The outsiders

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Articles by Edward

Edward Roe

Investment Manager

1 August 2023

There’s an old joke which says you only need to read two books to learn the sum of all knowledge: What They Teach You at Harvard Business School and What They Don’t Teach You at Harvard Business School.

Although The Outsiders might be published by that venerable institution, its place is squarely in the second canon – it’s about what you don’t get from an MBA. Thorndike’s motive for writing this book is that “there are no courses on capital allocation at the top business schools.”

He sees two key roles for the chief executives of a company: management of operations; and allocation of capital. His observation is that CEOs focus their energy disproportionately on the former.

This makes sense as CEOs usually get the top job because of their success in lower level management roles, where capital allocation is less important. But, for Thorndike, the hallmark of exceptional company leadership is the delivery of long-term returns for shareholders, and this can only come from quality capital allocation.

The Outsiders features the stories of eight CEOs, each of whom met two simple criteria. First, their companies’ share price returns materially outperformed their peers. And second, they beat Jack Welch’s record of returns set during his tenure at General Electric.

The executives came from different walks of life, and each was unconventional in their own way. Bill Anders was the lunar module pilot on Apollo 8 before running General Dynamics, and Katharine Graham inherited the Washington Post from her father, Eugene Meyer, the fifth chairman of the Federal Reserve.

However, Thorndike doesn’t focus on the traits or experience that made these individuals unique, but on what they had in common.

They were outsiders to the corporate world. All but one were new to their industries, and none had been a CEO before. Most lived away from the commercial hubbub of the Boston/New York corridor – Warren Buffett (Berkshire Hathaway) in Omaha and John Malone (Tele-Communications Inc) in Denver – which allowed them to think differently and independently, and to avoid the armies of bankers, consultants, lawyers and PR advisors who surround most C-suite executives.

However, the key similarity was their approach to company finance. The outsiders were united by a focus on per share value maximisation, not overall revenue growth or even profit growth.

This approach had a number of defining characteristics. They were not afraid to sell or shut down significant parts of their businesses if insufficiently profitable – they would deliberately shrink the company to improve returns. And they viewed the corporate landscape through the lens of their own companies’ shares. When their stock traded expensively, they would issue more to buy undervalued assets. Share buybacks were the benchmark against which to judge all other investments, and they would simply repurchase shares if there were no more attractive options.

These repurchases were not made to prop up stock prices or to offset option grants to executives, but because they were attractive investments.

This is in stark contrast to some of the financial engineering over recent years when corporations have conducted buybacks without reducing the share count. In effect, companies have been spending money

simply to sterilise the shares issued to employees as stock-based compensation. Over the past ten years, Facebook parent Meta has spent just shy of $100 billion on buybacks, but its shares outstanding have risen by over 12%.¹ Due to the collapse of Meta’s share price last year, the company had to authorise the issuance of an additional 425 million shares (16% 0f outstanding) to enable them to pay the same dollar value of stock-based compensation: the lower the shares go, the more of them they give away.

This isn’t the sort of return of capital for shareholders that drove the outsiders, but the enrichment of the C-suite by the back door.

Summarising the outsiders’ modus operandi, Thorndike notes “they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back lots of stock, minimised taxes, ran decentralised organisations, and focused on cash flow over reported net income”.

Elements of the book would give all but the most hard-nosed capitalists pause for thought. Cost-cutting and headcount reduction are celebrated, tax-minimisation lauded, and share buybacks praised as a productive use of capital. But from the starting point of Milton Friedman’s doctrine – that the goal of a firm is to maximise returns to shareholders – these are all logically consistent, and admirable, outcomes.

And Thorndike is right to focus on capital allocation, which remains a rare talent amongst even the most celebrated company executives. Recently, a colleague in Ruffer’s research team gave a copy of The Outsiders to the CEO of a large company who had tried (unsuccessfully) to make a potentially value-destructive acquisition. Perhaps the trick for investors is to find those who think like outsiders.

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The outsiders