To Benjamin Braddock (Dustin Hoffman in Mike Nichols’ film The Graduate), the well-meant one-word piece of advice was “plastics”. To the godfather of value investing, Benjamin Graham, the well-meant three word piece of financial advice was “margin of safety” – and that one happens to have lasted the test of time. Faced with the challenge of distilling the wisdom of the investment gods into just two words, I would offer the following coinage: “capital allocation”.
Close and lock the doors. Dim the lights. We are about to discuss one of the under-acknowledged holy grails of investing. Whether you are looking for a superior fund manager or for the more promising CEO of a listed business with real prospects, those two words are the ones you should be looking for: capital allocation. They will also be the key determinant of the relative success, or failure, of your own investment portfolio.
The ability to successfully allocate capital is what differentiates between the good fund manager and the bad one, between the billion-dollar market-cap company and the micro-cap also ran. It may be the single most important characteristic of any investment you ever make.
Follow the outsiders
In The Outsiders, which should be considered, alongside Benjamin Graham’s The Intelligent Investor, as one of the finest investment books ever written (Warren Buffett certainly thought so), William Thorndike examines the life and habits of eight truly unconventional but highly successful chief executives of US businesses. Their firms’ average returns outperformed the S&P 500 stock index by a factor of twenty – that is to say, an investment of $10,000 with each of these CEOs, on average, would have been worth over $1.5 million twenty-five years later. If you weren’t fortunate enough to have someone buy you a copy for Christmas, make amends by buying yourself a copy now. You will not regret it.
Here follows a straightforward comparison. On the one hand, the headquarters of FIFA. They comprise 11 acres on a wooded hill overlooking Zurich. The compound cost $255 million, and it includes five underground levels, clad in black Brazilian granite. The conference room has a floor of lapis lazuli. FIFA is a not-for-profit organisation, not that you could tell.
On the other hand, consider the headquarters of Capital Cities Broadcasting, under the management of Tom Murphy, a business owner almost clinically averse to spending cash. The business was based in a dilapidated former convent. When he was appointed as CEO of the firm, his board begged him to spruce the place up and project a more professional image to potential advertisers with the company. He responded by painting the two sides of the building facing the road. The other half of the building he left untouched. But Murphy was not neglectful of his shareholders. Capital Cities shares, under his stewardship, gave an extraordinary annual compound return of more than 22%, over a period of 19 years.
Or consider TCI (which under its CEO John Malone delivered a remarkable 30.3% compound annual return over 26 years). TCI’s corporate HQ contained a surprisingly small number of executives, even fewer secretaries, and a handful of peeling metal desks on Formica floors. The company employed just one receptionist and incoming calls were routed to an answerphone. When TCI staff went on the road for marketing purposes, they tended to stay at motels. TCI’s chief operating officer JC Sparkman confesses, “Holiday Inns were a rare luxury for us”.
You might also wish to consider one of the most celebrated investors of all time – Warren Buffett. His company’s investment returns from 1985 to 2005 compounded annually at an astonishing 25%, a track record of corporate outperformance than is almost unrivalled in financial history. But while the Berkshire Hathaway holding company now has more than a quarter of a million staff, the corporate headquarters in Omaha, Nebraska, caters to just 23. And Buffett lives in the same modest dwelling in Omaha that he bought back in 1958 for just $31,500.
As Thorndike makes abundantly clear, the most successful CEOs tend to be ultra-cautious when it comes to spending. As he emphasises, what every successful business manager and owner has in common is a fierce and unyielding respect for shareholders’ money. They acknowledge every day that they are a custodian of their shareholders’ sacred capital, and it is not to be squandered.
In fact, much of what we tend today to associate with a successful business turns out to be a masquerade – a Potemkin village of presumed wealth. Banks cultivate an image of opulence with the implied permanence of marble halls. This helps disguise the poverty at the heart of many of their balance sheets.
Many CEOs also devote considerable time and effort to promotional activity. But some of the most successful business owners have shunned investor relations almost completely, preferring to let the share price alone do the talking. Thorndike’s business owners are just such people.
So there are a number of corporate characteristics that represent red flags to the discerning investor. Lavish company HQs are among them. Thorndike points out that, over recent years, at least three media companies – The New York Times, IAC and Time Warner – have all constructed Taj Mahal-like edifices in midtown Manhattan, at vast expense to their shareholders.
Over the same period, not one of those companies has engaged in value-creating share repurchases or enjoyed market-beating returns. By contrast, not one of the outsider CEOs he profiles ever overspent on the company HQ.
What Thorndike’s outsiders also have in common is a rare ability to delegate. Their organisations are typically highly decentralised – there are very few staff at the corporate HQ to begin with. But there are also limits to delegation. The very best executives are also masters of capital allocation, and they tend to keep this to themselves.
Overcoming the “institutional imperative”
Charlie Munger, Buffett’s right-hand man, describes winning companies as “an odd blend of decentralised operations and highly centralised capital allocation”, and the mixture of delegation with hierarchy seems to act as a healthy antidote to what Buffett has otherwise disdainfully described as “the institutional imperative” (to underperform).
Successful capital allocation amounts to two things: spending wisely, and otherwise hoarding capital for its deployment to more productive ends further down the line. It is a message that also comes out loud and clear in Alice Schroeder’s biography of Warren Buffett, The Snowball. What Buffett learned at a prodigiously young age is that capital compounds, and that the forces of time can be harnessed to maximise capital over time provided that your money isn’t frittered away in the meantime. In other words, Buffett had an instinctive understanding of the power of compound returns and a laser-like focus on the time value of money. A dollar wasted today – either by being spent on a frivolity or on overpaying for an acquisition – is not merely a single dollar foregone. Over time it will amount to tens, hundreds, perhaps thousands of future dollars. So be frugal.
There are plenty of instructive lessons and investment tips within William Thorndike’s excellent book. Within my own asset management business we barely distinguish between company leaders and fund managers – because to excel, they both need to be skilled in the arts of capital allocation. What is the difference, for example, between a diversified holding company (such as Warren Buffett’s Berkshire Hathaway) and a diversified fund? Almost none – except that the holding company comes without management fees!
So if you are looking for pointers to superior investment returns – either from a portfolio of listed stocks or from a portfolio of well-managed funds (or perhaps both) – seek out managers with superior capital allocation skills. Look for executives who are disciplined and shareholder-friendly, with an acute attention to saving and not squandering shareholder capital. Look, too, for executives who don’t court the limelight, and who don’t fritter away their companies’ capital in expensive acquisitions or stock buybacks.
There is nothing wrong with buying back stock provided it’s done at the right price. The right price is at or ideally below book value. Whenever buybacks are conducted at a significant premium to book value, shareholder capital is simply being destroyed.
One of my favourite companies, for example, is Loews Corporation, managed by the Tisch family. Loews is an interesting assortment of businesses, including commercial property and casualty insurance, offshore oil and gas drilling, pipelines, and a chain of hotels. But one of the company’s most successful investments has been its own stock – bought back by the company at the right price. Every decade since 1970, Loews has bought back more than one quarter of its outstanding shares. Since 2010, the company has bought back and retired more than 18% of the stock. But these buybacks are only ever conducted at a discount to what the family consider the shares are actually worth. Since listing in 1965, Loews stock has returned annually, on average, 17% versus 10% for the S&P 500.
Two words. Capital allocation. Worth a million dollars, easily.
A Happy New Year to you all!