[00:02:36] Patrick Donley: We are in our third of a four part series. Our first two episodes that we did together, we focused on learning from two of history’s best known stock investors.

[00:02:46] Patrick Donley: We talked about Warren Buffett and his mentor, Benjamin Graham, but after recently reading the outsiders by William Thorndike, you are back once again to tell us about great investors, but from the perspective of CEOs. So, Shawn, I wanted to hear your thoughts on what ways CEOs are like stock investors.

[00:03:03] Shawn O’Malley: It’s a great question, Patrick and thanks again for having me back on to talk about some of our favorite books. The Outsiders is a really special one. When people imagine stock investors, I think they, that can mean different things. They probably think of wall street traders or hedge funds or financial advisors, but they probably don’t think of CEOs as being investors.

[00:03:22] Shawn O’Malley: And obviously some like Warren Buffett have stood out in that way for their investing prowess. But if you ask someone on the street, you know, what does a CEO look like and what is their job? Generally, they probably say things like to manage the company or decide corporate strategy. Hire and fire people or provide leadership and inspiration, or maybe you have no idea what CEOs do and you just think they’re overpaid.

[00:03:48] Shawn O’Malley: And that’s what this book outsiders is really about exploring the commonalities between the best CEOs of the last six decades. It’s a must read for many value investors since it was first published in 2012, partly because Warren Buffett himself has recommended it. And Thorndike in the book goes through these eight different case studies from his research on what makes a successful CEO with the crucial insight being that it’s a CEO’s job ultimately to be a capital allocator.

[00:04:19] Shawn O’Malley: And so there’s this question of what does that mean to be a capital allocator? And what they have to do is decide how to invest the company’s capital into new projects or expanding business units and also how to allocate human capital where people’s talents or efforts are best spent. So CEOs have two core responsibilities.

[00:04:38] Shawn O’Malley: The first one is this most common perception of what CEOs are in charge of, and that is ensuring the operations of the company run smoothly. And the second one is what’s more often overlooked, and it relates to capital allocation, as I just mentioned, and really determining what to do with the business’s cash flows.

[00:04:55] Shawn O’Malley: So the best CEOs are those who have mastered both, but perfecting the latter is a much rarer trait.

[00:05:01] Patrick Donley: So why do you think that is? Why is capital allocation so unintuitive to most CEOs?

[00:05:07] Shawn O’Malley: It’s the classic principal agent problem. As an owner in the business, you have a certain set of interests, namely that the business is run to generate excellent long term returns on your equity, but you’re probably going to want to hire an executive team to oversee operations for you.

[00:05:23] Shawn O’Malley: And that’s where the problem starts of finding the right people for this job and ensuring that your interests are perfectly aligned, which is just a lot easier said than done. The CEO who you appoint to run the company on your behalf will probably take some pride in running the business. But ultimately, they care about enriching themselves and their family and care a whole lot less about making you rich.

[00:05:45] Shawn O’Malley: And they probably want to create as much wealth for themselves as they can while delivering the minimum necessary performance to keep you satisfied. So you don’t fire them. And the typical solution to this problem is to try to make executives into owners of the company by paying them stock options and ensuring they have some sort of stake in the business.

[00:06:04] Shawn O’Malley: But that isn’t really a perfect solution because that can incentivize short term thinking still. One example is, you know, it can push them to want to push up the stock price. To maximize the value of their stock options, especially if they think that they’re not going to be there for the long term, right?

[00:06:21] Shawn O’Malley: Most CEOs aren’t in the job for 20 years. And so if you go into it knowing that there’s a, it’s kind of like going into the NFL or being a professional athlete. If you go into it thinking that you might only have two or three years to maximize your earnings from this very privileged position. You’re going to do everything you can to boost the value of those stock options and then cash out when you get the chance.

[00:06:42] Shawn O’Malley: And yeah, that’s certainly going to lead them to do things that are not in your best interest as the owner of the business. And that’s the principal agent problem in a nutshell. One tangible way to think about this is in CEO’s decisions on paying out dividends. If there aren’t attractive ways to reinvest cash that’s produced by the company’s operations, the CEO is supposed to pay out that cash to shareholders so they can reinvest it elsewhere and earn better returns.

[00:07:09] Shawn O’Malley: That’s just capitalism. If a CEO’s compensation is tied to stock options, like I said, which are tied to the stock’s price, ultimately, then the CEO is going to want to retain as much money as possible in the business. To bolster the company’s market value and therefore the stock price, which isn’t as good as it sounds for shareholders.

[00:07:28] Shawn O’Malley: Yes. A higher stock price today will make some people happy, but if it means plowing cash back into unprofitable business units, just for the sake of growth. Then over time, you’re destroying value for shareholders and by paying dividends, cash is being taken out of the company’s bank accounts, reducing the size of the kingdom that executives rule over.

[00:07:48] Shawn O’Malley: And I just, you know, for anyone to consider, how many people do, you know, in charge of something that want to be less influential over time, right? It doesn’t happen by paying out dividends. You’re voluntarily reducing the size of the kingdom that you oversee. And so if you run an organization, I think you probably just want it to get bigger and bigger because that’s what makes you more important and influential in society.

[00:08:11] Shawn O’Malley: But anyone who’s taken a corporate finance 101 class should know that growing a company’s operations and revenues doesn’t automatically translate to better returns on equity for shareholders. And in fact, growing too aggressively can destroy a business over time. So again, there’s some really subtle ways that the interests of the managers of the business can diverge from what’s in the shareholder’s best interest, which are the people who fundamentally own the company.

[00:08:39] Shawn O’Malley: On top of that, paying stock options to executives is just really dilutive. Even though stock options are treated as this magical free currency that can be awarded to attract. Top CEOs. In reality, the cost is that existing shareholders see their slice of the ownership pie and the company get trimmed down.

[00:08:57] Shawn O’Malley: It’s kind of similar to inflation. If you think about it, it’s stock based compensation slowly eats away at the value of your investment over time without even you maybe even realizing it by creating more shares and reducing your ownership stake in the business. So there is definitely a principal agent problem at hand here.

[00:09:15] Shawn O’Malley: And it’s not that CEOs are inherently unable to think like capital allocators. It’s that their compensation structure and the nature of their job generally push them to do things in their own self-interest. And because most shareholders don’t want to be super actively involved with. Managing every company they invest in that they sort of allow executives to get away with all of this.

[00:09:37] Patrick Donley: Beyond the mismatch and incentives, that’s usually between owners of the business and managers of it. Are there other factors that contribute to poor capital allocation by CEOs?

[00:09:47] Shawn O’Malley: Yeah, the phenomenon of CEOs being bad capital allocators isn’t entirely a principal agent problem. Thorndike outlines how the best people for the job of CEO are often not the ones selected.

[00:09:59] Shawn O’Malley: It’s sort of like politics. The person who’s actually willing to run for office and take on all the associated headaches is probably not the best person for the job, but they’re really charming and their egos push them toward the spotlight. And if you’re on the board of a company, you have to select someone for the job.

[00:10:15] Shawn O’Malley: So these politician types usually end up winning out and the CEO then becomes the person who is the best at representing the company to the media and is probably someone who excelled in one or two more narrowly focused roles within the company, like marketing or sales or product development, and now they’re looking at the entire thing from the top down.

[00:10:35] Shawn O’Malley: And being asked to make very difficult decisions about how to allocate capital. But obviously that’s not what they’re schooled in. These people are not schooled in investing and resource allocation. So Thorndike uses this metaphor of someone spending a decade perfecting their skills as a musician and climbing up the ladder.

[00:10:52] Shawn O’Malley: And at the last rung to climb, instead of being asked to perform at Carnegie Hall, they’re asked to become the chairman of the federal reserve. And I think that’s what happens with the CEO in many cases. You know, we say, oh, well, you are a rockstar at running our marketing department. So now can you please be CEO and make capital allocation decisions, even though you’ve never had any formal training and thinking that way.

[00:11:16] Shawn O’Malley: And I don’t want to understate the importance of the skills gap at all. If you’re the CEO for 10 years on a, of a company that retains 10 percent of its net worth and earnings each year, you’d have been in charge of allocating 60 percent of the company’s capital. So not knowing how to think like an investor is a really big problem for a CEO.

[00:11:36] Patrick Donley: The book talks about the CEO’s toolkit for capital allocation with five general options for deploying capital. The first is you can invest in existing operations. Second, you can acquire other businesses. You can issue dividends to shareholders. You can pay down debt. And then finally, you can repurchase shares of the company’s own stock.

[00:11:55] Patrick Donley: The sources of capital for these decisions are cash generated by the business’s operations and funds raised from issuing debt or selling stock. Given that CEOs pretty much all have the same toolkit available and can really only play the hand they’re dealt with to the best of their ability, how can we better measure and compare a CEO performance?

[00:12:14] Shawn O’Malley: It’s funny because even though running a business and investing are very quantitative, there isn’t some objective and universal metric for grading CEO performance. It’s a complicated calculation, but in football, we can use QB ratings to try and objectively compare how players on different teams are performing.

[00:12:34] Shawn O’Malley: And in basketball, you can look at like. The shooting percentage or in baseball, you can look at a pitcher’s ERA to compare performance. And those will all do a pretty good job of telling you how they’re doing it. Not a perfect job, but pretty good. Even in other professions, there are clear ways to grade performance.

[00:12:51] Shawn O’Malley: You know, how many complications does a surgeon have each year? How many cases does a lawyer win? How many cars does a car salesman sell? Right? We have some ways of measuring and comparing performance, but when it comes to CEOs as a society, I think we’ve just totally failed and agreeing on the right way to evaluate their performance or to put it another way, the commonly accepted ways for doing this.

[00:13:13] Shawn O’Malley: Are deeply flawed as we’ve already talked about. Growth isn’t by definition a good thing for businesses, especially if it’s garnered at too steep of a price. We can just look at. We work from a couple years ago, right? Anyone can throw a ton of money and sell a bunch of stock and put that money toward every possible opportunity until they reach some massive scale of operations.

[00:13:33] Shawn O’Malley: But if that foundation isn’t built on sound investments, the ground is going to collapse beneath you eventually. So you don’t need an MBA to know this stuff. But at the same time, when we think of great CEOs, we have this bias to think of only those at the biggest companies. Being the CEO of Apple is sort of like being on the Yankees.

[00:13:52] Shawn O’Malley: You know, you’re a rockstar you’re a household name in the corporate world, and then the message to other CEOs is to grow your company as big as possible. Otherwise, you’ll never get that recognition on CNBC or, you know, in the media. And as we’ve already talked about, CEOs are typically the types of people who want that recognition.

[00:14:10] Shawn O’Malley: That’s why you take on what is a pretty brutal and consuming job. So you can have that notoriety. And if a company grows its revenues by a billion dollars, the business media wants to anoint them as the best CEO of all time. But that’s just a nominal number though. A medium sized public company that doubles its 1 billion in revenue to 2 billion.

[00:14:31] Shawn O’Malley: Is going to get very different recognition than a company with 50 billion in sales that grows to 51. One is just going to get a lot more attention than the other, even though it’s actually far more impressive for the medium sized company to have done that. And this is basically what Thorndike spends an entire chapter of the book talking about that we need to adjust for size, the performance of CEOs.

[00:14:54] Shawn O’Malley: It’s comparing the GDP of the US and Panama, right? You can’t just use nominal numbers. Any meaningful comparison is going to be based on per capita figures. So that’s sort of the backdrop for his suggestion that we should grade CEOs based on their track record. And growing the per share value of companies stock over time and contrasting that with the returns offered in the broader market and with their industry peers.

[00:15:20] Shawn O’Malley: So for shorter periods of time, the flashy CEO or the hot new product will gain a lot of momentum, but over 10 or 20 years, those capital allocation decisions will bear themselves out in the stock price. Either you made intelligent acquisitions, borrowed at the right times, reinvested, and the right parts of your company knew when to pay dividends and when not to, or you didn’t.

[00:15:41] Shawn O’Malley: And that’s going to show up in your track record of shareholder returns. And what we know from the outsider CEOs, which are these eight great CEOs from the book is that there’s a blueprint for CEO excellence and a CEO’s ability to embrace investors. Mindset is critical to that. There’s this great quote from the book, kind of related to this from NFL coach, Bill Parcells, who says you are what your record says you are.

[00:16:04] Shawn O’Malley: And there’s another one really good too with John Templeton, who says success leaves traces. So Thorndike devotes the book to this central question, who are truly the best CEOs in recent history in terms of the returns they created on each dollar invested in the company and what do they have in common, what traces of success do they leave behind to, to quote John Templeton.

[00:16:26] Patrick Donley: There’s another really great quote in that chapter from Warren Buffett, who definitely knows a thing or two about identifying exceptional CEOs. He says it’s almost impossible to overpay the truly extraordinary CEO, but the species is rare. I wanted to hear from you a little bit about the traces of success, what those look like and how we can identify these rare, but excellent CEOs.

[00:16:49] Shawn O’Malley: I think you said it best. I’m tempted to say that we can just look at the companies Buffett has invested in. And the CEOs he’s spoken most highly of, and you’re going to find some of those rare breeds. And it’s true that several of the eight CEOs Thorndike identifies in this study on outsiders are people that Buffett recognized at the time as being special.

[00:17:09] Shawn O’Malley: And especially far before others noticed there, you know, how exceptional they were doing in compounding the value of their companies. One of those great examples is Cap and Graham. Who took over the Washington Post and quickly displayed enough of the capital allocation characteristics to attract Warren Buffett.

[00:17:26] Shawn O’Malley: As an investor, after just a few years, same with Bill Andrews, who helped turn around general dynamics in the 1990s, Warren Buffett is sort of the shining example of what an outsider CEO looks like since he’s done better than anyone at taking a dollar invested in Berkshire and compounding it into being worth a whole lot more, but the seven other CEOs in the book landed on many of the same frameworks and values and what they all did well was allocate capital.

[00:17:51] Shawn O’Malley: They didn’t borrow money to do massive share buybacks at mind bogglingly high prices, which is sort of all the rage in corporate America today. Nor did they blindly overpay for acquisitions. They didn’t issue dividends simply because shareholders like the income, and they certainly weren’t worried about fitting in.

[00:18:08] Shawn O’Malley: Instead, these CEOs were deeply humble and practical. People who probably felt uncomfortable about the idea of riding in a corporate private jet, or even having one for that matter. They didn’t love the media either. These CEOs spend little time doing interviews or going on TV. Honestly, if the CEO of your company is constantly doing podcasts and TV appearances, that’s a red flag.

[00:18:29] Shawn O’Malley: Shouldn’t they be focused on running the business, keeping their head down? The outsider CEOs rejected a lot of these more vain pursuits that come with running a company, including giving quarterly guidance to Wall Street. Why waste time trying to predict the future when you could instead spend that time focused on driving the best results possible?

[00:18:47] Shawn O’Malley: Not giving guidance avoids any illusions that business performance will be steadily growing each quarter, which anyone who’s ever run a business knows is just not possible, right? And they also avoided constantly consultants and bankers to outsource their thinking to, and instead they kept really close circles of trusted confidants.

[00:19:05] Shawn O’Malley: In their personal lives, they were probably simple and boring, modest people, but in their professional lives, they were bold and unique, intelligent iconoclasts, as Thorndike calls them, which is literally translated from ancient Greek to mean smashers of icons, people who are unapologetically different, not concerned with social etiquette and norms.

[00:19:27] Shawn O’Malley: And that meant having the courage to make the best decisions from a capital allocation standpoint before they are fashionable to do so. In some cases, I’m in buying back stock at extremely discounted prices. Even before that had become an acceptable practice on wall street or divesting beloved business units, if they were being offered unbeatable prices for them.

[00:19:47] Shawn O’Malley: So they embraced what was a very rewarding combination of knowing how and when to buy low and sell high to be cliche. The point being, if you do what everyone else is doing as a CEO, you can have best deliver average returns to truly stand out. You have to zig when others zag and the outsider CEOs did that beating the broader market average by something like over 20 times over their tenures.

[00:20:10] Shawn O’Malley: And beating out their peers by an average of over seven times in terms of the compounded returns they delivered to shareholders.

[00:20:17] Patrick Donley: It’s interesting to think about CEOs needing to zig when others zag because it’s something Buffett has talked about at length throughout his career. He’s got an expression for it, which he calls the institutional imperative, which is this powerful and visible force pushing CEOs to not do anything too bold to not rock the boat.

[00:20:33] Patrick Donley: It kind of brings everyone towards this kind of status quo, mediocrity and stagnation. In some ways, what defined the outsiders CEOs the most was their ability to resist this institutional imperative. How do you think they were able to do that?

[00:20:48] Shawn O’Malley: The institutional imperative idea resonates because we’ve all been a part of organizations where bureaucracy and groupthink.

[00:20:56] Shawn O’Malley: Get in the way of common sense. It’s not really surprising then that although we all fantasize about what we would do differently at the top, when we get there, we find it more comfortable to do what is already accepted. Even if it isn’t working very well, nobody wants to be the one who goes out on a limb and just gets things totally wrong.

[00:21:14] Shawn O’Malley: So what I think is special about the outsiders is that there’s normally this divide between the people who can run businesses and the people who invest in businesses, and they very much bridge that divide. It’s a lot easier to resist the pressures of the institutional imperative when you see yourself as not just someone running the business, but an owner tasked with allocating its resources to me.

[00:21:36] Shawn O’Malley: That’s just a completely different mindset. You’re thinking shifts from how can I not lose my job? To what should I do, that will be best for the owners of this business, including myself. The key being that as a CEO, you see yourself as an owner and then an employee, not the other way around. And another theme among the outsider CEOs is that they were in lean.

[00:21:57] Shawn O’Malley: Decentralized organizations. There is no bureaucratic bloat and no layers of advisors or middle managers who would force that kind of stagnation over time. In each case, the managers of their subsidiary businesses were given a ton of discretion to run things as they saw fit. Meaning much of the operational decisions were delegated while the outsider CEOs maintained strict capital allocation decisions from the top down.

[00:22:22] Shawn O’Malley: These CEOs never compromised their independent thinking on capital allocation, even though they knew how to delegate effectively in almost every other area. As a result, their corporate headquarters would typically be very small with most of the workforce instead being on the ground, manning the businesses.

[00:22:39] Shawn O’Malley: The most extreme example is. Of course, Warren Buffett’s Berkshire Hathaway, which is less than 30 employees at corporate headquarters, which oversees something like over 300, 000 employees. And having this blend of loose control over operations while having tight control over capital allocation decisions has clearly worked pretty well for these CEOs and hedging against the so called institutional imperative.

[00:23:03] Shawn O’Malley: So long as there’s always someone disciplined enough and self-assured enough at the top to make sure capital is being put toward its best uses. Thorndike is actually a big fan of checklist two, which he says can inoculate CEOs from the pressure of the institutional imperative and the pull toward mediocrity.

[00:23:20] Shawn O’Malley: He ends the book with a checklist for outsider CEOs. The first is basically to ensure that capital allocation is done by the CEO and not delegated, and then to define a hurdle rate, which is the minimum acceptable return for a new project. From there, a CEO should calculate the expected returns for all relevant internal and external investment opportunities.

[00:23:42] Shawn O’Malley: So this could be buying background stock and then ranking those options by the potential returns and the odds of success or the risk that they each have. And from there, you would probably want to generally use cash in debt levels, very conservatively, decentralized operations as much as possible and retain capital only if you’re confident it can earn returns above your hurdle rate.

[00:24:03] Shawn O’Malley: So it sounds pretty simple when you break it down into this kind of basic checklist, but as with everything in investing, it’s easier to know what should be done in theory. Then to do so in practice, right? Just to ask anyone who panicked and sold during the worst of a bear market, because they thought the world was ending.

[00:24:21] Shawn O’Malley: It’s probably the same person who a few months earlier would have told you about the dangers of falling in the crowd and being too emotional.

[00:24:27] Patrick Donley: Let’s talk about the outsiders CEOs more specifically. Each one makes for a great case study. We don’t have time to cover them all today. So I’m curious, which of these CEOs stood out the most to you?

[00:24:38] Shawn O’Malley: We mentioned her briefly earlier, but. Catherine Graham of the Washington Post has such an interesting story and not just because she’s the only woman on the list. At 46 years old, Graham is a mother of four who hasn’t had any real work experience in years. And she grows up living this fabulously wealthy lifestyle with her dad being the CEO of the Washington Post.

[00:24:59] Shawn O’Malley: But when he dies, she’s suddenly tasked with taking things over. And you can just imagine the imposter syndrome she must’ve felt. Not only was she trying to live up to her dad’s career. But when she took over in the 1960s, she was the only female CEO of a fortune 500 company. Yet, she oversaw the Washington Post’s rise into one of America’s great journalistic institutions, rivaling the New York Times.

[00:25:22] Shawn O’Malley: Her defining moment comes at the height of the Vietnam War and in deciding whether to publish the Pentagon Papers. Which is a pretty damning internal assessment of how the war was going that had been leaked. And so the New York Times gets barred from publishing these papers on a court order. Which leaves the Washington Post with a chance to exclusively do some of what would be the most important reporting of the century.

[00:25:45] Shawn O’Malley: But at the same time, the Nixon administration threatens to undermine the company’s broadcast licenses if they publish the report. So the decision falls squarely on Graham’s shoulders, who barely has any time to consult with her lawyers on whether to publish the story or pass on it. And all the while risking some sort of legal fallout from the White House that they do publish.

[00:26:05] Shawn O’Malley: So, she makes the bold decision to publish, and in doing so, she cements the Washington Post’s editorial legacy for decades. And then after that, leads them to lead the charge on investigating the Watergate scandal, which, as we all know, precipitated Nixon’s impeachment, and ultimately earned the Post a Pulitzer Prize.

[00:26:23] Shawn O’Malley: So it’s a really fun story, but Graham’s accomplishments, the CEO are not limited to reporting by any means from the time the Washington post IPO in 1971 to 1993, when she stepped down, she oversaw a 23 percent compound annual return for shareholders. She made many wonderful business decisions over the time, but what stood out to me most was a moment where.

[00:26:47] Shawn O’Malley: Her humility and open mindedness really shine through. And that happened since 1973, when a little known outsider started buying up a massive stake in the company. And there was a lot of internal concern over who this person was and what they wanted. And Graham meets with their team and basically everyone tells her to ignore this investor who they see as a threat.

[00:27:08] Shawn O’Malley: Yet Graham kind of goes out on a whim and decides to meet with this fellow who is so aggressively buying up stock and influence over the company. And after meeting him, she goes against the insider advice even further and offers him a board seat. And of course that person was Warren Buffett. Obviously, this is well before he was as famous as he is today.

[00:27:29] Shawn O’Malley: So her decision to meet with Buffett and being able to quickly realize his trustworthiness and welcome him onto the company’s board is really inspiring. And it certainly wouldn’t have seemed to be a clearly a right decision as it is today. It would have been a lot easier to just listen to her colleagues and essentially shun this outsider and assume that they had some sort of bad intentions.

[00:27:51] Shawn O’Malley: Instead, she brings him in and learns from him. And I don’t want to make it sound like, you know, but Buffett is responsible for her achievements at all. But he’s a pretty powerful ally to have on your side and learn from, especially in terms of making capital allocation decisions. So like Buffett Graham has this uncommon patience that comes through an unusual amount of self-restraint.

[00:28:12] Shawn O’Malley: For years, the post had by far the most conservative balance sheet of any newspaper. And while her peers were going around buying up as many small newspapers as they possibly could to try to expand their clout. Graham happily sat on the sidelines for long periods with no activity. Instead, she focused on diversifying the company outside of the newspaper business, and by the time she stepped down, 50 percent of its revenue came from non-print sources.

[00:28:39] Shawn O’Malley: I’d say her story is emblematic of the other Outsider CEOs, too. She has this deeply contrarian instinct. When other major newspapers were locked into a frenzy of buying up every smaller peer they could find, being the odd man out and being self-assured enough to recognize that’s not the strategy she wanted to follow, I think is very admirable.

[00:28:59] Shawn O’Malley: There would have been a lot of pressure from people asking, you know, hey, well, why aren’t we doing this too? Why everybody else is doing it? Which is another example of this institutional imperative idea that we talked about. If all your peers are going in one direction, it takes some serious courage to say we’re going to go the other way.

[00:29:13] Shawn O’Malley: Not only are we not going to expand our footprint in the print newspaper industry, but we’re actually going to diversify out of it years before it was clear how disruptive the internet would be. So she just had a lot of that self-assured confidence and foresight.

[00:29:29] Patrick Donley: I think it’s also worth mentioning Henry Singleton of Teledyne, who in 1980, Buffett said had the best operational and capital deployment track record in all of American business.

[00:29:40] Patrick Donley: Even though conglomerate is a bit of a dirty word now, in the 1960s, conglomerates were all the rage. Singleton was a trailblazer in this conglomerate model. He bought 130 companies in 8 years to build out Teledyne. And the focus was on acquiring leading companies in narrow niches, regardless of the industry.

[00:29:59] Patrick Donley: He also made these acquisitions at dirt cheap prices and never paid more than 12 times earnings for a company. How do you think Singleton compares as a capital allocator?

[00:30:10] Shawn O’Malley: 40 years after Buffett made those comments about Singleton, I think it’s safe to say that with Buffett still going, he probably deserves that title now as the best CEO in American business history.

[00:30:21] Shawn O’Malley: But Henry Singleton certainly earns a mention under his guidance. IntelliDen’s first 10 years as a public company, its earnings grew 64 fold. So to your point, Singleton built a rock solid conglomerate based on owning leading businesses at very reasonable prices. And he wasn’t afraid to issue stock for these acquisitions because there was such a premium being paid in the market for conglomerate stocks.

[00:30:45] Shawn O’Malley: Teledyne shares would often trade between 20 and 50 times earnings. So it’s hopefully not too hard to see that if you’re buying great companies at less than 10 times earnings, which is what they were doing and using your own stock as the currency for these deals, which is trading at something like five times higher, you’re doing a very good job of creating value for shareholders.

[00:31:06] Shawn O’Malley: But what’s unique about Singleton too, is how he completely pivots when the circumstances change. After that first decade for Teledyne, conglomerates fell out of favor across wall street. And for really no good reason, the multiple on Teledyne stock gets completely chopped down, even though earnings per share are actually skyrocketing at this time.

[00:31:24] Shawn O’Malley: And under these new circumstances, it’s clearly not as advantageous at all to use your discounted stock to continue making acquisitions. That’s just going to be delusionary. Instead, Singleton decides in 1972 that Teledyne’s stock is so cheap, using the company’s funds to buy back shares and reduce the shares outstanding is going to be the most attractive investment option available.

[00:31:46] Shawn O’Malley: Beginning then, Teledyne undergoes an unprecedented 12 year spree of aggressive share buybacks. On one occasion, Singleton bought back more than 20 percent of all of the company’s outstanding shares. It was a very tax efficient way of returning capital to shareholders at scale compared to paying out dividends.

[00:32:04] Shawn O’Malley: And at the end of all this, Singleton puts on a masterclass in buying low and selling high. On average, he bought back the company’s stock at a multiple of eight times earnings. And he sold shares for acquisitions at an average multiple of 25 times earnings. And then in the 1980s, when it became clear that not even substantial buybacks could bring Teledyne stock to its intrinsic value, Singleton started spinning off subsidiary businesses to unlock value.

[00:32:31] Shawn O’Malley: In those spinoffs, businesses would be carved off as independent public companies, but Teledyne shareholders would retain their interest in them with new shares in these companies. And because they were now pure plays in their industry and no longer connected to a conglomerate, these spinoffs would trade at a much higher valuation than when they operated from within Teledyne, hence unlocking value, as some people say.

[00:32:53] Shawn O’Malley: So to recap, in Singleton’s first three decades, he begins with this focus on making high quality acquisitions at cheap prices in the 1960s, using the market premium on his conglomerate to his advantage. And then in the 1970s, when conglomerate stocks get punished. He bought back Teledyne stock. And then in the 1980s, he begins dismantling this conglomerate that he built to further unlock value for shareholders.

[00:33:16] Shawn O’Malley: And the last pivot comes in 1987, when after 27 years of eschewing dividends, he opted to pay out a large special dividend to shareholders since he couldn’t find a better use for the cash. And at each point along the way, he was always making assessments about the comparative attractiveness of acquisitions, spinoffs, buybacks, and dividends.

[00:33:37] Shawn O’Malley: Didn’t hesitate to completely change strategies if it was in shareholders’ best interests. And obviously I think you could say he did a pretty good job with that. A dollar invested in Teledyne in 1963 would’ve been worth $180 in 1990 versus only $27 if you had invested in a broad group of conglomerates and $15 if you’d invest in the S and P 500. So that’s a 12 times outperformance of the market average.

[00:34:03] Patrick Donley: It’s pretty incredible. And just to wrap things up today, I wanted to connect the book here to a broader audience. I don’t want people to think just because you’re not a CEO, that the stories aren’t relevant to our listeners today. Even though we’ve been talking about CEOs, a big publicly traded companies. My last question is what lessons can be learned from the outsiders for entrepreneurs or for anyone managing smaller companies?

[00:34:27] Shawn O’Malley: For starters, I think the book is very relevant to any stock investor, obviously looking to identify the traits of companies with high likelihood of outperforming the market. I know some people want to hedge management risk by finding businesses so good that anyone can run them, but there’s also, in my opinion, something to be said about looking for companies with shareholder focused management.

[00:34:50] Shawn O’Malley: I think that’s just going to make everything a lot easier in the long run. When you have management that’s working in your favor and not against you, and after reading it, or hopefully even after just listening to this episode, you should have some idea of the type of CEO you should be attracted to as an investor and which ones instead raise red flags for you.

[00:35:09] Shawn O’Malley: I’ll also mention that capital allocation decisions aren’t confined to CEOs of major companies. If you manage a business of any size, you’re going to face similar capital allocation tradeoffs. If you run a successful high end bakery, for example, and you have a high class problem of having more demand than you can fulfill, you probably make this easy decision to expand your business.

[00:35:31] Shawn O’Malley: But then things get more complicated when you consider how you could expand into the space next door, or you could fill an entirely new building on the other side of town. Expanding right next door is going to be a lot easier to manage, but it might not really expand your capacity that much. You’re still probably going to struggle to meet all your demand, but also, it’s a cheaper option.

[00:35:50] Shawn O’Malley: On the other hand, if you expand into a second location, you’ll handle much more business, but you take on a whole new set of risks, right? You’re going to have to invest more capital upfront to establish the new location, running operations on two different sides of town is going to be more complicated and there’s going to be more uncertainty about whether this new part of the market will be interested in your products.

[00:36:11] Shawn O’Malley: So the trade-off is expand across town with more uncertainty and cost, but with greater capacity to drive sales or expand next door, which won’t increase your capacity as much, but comes with less costs and less uncertainty because you’ve already had such strong demand at that location. It’s a hypothetical, obviously, but it’s not too difficult to think that many local business owners Face questions like this every day.

[00:36:36] Shawn O’Malley: So the question is, what should you do? And no one can answer that for you. But if you’re an outsider CEO, you’re going to focus not on which opportunity drives revenue up the most, but instead you’re going to be focused on determining which is likelier to deliver better returns on your equity over time.

[00:36:52] Shawn O’Malley: And the trick is that doing nothing at all can feel boring or even demoralizing to some people. That’s why thinking like a stingy capital allocator who can recognize when it makes sense to scale down their business and put capital to use elsewhere is so challenging, especially as a person running the business. It’s very hard to resist that urge. You want to keep growing bigger and bigger.

[00:37:12] Patrick Donley: Thanks Shawn. I really do appreciate your time and insights that you’ve shared with us today from the outsiders. Next week, we’ll be back for our fourth and final installment where we will be discussing one of my favorite books. It’s one that sits on my coffee table, Poor Charlie’s Almanac. We’ll see you all back here next week. Thanks, Shawn.

[00:37:28] Shawn O’Malley: Thanks for having me.

[00:37:29] Patrick Donley: Okay, folks, that’s all I had for today’s episode. I hope you enjoyed the show and I’ll see you back here real soon.

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