strategies in monopoly markets. Unhappy with the bureaucratic culture at AT&T, he joined McKinsey as a consultant.
While at McKinsey, he studied the cable industry, and he immediately saw an attractive opportunity:
In 1970, one of his clients at McKinsey, General Instrument, made an offer to him to run Jerrold, its cable television equipment division. Within two years, he was made an offer by TCI to join as CEO.
TCI was founded in 1956 by Bob Magness and had gone public in 1970. In 1973, when Malone joined, it had 600,000 subscribers and was the #4 cable company in the US. It had taken on a troubling amount of debt—17 times revenue—and was dangerously close to bankruptcy.
Malone’s first priority was to keep TCI out of bankruptcy. He instituted a new lean culture focused on financial discipline, estimating that growing subscribers by 10% per year while maintaining margins would keep them out of bankruptcy. He maintained frugality at headquarters, keeping just a single receptionist and grouping multiple executives in the same motel room when traveling.
Characteristic of outsider CEOs, Malone had a COO, J.C. Sparkman, who enforced budgeting and cash flow benchmarks at the operating divisions. Managers who underperformed were fired.
Over his first 4 years, Malone pushed TCI to produce the highest margins in the cable industry and saw consistent subscriber growth and cash flow.
Once TCI stabilized, Malone could pursue his master strategy: a virtuous cycle of growth.
At cable companies, the largest expense (40% of operating expenses) was paid to content suppliers (called programmers) like HBO and MTV. Larger cable providers were able to negotiate lower fees per subscriber. Malone realized that the key was to increase size, which would allow for increasingly better business economics, which would in turn allow for increased size.
Here’s how the virtuous cycle worked in more detail:
In essence, larger cable companies could pay more for acquisitions than smaller competitors, since they could extract more value from them.
Malone executed the strategy relentlessly, acquiring 482 companies from 1973 to 1989 (this was a rate of one every two weeks). His sole focus was on acquiring subscribers at good prices.
Maintaining financial discipline, Malone avoided the costly competitions for urban markets, instead focusing on rural and suburban areas. He felt other cable companies were bidding up the price of urban markets, thus making them unprofitable; indeed, when years later the urban companies failed under too much debt and low profits, Malone acquired them at much lower prices, leading to better economics.
In 1982, TCI became the largest cable provider, with 2.5 million subscribers.
In addition to growing subscribers, Malone was interested in partnering with cable programmers. He took minority stakes in new programming businesses, in exchange for capital and access to TCI’s subscriber scale. Thus Malone built partnerships with rising channels such as BET, Discovery, and QVC. He was unique among cable companies for doing so at the time. These investments would be a large part of TCI’s ultimate value.
Through the 1990s, a shifting environment put a damper on the cable industry. New regulation limited cable rates and access to debt for cable companies, which stifled growth. Furthermore, the cable industry faced increasing competition from satellite television.
Realizing that better opportunities might lay outside cable, Malone shifted his focus:
As the 1990s wore on, Malone became increasingly concerned about TCI’s future. In addition to the regulation and competition from satellite television, TCI’s rural cable networks were also wearing down and would need to be upgraded at significant expense. He also didn’t have a clear successor (his COO Sparkman retired in 1995).
In 1998, he found a buyer in AT&T and negotiated a striking deal—$43.5 billion in stock, which was 12 times EBITDA and $2,600 per subscriber. In addition, he negotiated a long-term deal for Liberty Media’s programming on AT&T cable.
Like many acquisitive outsider CEOs, Malone used debt to finance acquisitions. As described earlier, he saw that growth for cable companies could come more cheaply than expected—depreciation of capital expenditures and interest expenses would reduce taxes, even if the company had healthy cash flow. Furthermore, increasing scale allowed TCI to access cheaper debt.
Through much of his tenure, he maintained a ratio of 5x debt to EBITDA. Malone also structured the debt intelligently to prevent defaults in one loan from cascading and causing systemic problems—in technical terms, he avoided cross-collateralization. (Shortform note: Enron’s downfall was caused in large part because of complicated dependencies between their loans. Read our summary of The Smartest Guys in the Room to learn more.)
As described earlier, Malone engaged in acquisitions to fuel the virtuous cycle of subscriber growth, leading to better economic terms with content programmers, leading to further subscriber growth.
Like many outsider CEOs, Malone wasn’t haphazard about acquisitions. He had a clear rule—pay a maximum of five times cash flow, after all the fee discounts and operational efficiencies were realized. This simple rule let him move quickly when the price was right, and let him walk away quickly when it exceeded his maximum price.
After the acquisition, like Tom Murphy and Capital Cities, Malone and Sparkman would institute a lean environment and cut all unnecessary expenses. For example, for one cable franchise, TCI cut payroll in half and moved the team from a downtown skyscraper office to a tire warehouse.
Malone believed that the conventional measure of company performance, earnings per share, was a foolish yardstick for the growing cable industry. He saw that higher earnings meant paying more taxes, which would bleed money that could be used to scale a cable company.
Therefore, he ignored EPS, instead focusing on cash flow. In fact, Malone pioneered the use of EBITDA (earnings before interest, taxes, depreciation, and amortization). At the time, EBITDA was a radically new reflection of a company’s cash flow; today, it’s universal in financial analysis.
As a capital allocator, Malone only invested in projects that provided clear and compelling returns. One project that often did not meet this bar was improving cable infrastructure. Capital expenditures would reduce cash flow, and he did not see the return on investment on upgrading to new technology. Knowing that implementing new media technology was costly and difficult, he preferred to wait for his competitors to scramble over each other and pave the way first; then he learned from their mistakes and pursued only the paths proven to be economically viable.
He was not shy about one area of investment—joint ventures. At the time of sale, he had developed 41 partnership interests, many in programmers. Among his competitors, he was unique in recognizing the value of investing in cable entrepreneurs and having a mutually beneficial relationship by providing scale to the burgeoning programmers.
Like other outsider CEOs, Malone repurchased a large portion of shares—over 40% of outstanding shares. He took advantage when TCI stock reached especially low multiples. When allocating capital, he would compare the value of buying back stock to making more acquisitions, then make the more profitable transaction.
The Washington Post was owned by Eugene Meyer, whose daughter was Katharine Graham. Her husband, Philip Graham, was hired by Meyer to lead the Washington Post from 1946 to 1963. However, Philip committed suicide in 1963, and Katharine was expected to take over management.
An inexperienced executive, Katharine hadn’t worked for 20 years when she took the CEO role. But through wise decisions around both editorial and business, the help of strong executives, and a key advisor by the name of Warren Buffett, she led the Post to be the most successful newspaper company of its class.
From 1971 to 1993, the Washington Post Company showed a 22.3% annual return rate, compared to 7.4% for the S&P 500 and 12.4% for public newspapers.
$1 invested at the beginning would have been worth $89 by the end. This outperformed the S&P by 18 times, and her peers by six times.
In 1963, Katharine Graham became CEO of the Washington Post. At the time, the Post had grown to include Newsweek magazine and three TV stations. She spent a few years learning the ropes.
In 1967, she made an unconventional staffing choice—she replaced her veteran editor-in-chief with a young firebrand, Ben Bradlee. Changing from a veteran to a newcomer was an odd choice, but Graham believed she needed someone with a better grasp of the 1960s zeitgeist. Bradlee’s energy would prove vital in raising the profile of the Post’s newsroom in its stories.
In 1971 and 1972, the Post clashed with the Nixon administration over stories critical of the presidency. This included the breakthrough investigation of the Watergate scandal. Despite the Nixon administration’s threats to impede the Post with regulatory scrutiny, Graham pushed forward and published the stories. These elevated the stature of the Washington Post, putting it on equal footing with the New York Times.
In 1971, Graham took the Washington Post Company public to raise money for acquisitions. She started by buying the Trenton Times, which was a #2 paper in a competitive market and showed mediocre performance. This would teach her discipline in acquisitions going forward.
In 1974, a relative unknown began buying stock in the Post, ending with 13% ownership. His name was Warren Buffett. While her board counseled her to avoid the unknown, she met with him and found his advice indispensable, and she invited him to join the board. He would prove to be vital throughout Graham’s tenure, advising her around capital allocations.
In 1975, the Post faced a worker’s strike from the paper printers. Determined not to give in, Graham hastily hired a crew to man newspapers, publishing for 139 days before the printers conceded. Winning many favorable concessions, Graham made big improvements to the Post’s margins.
Around this time, Buffett advised Graham to repurchase Post shares, given their low prices. She repurchased 40% of Post shares, an unusual move that her competitors didn’t follow.
In 1981, the other major newspaper in Washington, the Washington Star, shut down. The Post became a monopoly daily newspaper in Washington, D.C., which greatly increased its circulation and profitability.
Also in 1981, Graham hired a strong COO, Dick Simmons. Like other COOs for the outsider CEOs in this book, Simmons carried operational excellence to the Post’s business units, increasing margins improving compensation structure.
During the 1980s, the newspaper industry went on an acquisition spree, bidding up prices aggressively. Graham didn’t participate, finding the assets overpriced. Instead, they looked to businesses outside media, acquiring companies in telephone, test preparation (Kaplan), and cable television (from Capital Cities). Each of these would both rise in value and provide a valuable counterweight to the newspaper business as it declined due to the Internet.
As the early 1990s approached with a recession, the Post became acquisitive while its competitors sat back, over-saddled with debt. Graham purchased companies at significant discounts in cable television, TV, and education.
Graham stepped down in 1993, leaving a legacy of strong performance and excellent financial returns.
As with the other outsider CEOs, Graham’s choices around how to get money and how to spend it caused the Post’s outperformance:
Ralston Purina was a consumer packaged goods company producing commercial animal feed, consumer pet food, and human foods. When Stiritz joined as CEO in 1981, Ralston had a muddled focus (having purchased a hockey team and ski resort) and a stagnant stock price. Stiritz revitalized the company with discipline, divesting unprofitable business units and acquiring new genuinely synergistic businesses. In 2001, Ralston merged with Nestle in a transaction worth $10.4 billion.
From 1981 to 2001, Ralston showed a 20.0% annual return rate, compared to 14.7% for the S&P 500 and 17.7% for peer companies.
$1 invested at the beginning would have been worth $38 by 2001. This outperformed the S&P by 2.5 times, and his peers by 50%.
In the 20th century, consumer packaged goods companies like Heinz and Kellogg largely moved together as a pack. They were considered stable blue-chip stocks, paying out dividends and resisting recessions. During the 1960s and 1970s, they acquired aggressively in pursuit of synergy and vertical integration, ending up in industries like restaurants and agriculture.
Ralston Purina had done the same. With its core in agricultural feed, it had ended up with broad interests in a fast food chain (Jack in the Box), crop farms, a hockey team (the St. Louis Blues), and a ski resort. In 1980, when CEO Hal Dean stepped down, its stock price was the same as a decade prior.
During the board’s search for CEO, an internal executive Bill Stiritz submitted an unsolicited plan for revitalizing the company—sell businesses that were performing poorly, and reorganize the company around its high-margin consumer brands. The board director read the plan and knew it was the right direction. Stiritz got the job.
Stiritz had spent his early career at Pillsbury as a field rep and at an advertising agency. This would provide on-the-ground experience in both distribution and marketing. In 1964, at 30 years old, he joined Ralston Purina in the consumer products division (pet foods and cereals), considered one of the weakest divisions of the company. He introduced still-famous brands Purina Puppy and Cat Chow, and, during his time in the division, its profits increased 50-fold.
Unlike other outsider CEOs, Stiritz had been an insider at the company for over a decade. But he brought an unconventional plan that deviated from competitors. He knew that the consumer brands had attractive economics (high margins, low capital requirements), and focusing on this core would propel Ralston to new heights of profitability. When he became CEO in 1981, he implemented his plan decisively.
First, he sold the non-core businesses such as Jack in the Box, the hockey team, and the agricultural operations.
Then he made two large acquisitions—Continental Baking (including Twinkies and Wonder Bread) and Energizer Battery, totaling over $2.2 billion and 30% of Ralston’s market capitalization. Both businesses had languished under their previous owners, due to neglect or insufficient skillset. Ralston quickly improved its performance by improving marketing (launching the Energizer bunny campaign), improving distribution, launching new product lines, and reducing costs. Over their lifetime at the company, Energizer would generate 21% annualized returns, and Continental 13%.
Over the 1980s, he continued executing the plan, adding acquisitions that would strengthen the consumer brand core while divesting businesses that could not generate sufficient returns. The company’s financial metrics improved considerably—return on equity increased from 15% to 37%, and pre-tax profit margins increased from 9% to 15%.
In the 1990s, he continued focusing the company. He spun-off smaller brands like Chex cereals into a new company, Ralcorp, and he sold the last of the agricultural operations to DuPont.
His last two moves were defining moments:
With this done, Stiritz had turned around a stagnating company, made it the dominant player in consumer goods, and returned considerable value to shareholders.
Stiritz took a quantitative approach to management. A poker player in his youth, he saw capital allocation like poker—read the table, calculate odds, and know when to bet big when you’re likely to win. He would use his quantitative approach in capital allocation, such as deciding between repurchasing shares and conducting an acquisition, based on return on investment.
He saw analysis as critical to independent thinking, particularly in the CEO position. He felt that CEOs who lacked an analytical mindset (for instance, if they came from areas like marketing or legal) were handicapped in their role.
Stiritz’s first focus was on improving the high-margin, low-capital-requirement consumer businesses. He exited businesses that were once critical but had become commoditized, such as agricultural feed, while reinvesting in its key consumer brands.
This generated cash flow to use to raise debt, buy back stock, and make acquisitions.
Stiritz was fond of using leverage to achieve higher returns on equity. This followed the leveraged buyout practices of private equity firms, but it was an unorthodox move for packaged goods companies, which preferred having conservative balance sheets. Over his tenure, he kept an average debt-to-cash flow ratio of 2.6, compared to 1.7 for his competitors.
Buying back shares was controversial in the 1980s, since it meant shrinking the company or admitting that there were no worthwhile investments to make. Instead, Stiritz used buybacks as a yardstick for return on investment—if an acquisition or internal investment could beat the return on buying back shares, it was worth doing. As with other outsider CEOs, most shares were purchased when company stock was at low P/E ratios.
Stiritz focused on companies that could be reinvigorated by Ralston’s expertise in marketing, product development, and distribution. He liked companies that had been neglected by their previous owners, such as Continental Baking and Energizer.
When purchasing companies, Stiritz preferred to negotiate through direct contact, not with investment bankers, whom he considered parasitic. He would often show up alone to meetings where the opposition was staffed with a row of advisers.
Like Malone at TCI, Stiritz rejected the conventional metrics of the day, such as reported earnings and book value. Instead, he focused on more meaningful metrics like EBITDA and internal rate of return, both of which had gained early acceptance among private equity investors.
General Cinema was a movie theater company founded in 1922 by Phillip Smith, who expanded drive-in theaters throughout New England and the Midwest. When he died in 1962, his son Dick Smith took over as CEO. Dick further expanded the company’s theater locations, then diversified into unrelated businesses such as beverage bottling and retail. While diversifying acquisitions often end in failure, Smith executed them with finesse, leading to fantastic performance when the company’s divisions were sold at premium prices in the 2000s.
From 1962 to 2005, General Cinema (and its spinoffs) showed a 16.1% annual return rate, compared to 9% for the S&P 500 and 9.8% for GE.
$1 invested at the beginning would have been worth $684 by the end. This outperformed the S&P by 15.8 times, and GE by 11.4 times.
In 1962, when Dick Smith was 37 years old, he took over as CEO of General Cinema. He had been working in the family business after graduating from college and World War II.
Movie theaters had strong economics:
Smith’s first move was to expand the company’s theater footprint. He innovated in three ways:
By the late 1960s, he figured that theater growth would likely plateau at some point, so he began looking to diversify into other businesses. His ultimate goal was to have three legs in the company, each a strong business that wasn’t correlated with the others.
In 1968, he entered beverage bottling by purchasing American Beverage Company (ABC), the largest independent Pepsi bottler, for 20% of his company’s enterprise value. His work in theater concessions had given him an appreciation for the attractive market dynamics of beverage bottling:
Over the next decade, Smith purchased more bottling companies. Increasing scale allowed for ever more efficient operations, such as negotiating down can prices and buying its own sugar instead of having it supplied by Pepsi.
With this business established, Smith searched for his third leg. He explored broadcast media, though the prices were so high he never made a meaningful entry. He engaged in making minority investments in public companies.
His opportunity came in 1985, when he was called in to help retail conglomerate Carter Hawley Hale (CHH) avoid a hostile takeover. CHH owned properties such as department stores Broadway and Neiman Marcus. CHH desperately needed an investor to buy a substantial portion of shares to defeat the takeover, and they needed a response within a literal few days.
Smith realized that the seller’s urgency and tight timetable meant that very few buyers would participate, and so he could have immense negotiating leverage. Over the weekend, he and his team scrutinized the deal, prepared financing, and closed the deal by Thursday.
Flexing his leverage, Smith secured very favorable terms—a preferred security guaranteed them a 10% return, gave them an option to convert to 40% of common stock, and options to buy operating divisions of CHH. In essence, they borrowed money at 6% to earn 10%.
Later, General Cinema exchanged its 40% stock in CHH for 60% of the retail division that included Neiman Marcus. Smith saw that Neiman Marcus was poorly managed by its owner, and growth of stores would allow a premium on exit.
Altogether, this investment in CHH would ultimately return at a rate of 51.2%—good work for a weekend.
In the late 1980s, the Pepsi beverage industry soured due to aggression from Coke and increased competition for buying beverage franchises. He sold the bottling business to Pepsi and started looking for another third leg.
In 1990, the publisher Harcourt Brace Jovanovich (HBJ) piqued his attention. HBJ published in education and science. In 1986, it faced the threat of a hostile takeover, and so it took on a large amount of debt and paid a large dividend. HBJ avoided a takeover, but it now staggered under its debt. It began missing debt payments, and vulture investors circled, waiting for a kill. HBJ decided to go up for auction.
As with CHH, Smith knew that he had leverage in this acquisition. HBJ’s complicated debt required a complicated deal, which would scare off buyers. However, publishing had low capital requirements and few assets, thus improving its economics.
Over 18 months, Smith negotiated with its creditors and ultimately purchased the company for $1.56 billion, over 60% of General Cinema’s market capitalization. He got it at a discount of 6 times cash flow.
Over the 1990s and 2000s, Smith gradually sold the operating businesses:
With this, General Cinema ceased to operate, returning tremendous value for shareholders through 43 years of Dick Smith’s leadership.
Smith’s acquisitions often featured special opportunities where he could exert leverage.
Smith collaborated closely with three top executives: his CFO, COO, and legal counsel. They actively debated company strategy, and Smith invited them to publicly disagree with him, even in front of the board.
As with other outsider CEOs, Smith left day-to-day operations to his three top executives, instead focusing on strategy and capital allocation.
In general, for capital allocations, Smith behaved like other outsider CEOs in these ways:
Saving the best for last, the author ends with Warren Buffett’s staggering returns over the 50-plus year history of Berkshire Hathaway. Starting with buying a textile company in 1965, Buffett grew Berkshire Hathaway into one of the world’s largest companies.
Over the years, Buffett excelled in all manners of investments—in both public and private companies, with ownership of both minority and total stakes. He famously made use of insurance float to fund investments in higher-return companies, held a small basket of companies for very long periods of time, and acted aggressively when everyone else was ducking for fear.
From 1965 to 2011, Berkshire Hathaway showed a 20.7% annual return rate, compared to 9.3% for the S&P 500.
$1 invested at the beginning would have been worth $6,265 by 2011. This outperformed the S&P by a staggering 100 times.
Born in 1930 in Omaha, Nebraska, Warren Buffett was the son of a stockbroker and the grandson of a grocery store owner. His early entrepreneurial activities included paper routes and reselling soft drinks.
When he was 19, he read The Intelligent Investor by Benjamin Graham, which converted him into value investing—buying companies that were cheap relative to their intrinsic value (which was based on the company’s balance sheet). He began investing the profits from his ventures, worth about $10,000 in today’s dollars.
When pursuing his MBA, he chose to go to Columbia, where Graham was a professor. After graduating, Buffett asked Graham for a job at his investment firm, but Graham declined. Buffett returned to Omaha to work as a stock broker, where he continued researching investments. Here he happened on GEICO, an insurance company that featured competitive advantages and a great value for the price. He invested most of his money in GEICO.
In 1954, Graham finally offered Buffett a job, and Buffett continued researching underpriced public companies, which were often cheap, low-quality companies (Buffett called them “cigar butts”). When Graham closed his firm in 1956 to focus on other interests, Buffett started his own fund in Omaha, raising $105,000 (a bit under $1 million today). Over the next decade, Buffett continued investing by Graham’s value philosophy, achieving an average 30% annual return even without using debt.
But in the mid-1960s, Buffett began deviating from the value method, instead investing in high-quality companies that had a strong competitive profile and long-term prospects. His early investments in this style included Disney and American Express.
In 1965, Buffett purchased the textile company Berkshire Hathaway, a 100-year-old family business, through a hostile takeover. The company was only worth $18 million in enterprise value and was in a commodity business, but Buffett saw it as a platform to build his investments around. After installing a new CEO, who optimized operations, Berkshire Hathaway had $14 million of profit.
Buffett used this profit to buy National Indemnity, an insurance company that generated a large amount of float—the value of premiums received before they are paid out as claims. Insurance companies rely on investment returns from float to generate a profit; sometimes years can pass between when premiums are received and when they need to be paid out. In essence, Berkshire was able to receive cash at 3% and invest it at 13%. Buffett used this float to invest in businesses, sometimes buying them outright. His purchases included a newspaper in Omaha and a local bank in Illinois.
His investing style was further honed in the 1970s, as inflation was a common concern among investors. The typical thinking was that hard assets like gold were the best protection against inflation. Buffett saw differently, and developed key components of his investment thesis:
In short, where Benjamin Graham might have considered a company too expensive based on its book value, Buffett saw it could be cheap, because of the company’s long-term potential to consistently generate high returns on capital.
One example is illustrative—in 1972, Buffett purchased See’s Candies for $25 million, when it had $7 million in book value and $4.2 million in pretax profits. At 3 times book value, it would have been too expensive for Graham, but at 6 times pretax income and strong brand loyalty, it was a reasonable purchase. Over the decades, See’s Candies has not grown unit sales tremendously, but its strong brand allowed it to raise prices consistently. See’s earned a 32% annual return over 27 years and has provided $1.65 billion in cash flow for reinvestment.
Throughout the 1970s and 1980s, Buffett thus began investing in high-quality, enduring companies, such as the Washington Post, GEICO, and General Foods. He both made minority investments and purchased companies outright, such as with See’s Candies and the Nebraska Furniture Mart.
Among its many investments in the decades since, Berkshire Hathaway is known for these highlights:
Berkshire Hathaway continues to be one of the most highly valued enterprises in the world. Having avoided stock splits in its history, Berkshire shares are now worth hundreds of thousands of dollars each.
A big part of Berkshire’s investment strategy is its use of low-cost insurance float to invest in higher-return businesses. As a reminder, insurance float is money the company receives in premiums before they are paid out as claims. The time gap can be many years. In essence, this is like getting cash at 3% to reinvest at 13%.
Over the years, Berkshire continued scaling up the strategy in an accelerating flywheel effect. He could use insurance float to purchase companies that generated cash flow, which in turn he could use to buy more insurance companies, which generated more float to purchase companies. Insurance float grew from $237 million in 1970 to $70 billion in 2011.
As a large diversified company, Buffett also had more control over his insurance companies’ underwriting to maximize profitability. When premium pricing was low, Buffett’s insurance companies would underwrite fewer premiums; when pricing was high, it would take advantage by underwriting multiple-fold more in premiums. For instance, between 1984 to 1986, premiums grew sixfold, then shrank 73% by 1989. It’d be difficult for an independent public insurer to do the same, since its investors expect smooth performance.
Having had extensive experience in investing before starting Berkshire Hathaway, Buffett had a wider range of investment options than most CEOs. Typical CEOs only look within their immediate industry. In contrast, Buffett has made investments in a vast array of industries (from beverages to industrials). Even his investments take a wide range of flavors, including investments in both private and public companies, both minority investments and complete acquisitions, and at times making big bets in bonds and currencies.
Buffett has said that as an investor, it’s important to be “fearful when others are greedy, and greedy when others are fearful.”
Buffett is content to be patient for years when companies are overvalued and he doesn’t see acceptable opportunities. Then, when other investors are in turmoil (as in the 2008 financial crisis), Buffett strikes aggressively.
Beyond larger trends, Buffett enjoys finding opportunities within industries and individual companies. Pessimism within an industry can obscure strong performers within the industry—Buffett invested in Freddie Mac in 1989 during the recession, and in General Dynamics in 1992 during the defense industry slump. He also finds companies in the midst of a major strategic change, such as when a new CEO announces a focus on the company core and divestments of low-performing businesses.
This also means being ruthless about not tolerating poor performance and low returns. When Buffett purchased Berkshire Hathaway in 1965, he chose never to enter textiles again, seeing it as a commodity business with poor long-term prospects. Instead, he merely harvested capital from Berkshire and invested it elsewhere. Choosing what not to do is often as important as choosing what to do.
Portfolio management concerns 1) how many stocks an investor owns and 2) how long he holds them.
Buffett believes that great companies are rare, and that concentrated portfolios generate great returns. Berkshire has advised students that if they were only limited to 20 total investments throughout their career, they would drastically improve their performance. As a result, Berkshire is famously concentrated among its holdings. The top five holdings typically make up 60-80% of Berkshire’s value. At one time, Buffett had 40% invested in American Express.
In contrast, mutual funds are often made up of hundreds of stocks, with no single stock making up more than a few percentage points.
Buffett also holds stocks for a very long time—his top holdings have been held for over 20 years. This lack of transaction activity allows compound interest to continue generating massive returns without leakage through taxes. In contrast, mutual funds often hold for less than one year.
Inversely, Buffett aims for Berkshire shareholders to be long-term partners as well. He has never split Berkshire shares, which currently trade at hundreds of thousands of dollars.
Despite Berkshire’s companies employing 270,000 people, its headquarters has only 23 people.
Warren Buffett is famously hands-off with his management of owned companies, believing this reduces overhead and encourages entrepreneurship. When he buys a company, he leaves the management team in place and rarely makes changes. Then Buffett doesn’t expect the CEO to call him unless Buffett can help. There are no regular budget meetings. As long as the company performs, Buffett leaves them alone.
This is a major part of Berkshire’s appeal when sellers consider being acquired by Berkshire—unlike a private equity buyer or larger company, Berkshire will allow management to continue running the business. This gives Berkshire an advantage in appealing to certain types of sellers.
However, like most other outsider CEOs, Buffett is completely centralized in capital allocations. All capital flows to headquarters to allocate. Buffett personally takes charge of negotiations, and he does not rely on investment bankers or business development to make deals.
Buffett also believes in having a relatively small board, and requiring all board directors to have a personal stake in decisions. This means:
This aligns board members much better with the performance of the business. In contrast, board members who have little ownership in the business, have insurance that protects them from downside, and are paid large fees are far less interested in guiding the company correctly.
Buffett is remarkably quick at making a purchase decision. He spends less time on due diligence and often makes deals within days. He never visits company locations and rarely meets management. He can move quickly because he only invests in industries he knows deeply, and he has honed his investment criteria. This lets him filter the key performance indicators of a business.
Buffett also avoids auctions, believing they drive up valuation needlessly. He prefers that owners call him and offer a price, with Buffett returning his answer within 5 minutes.
Here’s a 10-step checklist for outsiders:
We’ve covered 8 standout CEOs and their companies, mostly in the latter half of the 20th century. But how applicable are the lessons here? Are they still relevant in the modern day? And are the lessons relevant for small businesses or managers? The author argues yes to both.
The author argues the principles in this book are timeless, studying two examples: Pre-Paid Legal, and Exxon.
Pre-Paid Legal (known today as LegalShield) provides legal insurance—for a fixed annual premium, customers have their unexpected legal costs covered, including expenses for litigation, wills, and trusts.
Growing quickly through the 1990s, its revenue flattened. Despite the lack of revenue growth, its stock price grew by 4 times. How did Pre-Paid Legal achieve this? As you might expect, the answer came in its capital allocation decisions:
The company sold for $650 million to private equity in 2011.
From 1977 to 2011, ExxonMobil showed a 15% annual return for investors, exceeding the overall market and competitors. The cause, once again, was intelligent capital allocation:
What if you’re not a CEO of a large public company? Are the decisions relevant to everyday managers and business owners?
The author argues yes—what’s shown here is a rational approach to capital allocation: figure out the value of all the options available to you, then choose the most profitable ones, ignoring conventional wisdom and what your competitors are doing.
Here’s a realistic example. Imagine you own a single-location bakery, and you have more demand than you can service. You consider two possible options: 1) expanding your current store, 2) opening a second store in a new location.
Using the checklist of the outsider CEOs, work through the following steps:
Even though this example concerns a relatively small business, it uses the same thought process that CEOs of Fortune 500 companies use. And by going through this decision methodically like outsider CEOs, you’ll arrive at the optimal answer for your situation—regardless of what conventional wisdom tells you to do or what your competitors are doing.
Reflect on the patterns found in outsider CEOs and how they might apply to your management.
What are some of the most surprising habits of outsider CEOs that you don't do yourself or you don't see commonly done?
Outsider CEOs saw their primary job as capital allocation. How could you improve your approach to capital allocation?
Outsider CEOs were unfailingly rational in their approach to strategy, examining all their options quantitatively and choosing whatever was best at the moment. How can you improve your approach to strategy in this way?
How can you be more independent in your thinking as a manager?