Book Notes – The Outsiders

I recently finished William Thorndike’s book “The Outsiders – Eight Unconventional CEOs and Their Radically Rational Blueprint for Success”, and think it is a great read. As usual, I jotted down the most important lessons & thoughts to me and document them below.

To get an initial understanding of the quality of this book, it is worth mentioning the origin of this book. Thorndike is a PE investor and a founding partner of Housatonic. When he was preparing a presentation to CEOs of their portfolio companies about “what makes an exceptional CEO” circa 2004, Thorndike wanted to do a case study of Henry Singleton, whom he regarded as one of the best CEOs, with the help of a HBS second year student. From there, Thorndike and subsequent then-HBS second year students continued studying 7 more CEOs who had pass his rigorous test (beat annualized returns of both peers & Jack Welch’s GE during their tenures by large margin), one CEO a year. Note that GE during Welch’s tenure has 20~% annualized return, which itself is a very high bar. Along the way, Thorndike found striking similarities between these CEOs and decide to make a book on these traits. Here is a Harvard Business Review short podcast in 2014 about the book & its origin [Link].

TheOutsiders

Below are important points & thoughts to me:

  • How to avoid Valeant: An inversed thought, but I think this is the most important lesson/thought I have from reading this book. It’s no coincidence that so many renowned value investors (Bill Ackman, Ruane Cunniff & Goldfarb, etc.) fell for Valeant – as J. Michael Pearson basically tried to model himself to these CEOs. Ackman had a pitch presentation for Valeant with the title of “The Outsider” with explicit reference of this book and nominating Pearson to be the ninth CEO fitting this book, you can see it here [Link]. William Thorndike, during a Motley Fool interview in 2014, also called out Valeant when asked about any younger generation CEOs he liked. Below is an excerpt where Throndike compared Pearson to Malone in their “roll up” strategy. [Link]

JOE MAGYER:

Who are the younger CEOs you see out there today who are succeeding with outsider-style leadership and capital allocation?

WILL THORNDIKE:

I think there are a number of CEOs who are currently following this path. It would include the Rales brothers of Danaher and Colfax. Nick Howley of TransDigm, which is a wonderful aviation components company that I know you guys are familiar with. The guy who runs a software company in Canada called Constellation Software. The CEO’s name is Mark Leonard.

I know you know a group of insurance companies that follow these sort of Buffett principles and are very close to this whole approach — Markel (NYSE:MKL) and Fairfax and White Mountains. There’s a home builder called NVR. I recently came across a utility business called Calpine (NYSE:CPN)that’s doing some interesting things. There are definitely current exemplars out there. We were following this to different degrees. It’s been fun to watch that.

By the way, Valeant Pharmaceuticals (NYSE:VRX) is a really interesting case as to whether or not the CEO there, Mike Pearson, is an outsider. Of course, being very much in the news with the Allergan bid.

JOE MAGYER:

One of the funny things about the style of management is that it’s easy to look back at a single instance and say, “Well, this was clearly brilliant and it clearly worked.” But at the time, these guys were totally either ignored or they were ignoring other people. As you look at some of these, like the Valeant situation today, there are a lot of people who have strong opinions about whether or not its approach is working. I think you could look at other names like Jeff Bezos of Amazon (Nasdaq:AMZN), which a lot of value investors wouldn’t consider, but there’s a lot of Sam Walton and John Malone there.

I guess what I’m getting at is if you’re in the moment of looking for the qualities that you have as an outsider CEO, how do everyday investors go about identifying those kinds of CEO leaders in the here and now? A lot of times they’re off the grid or their style is so unconventional that they’d never show up on a screen and you wouldn’t see them on television.

WILL THORNDIKE:

That’s a good question. And by the way, I do think that the current reaction to the Valeant-Allergan side and sort of the bear case is very similar to concerns that were heard across John Malone’s entire career at TCI. There are very interesting similarities there, I think, to the reactions and concerns being raised.

I think, over time, you can assess a CEO’s fit with this approach by their actions. By the acquisitions they make. By the stock repurchases. And I think over time what they do, ultimately, is sort of the key guide to whether or not they’re following this approach and whether or not they’re CEOs that you want to invest with. A marker of this that could be quite predictive is the way they describe — or they think about and describe — their business I think can be very revealing.

And specifically, if they have developed idiosyncratic metrics that they are optimizing the business around, I think that can be a very strong signal of the presence of this sort of world view, specifically to the degree they’re talking about the cash economics of the business as opposed to the broader accounting conventions and expressing those on a per-share basis. Those are the two key hallmarks, I think.

Retrospectively, there is one thing of Valeant I suspect would fail to pass my “Tao” factor check, which broadly speaking means whether this business bring value to all constituents in the value chain. That is its strategy to aggressively cut R&D as a drug company. I know price hiking is controversial and is despised by many, but I can see it neutrally. On one hand, cure or relief from diseases has subjective utility, thus it’s hard to quantify how much is a “fair” price. On the other hand, it is certainly a play to exploit the broken US health care system and could cause unfair distribution of social welfare. My point is price hiking itself is not as bad as cutting R&D. My test for unconventional practices is to imagine what if the whole industry adopts such practices, would it make the society better or worse place. If every drug company raise prices (which is still happening prevalently), there will be higher health care burden on the whole society, but as it’s widely spread out, the society is marginally worse off. Whereas if all drug companies start to see R&D as a pure expense burden and aggressively cut it, it soon won’t be any new drugs which would be significantly worse off for the society.

Additionally, I think it’s an evidence of market efficiency, where any edge (in this case qualitative assessment of CEO) if becomes well known, would be less reliable, because 1) more investor will have this edge thus incorporating these information into prices & 2) in this case, CEOs will adopt these practices (think of share buybacks these days) just to be looked good by investors, thus polluting the signal. The next level thinking is then how do you find out the ones with “genuine” unconventional decision-making processes.

  • Rationality: The subtitle of the book already did a great job summarizing the most important trait of these exceptional CEOs – radical rationality. In my opinion, it is the “first principle” reason for their business’ outstanding performance, the specifics (like emphasis on capital allocation & decentralized organizational structures, etc.) are manifestations of this radical rationality in different areas. Inspired by Charlie Munger, my understanding of “rationality” is: the ability to perceive beings as is, rather than as how you wish the beings to be. In Taoism, a relevant quote of Lao Zi is 大道无情, which literally means “the great Tao has no feelings”. It conveys a similar message that the underlying rule of how things work is neutral thus perceiving it with emotion/ideology/bias could only get a distorted version. In other words, the Tao can only be grasped by radical rationality.

 

  • Valuation of business: Keep it simple but focus heavily on the quality of key assumptions with probabilistic view. Charlie Munger had once joked Warren Buffett saying something like “…I’ve never seen Warren did a DCF…” And Buffet quipped back something like “…there are things you only do in private…”. Many other CEOs in this book share this trait. For example, John Malone developed a simple rule for TCI’s acquisition program: “only purchase company if the price translated into a maximum multiple of five times cash flow after the easily quantifiable benefits from programing discounts and overhead elimination had been realized”. This is a single sheet, if not back of an envelope, calculation. Bill Stiritz of Ralston Purina was also known for going to deal table single handed with a legal pad (for which he has his single page valuation of the underlying business).

 

  • Personality: Most of these CEOs are modest & humble, I think I can relate these characteristics to “higher sense of the being”. Basically, they all have higher pursuit than merely financial goal. Kay Graham of Washington Post may be a different category CEO in this sense. In my opinion, she has extraordinary “human capital allocation” skill, by which she knows who has what quality and whether she can trust them. It’s hard to quantify this skill, but it is still a manifestation of her rationality.

 

  • Leon Cooperman on Henry Singleton: Leon Cooperman of Omega Advisors is known for spotting Teledyne and Henry Singleton’s genius early on. I want to share his study of Henry Singleton and the importance of CEO’s capital allocation. [Slides deck here: 20071128_leon-cooperman-value-investing-congress-henry-singleton]. It is a great work and a must read for any investor. Don’t just take my words. After receiving and reviewing this exact deck from Cooperman, Warren Buffett replied to Cooperman with below mail [Link]:

November 23, 2007

Dear Leon,

I don’t think you could have picked two better subjects. Henry is a manager that all investors, CEOs, would-be CEOs, and MBA students should study. In the end, it was 100% rational and there are very few CEOs about whom I can make that statement.

The stock-repurchase situation is fascinating to me. That’s because the answer is so simple. You do it when you are buying dollar bills at clear cut and significant discount and only then.

As a general observation I would say that most companies that repurchased shares 30 years ago were doing it for the right reasons, and most companies doing it now are wrong when doing so. Time after time, I see managers who are attempting to be fashionable or subconsciously hoping to support their stock. Loews is a great example of a company that’s always repurchased shares for the right reasons. I could give examples of the reverse, but I follow the dictum praise by name, criticize by category.

Best regards

Warren

  • Decentralization: How do you run a decentralized organization? I think the key is human capital allocation. Basically, how to identify talents and empower them. This book, based on Thorndike’s emphasis on financial capital allocation side, hasn’t explored this trait too much, but I think this is another very important factor for these businesses’ long-term success. Just like radical rational investors seeks radical rational CEOs, CEOs could seek subordinates who possess radical rationality, judging by their operational activities.

 

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