Great Books Distilled: Books by History's Greatest Innovators, Founders, and Investors

The page is a reading list sharing the best books written by history's greatest innovators, founders, and investors. This is a reading list for people who don’t have time for unimportant books—which should be everyone. I only list the best books I've read and recommend.

All Book Summaries

For the best books that I read, I go through the painstaking effort to put together and publish my personal notes including highlights, excerpts, and takeaways. You get the best 5% of the ideas in these books in a form that takes 20 minutes at most to read.

Great Books by Category

These are the best books to read, listed by category. Along with a few collections of rare and hard-to-find speeches, lectures, talks, interviews, letters, and memos that are a great way to go deeper.

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Daniel Scrivner

The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by Will Thorndike

This is part of my book summary collection which includes The Essays of Warren Buffett, Poor Charlie's Almanack, Special Operations Mental Toughness, and 50+ more. Browse them all to find the best ideas from history's greatest books →

"It is impossible to produce superior performance unless you do something different." — John Templeton

What makes a successful CEO? Most people call to mind a familiar definition: a seasoned manager with deep industry expertise. Others might point to the qualities of today's so-called celebrity CEOs charisma, virtuoso communication skills, and a confident management style. But what really matters when you run an organization? What is the hallmark of exceptional CEO performance? Quite simply, it is the returns for the shareholders of that company over the long term.

In this refreshing, counterintuitive audiobook, author Will Thorndike brings to bear the analytical wisdom of a successful career in investing, closely evaluating the performance of companies and their leaders. You will meet eight individualistic CEOs whose firms' average returns outperformed the S&P 500 by a factor of twenty in other words, an investment of $10,000 with each of these CEOs, on average, would have been worth over $1.5 million twenty-five years later. You may not know all their names, but you will recognize their companies: General Cinema, Ralston Purina, The Washington Post Company, Berkshire Hathaway, General Dynamics, Capital Cities Broadcasting, TCI, and Teledyne.

In The Outsiders, you'll learn the traits and methods striking for their consistency and relentless rationality that helped these unique leaders achieve such exceptional performance. Humble, unassuming, and often frugal, these "outsiders" shunned Wall Street and the press, and shied away from the hottest new management trends. Instead, they shared specific traits that put them and the companies they led on winning trajectories: a laser-sharp focus on per share value as opposed to earnings or sales growth; an exceptional talent for allocating capital and human resources; and the belief that cash flow, not reported earnings, determines a company's long-term value.

Drawing on years of research and experience, Thorndike tells eye-opening stories, extracting lessons and revealing a compelling alternative model for anyone interested in leading a company or investing in one and reaping extraordinary returns.

Book Summary

This is my book summary of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike. This book summary includes my favorite quotes, excerpts, stories, notes, and ideas from the book.

The Outsiders in Three Sentences

CEOs compete in a highly quantitative field and yet there is no single, accepted metric for measuring their performance.  The Outsiders proposes that it’s the increase in a company’s per share value (against their peers), however, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO’s greatness. It profiles eight CEOs that have delivered incredible growth in per share value — from Henry Single with Teledyne, and Katharine Graham with The Washington Post, to Warren Buffett with Berkshire Hathaway.

The Outsiders in 15 Short Bullet Points

Here is a summary of the key points from The Outsiders by William Thorndike in 15 short bullet points:

  • The book profiles 8 unconventional CEOs who significantly outperformed the market and their peers over long periods of time.
  • These CEOs include Warren Buffett (Berkshire Hathaway), Tom Murphy (Capital Cities), Henry Singleton (Teledyne), Bill Anders (General Dynamics), John Malone (TCI), Katharine Graham (Washington Post), Bill Stiritz (Ralston Purina), and Dick Smith (General Cinema).
  • The CEOs had some common traits: they were frugal, humble, analytical, independent thinkers, understated, and focused on operations over public relations.
  • Most were first-time CEOs without a lot of prior management experience and were new to their industries, providing a fresh perspective.
  • They avoided bankers/advisors, preferred decentralized organizations, and often took on high debt levels.
  • The CEOs had a laser-like focus on smart capital allocation as the key driver of value creation.
  • They always did the math themselves on the return on investment for opportunities using conservative assumptions.
  • Maximizing value on a per-share basis, not just overall growth, was the priority - they were careful about diluting shareholders.
  • Making occasional big bets when the time was right and avoiding overpriced deals was key to their success.
  • Thorndike argues these CEOs had "the best operating and capital deployment record in American business."
  • A dollar invested with Teledyne's Henry Singleton in 1963 would have been worth $180 by 1990 vs $15 in the S&P 500.
  • These CEOs thought long-term and didn't fret over meeting quarterly earnings expectation.
  • They considered the full range of options for deploying capital, including buybacks, dividends, and selling off parts of the business at time.
  • The CEOs were iconoclastic and unafraid to go against the grain of what their peers and the press thought they should do.
  • Thorndike provides a rational "outsider's checklist" for effective capital allocation based on the shared practices of these exceptional CEOs.

Measuring the Performance of CEOs

CEOs, like professional athletes, compete in a highly quantitative field, and yet there is no single, accepted metric for measuring their performance, no equivalent of ERA for baseball pitchers, or complication rate for surgeons, or goals against average for hockey goalies. The business press doesn't attempt to identify the top performers in any rigorous way.

Instead, they generally focus on the largest, best-known companies, the Fortune 100, which is why the executives of those companies are so often found on the covers of the top business magazines. The metric that the press usually focuses on is growth in revenues and profits. It's the increase in a company's per share value, however, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO's greatness. It's as if Sports illustrated put only the tallest pitchers and widest goalies on its cover.

In assessing performance, what matters isn't the absolute rate of return but the return relative to peers and the market. You really only need to know three things to evaluate a CEO's greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500). Context matters greatly—beginning and ending points can have an enormous impact.

The other important element in evaluating a CEO's track record is performance relative to peers, and the best way to assess this is by comparing a CEO with a broad universe of peers. As in the game of duplicate bridge, companies competing within an industry are usually dealt similar hands, and the long-term differences between them, therefore, are more a factor of managerial ability than external forces.

Let's look at an example from the mining industry. It's almost impossible to compare the performance of a gold mining company CEO in 2011, when gold prices topped out at over $1,900 an ounce, with that of an executive operating in 2000, when prices languished at $400. CEOs in the gold industry cannot control the price of the underlying commodity. They must simply do the best job for shareholders, given the hand the market deals them, and in assessing performance, it's most useful to compare CEOs with other executives operating under the same conditions. When a CEO generates significantly better returns than both his peers and the market, he deserves to be called "great."

The Role of Capital Allocation in a CEO’s Performance

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important. Singleton, in contrast, gave most of his attention to the latter task.

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Essentially, capital allocation is investment, and as a result all CEOs are both capital allocators and investors. In fact, this role just might be the most important responsibility any CEO has, and yet despite its importance, there are no courses on capital allocation at the top business schools. As Warren Buffett has observed, very few CEOs come prepared for this critical task:

The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineer-ing, administration, or sometimes, institutional politics. Once they become CEOs, they now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it's as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead, to be named Chairman of the Federal Reserve!

This inexperience has a direct and significant impact on investor returns. Buffett stressed the potential impact of this skill, pointing out that after ten years on the job, a CEO whose company annually retains earnings equal to 10 percent of net worth will have been responsible for the deployment of more than 60 percent of all the capital at work in the business."

If you think of capital allocation more broadly as resource allocation and include the deployment of human resources, you find again that Singleton had a highly differentiated approach. Specifically, he believed in an extreme form of organizational decentralization with a wafer-thin corporate staff at headquarters and operational responsibility and authority concentrated in the general managers of the business units. This was very different from the approach of his peers, who typically had elaborate headquarters staffs replete with vice presidents and MBAs.

It turns out that the most extraordinary CEOs of the last fifty years, the truly great ones, shared this mastery of resource allocation.

The Commonalities of Outlier CEOs

In 1988, Warren Buffett wrote an article on investors who shared a combination of excellent track records and devotion to the value investing principles of legendary Columbia Business School professors Benjamin Graham and David Dodd. Graham and Dodd's unorthodox investing strategy advocated buying companies that traded at material discounts to conservative assessments of their net asset values.

To illustrate the strong correlation between extraordinary investment returns and Graham and Dodd's principles, Buffett used the analogy of a national coin-flipping contest in which 225 million Americans, once a day, wager a dollar on a coin toss. Each day the losers drop out, and the next day the stakes grow as all prior winnings are bet on the next day's flips. After twenty days, there are 215 people left, each of whom has won a little over $1 million. Buffett points out that this outcome is purely the result of chance and that 225 million orangutans would have produced the same result. He then introduces an interesting wrinkle:

If you found, however, that 40 of them came from a particular zoo in Omaha, you would be pretty sure you were on to something. ...Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer and you found that 400 cases occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.

Conventional CEOs rarely trounce the market or their peers. As in the world of investing, there are very few extraordinary managerial coin-flippers, and if you were to list them, not surprisingly, you would find they were also iconoclasts.

These managerial standouts, the ones profiled in this book, ran companies in both growing and declining markets, in industries as diverse as manufacturing, media, defense, consumer products, and financial services. Their companies ranged widely in terms of size and maturity. None had hot, easily repeatable retail concepts or intellectual property advantages versus their peers, and yet they hugely outperformed them.

Like Singleton, they developed unique, markedly different approaches to their businesses, typically drawing much comment and questioning from peers and the business press. Even more interestingly, although they developed these principles independently, it turned out they were iconoclastic in virtually identical ways. In other words, there seemed to be a pattern to their iconoclasm, a potential blueprint for success, one that correlated highly with extraordinary returns.

They seemed to operate in a parallel universe, one defined by devotion to a shared set of principles, a worldview, which gave them citizenship in a tiny intellectual village. Call it Singletonville, a very select group of men and women who understood, among other things, that:

  • Capital allocation is a CEO's most important job.
  • What counts in the long run is the increase in per share value, not overall growth or size.
  • Cash flow, not reported earnings, is what determines long-term value.
  • Decentralized organizations release entrepreneurial energy and keep both costs and "rancor" down.
  • Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press) can be distracting and time-consuming.
  • Sometimes the best investment opportunity is your own stock.
  • With acquisitions, patience is a virtue ... as is occasional boldness.

Interestingly, their iconoclasm was reinforced in many cases by geography. For the most part, their operations were located in cities like Denver, Omaha, Los Angeles, Alexandria, Washington, and St. Louis, removed from the financial epicenter of the Boston/New York corridor. This distance helped insulate them from the din of Wall Street conventional wisdom. (The two CEOs who had offices in the Northeast shared this predilection for nondescript locations—Dick Smith's office was located in the rear of a suburban shopping mall, Tom Murphy's was in a former midtown Manhattan residence sixty blocks from Wall Street.)

The residents of Singletonville, our outsider CEOs, also shared an interesting set of personal characteristics: They were generally frugal (often legendarily so) and humble, analytical, and understated. They were devoted to their families, often leaving the office early to attend school events. They did not typically relish the outward-facing part of the CEO role. They did not give chamber of commerce speeches, and they did not attend Davos. They rarely appeared on the covers of business publications and did not write books of management advice. They were not cheerleaders or marketers or backslappers, and they did not exude charisma.

They were very different from high-profile CEOs such as Steve Jobs or Sam Walton or Herb Kelleher of Southwest Airlines or Mark Zuckerberg. These geniuses are the Isaac Newtons of business, struck apple-like by enormously powerful ideas that they proceed to execute with maniacal focus and determination. Their situations and circumstances, however, are not remotely similar (nor are the lessons from their careers remotely transferable) to those of the vast majority of business executives.

The outsider CEOs had neither the charisma of Walton and Kelleher nor the marketing or technical genius of Jobs or Zuckerberg. In fact, their circumstances were a lot like those of the typical American business executive. Their returns, however, were anything but quotidian.

On average they outperformed the S&P 500 by over twenty times and their peers by over seven times—and our focus will be on looking at how those returns were achieved. We will, as the Watergate informant Deep Throat suggested, "follow the money," looking carefully at the key decisions these outsider CEOs made to maximize returns to shareholders and the lessons those decisions hold for today's managers and entrepreneurs.

Superior Performance Demands Thinking and Acting Differently

The CEOs in The Outsiders, consistently made very different decisions than their peers did. They were not however blindly contrarian. Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions.

In this way, their iconoclasm was similar to Billy Beane's as described by Michael Lewis in Moneyball? Beane, the general manager of the perennially cash-strapped Oakland A's baseball team, used statistical analysis to gain an edge over his better-heeled competitors. His approach centered on new metrics—on-base and slugging percentages—that correlated more highly with team winning percentage than the traditional statistical troika of home runs, batting average, and runs batted in.

Beane's analytical insights influenced every aspect of how he ran the A's-from drafting and trading strategies to whether or not to steal bases or use sacrifice bunts in games (no, in both cases). His approach in all these areas was highly unorthodox, yet also highly successful, and his team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job.

Like Beane, Henry Singleton and the seven other executives developed unique, iconoclastic approaches to their businesses that drew much comment and questioning from peers and the business press. And, like Beane's, their results were exceptional, handily outperforming both the legendary Welch and their industry counterparts.

They came from a variety of backgrounds: one was an astronaut who had orbited the moon, one a widow with no prior business experience, one inherited the family business, two were highly quantitative PhDs, one an investor who'd never run a company before. They were all, however, new to the CEO role, and they shared a couple of important traits, including fresh eyes and a deep-seated commitment to rationality.

Outsider CEOs are Foxes, Not Hedgehogs

Isaiah Berlin, in a famous essay about Leo Tolstoy, introduced the instructive contrast between the "fox," who knows many things, and the "hedgehog," who knows one thing but knows it very well. Most CEOs are hedgehogs—they grow up in an industry and by the time they are tapped for the top role, have come to know it thoroughly. There are many positive attributes associated with hedgehogness, including expertise, specialization, and focus.

Foxes, however, also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes. They had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results.

Rebels Against the “Corporate Imperative”

In the 1986 Berkshire Hathaway annual report, Warren Buffett looked back on his first twenty-five years as a CEO and concluded that the most important and surprising lesson from his career to date was the discovery of a mysterious force, the corporate equivalent of teenage peer pressure, that impelled CEOs to imitate the actions of their peers. He dubbed this powerful force the institutional imperative and noted that it was nearly ubiquitous, warning that effective CEOs needed to find some way to tune it out.

The CEOs in this book all managed to avoid the insidious influence of this powerful imperative. How? They found an antidote in a shared managerial philosophy, a worldview that pervaded their organizations and cultures and drove their operating and capital allocating decisions. Although they arrived at their management philosophies independently, what's striking is how remarkably similar the ingredients were across this group of executives despite widely varying industries and circumstances.

Embracers of Decentralization

Each ran a highly decentralized organization; made at least one very large acquisition; developed unusual, cash flow-based metrics; and bought back a significant amount of stock. None paid meaningful dividends or provided Wall Street guidance. All received the same combination of derision, wonder, and skepticism from their peers and the business press. All also enjoyed eye-popping, credulity-straining performance over very long tenures (twenty-plus years on average).

CEOs as Careful Deployers of Firm Resources

The business world has traditionally divided itself into two basic camps: those who run companies and those who invest in them. The lessons of these iconoclastic CEOs suggest a new, more nuanced conception of the chief executive's job, with less emphasis placed on charismatic leadership and more en careful deployment of firm resources.

At bottom, these CEOs thought more like investors than man-agers. Fundamentally, they had confidence in their own analytical skills, and on the rare occasions when they saw compelling discrepancies between value and price, they were prepared to act boldly. When their stock was cheap, they bought it (often in large quantities), and when it was expensive, they used it to buy other companies or to raise inexpensive capital to fund future growth.

These eight CEOs were not charismatic visionaries, nor were they drawn to grandiose strategic pronouncements. They were practical and agnostic in temperament, and they systematically tuned out the noise of conventional wisdom by fostering a certain simplicity of focus, a certain asperity in their cultures and their communications. Scientists and mathematicians often speak of the clarity " on the other side" of complexity, and these CEOs—all of whom were quantitatively adept (more had engineering degrees than MBAs)—had a genius for simplicity, for cutting through the clutter of peer and press chatter to zero in on the core economic characteristics of their businesses.

Cash Flow Over Reported Earnings

In all cases, this led the outsider CEOs to focus on cash flow and to forgo the blind pursuit of the Wall Street holy grail of reported earnings. Most public company CEOs focus on maximizing quarterly reported net income, which is understandable since that is Wall Street's preferred metric. Net income, however, is a bit of a blunt instrument and can be significantly distorted by differences in debt levels, taxes, capital expenditures, and past acquisition history.

As a result, the outsiders (who often had complicated balance sheets, active acquisition programs, and high debt levels) believed the key to long-term value creation was to optimize free cash flow, and this emphasis on cash informed all aspects of how they ran their companies—from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems.

This single-minded cash focus was the foundation of their iconoclasm, and it invariably led to a laser-like focus on a few select variables that shaped each firm's strategy, usually in entirely different directions from those of industry peers. For Henry Singleton in the 1970s and 1980s, it was stock buybacks; for John Malone, it was the relentless pursuit of cable subscribers; for Bill Anders, it was divesting noncore businesses; for Warren Buffett, it was the generation and deployment of insurance float.

At the core of their shared worldview was the belief that the primary goal for any CEO was to optimize long-term value per share, not organizational growth. This may seem like an obvious objective; however, in American business, there is a deeply ingrained urge to get bigger Larger companies get more attention in the press; the executives of those companies tend to earn higher salaries and are more likely to be asked to join prestigious boards and clubs. As a result, it is very rare to see a company proactively shrink itself. And yet virtually all of these CEOs shrank their share bases significantly through repurchases. Most also shrank their operations through asset sales or spin-offs, and they were not shy about selling (or closing) underperforming divisions. Growth, it turns out, often doesn't correlate with maximizing shareholder value.

This pragmatic focus on cash and an accompanying spirit of proud iconoclasm (with just a hint of asperity) was exemplified by Henry Singleton, in a rare 1979 interview with Forbes magazine: "After we acquired a number of businesses, we reflected on business. Our conclusion was that the key was cash flow. ... Our attitude toward cash generation and asset management came out of our own thinking." He added (as though he needed to), "It is not coped."

Henry Singleton and Teledyne

Henry Singleton has the best operating and capital deployment record in American business... if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good as Singleton's. — Warren Buffett, 1980
I change my mind when the facts change. What do you do? — John Maynard Keynes

Who is Henry Singleton?

Known today only to a small group of investors and cognoscenti, Henry Singleton was a remarkable man with an unusual back ground for a CEO. A world-class mathematician who enjoyed playing chess blindfolded, he had programmed MIT's first computer while earning a doctorate in electrical engineering. During World War II, he developed a "degaussing" technology that allowed Allied ships to avoid radar detection, and in the 1950s, he created an inertial guidance system that is still in use in most military and commercial aircraft. All that before he founded a conglomerate, Teledyne, in the early 1960s and became one ef history's great CEOs.

Conglomerates were the Internet stocks of the 1960s, when large numbers of them went public. Singleton, however, ran a very unusual conglomerate. Long before it became popular, he aggressively repurchased his stock, eventually buying in over 90 percent of Teledyne's shares; he avoided dividends, emphasized cash flow over reported earnings, ran a famously decentralized organization, and never split the company's stock, which for much of the 1970s and 1980s was the highest priced on the New York Stock Exchange (NYSE). He was known as "the Sphinx" for his reluctance to speak with either analysts or journalists, and he never once appeared on the cover of Fortune magazine.

Singleton was an iconoclast and the idiosyncratic path he chose to follow caused much comment and consternation on Wall Street and in the business press. It turned out that he was right to ignore the skeptics. The long-term returns of his better-known peers were generally mediocre-averaging only 11% per annum, a small improvement over the S&P 500.

Singleton, in contrast, ran Teledyne for almost thirty years, and the annual compound return to his investors was an extraordinary 20.4%. If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180. That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500. Remarkably, Singleton outperformed the index by over twelve times.

Using our definition of success, Singleton was a greater CEO than Jack Welch. His numbers are simply better: not only were his per share returns higher relative to the market and his peers, but he sustained them over a longer period of time (twenty-eight years versus Welch's twenty) and in a market environment that featured several protracted bear markets.

His success did not stem from Teledyne's owning any unique, rapidly growing businesses. Rather, much of what distinguished Singleton from his peers lay in his mastery of the critical but somewhat mysterious field of capital allocation the process of deciding how to deploy the firm's resources to earn the best possible return for shareholders.

Singleton was a master capital allocator, and his decisions in navigating among these various allocation alternatives differed significantly from the decisions his peers were making and had an enormous positive impact on long-term returns for his shareholders. Specifically, Singleton focused Teledyne's capital on selective acquisitions and a series of large share repurchases. He was restrained in issuing shares, made frequent use of debt, and did not pay a dividend until the late 1980s. In contrast, the other conglomerates pursued a mirror-image allocation strategy—actively issuing shares to buy companies, paying dividends, avoiding share repurchases, and generally using less debt. In short, they deployed a different set of tools with very different results.

Components on Henry Singleton’s strategy with Teledyne:

  • Took advantage of the high P/E multiple on conglomerates, the tech stocks of their day, to acquire small companies using Teledyne’s stock. All but two acquisitions were done using Teledyne’s stock, much of which was newly issued — expanding the company’s total share count.
  • Once this high multiple vanished, Teledyne made no other acquisitions and laid off their deal team. They then switched to focus completely on bottom-line free cash flow generation—shunning any focus on top-line earnings growth.
  • As Teledyne’s multiple fell further, Henry Single used the cash that Teledyne’s companies produced to acquire Teledyne’s stock aggressively. As Munger said, “No one has ever bought in shared as aggressively.” These stock purchases produced an incredible 42% compound annual return.
  • Henry Singleton became the first CEO to invest the vast majority (77%) of Teledyne’s insurance portfolios in public equities. He also embraced an incredibly concentrated approach to investing, allocating over 70% of this equity portfolios in just 5 companies.
  • Finally, Teledyne pioneered the use of spin-offs. In the words of longtime board member Fayez Sarofim, Singleton believed “there was a time to conglomerate and a time to deconglomerate.” Teledyne spun off their first company, Argonaut, in 1986.


In early 1987, Teledyne, a midsize conglomerate with a reputation for unconventional behavior, declared a dividend. This seemingly innocuous event attracted inordinate attention in the business press, including a front-page article in the Wall Street Journal. What did the Journal find so newsworthy?

For most of the twentieth century, public companies were expected to pay out a portion of their annual profits as dividends.Many investors, particularly senior citizens, relied on these dividends for income and looked closely at dividend levels and policies in making investment decisions. Teledyne, however, alone among 1960s-era conglomerates, steadfastly refused to pay dividends, believing them to be tax inefficient (dividends are taxed twice—once at the corporate level and again at the individual level).

In fact, under its reclusive founder and CEO, Henry Single-ton, this dividend policy was, as we've seen, just one in a series of highly unusual and contrarian practices at Teledyne. In addition to eschewing dividends, Singleton ran a notoriously decentralized operation; avoided interacting with Wall Street analysts; didn't split his stock; and repurchased his shares as no one else ever has, before or since.

All of this was highly unusual and idiosyncratic, but what really set Singleton apart and eventually made him a Garbo-like legend was his returns, which dwarfed both the market and his conglomerate peers. Singleton managed to grow values at an extraordinary rate across almost thirty years of wildly varying macroeconomic conditions, starting in the "go-go" stock market of the 1960s and ending in the deep bear market of the early 1990s.

He did this by continually adapting to changing market conditions and by maintaining a dogged focus on capital allocation. His approach differed significantly from his peers, and the seeds of this iconoclasm can be traced to his background, which was highly unusual for a Fortune 500 CEO.

Conglomerate in the 1960s

Conglomerates, companies with many, unrelated business units, were the Internet stocks of their day. Taking advantage of their stratospheric stock prices, they grew by voraciously and often indiscriminately acquiring businesses in a wide range of industries.

These purchases initially brought higher profits, which led to still higher stock prices that were then used to buy more companies.Most conglomerates built up large corporate headquarters staffs in the belief that they could find and exploit synergies across their disparate companies, and they actively courted Wall Street and the press in order to boost their stock. Their halcyon days, how-ever, came to an abrupt end in the late 1960s when the largest of them (ITT, Litton Industries, and so on) began to miss earnings estimates and their stock prices fell precipitously.

The conventional wisdom today is that conglomerates are an inefficient form of corporate organization, lacking the agility and focus of "pure play" companies. It was not always so—for most of the 1960s, conglomerates enjoyed lofty price-to-earnings (P/E) ratios and used the currency of their high-priced stock to engage in a prolonged frenzy of acquisition. During this heady period, there was significantly less competition for acquisitions than today (private equity firms did not yet exist), and the price to buy control of an operating company (measured by its P/E ratio) was often materially less than the multiple the acquirer traded for in the stock market, providing a compelling logic for acquisitions.

Henry Singleton’s Approach to Acquisitions

Singleton took full advantage of this extended arbitrage opportunity to develop a diversified portfolio of businesses, and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to specialty metals and insurance. All but two of these companies were acquired using Teledyne's pricey stock.

Singleton's approach to acquisitions, however, differed from that of other conglomerateurs. He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets. As Jack Hamilton, who ran Teledyne's specialty metals division, summarized his business to me, "We specialized in high-margin products that were sold by the ounce, not the ton." Singleton was a very disciplined buyer, never paying—more than twelve times earnings and purchasing most companies at significantly lower multiples. This compares to the high P/E multiple on Teledyne's stock, which ranged from a low of 20 to a high of 50 over this period.

In 1967, in his largest acquisition to date, Singleton acquired Vasco Metals for $43 million and elevated its president, George Roberts, to the role of president of Teledyne, taking the titles of CEO and chairman for himself. Roberts had been Singleton's roommate at the Naval Academy, where he had been admitted at age sixteen as the youngest freshman in the school's history (before both he and Singleton transferred due to Depression-era tuition aid cuts). Roberts also had a scientific background, having graduated from Carnegie Mellon with a PhD in metallurgy before holding a series of executive positions at various specialty metals companies, eventually joining Vasco in the early 1960s as president.

Once Roberts joined the company, Singleton began to remove himself from operations, freeing up the majority of his time to focus on strategic and capital allocation issues.

Shortly thereafter, Singleton became the first of the conglomerateurs to stop acquiring. In mid-1969, with the multiple on his stock falling and acquisition prices rising, he abruptly dismissed his acquisition team. Singleton, as a disciplined buyer, realized that with a lower P/E ratio, the currency of his stock was no longer attractive for acquisitions. From this point on, the company never made another material purchase and never issued another share of stock.

The effectiveness of this acquisition strategy was astounding. Over its first ten years as a public company, Teledyne's earnings per share (EPS) grew an astonishing sixty-four-fold, while shares outstanding grew less than fourteen times, resulting in significant value creation for shareholders.

Henry Singleton’s Focus on Decentralization

In contrast to peers like Thornton and Harold Geneen at ITT, Singleton and Roberts eschewed the then trendy concepts of "integration" and "synergy" and instead emphasized extreme decentralization, breaking the company into its smallest component-parts and driving accountability and managerial responsibility as far down into the organization as possible. At headquarters, there were fewer than fifty people in a company with over forty thousand total employees; and no human resource, investor relations, or business development departments. Ironically, the most successful conglomerate of the era was actually the least conglomerate-like in its operations.

This decentralization fostered an objective, apolitical culture at Teledyne. Several former company presidents mentioned this refreshing lack of politics—managers who made their numbers did well; those whe did not, moved on. As one told me, "No one worried who Henry was having lunch with."

Henry Singleton’s Pivot to Free Cash Flow Generation

Once the acquisition engine had slowed in 1969, Roberts and Singleton turned their attention to the company's existing operations. In another departure from conventional wisdom, Singleton eschewed reported earnings, the key metric on Wall Street at the time, running his company instead to optimize free cash flow. He and his CFO, Jerry Jerome, devised a unique metric that they termed the Teledyne return, which by averaging cash flow and net income for each business unit, emphasized cash generation and became the basis for bonus compensation for all business unit general managers. As he once told Financial World magazine, "If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings." Not a quote you're likely to hear from the typical Wall Street-focused Fortune 500 CEO today.
Singleton and Roberts quickly improved margins and dramatically reduced working capital at Teledyne's operations, generating significant cash in the process. The results can be seen in the consistently high return on assets for Teledyne's operating businesses, which averaged north of 20 percent throughout the 1970s and 1980s. Warren Buffett's partner, Charlie Munger, describes these extraordinary results as "miles higher than anybody else… utterly ridiculous."

The net result of these initiatives was that, starting in 1970, the company generated remarkably consistent profitability across a wide variety of market conditions. This influx of cash was sent to headquarters to be allocated by Singleton The decisions he made in deploying this capital were, not surprisingly, highly unusual (and effective).

Packard Bell: A Rare Misstep
One division that did not meet Singleton's exacting standards was the Packard Bell television set manufacturing business, and it is interesting to see how he and Roberts handled this rare underperforming business unit. When they realized that Packard Bell had a permanent competitive disadvantage relative to its lower-cost Japanese competitors and could no longer earn acceptable returns, they immediately closed it, becoming the first American manufacturer to exit the industry (all the others followed over the next decade).

Henry Singleton’s Pivot to Share Buybacks

In early 1972, with his cash balance growing and acquisition multiples still high, Singleton placed a call from a midtown Manhattan phone booth to one of his board members, the legendary venture capitalist Arthur Rock (who would later back both Apple and Intel). Singleton began: "Arthur, I've been thinking about it and our stock is simply too cheap. I think we can earn a better return buying our shares at these levels than by doing almost anything else. I'd like to announce a tender—what do you think?" Rock reflected a moment and said, "I like it."

With those words, one of the seminal moments in the history of capital allocation was launched. Starting with that 1972 tender and continuing for the next twelve years, Singleton went on an unprecedented share repurchasing spree that had a galvanic effect on Teledyne's stock price while also almost single-handedly overturning long-held Wall Street beliefs.

To say Singleton was a pioneer in the field of share repurchases is to dramatically understate the case. It is perhaps more accurate to describe him as the Babe Ruth of repurchases, the towering, Olympian figure from the early history of this branch of corporate finance. Prior to the early 1970s, stock buybacks were uncommon and controversial. The conventional wisdom was that repurchases signaled a lack of internal investment opportunity, and they were thus regarded by Wall Street as a sign of weakness.Singleton ignored this orthodoxy, and between 1972 and 1984, in eight separate tender offers, he bought back an astonishing 90 percent of Teledyne's outstanding shares. As Munger says, "No one has ever bought in shares as aggressively."

Singleton believed repurchases were a far more tax-efficient method for returning capital to shareholders than dividends, which for most of his tenure were taxed at very high rates. Singleton believed buying stock at attractive prices was self-catalyzing, analogous to coiling a spring that at some future point would surge forward to realize full value, generating exceptional returns in the process. These repurchases provided a useful capital allocation benchmark, and whenever the return from purchasing his stock looked attractive relative to other investment opportunities, Singleton tendered for his shares.

Repurchases became popular in the 1990s and have frequently been used by CEOs in recent years to prop up sagging stock prices. Buybacks, however, add value for shareholders only if they are made at attractive prices. Not surprisingly, Singleton bought extremely well, generating an incredible 42% compound annual return for Teledyne's shareholders across the tenders.

These tender offers were in almost every case oversubscribed. Singleton had done the analysis and knew these buybacks were compelling, and with the strength of his conviction always bought all shares offered. These repurchases were very large bets for Teledyne, ranging in size from 4% to an unbelievable 66% of the company's book value at the time they were announced. In all, Singleton spent an incredible $2.5 billion on the buybacks.

From 1971 to 1984, Singleton bought back huge chunks of Teledyne's stock at low P/Es while revenues and net income continued to grow, resulting in an astonishing fortyfold increase in earnings per share.

It's important, however, to recognize that this obsession with repurchases represented an evolution in thinking for Singleton, who, earlier in his career when he was building Teledyne, had been an active and highly effective issuer of stock.

Great investors (and capital allocators) must be able to both sell high and buy low. The average price-to-earnings ratio for Teledyne's stock issuances was over 25. In contrast, the average multiple for his repurchased was under 8.

Henry Singleton’s Concentrated Approach to Investing Within Insurance Portfolios

Singleton had been fascinated by the stock market since his teens.George Roberts told me a story of Singleton on leave in New York during World War II standing at the window of a brokerage firm for hours, watching the scroll of stock prices go by on ticker tape.

In the mid-1970s, Singleton finally had an opportunity to act on this lifelong fascination when he assumed direct responsibility for investing the stock portfolios at Teledyne's insurance subsidiaries during a severe bear market with P/E ratios at their lowest levels since the Depression. In the area of portfolio management, as with acquisitions, operations, and repurchases, Singleton developed an idiosyncratic approach with excellent results.

a significant contrarian move, he aggressively reallocated the assets in these insurance portfolios, increasing the total equity allocation from 10 percent in 1975 to a remarkable 77 percent by 1981. Singleton's approach to implementing this dramatic portfolio shift was even more unusual. He invested over 70 percent of the combined equity portfolios in just five companies, with an incredible 25 percent allocated to one company (his former employer, Litton Industries). This extraordinary portfolio concentration (a typical mutual fund owns over one hundred stocks) caused consternation on Wall Street, where many observers thought Singleton was preparing for a new round of acquisitions.

Singleton had no such intention, but it is instructive to look more closely at how he invested these portfolios. His top holdings were invariably companies he knew well (including smaller conglomerates like Curtiss-Wright and large energy and insurance companies like Texaco and Aetna), whose P/E ratios were at or near record lows at the time of his investment. As Charlie Munger said of Singleton's investment approach, "Like Warren and me, he was comfortable with concentration and bought only a few things that he understood well."

Henry Singleton’s Embrace of Spin-Offs

Singleton was a pioneer in the use of spin-offs, which he believed would both simplify succession issues at Teledyne (by reducing the company's complexity) and unlock the full value of the company's large insurance operations for shareholders. In the words of longtime board member Fayez Sarofim, Singleton believed "there was a time to conglomerate and a time to deconglomerate." The time for deconglomeration finally arrived in 1986 with the debut spin-off of Argonaut, the company's worker's compensation insurer.

Next, in 1990, Singleton spun off Unitrin, the company's largest insurance operation, with Jerry Jerome as CEO. This was a significant move as Unitrin accounted for the majority of Teledyne's enterprise value at that time. It has had excellent returns since going public under the leadership of Jerome and his successor, Dick Vie.

Starting in the mid-to-late 1980s, Teledyne's non-insurance operations slowed in the face of a cyclical downturn in the energy and specialty metals markets and fraud charges at its defense business. In 1987, at a time when both acquisition and stock prices (including his own) were at historic highs, Singleton concluded that he had no better, higher-returning options for deploying the company's cash flow, and declared the company's first dividend in twenty-six years as a public company. This was a seismic event for longtime Teledyne observers, signaling the arrival of a new phase in the company's history.

Henry Singleton’s Track Record

Singleton left behind an extraordinary record, dwarfing both his peers and the market. From 1963 (the first year for which we have reliable stock data) to 1990, when he stepped down as chair-man, Singleton delivered a remarkable 20.4% compound annual return to his shareholders (including spin-offs), compared to an 8.0% return for the S&P 500 over the same period and an 11.6% return for other major conglomerate stocks.

A dollar invested with Henry Singleton in 1963 would have been worth $180.94 by 1990, an almost ninefold outperformance versus his peers and a more than twelvefold outperformance versus the S&P 500, leaving Jack Welch a distant speck in his rearview mirror.

Henry Singleton’s Approach

One of the most important decisions any CEO makes is how he spends his time—specifically, how much time he spends in three essential areas: management of operations, capital allocation, and investor relations. Henry Singleton's approach to time management was, not surprisingly, very different from peers like Tex Thornton and Harold Geneen and very similar to his fellow outsider CEOs.

As he told Financial World magazine in 1978, "I don't reserve any day-to-day responsibilities for myself, so I don't get into any particular rut. I do not define my job in any rigid terms but in terms of having the freedom to do whatever seems to be in the best interests of the company at any time." Singleton eschewed detailed strategic plans, preferring instead to retain flexibility and keep options open. As he once explained at a Teledyne annual meeting, "I know a lot of people have very strong and definite plans that they've worked out on all kinds of things, but we're subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible." In a rare interview with a Business Week reporter, he explained himself more simply: "My only plan is to keep coming to work. I like to steer the boat each day rather than plan ahead way into the future.”

Unlike conglomerate peers such as Thornton or Geneen or Gulf & Western's colorful Charles Bluhdorn, Singleton did not court Wall Street analysts or the business press. In fact, he believed investor relations was an inefficient use of time, and simply refused to provide quarterly earnings guidance or appear at industry conferences. This was highly unconventional behavior at a time when his more accommodating peers were often on the cover of the top business magazines.

Henry Singleton’s Prowess at Buying Back Teledyne’s Stock

Even in a book filled with CEOs who were aggressive in buying back stock, Singleton is in a league of his own. Given his voracious appetite for Teledyne's shares and the overall high levels of repurchases among the outsider CEOs, it's worth looking a little more closely at Singleton's approach to buybacks, which differed significantly from that of most CEOs today.

Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market. This approach is careful, conservative, and, not coincidentally, unlikely to have any meaningful impact on long-term share values. Let's call this cautious, methodical approach the "straw."

The other approach, the one favored by the CEOs in this book and pioneered by Singleton, is quite a bit bolder. This approach features less frequent and much larger repurchases timed to coincide with low stock prices—typically made within very short periods of time, often via tender offers, and occasionally funded with debt. Singleton, who employed this approach no fewer than eight times, disdained the "straw," preferring instead "suction hose."

Singleton's 1980 share buyback provides an excellent example of his capital allocation acumen. In May of that year, with Teledyne's P/E multiple near an all-time low, Singleton initiated the company's largest tender yet, which was oversubscribed by threefold. Singleton decided to buy all the tendered shares (over 20 percent of shares outstanding), and given the company's strong free cash flow and a recent drop in interest rates, financed the entire repurchase with fixed-rate debt.

Henry Singleton: The Original Warren Buffett

Many of the distinctive tenets of Warren Buffett's unique approach to managing Berkshire Hathaway were first employed by Singleton at Teledyne. In fact, Singleton can be seen as a sort of proto-Buffett, and there are uncanny similarities between these two virtuoso CEOs, as the following list demonstrates.

  • The CEO as investor. Both Buffett and Singleton designed organizations that allowed them to focus on capital allocation, not operations. Both viewed themselves primarily as investors, not managers.
  • Decentralized operations, centralized investment decisions. Both ran highly decentralized organizations with very few employees at corporate and few, if any, intervening layers between operating companies and top management.
Both made all major capital allocation decisions for their companies.
  • Investment philosophy. Both Buffett and Singleton focused their investments in industries they knew well, and were comfortable with concentrated portfolios of public securities.
  • Approach to investor relations. Neither offered quarterly guidance to analysts or attended conferences. Both provided informative annual reports with detailed business unit information.
  • Dividends. Teledyne, alone among conglomerates, didn't pay a dividend for its first twenty-six years. Berkshire has never paid a dividend.
  • Stock splits. Teledyne was the highest-priced issue on the NYSE for much of the 1970s and 1980s. Buffett has never split Berkshire's A shares (which now trade at over $120,000 a share).
  • Significant CEO ownership. Both Singleton and Buffett had significant ownership stakes in their companies (13 percent for Singleton and 30-plus percent for Buffet). They thought like owners because they were owners.
  • Insurance subsidiaries. Both Singleton and Buffett recognized the potential to invest insurance company "float" to create shareholder value and for both companies, insurance was the largest and most important business.
  • The restaurant analogy. Phil Fisher, a famous investor, once compared companies to restaurants—over time through a combination of policies and decisions (analogous to cuisine, prices, and ambiance), they self-select for a certain clientele. By this standard, both Buffett and Singleton intentionally ran highly unusual restaurants that over time attracted like-minded, long-term-oriented customer/shareholders.

Tom Murphy and Capital Cities Broadcasting

Tom Murphy and Dan Burke were probably the greatest two-person combination in management that the world has ever seen or maybe ever will see. — Warren Buffett

In speaking with business school classes, Warren Buffett often compares the rivalry between Tom Murphy's company, Capital Cities Broadcasting, and CBS to a trans-Atlantic race between a rowboat and the QE2, to illustrate the tremendous effect management can have on long-term returns.

When Murphy became the CEO of Capital Cities in 1966, CBS, run by the legendary Bill Paley, was the dominant media business in the country, with TV and radio stations in the country's largest markets, the top-rated broadcast network, and valuable publishing and music properties. In contrast, at that time, Capital Cities had five TV stations and four radio stations, all in smaller markets. CBS's market capitalization was sixteen times the size of Capital Cities'. By the time Murphy sold his company to Disney 35 years later, however, Capital Cities was three times as valuable as CBS. In other words, the rowboat had won. Decisively.

So, how did the seemingly insurmountable gap between these two companies get closed? The answer lies in fundamentally different management approaches, CBS spent much of the 1960s and 1970s taking the enormous cash flow generated by its network and broadcast operations and funding an aggressive acquisition program that led it into entirely new fields, including the purchase of a toy business and the New York Yankees baseball team. CBS issued stock to fund some of these acquisitions, built a landmark office building in midtown Manhattan at enormous expense, developed a corporate structure with 42 Presidents and Vice Presidents, and generally displayed what Buffett's partner, Charlie Munger, calls "a prosperity-blinded indifference to unnecessary costs."

Paley's strategy at CBS was consistent with the conventional wisdom of the conglomerate era, which espoused the elusive benefits of "diversification" and "synergy" to justify the acquisition of unrelated businesses that, once combined with the parent company, would magically become both more profitable and less susceptible to the economic cycle. At its core, Paley's strategy focused on making CBS larger.

In contrast, Murphy's goal was to make his company more valuable. As he said to me, "The goal is not to have the longest train, but to arrive at the station first using the least fuel." Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well. Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS's rival broadcast network ABC. The relative results speak for themselves.

The formula that allowed Murphy to overtake Paley's QE2 was deceptively simple: focus on industries with attractive economic characteristics, selectively use leverage to buy occasional large properties, improve operations, pay down debt, and repeat. As Murphy put it succinctly in an interview with Forbes, "We just kept opportunistically buying assets, intelligently leveraging the company, improving operations and then we'd take a bite of something else." What's interesting, however, is that his peers at other media companies didn't follow this path. Rather, they tended, like CBS, to follow fashion and diversify into unrelated businesses, build large corporate staffs, and overpay for marquee media properties.

Capital Cities under Murphy was an extremely successful example of what we would now call a roll-up. In a typical roll-up, a company acquires a series of businesses, attempts to improve operations, and then keeps acquiring, benefiting over time from scale advantages and best management practices. This concept came into vogue in the mid-to-late 1990s and flamed out in the early 2000s as many of the leading companies collapsed under the burden of too much debt. These companies typically failed because they acquired too rapidly and underestimated the difficulty and importance of integrating acquisitions and improving operations.

Murphy's approach to the roll-up was different. He moved slowly, developed real operational expertise, and focused on a small number of large acquisitions that he knew to be high-probability bets. Under Murphy, Capital Cities combined excellence in both operations and capital allocation to an unusual degree. As Murphy told me, "The business of business is a lot of little decisions every day mixed up with a few big decisions."

How Tom Murphy Built Capital Cities

After Smith's death, Murphy became CEO (at age forty). The company had finished the preceding year with revenue of just $28 million. Murphy's first move was to elevate Burke to the role of president and chief operating officer. Theirs was an excellent partnership with a very clear division of labor: Burke was responsible for daily management of operations, and Murphy for acquisitions, capital allocation, and occasional interaction with Wall Street. As Burke told me, "Our relationship was built on a foundation of mutual respect. I had an appetite for and a willingness to do things that Murphy was not interested in doing." Burke believed his "job was to create the free cash flow and Murphy's was to spend it." He exemplifies the central role played in this book by exceptionally strong COOs whose close oversight of operations allowed their CEO partners to focus on longer-term strategic and capital allocation issues.

Once in the CEO seat, it did not take Murphy long to make his mark. In 1967, he bought KTRK, the Houston ABC affiliate, for $22 million—the largest acquisition in broadcast history up to that time. In 1968, Murphy bought Fairchild Communications, a leading publisher of trade magazines, for $42 million. And in 1970, he made his largest purchase yet with the acquisition of broadcaster Triangle Communications from Walter Annenberg for $120 million. After the Triangle transaction, Capital Cities owned five VHF TV stations, the maximum then allowed by the FCC.

Murphy next turned his attention to newspaper publishing, which, as an advertising-driven business with attractive margins and strong competitive barriers, had close similarities to the broadcasting business. After purchasing several small dailies in the early 1970s, he bought the Fort Worth Telegram for $75 million in 1974 and the Kansas City Star for $95 million in 1977. In 1980, looking for other growth avenues in related businesses, he entered the nascent cable television business with the purchase of Cable-com for $139 million.

During the extended bear market of the mid-1970s to early 1980s, Murphy became an aggressive purchaser of his own shares, eventually buying in close to 50 percent, most of it at single-digit price-to-earnings (P/E) multiples. In 1984, the FCC relaxed its station ownership rules, and in January 1986, Murphy, in his masterstroke, bought the ABC Network and its related broadcasting assets (including major-market TV stations in New York, Chicago, and Los Angeles) for nearly $3.5 billion with financing from his friend Warren Buffett.

The ABC deal was the largest non-oil and gas transaction in business history to that point and an enormous bet-the-company transaction for Murphy, representing over 100 percent of Capital Cities' enterprise value. The acquisition stunned the media world and was greeted with the headline "Minnow Swallows Whale" in the Wall Street Journal. At closing, Burke said to media investor Gordon Crawford, "This is the acquisition I've been training for my whole life."

The core economic rationale for the deal was Murphy's conviction that he could improve the margins for ABC's TV stations from the low thirties up to Capital Cities industry-leading levels (50-plus percent). Under Burke's oversight, the staff that oversaw ABC' TV station group dropped from sixty to eight, the head count at the flagship WABC station in New York was reduced from six hundred to four hundred, and the margin gap was closed in just two years.

Burke and Murphy wasted little time in implementing Capital Cities' lean, decentralized approach-immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed. They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan. As Bob Zelnick of ABC News said, "After the mid-80s, we stopped flying first class."

A story from this time demonstrates the culture clash between network executives and the leaner, more entrepreneurial acquir-ers. ABC, in fact the whole broadcasting industry, was a limousine culture—one of the most cherished perks for an industry executive was the ability to take a limo for even a few blocks to lunch. Murphy, however, was a cab man and from very early on showed up to all ABC meetings in cabs. Before long, this practice rippled through the ABC executive ranks, and the broader Capital Cities ethos slowly began to permeate the ABC culture. When asked whether this was a case of leading by example. Murphy responded, "Is there any other way?"

Tom Murphy’s Embrace of Decentralization

One of the major themes in this book is resource allocation.

There are two basic types of resources that any CEO needs to allocate: financial and human. We've touched on the former already. The latter is, however, also critically important, and here again the outsider CEOs shared an unconventional approach, one that emphasized flat organizations and dehydrated corporate staffs.

There is a fundamental humility to decentralization, an admission that headquarters does not have all the answers and that much of the real value is created by local managers in the field. At no company was decentralization more central to the corporate ethos than at Capital Cities.

The hallmark of the company's culture—extraordinary autonomy for operating managers—was stated succinctly in a single paragraph on the inside cover of every Capital Cities annual report: "Decentralization is the cornerstone of our philosophy. Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs. All decisions are made at the local level... We expect our managers... to be forever cost conscious and to recognize and exploit sales potential."

Headquarters staff was anorexic, and its primary purpose was to support the general managers of operating units. There were no vice presidents in functional areas like marketing, strategic planning, or human resources; no corporate counsel and no public relations department (Murphy's secretary fielded all calls from the media). In the Capital Cities culture, the publishers and station managers had the power and prestige internally, and they almost never heard from New York if they were hitting their numbers. It was an environment that selected for and promoted independent, entrepreneurial general managers. The company's guiding human resource philosophy, repeated ad infinitum Murphy, was to "hire the best people you can and leave them alone." As Burke told me, the company's extreme decentralized approach "kept both costs and rancor down."

The guinea pig in the development of this philosophy was Dan Burke himself. In 1961, after he took over as general manager at WTEN, Burke began sending weekly memos to Murphy as he had been trained to do at General Foods. After several months of receiving no response, he stopped sending them, realizing his time was better spent on local operations than on reporting to headquarters. As Burke said in describing his early years in Albany, "Murphy delegates to the point of anarchy."

Tom Murphy’s Emphasis on Frugality

Frugality was also central to the ethos. Murphy and Burke realized early on that while you couldn't control your revenues at a TV station, you could control your costs. They believed that the best defense against the revenue lumpiness inherent in advertising-supported businesses was a constant vigilance on costs, which became deeply embedded in the company's culture.

In fact, in one of the earliest and most often told corporate legends, Murphy even scrutinized the company's expenditures on paint. Shortly after Murphy arrived in Albany, Smith asked him to paint the dilapidated former convent that housed the studio to project a more professional image to advertisers. Murphy's immediate response was to paint the two sides facing the road leaving the other sides untouched ("forever cost conscious"). A picture of WTEN still hangs in Murphy's New York office.

Murphy and Burke believed that even the smallest operating decisions, particularly those relating to head count, could have unforeseen long-term costs and needed to be watched constantly. Phil Meek, head of the publishing division, took this message to heart and ran the entire publishing operation (six daily newspapers, several magazine groups, and a stable of weekly shoppers) with only three people at headquarters, including an administrative assistant.

Burke pursued economic efficiency with a zeal that earned him the nickname "The Cardinal." To run the company's dispersed operations, he developed a legendarily detailed annual budgeting process. Each year, every general manager came to New York for extensive budget meetings. In these sessions, management presented operating and capital budgets for the coming year, and Burke and his CFO, Ron Doerfler, went through them in line-by-line detail (interestingly. Burke could be as tough on minority hiring shortfalls as on excessive costs).

The budget sessions were not perfunctory and almost always produced material changes. Particular attention was paid to capital expenditures and expenses. Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as "a form of report card." Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.

Tom Murphy’s Focus on Revenue Growth

The company did not simply cut its way to high margins however. It also emphasized investing in its businesses for long-term growth. Murphy and Burke realized that the key drivers of profitability in most of their businesses were revenue growth and advertising market share, and they were prepared to invest in their properties to ensure leadership in local markets.

For example, Murphy and Burke realized early on that the TV station that was number one in local news ended up with a disproportionate share of the market's advertising revenue. As a result, Capital Cities stations always invested heavily in news talent and technology, and remarkably, virtually every one of its stations led in its local market. In another example, Burke insisted on spending substantially more money to upgrade the Fort Worth printing plant than Phil Meek had requested, realizing the importance of color printing in maintaining the Telegram's long-term competitive position. As Phil Beuth, an early employee, told me, "The company was careful, not just cheap."

Tom Murphy’s Hiring Practices

The company's hiring practices were equally unconventional. With no prior broadcasting experience themselves before joining Capital Cities, Murphy and Burke shared a clear preference for intelligence, ability, and drive over direct industry experience. They were looking for talented, younger foxes with fresh perspectives. When the company made an acquisition or entered a new industry, it inevitably designated a top Capital Cities executive, often from an unrelated division, to oversee the new property. In this vein, Bill James, who had been running the flagship radio property, WJR in Detroit, was tapped to run the cable division, and John Sias, previously head of the publishing division, took over the ABC Network. Neither had any prior industry experience; both produced excellent results.

Tom Murphy Empowered Young Leaders

Murphy and Burke were also comfortable giving responsibility to promising young managers. As Murphy described it to me, "We'd been fortunate enough to have it ourselves and knew it could work." Bill James was 35 and had no radio experience when he took over WJR; Phil Meek came over from the Ford Motor Company at thirty-two with no publishing experience to run the Pontiac Press; and Bob Iger was 37 and had spent his career in broadcast sports when he moved from New York to Hollywood to assume responsibility for ABC Entertainment.

The company also had exceptionally low turnover. As Robert Price, a rival broadcaster, once remarked, "We always see lots of résumés but we never see any from Capital Cities." Dan Burke related to me a conversation with Frank Smith on the effectiveness of this philosophy. Burke recalls Smith saying, "The system in place corrupts you with so much autonomy and authority that you can't imagine leaving."

Tom Murphy’s Approach to Capital Allocation

In the area of capital allocation, Murphy's approach was highly differentiated from his peers. He eschewed diversification, paid deminimis dividends, rarely issued stock, made active use of leverage, regularly repurchased shares, and between long periods of inactivity, made the occasional very large acquisition.

The two primary sources of capital for Capital Cities were internal operating cash flow and debt. As we've seen, the company produced consistently high, industry-leading levels of operating cash flow, providing Murphy with a reliable source of capital to allocate to acquisitions, buybacks, debt repayment, and other investment options.Murphy also frequently used debt to fund acquisitions, once summarizing his approach as "always, we've taken the assets once we've paid them off and leveraged them again to buy other assets." After closing an acquisition, Murphy actively deployed free cash flow to reduce debt levels, and these loans were typically paid down ahead of schedule. The bulk of the ABC debt was retired within three years of the transaction. Interestingly, Murphy never borrowed money to fund a share repurchase, preferring to utilize leverage for the purchase of operating businesses.

Murphy and Burke actively avoided dilution from equity offerings. Other than the sale of stock to Berkshire Hathaway to help finance the ABC acquisition, the company did not issue new stock over the twenty years prior to the Disney sale, and over this period total shares outstanding shrank by 47% as a result of repeated repurchases.

Acquisitions were far and away the largest outlet for the company's capital during Murphy's tenure. According to recent studies, somewhere around two-thirds of all acquisitions actually destroy value for shareholders. How then was such enormous value created by acquisitions at Capital Cities? Acquisitions were Murphy's bailiwick and where he spent the majority of his time.

He did not delegate acquisition decisions, never used investment bankers, and over time, evolved an idiosyncratic approach that was both effective and different in significant and important ways from his competitors.

To Murphy, as a capital allocator, the company's extreme decentralization had important benefits: it allowed the company to operate more profitably than its peers (Capital Cities had the highest margins in each of its business lines), which in turn gave the company an advantage in acquisitions by allowing Murphy to buy properties and know that under Burke. they would quickly be made more profitable, lowering the effective price paid. In other words, the company's operating and integration expertise occasionally gave Murphy that scarcest of business commodities: conviction.

And when he had conviction, Murphy was prepared to act aggressively. Under his leadership, Capital Cities was extremely acquisitive, three separate times doing the largest deal in the history of the broadcast industry, culminating in the massive ABC transaction. Over this time period, the company was also involved with several of the largest newspaper acquisitions in the country, as well as transactions in the radio, cable TV, and magazine publishing industries.

How Tom Murphy Acquired Companies at Capital Cities

Murphy was willing to wait a long time for an attractive acquisition. He once said. "I get paid not just to make deals, but to make good deals." When he saw something that he liked, however, Murphy was prepared to make a very large bet, and much of the value created during his nearly 30 year tenure as CEO was the result of a handful of large acquisition decisions, each of which produced excellent long-terms returns. These acquisitions each represented 25% or more of the company's market capitalization at the time they were made.

Murphy was a master at prospecting for deals. He was known for his sense of humor and for his honesty and integrity. Unlike other media company CEOs, he stayed out of the public eye (although this became more difficult after the ABC acquisition). These traits helped him as he prospected for potential acquisitions. Murphy knew what he wanted to buy, and he spent years developing relationships with the owners of desirable properties. He never participated in a hostile takeover situation, and every major transaction that the company completed was sourced via direct contact with sellers, such as Walter Annenberg of Triangle and Leonard Goldenson of ABC.

He worked hard to become a preferred buyer by treating employees fairly and running properties that were consistent leaders in their markets. This reputation helped him enormously when he approached Goldenson about buying ABC in 1984 (in his typical self-deprecating style, Murphy began his pitch with "Leonard, please don't throw me out the window, but I'd like to buy your company.")

Beneath this avuncular, outgoing exterior, however, lurked a razor-sharp business mind. Murphy was a highly disciplined buyer who had strict return requirements and did not stretch for acquisitions—once missing a very large newspaper transaction involving three Texas properties over a $5 million difference in price. Like others in this book, he relied on simple but powerful rules in evaluating transactions. For Murphy, that benchmark was a double-digit after-tax return over 10 years without leverage. As a result of this pricing discipline, he never prevailed in an auction, although he participated in many. Murphy told me that. his auction bids consistently ended up at only 60% to 70% of the eventual transaction price.

How Tom Murphy Negotiated

Murphy had an unusual negotiating style. He believed in "leaving something on the table" for the seller and said that in the best transactions, everyone came away happy. He would often ask the seller what they thought their property was worth, and if he thought their offer was fair he'd take it (as he did when Annenberg told him the Triangle stations were worth ten times pre-tax profits). If he thought their proposal was high he would counter with his best price, and if the seller rejected his offer, Murphy would walk away. He believed this straightforward approach saved time and avoided unnecessary acrimony.

Tom Murphy’s Approach to Share Repurchases

Share repurchases were another important outlet for Murphy, providing him with an important capital allocation benchmark, and he made frequent use of them over the years. When the company's multiple was low relative to private market comparables, Murphy bought back stock. Over the years, Murphy devoted over $1.8 billion to buybacks, mostly at single-digit multiples of cash flow. Collectively, these repurchases represented a very large bet for the company, second in size only to the ABC transaction, and they generated excellent returns for shareholders, with a cumulative compound return of 22.4% over nineteen years. As Murphy says today, "I only wished I'd bought more.

Warren Buffett and Berkshire Hathaway

You shape your houses and then your houses shape you. — Winston Churchill
The most powerful force in the universe is compound interest. — Albert Einstein
Being a CEO has made me a better investor, and vice versa. — Warren Buffett

Berkshire Hathaway, a one-hundred-year-old textile company located in New Bedford, Massachusetts, had been owned by the same two local families, the Chaces and the Stantons, for generations. The company, a vestige of the glory days of New England enterprise, was the unlikely target of an early hostile takeover in 1965—hostile, at least, to the company's stubborn septuagenarian CEO, Seabury Stanton. Stanton, by refusing to meet with a large, disgruntled investor, had created an unexpectedly formidable adversary.

The company was ultimately taken over, after an extended proxy fight, by this most unlikely raider— a little-known, jug-eared, thirty-five-year-old wunderkind from Nebraska named Warren Buffett. Buffett ran a small investment partnership out of a nondescript office building in Omaha and had no prior management experience.

He was very different from the notorious LBO barons of the 1980s, however. First of all, he was not very hostile, having established a close relationship with the Chace family before making his move. Second, he didn't use any debt—this was a long way from Gordon Gekko or Henry Kravis.

Buffett had been attracted to Berkshire by its cheap price relative to book value. At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization. From this undistinguished start, unprecedented results followed; and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs. These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares. Buffett bought his first share of Berkshire for $7; today it trades for over $120,000 a share.

How, from such an unlikely starting point, Buffett effected this remarkable transition and how his background as an investor shaped his unique approach to managing Berkshire is a compelling story.

See’s Candy: The Turning Point for Berkshire Hathaway

A pivotal investment in Buffett's shift in investment focus from "cigar butts" to "franchises" was the acquisition in 1972 of See's Candies.

Buffett and Munger bought See's for $25 million. At the time, the company had $7 million in tangible book value and $4.2 million in pretax profits, so they were paying a seemingly exorbitant multiple of over three times book value (but only six times pre-tax income).

See's was expensive by Graham's standards, and he would never have touched it. Buffett and Munger, however, saw a beloved brand with excellent returns on capital and untapped pricing power, and they immediately installed a new CEO, Chuck Huggins, to take advantage of this opportunity.

See's has experienced relatively little unit growth since it was acquired, but due to the power of its brand, it has been able to consistently raise prices, resulting in an extraordinary 32% compound return on Berkshire's investment over its first 27 years. (After 1999, See's results were no longer reported separately.)

During the last 39 years, the company has sent $1.65 billion in free cash to Omaha on an original investment of $25 million. This cash has been redeployed with great skill by Buffett, and See's has been a critical building block in Berkshire's success. (Interestingly, purchase price played a relatively minor role in generating these returns: had Buffett and Munger paid twice the price, the return would still have been a very attractive 21%.)

How Warren Buffett Built Berkshire Hathaway

Fear of inflation was a constant theme in Berkshire's annual reports throughout the 1970s and into the early 1980s. The conventional wisdom at the time was that hard assets (gold, timber, and the like) were the most effective inflation hedges. Buffett, however, under Munger's influence and in a shift from Graham's traditional approach, had come to a different conclusion. His contrarian insight was that companies with low capital needs and the ability to raise prices were actually best positioned to resist inflation's corrosive effects.

This led him to invest in consumer brands and media properties—businesses with "franchises," dominant market positions, or brand names. Along with this shift in investment criteria came an important shift to longer holding periods, which allowed for long-term pretax compounding of investment values.

It is hard to overstate the significance of this change. Buffet was switching at midcareer from a proven, lucrative investment approach that focused on the balance sheet and tangible assets, to an entirely different one that looked to the future and emphasized the income statement and hard-to-quantify assets like brand names and market share. To determine margin of safety, Buffett relied now on discounted cash flows and private market values instead of Graham's beloved net working capital calculation. It was not unlike Bob Dylan's controversial and roughly contemporaneous switch from acoustic to electric guitar.

This tectonic shift played itself out throughout the 1970s in Berkshire's insurance portfolios, which saw an increasing proportion of media and branded consumer products companies. By the end of the decade, this transition was complete, and Buffett's portfolio included outright ownership of See's Candies and the Buffalo News as well as large stock positions in the Washington Post, GEICO, and General Foods.

In the first half of the 1980s, Buffett focused on adding to the company's portfolio of wholly owned companies, buying the Nebraska Furniture Mart for $60 million in 1983 and Scott Fetzer, a conglomerate of niche industrial businesses, in 1985 for $315 million. In 1986, he made his largest investment yet, committing $500 million to help his friend Tom Murphy, the CEO of Capital Cities, acquire ABC. Buffett and Berkshire ended up owning 18 percent of the combined company, and it became the third of his "permanent" stock holdings, alongside GEICO and The Washington Post Company.

By 1987, in advance of the October market crash, Buffett had sold all of the stocks in his insurance company portfolios, except for his three core positions. After the Capital Cities transaction, he did not make another public market investment until 1989, when he announced that he had made the largest investment in Berkshire's history: investing an amount equal to one-quarter of Berkshire's book value in the Coca-Cola Company, purchasing 7% of its shares.

In the late 1980s, Buffett made a handful of investments in convertible preferred securities in publicly traded companies, including Salomon Brothers, Gillette, US Airways, and Champion Industries. The dividends from these securities were tax advantaged, providing Berkshire with an attractive yield and the potential for upside (via the ability to convert to common stock) if the companies performed well.

In 1991, Salomon Brothers was at the center of a major financial scandal, accused of fixing prices in government Treasury bill auctions, and Buffett was drafted as interim CEO to help the company navigate the crisis. He devoted himself full-time for a little over nine months to this project, calming regulators, installing a new CEO, and attempting to rationalize Salomon's byzantine compensation programs. In the end, the company ended up paying a relatively small settlement and eventually returned to its former prosperity. Late in 1996, Salomon was sold to Sandy Weill's Travelers Corporation for $9 billion, a significant premium to Buffett's investment cost.

In the early 1990s, Buffett continued to make selected, sizable public market investments, including large positions in Wells Fargo (1990), General Dynamics (1992), and American Express (1994). As the decade progressed, Buffett once again shifted his focus to acquisitions, culminating in two significant insurance transactions: the $2.3 billion purchase in 1996 of the half of GEICO that he did not already own and the purchase of reinsurer General Re in 1998 for $22 billion in Berkshire stock, the largest transaction in the company's history.

In the late 1990s and early 2000s, Buffett was an opportunistic buyer of private companies, many of them in industries out of favor after the September 11 terrorist attacks, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes. He also made a series of significant investments in the electric utility industry through MidAmerican Energy, a joint venture with his Omaha friend Walter Scott, the former CEO of Kiewit Construction.

During this period, Buffett was also active in a variety of investing areas outside of traditional equity markets. In 2003, he made a large ($7 billion) and very lucrative bet on junk bonds, then enormously out of favor. In 2003 and 2004, he made a significant ($20 billion) currency bet against the dollar, and in 2006, he announced Berkshire's first international acquisition: the $5 billion purchase of Istar, a leading manufacturer of cutting tools and blades based in Israel that has prospered under Berkshire's ownership.

Several years of inactivity followed, interrupted by the financial crisis in the wake of the Lehman Brothers bankruptcy, after which Buffett entered one of the most active investing periods of his career. This stretch of activity reached its climax with Berkshire's purchase of the nation's largest railroad, the Burlington Northern Santa Fe, in early 2010 at a total valuation of $34.2 billion.

So, here are those interplanetary numbers. From June, 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company's shares had increased at a phenomenal compound rate of 20.7%, dwarfing the 9.3% returns of the S&P 500 over the same period. A dollar invested at the time of Buffett's takeover was worth $6,265 just 45 years later. (A dollar invested at the time of Buffett's first stock purchase was worth over $10,000.) That same dollar invested in the S&P was worth $62.

During Buffett's long tenure, Berkshire Hathaway's returns have exceeded those of the S&P by an extraordinary hundredfold, massively outperforming any index of peers.

Warren Buffett’s Strategy for Building Berkshire Hathaway

Buffett's exceptional results derived from an idiosyncratic approach in three critical and interrelated areas: Capital generation, capital allocation, and management of operations.

Charlie Munger has said that the secret to Berkshire's long-term success has been its ability to "generate funds at 3% and invest them at 13%," and this consistent ability to create low-cost funds for investment has been an underappreciated contributor to the company's financial success. Remarkably, Buffett has almost entirely eschewed debt and equity issuances—virtually all of Berkshire's investment capital has been generated internally.

The company's primary source of capital has been float from its insurance subsidiaries, although very significant cash has also been provided by wholly owned subsidiaries and by the occasional sale of investments. Buffett has in effect created a capital "flywheel" at Berkshire, with funds from these sources being used to acquire full or partial interests in other cash-generating businesses whose earnings in turn fund other investments, and so on.

Insurance is Berkshire's most important business by a wide margin and the critical foundation of its extraordinary growth. Buffett developed a distinctive approach to the insurance business, which bears interesting similarities to his broader approach to management and capital allocation.

When Buffett acquired National Indemnity in 1967, he was among the first to recognize the leverage inherent in insurance companies with the ability to generate low-cost float. The acquisition was, in his words, a "watershed" for Berkshire. As he explains, "Float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money." This is another example of a powerful iconoclastic metric, one that the rest of the industry largely ignored at the time.

Over time, Buffett evolved an idiosyncratic strategy for his insurance operations that emphasized profitable underwriting and float generation over growth in premium revenue. This approach, wildly different from most other insurance companies, relied on a willingness to avoid underwriting insurance when pricing was low, even if short-term profitability might suffer, and, conversely, a propensity to write extraordinarily large amounts of business when prices were attractive.

This approach led to lumpy, but highly profitable, underwriting results. As an example, in 1984, Berkshire's largest property and casualty (P&C) insurer, National Indemnity, wrote $62.2 million in premiums. Two years later, premium volumes grew an extraordinary sixfold to $366.2 million. By 1989, they had fallen back 73% to $98.4 million and did not return to the $100 million level for 12 years. Three years later, in 2004, the company wrote over $600 million in premiums. Over this period, National Indemnity averaged an annual underwriting profit of 6.5% as a percentage of premiums. In contrast, over the same period, the typical property and casualty insurer averaged a loss of 7%.

This sawtooth pattern of revenue would be virtually impossible for an independent, publicly traded insurer to explain to Wall Street. Because, however, Berkshire's insurance subsidiaries are part of a much larger diversified company, they are shielded from Wall Street scrutiny. This provides a major competitive advantage allowing National Indemnity and Berkshire’s other insurance businesses to focus on profitability, not premium growth. As Buffet has said, "Charlie and I have always preferred a lumpy 15 percent to a smooth 12 percent return."

Float for all of Berkshire's insurance businesses grew enormously over this period, from $237 million in 1970 to over $70 billion in 2011. This incredibly low-cost source of funds has been the rocket fuel propelling Berkshire's phenomenal results, and, as we will see, these alternating periods of inactivity and decisive action mirror the pattern of Berkshire's investing activities. In both insurance and investing, Buffett believes the key to long-term success is "temperament," a willingness to be "fearful when others are greedy and greedy when they are fearful."

The other important source of capital at Berkshire has been earnings from wholly owned companies. These earnings have become increasingly important over the last two decades as Buffett has added aggressively to Berkshire's portfolio of businesses. In 1990, pretax earnings from wholly owned operating companies were $102 million. In 2000, they were $918 million, a 24.5% compound growth rate. By 2011, they had reached an extraordinary $6.9 billion.

How Warren Buffett Deploys and Allocates Capital at Berkshire Hathaway

Now we'll turn our attention to how Buffett deploys the geyser of capital provided by Berkshire's operations. Whenever Buffett buys a company, he takes immediate control of the cash flow, insisting that excess cash be sent to Omaha for allocation. As Charlie Munger points out, "Unlike operations (which are very centralized), capital allocation at Berkshire is highly centralized." This mix of loose and tight, of delegation and hierarchy, was present at all the other outsider companies but generally not to Berkshire's extreme degree.

Buffett, already an extraordinarily successful investor, came to Berkshire uniquely prepared for allocating capital. Most CEOs are limited by prior experience to investment opportunities within their own industry—they are hedgehogs. Buffett, in contrast, by virtue of his prior experience evaluating investments in a wide variety of securities and industries, was a classic fox and had the advantage of choosing from a much wider menu of allocation op-tions, including the purchase of private companies and publicly traded stocks. Simply put, the more investment options a CEO has, the more likely he or she is to make high-return decisions, and this broader palate has translated into a significant competitive advantage for Berkshire.

Buffett's approach to capital allocation was unique: he never paid a dividend or repurchased significant amounts of stock. Instead, with Berkshire's companies typically requiring little capital investment, he focused on investing in publicly traded stocks and acquiring private companies, options not available to most CEOs who lacked his extensive investment experience. Before we look at these two areas, however, let's first examine a critical early decision.

After a brief flirtation with the textile business, Buffett chose early on to make no further investments in Berkshire's low-return legacy suit-linings business and to harvest all excess capital and deploy it elsewhere. In contrast, Burlington Industries, the largest company in the textile business then and now, chose a different path, deploying all available capital into its existing business between 1965 and 1985. Over that 26 year period, Burlington's stock appreciated at a paltry annual rate of 0.6%; Berkshire's compound return was a remarkable 27%. These differing results tell an important capital allocation parable: the value of being in businesses with attractive returns on capital, and the related importance of getting out of low-return businesses.

This was a key decision for Berkshire and makes a more general point. A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns. The outsider CEOs were generally ruthless in closing or selling businesses with poor future prospects and concentrating their capital on business units whose returns met their internal targets. As Buffett said when he finally closed Berkshire's textile business in 1985, "Should you find vourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

How Warren Buffett Invests Berkshire Hathaway’s Insurance Portfolios

Buffett is still best known for stock market investing, which was the primary channel for Berkshire's capital during his first twenty-five years as CEO. Buffett's public market returns are Ruthian by any measure, and there are several different ways to look at them.

As we have seen, the average returns for the Buffett Partnership from 1957 to 1969 were 30.4%, and according to a study in Money Week magazine, Berkshire's investment returns from 1985 through 2005 were an extraordinary 25%.

Because of its importance to Berkshire's overall returns and the window it provides on Buffett's broader capital allocation philosophy, it's worth taking a close look at one particular facet of Buffett's approach to public market investing: portfolio management. Portfolio management—how many stocks an investor owns and how long he holds them—has an enormous impact on returns. Two investors with the same investment philosophy but different approaches to portfolio management will produce dramatically different results. Buffett's approach to managing Berkshire's stock investments has been distinguished by two primary characteristics: a high degree of concentration and extremely long holding periods. In each of these areas, his thinking is unconventional.

Buffett believes that exceptional returns come from concentrated portfolios, that excellent investment ideas are rare, and he has repeatedly told students that their investing results would improve if at the beginning of their careers, they were handed a twenty-hole punch card representing the total number of investments they could make in their investing lifetimes. "We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it."

Buffett's pattern of investment at Berkshire has been similar to the pattern of underwriting at his insurance subsidiaries, with long periods of inactivity interspersed with occasional large in-vestments. The top five positions in Berkshire's portfolio have typically accounted for a remarkable 60-80% of total value. This compares with 10-20% for the typical mutual fund portfolio. On at least four occasions, Buffett invested over 15% of Berkshire's book value in a single stock, and he once had 40% of the Buffett Partnership invested in American Express.

The other distinguishing characteristic of Buffett's approach to portfolio management is extraordinarily long holding periods. He has held his current top five stock positions (with the exception of IBM, which was purchased in 2011) for over 20 years on average. This compares with an average holding period of less than one year for the typical mutual fund. This translates into an exceptionally low level of investment activity, characterized by Buffett as "inactivity bordering on sloth."

These two portfolio management tenets combine to form a powerful and highly selective filter, one that very few companies pass through.

Interestingly, despite his historic advocacy of stock repurchases, Buffett (with the exception of a few small, early buybacks) is the only CEO in this book who did not buy back significant amounts of his company's stock. Despite admiring and encouraging the repurchases of other CEOs, he has felt buybacks were counter to Berkshire's unique, partnership-like culture and could potentially tamper with the bonds of trust built up over many years of honest, forthright communications and outstanding returns.

That being said, Buffett is nothing if not opportunistic. On the rare occasions (two, actually) when Berkshire's stock traded for extended periods at valuations well below intrinsic value, Buffett broke with tradition and explored a repurchase—as he did in early 2001, when the stock fell precipitously during the Internet bubble, and, more recently, in September 2011, when he announced that he would buy back significant amounts of stock at prices below 1.1 times book value. In both cases, the stock quickly moved up, preventing Berkshire from purchasing a meaningful number of shares.

How Warren Buffett Acquires Companies at Berkshire Hathaway

The other major outlet for Berkshire's capital has been the purchase of private companies. This channel has quietly become the primary one for Buffett over the last twenty years, culminating in the massive Burlington Northern purchase in early 2010. His approach to these acquisitions is homegrown and unique.

Buffett has created an attractive, highly differentiated option for sellers of large private businesses, one that falls somewhere between an IPO and a private equity sale. A sale to Berkshire is unique in allowing an owner/operator to achieve liquidity while continuing to run the company without interference or Wall Street scrutiny. Buffett offers an environment that is completely free of corporate bureaucracy, with unlimited access to capital for worthwhile projects. This package is highly differentiated from the private equity alternative, which promises a high level of investor involvement and a typical five-year holding period before the next exit event.

Buffett never participates in auctions. As David Sokol, the (now former) CEO of MidAmerican Energy and NetJets, told me, "We simply don't get swept away by the excitement of bidding." Instead, remarkably, Buffett has created a system in which the owners of leading private companies call him. He avoids negotiating valuation, asking interested sellers to contact him and name their price. He promises to give an answer "usually in five minutes or less." This requirement forces potential sellers to move quickly to their lowest acceptable price and ensures that his time is used efficiently.

Buffett does not spend significant time on traditional due diligence and arrives at deals with extraordinary speed, often within a few days of first contact. He never visits operating facilities and rarely meets with management before deciding on an acquisition. Tom Murphy told me, "Capital Cities was one of the biggest investments Berkshire had ever made.... It took only fifteen minutes to talk through the deal and agree on terms."

Buffett, the master delegator, has never, however, delegated capital allocation decisions. There is no business development team or investment committee at Berkshire, and Buffett never relies on investment bankers, accountants, or lawyers (with the exception of Munger) for advice. He does his own analytical work and handles all negotiations personally. He never looks at the forecasts provided by intermediaries, preferring instead to focus on historical financial statements and make his own projections.

He is able to move quickly because he only buys companies in industries he knows well, allowing him to focus quickly on key operating metrics. As Charlie Munger has said about Berkshire's approach to acquisitions, "We don't try to do acquisitions, we wait for no-brainers."

How Warren Buffett Manages Berkshire Hathaway’s Companies

Buffett, in addition to being the greatest investor of his generation, has proven to be an extremely effective manager of Berkshire's growing, polyglot portfolio of operating businesses. Over the last ten years, Berkshire has grown earnings per share significantly, and despite its size and diversity, the company operates with extraordinary efficiency—consistently ranking in the top quartile of the Fortune 500 for return on tangible assets.

Buffett came to the CEO role without any relevant operating experience and consciously designed Berkshire to allow him to focus his time on capital allocation, while spending as little time as possible managing operations, where he felt he could add little value. As a result, the touchstone of the Berkshire system is extreme decentralization. If Teledyne, Capital Cities, and the other companies in this book had decentralized management styles and philosophies, Berkshire's is positively anarchic by comparison.

In a company with over 270,000 employees, there are only 23 at corporate headquarters in Omaha. There are no regular budget meetings for Berkshire companies. The CEOs who run Berkshire's subsidiary companies simply never hear from Buffett unless they call for advice or seek capital for their businesses. He summarizes this approach to management as "hire well, manage little" and believes this extreme form of decentralization increases the overall efficiency of the organization by reducing overhead and releasing entrepreneurial energy.

In his 1986 Berkshire annual report, Buffett (as we saw in the introduction) described the discovery of the surprisingly powerful institutional imperative, which led managers to mindlessly imitate their peers. Cognizant of Churchill's quotation (which he has frequently cited), he has intentionally structured his company and life to avoid the effects of this imperative. Buffett spends his time differently than other Fortune 500 CEOs, managing his schedule to avoid unnecessary distractions and preserving uninterrupted time to read (five newspapers daily and countless annual reports) and think. He prides himself on keeping a blank calendar, devoid of regular meetings. He does not have a computer in his office and has never had a stock ticker.

Buffett's approach to investor relations is also unique and home-grown. Buffett estimates the average CEO spends 20% of his time communicating with Wall Street. In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance He prefers to communicate with his investors through detailed annual reports and meetings both of which are unique.

Printed on plain, uncoated paper with a simple, single-color cover, Berkshire's annual report looks different from other annual reports. The core of the report is a long essay written by Buffett (with editorial assistance from Carol Loomis) that provides a detailed review of the company's various businesses over the past year. The style is direct and informal, and the reports are models of concision and clarity, with detailed information for each operating division and an "owner's manual" clearly outlining Buffett and Munger's distinctive operating philosophy.

The annual meetings are also unique. The administrative portion of the meeting typically takes no more than fifteen minutes, after which Buffett and Munger answer questions from shareholders for up to five hours. The meetings attract enormous crowds (over 35,000 people attended the 2011 meeting), and Buffett has taken to referring to them as "the Woodstock of capitalism." The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship. (Also, whimsy and humor-when Buffett stepped out of character in the early 1990s and purchased a corporate plane, he dubbed it "The Indefensible" and disclosed it in the annual report in laughably small print.)

Another unconventional shareholder practice relates to stock splits. Buffett has famously eschewed splitting Berkshire's A shares, which currently trade at over $120,000, more than fifty times the price of the next-highest issue on the New York Stock Exchange (NYSE). He believes these splits are purely cosmetic and likens the process to dividing a pizza into eight versus four slices, with no change in calories or asset value delivered. Avoiding stock splits is yet another filter, helping Berkshire to self-select for long-term owners. In 1996, he reluctantly agreed to create a lower-priced class of B shares, which traded at one-thirtieth of the A shares and were the second-highest-priced issue on the NYSE. (In connection with the Burlington Northern deal in early 2010, Buffett agreed to split the B shares a further 50:1 to accommodate the railroad's smaller investors.)

Warren Buffett’s Approach to Corporate Governance

Warren Buffett's approach to corporate governance is also unconventional, contradicting many of the dictates of the Sarbanes-Oxley legislation. Buffett believes that the best boards are composed of relatively small groups (Berkshire has twelve directors) of experienced businesspeople with large ownership stakes. (He requires that all directors have significant personal capital invested in Berkshire's stock.) He believes directors should have exposure to the consequences of poor decisions (Berkshire does not carry insurance for its directors) and should not be reliant on the income from board fees, which are minimal at Berkshire.

This approach, which leaves him with a small group of "insiders" by Sarbanes-Oxley standards, provides a stark contrast with most public company boards, whose members rarely have meaningful personal capital invested alongside shareholders, whose downsides are limited by insurance, and whose fees often represent a high percentage of their total income. Which approach leads to better alignment with shareholders?

John Malone and Tele-Communications Inc (TCI)

Who is John Malone?

Malone was born in 1941 in Milford, Connecticut. His father was a research engineer and his mother a former teacher. Malone idolized his father, who traveled five days a week visiting plants for General Electric. As a teenager, he exhibited early mechanical ability and made pocket money buying, refurbishing, and selling used radios. He was athletic and competed in fencing, soccer, and track in high school. He graduated from Yale with a combined degree in economics and electrical engineering and almost immediately married his high school sweetheart, Leslie.

After Yale, Malone earned master's and PhD degrees in operations research at Johns Hopkins. His two academic fields, engineering and operations, were highly quantitative and shared a focus on optimization, on minimizing "noise" and maximizing "output." Indeed, Malone's entire future career can be thought of as an extended exercise in hyper-efficient value engineering, in maximizing output in the form of shareholder value and minimizing noise from other sources, including taxes, overhead, and regulations.

After earning his PhD, Malone took a job at Bell Labs, the highly prestigious research arm of AT&T. There, he focused on studying optimal strategies in monopoly markets. After extensive financial modeling, he concluded that AT&T should increase its debt level and aggressively reduce its equity base through share repurchases. This unorthodox advice was graciously received by AT&T's board (and promptly ignored).

After a couple of years, Malone concluded that AT&T's bureaucratic culture was not for him, and he took a job with McKinsey Consulting. Having promised his wife that he would not duplicate his father's travel schedule, he soon found himself on the road four days a week working for a variety of Fortune 500 companies. In 1970, when one of those clients, General Instrument, offered him the opportunity to run Jerrold, its rapidly growing cable television equipment division, he leapt at the opportunity. He was 29 years old.

At Jerrold, Malone actively cultivated relationships with the major cable companies, and after two years he was simultaneously courted by two of the largest operators: Steve Ross of Warner Communications and Bob Magness of Tele-Communications Inc. (TCI). Despite a salary that was 60 percent lower than Ross's offer, he chose TCI because Magness offered him a larger equity opportunity and because his wife preferred the relative calm of Denver to the frenetic pace of Manhattan.

The company Malone decided to join had a long history of aggressive growth and would soon be flirting with bankruptcy. Bob Magness had founded TCI in 1956, mortgaging his home to pay for his first cable system in Memphis, Texas. Magness, a peripatetic cottonseed salesman and rancher, had learned about the cable television business while hitchhiking, and like Malone fifteen years later, had immediately recognized its compelling economic characteristics. Magness was particularly quick to grasp the industry's favorable tax characteristics.

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows. If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely. Magness was among the first to fully recognize these attributes and made aggressive use of leverage to build his company, famously saying that it was "better to pay interest than taxes."

TCI went public in 1970 and, by 1973 when Malone joined, had become the fourth-largest cable company in the country, with six hundred thousand subscribers. Its debt at that time was equal to an astonishing seventeen times revenues. Magness had realized that he needed additional management talent to shepherd the company through the next phase of its growth, and after an extended courtship, had landed the McKinsey wunderkind. Malone brought an unusual combination of talents to TCI, including exceptional analytical ability, financial sophistication, technical savvy, and boldness. His tenure, however, got off to a rocky start.

In late 1972, the market for cable stocks was hot, and TCI planned an additional public offering to pay down a portion of its extraordinary debt load. Within months of Malone's arrival, however, the industry was blindsided by new regulations, and the market for cable stocks cooled, forcing the company to pull its offering and leaving it with an unsustainable debt position.

The sudden evaporation of liquidity that resulted from the 1973-1974 Arab oil embargo left the entire industry in a precarious position. TCI, however, with its new, 32 year old CEO, was burdened with significantly more debt than any of its peers and teetered on the edge of bankruptcy. "Lower than whale dung," is Malone's typically blunt assessment of his starting point at TCI.

Malone had been dealt a tough hand, and he and Magness spent the next several years keeping the lenders at bay and the company out of bankruptcy. They met constantly with bank-ers. At one point in a particularly tense lender meeting. Malone threw his keys on the conference room table and walked out of the room, saying "If you want the systems, they're yours." The panicked bankers eventually relented and agreed to amend the terms on TCI's loans.

During this period, Malone introduced a new financial and operating discipline to the company, telling his managers that if they could grow subscribers by 10% per year while maintaining margins, he would ensure that they stayed independent. A frugal, entrepreneurial culture emerged from these years and pervaded the company, extending from corporate headquarters down into field operations.

TCI's headquarters did not look like the headquarters of the largest company in an industry that was redefining the American media landscape. The company's offices were spartan, with few executives at corporate, fewer secretaries, and peeling metal desks on Formica floors. The company had a single receptionist, and an automated service answered the phone. TCI executives stayed together on the road, usually in motels—COOJ. C. Sparkman recalls, "Holiday Inns were a rare luxury for us in those days."

Malone saw himself as an investor and capital allocator, delegating responsibility for day-to-day operations to Sparkman, his longtime lieutenant, who managed the company's far-flung operations through a rigorous budgeting process. Managers were expected to hit their cash flow budget, and these targets were enforced with an almost military discipline by Sparkman, a for mer air force officer. Managers in the field had a high degree of autonomy, as long as they hit their numbers. System managers who missed monthly budgets were frequently visited by the itinerant COO, and under-performers were quickly weeded out.As a result of this frugality, TCI, for a long time, had the highest margins in the industry and gained a reputation with its investors and lenders as a company that consistently underpromised and overdelivered. In paging through analyst reports from early in the company's history, one can see a consistent recurring pattern of slightly higher-than-projected cash flow and subscriber numbers quarter after quarter.

13 Lessons from John Malone’s Approach to Building TCI

  • Acquired 482 companies with a focus on avoiding direct competition by acquiring less expensive rural and suburban subscribers.
  • Pioneered the active use of debt in the cable industry. He believed financial leverage had two important attributes: it magnified financial returns, and it helped shelter TCI’s cash flow from taxes through the deduction of interest payments.
  • Targeted a 5x Debt-to-EBITDA ratio.
  • Emphasized cash flow and invented EBITDA to go “further up the income statement” and arrive at the most pure definition of cash-generating ability.
  • Ruthless adherence to maximum acquisition price of 5x cash flow.
  • Focus on cutting costs to boost cash flow after acquisitions were made—typically cutting payroll by half or more, giving up fancy headquarters, and moving to low cost industrial buildings (including an old tire warehouse.
  • Extreme focus on minimizing taxes, building up tax loss carry forwards, and ensuring every transaction had a tax angle to it.
  • Embrace of joint ventures as a way to invest in new cable companies run by exceptional CEOs—building up a portfolio of 41 by the time TCI was acquired by AT&T.
  • Opportunistically repurchased shares during market downturns—purchasing 40% all of outstanding shares during his tenure.
  • Disdain for being a technology pioneer and willingness to move last and adopt technology only if it grew revenue. As he famously said, “We lost no major ground by waiting to invest. Unfortunately, pioneers in cable technology often have arrows in their back.”
  • Very small corporate headquarters staff with the only indulgence being a team of expensive tax experts. As Malone said, “We don’t believe in staff. Staff are people who second-guess people.”
  • Never paid dividends, or even considered them, and rarely paid down debt.
  • Pioneered the use of spin-offs and tracking stocks which he believed increased transparency into these businesses and separated TCI’s core cable business from their related interests that might attract regulatory scrutiny.

Why John Malone was attracted to the cable industry.

By 1970, John Malone had been at McKinsey long enough to know an attractive industry when he saw one, and the more Malone learned about the cable television business, the more he liked it. Three things in particular caught his attention: the highly predictable, utility-like revenues; the favorable tax characteristics; and the fact that it was growing like a weed. In his years at McKinsey, Malone had never before seen these characteristics in combination, and he quickly concluded that he wanted to build his career in cable.

The combination of high growth and predictability, in particular, was very attractive. During the 1960s and into the early 1970s, the cable industry exhibited very rapid growth, with subscriber counts growing over twentyfold, as rural communities across the country sought better reception of television signals for their favorite channels and programs. Cable television customers paid monthly and rarely disconnected, making the business highly quantifiable and allowing experienced executives to forecast customer growth and profitability with remarkable precision. This was a near-perfect fit with Malone's background, which was unusually quantitative. To paraphrase Norman Mailer it was a case of Superman coming to Supermarket.

How John Malone built TCI (Tele-Communications Inc).

By 1977, TCI had finally grown to the point that it was able to entice a consortium of insurance companies to replace the banks with lower-cost debt. With his balance sheet stabilizedMalone was finally able to go on the offensive and implement his strategy for TCI, which was highly unconventional and stemmed from a central strategic insight that had been germinating since he joined the company.

Malone, the engineer and optimizer, realized early on that the key to creating value in the cable television business was to maximize both financial leverage and leverage with suppliers, particularly programmers, and that the key to both kinds of leverage was size. This was a simple and deceptively powerful insight, and Malone pursued it with single-minded tenacity. As he told longtime TCI investor David Wargo in 1982, "The key to future profitability and success in the cable business will be the ability to control programming costs through the leverage of size."

In a cable television system, the largest category of cost (40% of total operating expenses) is the fees paid to programmers (HBO, MTV, ESPN, etc.). Larger cable operators are able to negotiate lower programming costs per subscriber, and the more subscribers a cable company has, the lower its programming cost (and the higher its cash flow) per subscriber. These discounts continue to grow with size, providing powerful scale advantages for the largest players.

Thus, the largest player with the lowest programming costs would have a sustainable advantage in making new acquisitions versus smaller players—they would be able to pay more for a cable company and still earn the same or better returns, thereby creating a virtuous cycle of scale that went something like this: if you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on ad infinitum. The logic and power of this feedback loop now seems obvious, but no one else at the time pursued scale remotely as aggressively as Malone and TCI.

Related to this central idea was Malone's realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.

It's hard to overstate the unconventionality of this approach. At the time, Wall Street evaluated companies on EPS. Period. For a long time, Malone was alone in this approach within the cable industry; other large cable companies initially ran their companies for EPS, only later switching over to a cash flow focus (Comcast finally switched in the mid-1980s) once they realized the difficulty of showing EPS while growing a cable business. As longtime cable analyst Dennis Leibowitz told me, "Ignoring EPS gave TCI an important early competitive advantage versus other public companies."

While this strategy now seems obvious and was eventually copied by Malone's public peers, at the time, Wall Street did not know what to make of it. In lieu of EPS, Malone emphasized cash flow to lenders and investors, and in the process, invented a new vocabulary, one that today's managers and investors take for granted. Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges. Today EBITDA is used throughout the business world, particularly in the private equity and investment banking industries.

How John Malone grew TCI through acquisitions.

The market for cable stocks remained volatile throughout the 1970s and into the early 1980s. Malone and Magness, concerned about the potential for a hostile takeover, took advantage of occasional market downturns to opportunistically repurchase stock, thereby increasing their combined stake. In 1978, they created a super-voting class of B shares, and through a complex series of repurchases and trades, were able to secure what longtime executive John Sie refers to as "hard control" of TCI by 1979, when their combined ownership of B shares reached 56%.

From this point forward, with control and a healthier balance sheet, Malone focused on achieving scale with a unique combination of relentlessness and creativity. Using the debt available from the company's new lenders, internal cash flow, and the occasional equity offering, Malone began an extraordinarily active acquisition program. Between 1973 and 1989, the company closed 482 acquisitions, an average of one every other week. To Malone, a subscriber was a subscriber was a subscriber. As longtime investor Rick Reiss said, "In the pursuit of scale, he was willing to look at beachfront property even if it was near a toxic waste dump," and over the years, he bought systems from sellers as diverse as the Teamsters and Lady Bird Johnson.

He did not however buy indiscriminately. In the late 1970s and early 1980s, the industry entered a new phase with the advent of satellite-delivered channels, such as HBO and MTV. Cable television suddenly went from a service primarily targeting rural customers with poor reception to one delivering highly desirable new channels to content-starved urban markets. As the industry entered this new stage, many of the larger cable companies began to focus on competing for large metropolitan franchises, and the bidding for these franchises quickly became heated and expensive.

Malone, however, unlike his peers, was uncomfortable with the extraordinary economic terms that municipalities were extracting from pliant cable operators, and alone among the larger cable companies, he refrained from these franchise wars, focusing instead on acquiring less expensive rural and suburban subscribers. By 1982, TCI was the largest company in the industry, with 2.5 million subscribers.

When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost. In this manner, the company gained control of the cable franchises for Pittsburgh, Chicago, Washington, St. Louis, and Buffalo.

Throughout the 1980s, aided by a very favorable mid-decade relaxation of FCC regulations, TCI continued to buy systems at an aggressive clip, mixing in occasional larger deals (Westinghouse and Storer Communications) with a steady stream of small transactions. In addition, the company continued to actively grow its portfolio of joint ventures, partnering legendary cable entrepreneurs such as Bill Bresnan, Bob Rosenkranz, and Leo Hindery to create cable companies in which TCL owned minority stakes. By 1987, the company was twice the size of its next-largest competitor, Time Inc.'s ATC.

Malone's creativity further evidenced itself in a wave of joint ventures in the late 1970s and early 1980s in which he partnered D with promising young programmers and cable entrepreneurs. A partial list of these partners reads like a cable hall of fame roster, including such names as Ted Turner John Sie, John Hendricks, and Bob Johnson. In putting these partnerships together, Malone was in effect an extremely creative venture capitalist who actively sought young, talented entrepreneurs and provided them with access to TCI's scale advantages (its subscribers and programming discounts) in return for minority stakes in their businesses. In this way, he generated enormous returns for his shareholders. When he saw an entrepreneur or an idea that he liked, he was prepared to act quickly.

Beginning in 1979, when he famously wrote Bob Johnson, the founder of Black Entertainment Television (BET), a $500,000 check at the end of their first meeting, Malone began to actively pursue ownership stakes in programming entities, offering in return a potent combination of start-up capital and access to TCI's millions of households. Malone led a consortium of cable companies in the bailout of Ted Turner's Turner Broadcasting System (whose channels included CNN and The Cartoon Network) when it flirted with bankruptcy in 1987; and by the end of the 1980s, TCI's programming portfolio would include Discovery, Encore, QVC, and BET in addition to the Turner channels. He was now a significant owner of both cable systems and cable programming.

The early 1990s produced an almost perfect storm of bad news for the cable industry, with the combined impact of new highly leveraged transaction (HLT) legislation in 1990 limiting the industry's access to debt capital and, more significantly, the FCC's tightening of cable regulations in 1993, which rolled back cable rates. Despite these negative developments, Malone continued to selectively acquire large cable systems (Viacom and United Artists Cable) and launch new programming networks, including Starz/Encore and a series of regional sports networks in partnership with Rupert Murdoch and Fox.

In 1993, in a stunning development, Malone reached an agreement to sell TCI to phone giant Bell Atlantic for $34 billion in stock. The deal was called off, however, as re-regulation hit and TCI's cash flow and stock price fell. As the decade progressed, Malone spent more time on projects outside of the core cable business. He led a consortium of cable companies in the creation of two sizable new entities: Teleport, a competitive telephone service, and Sprint/PCS, a joint venture with Sprint to bid on cellular franchises.

In pursuing these new initiatives, Malone was allocating the firm's capital and his own time to projects that he believed leveraged the company's dominant market position and offered compelling potential returns. In 1991, he spun off CI's minority interests in programming assets into a new entity, Liberty Media, in which he ended up owning a significant personal stake. This was the first in a series of tracking stocks that Malone created, including TCI Ventures (for Teleport, Sprint/PCS, and other non-cable assets) and TCI International (for TCI's ownership in miscellaneous foreign cable assets).

Malone was a pioneer in the use of spin-offs and tracking stocks, which he believed accomplished two important objectives: 1) increased transparency, allowing investors to value parts of the company that had previously been obscured by ICI's byzantine structure, and 2) increased separation between TCI's core cable business and other related interests (particularly programming) that might attract regulatory scrutiny. Malone started with the spin-off of the Western Tele-Communications microwave business in 1981, and by the time of the sale to AT&T, the company had spun off a remarkable fourteen different entities to shareholders. In utilizing these spin-offs, Malone, like Henry Singleton and Bill Stiritz, was consciously increasing the complexity of his business in pursuit of the best economic outcome for shareholders.

After Sparkman retired in 1995, Malone delegated authority for the company's cable operations to a new management team led by Brendan Clouston, a former marketing executive. Under Clouston, TCI began to centralize customer service and spend aggressively to upgrade its aging cable facilities. In the third quarter of 1996, however, TCI badly missed its forecast, losing subscribers for the first time in its history and showing a decline in quarterly cash flow. Malone, disappointed by these results, reassumed the helm and, uncharacteristically, took direct management control of operations, quickly reducing employee head count by 2,500, halting all orders for capital equipment, and aggressively renegotiating programming contracts. He also fired the consultants who had been hired to help with the system upgrade, and returned responsibility for customer service to the local system managers.

As operations stabilized and cash flow improved, he brought on Leo Hindery (the CEO of InterMedia Partners, a large TCI joint venture) to run operations, and returned his attention to strategic projects. Hindery continued the restructuring process: bringing back TCI veteran Marvin Jones as his COO, giving more responsibility to regional managers, and actively pursuing trades to more tightly cluster subscribers and reduce costs.

Once Hindery was on board, Malone focused his attention on developing digital set-top boxes that would allow the industry to compete effectively with the new satellite television providers, He courted Microsoft but eventually struck a deal with General Instrument, the industry's largest equipment manufacturer, for 10 million set-top boxes at $300 each. In return he asked for a significant equity stake in the company, eventually owning 16%.

In the middle of the operational crisis of 1996 and 1997, Bob Magness, Malone's mentor and longtime partner, died, throwing control of the company into question. Through a series of typically complex transactions, Malone was able, along with the company, to purchase Magness's super-voting shares, ensuring retention of "hard" control for the endgame phase at TCI.

How John Malone sold TCI to AT&T for an extraordinary $2,600 per subscriber.

In the late 1990s, several of Malone's strategic, non-cable projects began to bear significant fruit. He had been correct about their return potential—in 1997, Teleport was sold to AT&T for an astounding $11 billion, a twenty-eight-fold return on investment. In 1998, the Sprint/PCS joint venture was sold to Sprint Corporation for $9 billion in Sprint stock, and in 1999, General Instrument was sold to Motorola for $11 billion.

In the late 1990s, Malone shifted his attention to finding a home for TCI. Although Malone loved the cable business, he was a purely rational executive and, as early as 1981, had told analyst David Wargo, "I felt TCI might be worth $48 a share and would sell if someone offered us this." This target price continued to grow, and for a long, long time no one was willing to pay it. As the 1990s progressed, however, Malone saw a combination of factors clouding TCI's future: rising competition from satellite television, the enormous cost of upgrading the company's rural systems, and uncertainty about management succession. When he received an inquiry from AT&T's aggressive new CEO, Mike Armstrong, he eagerly initiated discussions. Characteristically, he handled the negotiations himself, often facing a sizable crowd of AT&T lawyers, bankers, and accountants across the table.

As talks between the two companies unfolded, Malone proved to be as adept at selling as he had been at acquiring. As Rick Beiss said,"He turned the board of AT&T upside down, shook every nickel from their pockets, and returned them to their board seats." The financial terms—twelve times EBITDA, $2,600 per subscriber—were extraordinary and, remarkably, the company received no discount for its patchwork guilt of decrepit rural systems. Not surprisingly, Malone, ever watchful of unnecessary taxes, structured the transaction as a stock deal allowing his investors to defer capital gains taxes.

In addition, Malone retained effective control of the Liberty programming subsidiary with six of nine board seats and secured an at-tractive, long-term carriage deal for Liberty's channels on AT&T's cable systems. This transaction was the final resounding validation of Malone's unique strategy at TCI: producing exceptional returns for his investors. Mind-boggling returns, in fact: in the 25 years after Malone took the helm at TCI, the entire cable industry grew enormously, and all the public companies in it prospered. No cable executive, however, created remotely as much value for shareholders as Malone. From his debut in 1973 until 1998 when the company was sold to AT&T, the compound return to TCI's shareholders was a phenomenal 30.3%, compared with 20.4% for other publicly traded cable companies and 14.3% for the S&P 500 over the same period.

A dollar invested with TCI at the beginning of the Malone era was worth over $900 by mid-1998. That same dollar was worth $180 if invested in the other publicly traded cable companies and $22 if invested in the S&P 500. Thus TCI outperformed the S&P by over fortyfold and its public peers by five-fold during Malone's tenure.

John Malone’s Strategy: Breaking Down How He Built TCI

The cable television business during Malone's tenure was extremely capital intensive, with enormous amounts of cash required to build, buy, and maintain cable systems. As Malone sought to achieve scale by growing his subscriber base, three primary sources of capital were available to him in addition to TCI's robust operating cash flow: debt, equity, and asset sales. His use of each of these sources was distinctive.

Malone pioneered the active use of debt in the cable industry. He believed financial leverage had two important attributes: it magnified financial returns, and it helped shelter TCI's cash fow from taxes through the deductibility of interest payments. Malone targeted a ratio of 5x debt to EBITDA) and maintained it throughout most of the 1980s and 1990s.

Scale allowed TCI to minimize its cost of debt, and Malone, having survived the harrowing experience of the mid-1970s, structured his debt with great care to lower costs and avoid cross-collateralization so that if one system defaulted on its debt, it would not affect the credit of the entire company. This compartmentalization into "bulkheads" (the term derived from Malone's fascination with all things nautical—he also sometimes referred to TCI's "bow wave of depreciation") caused further complexity in TCI's structure, but provided the company with substantial downside protection.

When it came to issuing equity, Malone was parsimonious, with the company's occasional offerings timed to coincide with record high multiples on his stock. As Malone said in a 1980 interview, "Our recent rise in stock price provided us with a good opportunity for this offering." He was justifiably proud of his stinginess in issuing equity and believed it was another factor that distinguished him from his peers.

Malone occasionally and opportunistically sold assets. He coolly evaluated the public and private values for cable systems and traded actively in both markets when he saw discrepancies. Malone carefully managed the company's supply of net operating losses (NOLs), accumulated over years of depreciation and interest deductions, which allowed him to sell assets without paying taxes. As a result of this tax shield was comfortable selling systems if prices were attractive, to raise capital to fund future growth. As Malone told David Wargo as early as 1981, "It makes sense to maybe sell off some of our systems... at 10 times cash flow to buy back our stock at 7 times."

Another key source of capital at the company was taxes not paid. As we've seen, tax minimization was a central component of Malone's strategy at TCI, and he took Magness's historical approach to taxes to an entirely new level. Malone abhorred taxes; they offended his libertarian sensibilities, and he applied his engineering mind-set to the problem of minimizing the "leakage" from taxes as he might have minimized signal leakage on an electrical engineering exam. As the company grew its cash flow by twentyfold over Malone's tenure, it never paid significant taxes.

In fact, Malone's one extravagance in terms of corporate staff was in-house tax experts. The internal tax team met monthly to determine optimal tax strategies, with meetings chaired by Malone himself. When he sold assets, he almost always sold for stock, (the reason that, to this day, Liberty has large holdings of News Corp., Time Warner, Sprint, and Motorola stock) or sheltered gains through accumulated NOLs, and he made constant use of the latest tax strategies. As Dennis Leibowitz said, "TCI hardly ever disposed of an asset unless there was a tax angle to it." No other cable company devoted remotely as much time and attention to this area as TCI.

Given the extraordinary growth in cable during the 1970s and 1980s, Malone had the luxury of high-return capital allocation options, and he structured TCI to optimize across them. As one might expect from his background, Malone had a coolly rational, almost surgical approach to capital allocation, and he was willing to look at any investment project that offered attractive returns regardless of complexity or unconventionality. Applying his engineering mind-set, Malone looked for no-brainers, focusing only on projects that had compelling returns. Interestingly, he didn't use spreadsheets, preferring instead projects where returns could be justified by simple math. As he once said, "Computers require an immense amount of detail. I'm a mathematician, not a programmer. I may be accurate, but I'm not precise."

In deciding how to deploy TCI's capital, Malone made choices that were starkly different from those of his peers. He never paid dividends (or even considered them) and rarely paid down debt. He was parsimonious with capital expenditures, aggressive in regard to acquisitions, and opportunistic with stock repurchases.

Until the advent of satellite competition in the mid-1990s, Malone saw no quantifiable benefit to improving his cable infrastructure unless it resulted in new revenues. To him, the math was undeniably clear: if capital expenditures were lower, cash flow would be higher. As a result, for years Malone steadfastly refused to upgrade his rural systems despite pleas from Wall Street.As he once said in a typically candid aside, "These [rural systems) are our dregs and we will not attempt to rebuild them."'' This attitude was very different from that of the leaders of other cable companies who regularly trumpeted their extensive investments in new technologies.

Ironically, this most technically savvy of cable CEOs was typically the last to implement new technology, preferring the role of technological "settler" to that of "pioneer." Malone appreciated how difficult and expensive it was to implement new technologies, and preferred to wait and let his peers prove the economic viability of new services, saying of an early-1980s decision to delay the introduction of a new setup box, "We lost no major ground by waiting to invest. Unfortunately, pioneers in cable technology often have arrows in their backs." TCI was the last public company to introduce pay-per-view programming (and when it did, Malone convinced the programmers to help pay for the equipment).

He was, however, prepared to invest when he needed to, and he was among the first in the industry to champion expensive new set-top boxes to help increase channel capacity and customer choice when satellite competition arose in the mid-1990s.

Far and away the largest capital allocation outlet for TCI was, of course, acquisitions. As we've seen, Malone was an aggressive, yet disciplined, buyer of cable systems, a seeming oxymoron. He bought more companies than anybody else—in fact, he bought more companies than his three or four largest competitors combined. Collectively, these acquisitions represented an enormous bet on the future of cable, an industry long characterized by regulatory uncertainty and potential competitive threats; and from 1979 through 1998, the average annual value of TI's acquisitions equaled a remarkable 17% of enterprise value (exceeding 20% in five of those years).

He was also, however, a value buyer, and he quickly developed a simple rule that became the cornerstone of the company's acquisition program: only purchase companies if the price translated into a maximum multiple of five times cash flow after the easily quantifiable benefits from programming discounts and overhead elimination had been realized. This analysis could be done on a single sheet of paper (or if necessary the back of a napkin). It did not require extensive modeling or projections.

What mattered was the quality of the assumptions and the ability to achieve the expected synergies. Malone and Sparkman trained their operations teams to be highly efficient in eliminating unnecessary costs from new acquisitions. Immediately after TCI took over the floundering Pittsburgh franchise from Warner Communications, it reduced payroll by half, closed the elaborate studios the prior owners had built for the city, and moved headquarters from a downtown skyscraper to a tire warehouse. Within months, the formerly unprofitable system was generating significant cash flow.

Malone's simple rule allowed him to act quickly when opportunity presented itself. When the Hoak family, owners of a million-subscriber cable business, decided to sell in 1987, Malone was able to strike a deal with them in an hour. He was also comfortable walking away from transactions that did not meet the rule. Paul Kagan, a longtime industry analyst, remembered Malone walking away from a sizable Hawaiian transaction that was only $1 million over his target price.

Malone, alone among the CEOs of major public cable companies, was also an opportunistic buyer of his own stock during periodic market downturns. As Dennis Leibowitz said, "None of the other public MSO's (multiple system operators) made any significant share repurchases over this period." In contrast, TCI repurchased over 40% of its shares during Malone's tenure. His timing with these purchases was excellent, producing an average compound return of over 40%.

An exchange with Dave Wargo in the early 1980s was typical of Malone's opportunistic philosophy regarding buybacks: "We are evaluating alternatives in order to buy our eguity at current prices to arbitrage the differential between its current multiple and the private market value." These buybacks provided a useful benchmark in evaluating other capital allocation options, including acquisitions. As Malone said to Wargo in 1981, "With our stock in the low twenties, purchasing it looks more attractive than buying private systems."

How John Malone used Joint Ventures to build value.

To the standard menu of five capital allocation alternatives, Malone added a sixth: investment in joint ventures. No CEO has ever used joint ventures as actively, or created as much value for his shareholders through them, as John Malone. Malone realized early on that he could leverage the company's scale into equity interests in programmers and other cable companies, and that these interests could add significant value for shareholders, with very little incremental investment. At the time of the sale to AT&T, the company had 41 separate partnership interests, and much of CI's long-term return is attributable to these cable and non-cable joint ventures.

Because of these polyglot joint ventures, TCI was notoriously hard to analyze and often sold at a discount to its cable peers. As David Wargo said, "To understand the company you had to read all of their footnotes and very few did." Malone, however, believed this complexity was a small price to pay for the enormous value created over the years by these projects.

As with many of Malone's initiatives, these joint ventures seem logical in hindsight, but at the time they were highly unconventional: no one else in the industry used joint ventures to increase system ownership, and only later did other MSOs begin to seek ownership stakes in programmers.

The culture that John Malone instilled at TCI.

Despite his cool, calculating, almost Spock-like approach, Malone was also successful in creating a very strong culture and engendering great employee loyalty. He did this by providing a powerful mix of incentive and autonomy. TCI had an aggressive employee stock purchase program in which the company matched employee contributions and invited participation from all levels in the organization. Many early employees (supposedly including Malone's longtime secretary) became millionaires, and this culture bred tremendous loyalty—in Malone's first 16 years at the helm, not a single senior executive left the company.

TCI's operations were remarkably decentralized, and as late as 1995, when Sparkman retired, the company had only 17 employees at corporate in a company with 12 million subscribers. As Malone put it with characteristic directness, "We don't believe in staff. Staff are people who second-guess people." The company did not have human resource executives and didn't hire a PR person until the late 1980s. TCI's culture was described by Dennis Leibowitz as a group of frugal, action-oriented "cowboys" who defined themselves in counterpoint to the more conservative and bureaucratic Easterners who ran the other large cable companies.

John Malone’s obsession with maximizing shareholder returns.

Malone created a model for savvy capital allocation in rapidly growing, capital-intensive businesses that has been followed by executives in industries as diverse as cellular telephony, records management, and communications towers. Among the CEOs in this book, he most resembles that other high-level mathematician (and PhD), Henry Singleton. For mathematicians, insights often come when variables are taken to extremes, and Malone was no exception. Nothing about TCI was characterized by half-measures. TCI was the largest company in the cable industry, with the lowest programming costs, least maintained facilities, most complex structure, and, oh yes, far and away the highest returns.

His management of TCI had a quality of asceticism about it. Every element of the company's strategy—from the pursuit of scale to tax minimization to the active use of financial leverage—was designed to optimize shareholder returns. As Malone said in summing up his analytically driven approach to building TCI, "They haven't repealed the laws of arithmetic... yet anyway." A fact for which his shareholders are eternally grateful.

William "Bill" Stiritz and Ralston Purina

10 Lessons from William Stiritz’s Approach to Rebuilding Ralston Purina

  • Reorganized the company around high margin and low capital requirement businesses.
  • Believed that businesses with predictable cash flows should employ debt to enhance shareholder returns. He maintained a debt-to-cash flow ratio 50% higher than his competitors and the industry.
  • Divested all other businesses that didn’t meet his criteria (hurdle rate) for profitability and returns.
  • Repurchased shares opportunistically, ultimately buying back 60% of Ralston’s shares. Used buyback returns as the internal hurdle rate for capital investment decisions—especially acquisitions. He viewed repurchases as the highest-probability investments he could make.
  • Preferred to acquire companies that had been mismanaged or undermanaged—especially neglected divisions within giant conglomerates.
  • Believed that “Leadership is analysis.” He prized independent thinking and analytical ability in leaders.
  • Disdained book value as a metric. Focused on EBITDA and Internal Rate of Return (IRR) as the best way to understand economic reality.
  • Disdained the false precision of detailed financial models when making acquisitions. He preferred to focus on a handful of key variables including market growth, competition, potential operating improvements, and cash generation. He once said, “I really only cared about the key assumptions going into the model. I wanted to know about the underlying trends in the market: its growth and competitive dynamics.”
  • Disdained outside advisers, especially investment bankers, and once described them as “parasitic.” He was surgical with his use of advisers and made of using different ones for each transaction so that no one felt secure about his business.
  • Embraced spin-offs as “the ultimate decentralization,” providing managers and shareholders with an attractive combination of transparency and autonomy. He also liked that it allowed managers to be compensated more directly for their operating results.

The story of how William Stiritz built Ralston Purina into the largest and most profitable packaged food company.

For most of the last 50 years, the large packaged goods companies, including household names such as Campbell Soup, Heinz, and Kellogg, were considered the bluest of blue-chip stocks for their attractive combination of predictable growth, recession resistance, and reliable dividends. These companies had long been paragons of financial conservatism, using little leverage, reliably paying dividends, and rarely repurchasing shares. Most of them had followed fashion and actively diversified during the 1960s and 1970s in the quixotic pursuit of synergy, and many had ended up in restaurant and agricultural businesses in search of the elusive benefits of "vertical integration."

Ralston Purina was fairly typical of this group. In the early 1980s, Ralston was a Fortune 100 company with a long history in agricultural feed products. During the 1970s under CEO Hal Dean, the company had followed the same path as its peers, taking the enormous cash flow provided by its traditional feed businesses and engaging in a diversification program that left it with a melange of operating divisions, ranging from mushroom and soybean farms to the Jack in the Box chain of fast-food restaurants, the St. Louis Blues hockey team, and the Keystone ski resort in Colorado. When Dean announced his retirement in 1980, the company's stock price had not moved in a decade.

After Dean's announcement, Ralston's board conducted a thorough search for his replacement, involving a wide slate of internal and external candidates. As the search unfolded, a number of top national candidates emerged (including Tom Wyman, later CEO of CBS). Late in the process, a lesser-known candidate—a longtime company man who was not even the lead internal candidate—improved his chances dramatically when he submitted an unsolicited memo to the board outlining in detail his strategy for the company. After reading it, influential director Mary Wells Lawrence (founder of the Wells, Rich, Greene advertising agency) telegrammed back, "bullseye." Within days that candidate, William Stiritz, had the job.

How William Stiritz became the CEO of Ralston Purina.

William Stiritz was an insider, having spent seventeen years at Ralston before becoming CEO at the age of 47. This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent. When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries.

Stiritz had an unusual educational background for a CEO. He had an interrupted undergraduate experience, attending the University of Arkansas for only a year before leaving for a 4-year stint in the navy when his funds ran out. During his years in the navy, he honed the poker skills that would eventually pay for his college tuition. After the navy, he returned to college, completing his degree at Northwestern, where he majored in business studies. He never earned an MBA. Repeatedly labeled "cerebral" by his colleagues and Wall Street analysts, he did, however, receive a master's degree in European history from Saint Louis University in his mid-thirties.

After Northwestern, he had worked at the Pillsbury Company, starting as a field rep placing cereal on store shelves in northern Michigan (one of his largest accounts was an Indian reservation). Stiritz believes this grassroots experience was essential in helping him understand the nuts and bolts of distribution channels. He was subsequently promoted to product manager, a position that gave him broader exposure to consumer packaged goods (CPG) marketing. Wanting to understand media and advertising better, he left after two years for the Gardner Advertising agency in St. Louis. At Gardner, he showed an early interest in quantitative approaches to marketing and was a pioneering user of the nascent Nielsen ratings service, which helped give him a detailed understanding of the relationship between market share and promotional spending.

Stiritz joined Ralston Purina in 1964 at age thirty and was assigned to the grocery products division (pet food and cereals), long considered the "redheaded stepchild" within Ralston's large portfolio of businesses. He worked there for several years in positions of increasing responsibility, becoming general manager of the division in 1971. During his tenure, the business grew dramatically, with operating profits increasing fiftyfold through a relentless program of new product introductions and line extensions.

Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry. For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament. These traits had helped him at the poker table and would serve him well as CEO.

How William Stiritz rebuilt Ralston Purina as CEO.

On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company. He fully appreciated the exceptionally attractive economics of the company's portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements. He immediately began to remove the underpinnings of his predecessor's strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns.

In his early years at the helm, Stiritz sold the Jack in the Box chain of fast-food restaurants, the mushroom farms, and the St. Louis Blues hockey franchise. The sale of the Blues in particular put Wall Street and the local business community on alert that the new CEO would be taking a radically different approach to managing Ralston.

Stiritz proceeded to sell other noncore businesses, including the company's soybean operations and miscellaneous restaurant and food service operations, leaving Ralston as a pure branded products company. In this regard, he was not unlike Warren Buffett in the early days at Berkshire Hathaway, extracting capital from the low-return textile business to deploy in much higher-return insurance and media businesses.

Starting in the early 1980s, Stiritz overcame initial board resistance and initiated an aggressive stock repurchase program. He was alone among the major branded products companies in pursuing buybacks, which he believed could generate compelling returns, and they would remain a central tenet of his capital allocation plan for the remainder of his tenure.

Starting in the mid-1980s, after the initial round of divestitures, Stiritz made two large acquisitions totaling a combined 30% of Ralston's enterprise value, both of them largely financed with debt. The first added Continental Baking, the maker of Twinkies and Wonder Bread, to Ralston's stable of brands. Stiritz bought Continental from the diversified conglomerate ITT, where it had languished as the company's lone packaged goods business. Under Ralston's management, distribution was expanded, redundant costs were eliminated, new products were introduced, and cash flow grew significantly, creating significant value for shareholders.

Next, in 1986, Stiritz made his largest purchase ever, acquiring the Energizer Battery division from Union Carbide for $1.5 Billion, equal to 20% of Ralston's enterprise value. Union Carbide was struggling in the wake of the Bhopal disaster, and its battery business, despite a strong brand name, had long been a neglected, noncore operation. Like ITT, Union Carbide was a motivated seller lacking in consumer products marketing expertise. Stiritz prevailed in an auction, paying an admittedly full price for an asset he felt had a uniquely attractive combination of a growing duopoly market and undermanaged operations.

As he had at Continental, Stiritz moved immediately to improve Energizer's products and marketing (including the creation of the famous ad campaign featuring the eponymous bunny), enhance distribution, and eliminate excess costs. With this series of actions, the first step in Stiritz's transformation of Ralston was complete. By the late 1980s, the percentage of Ralston's revenues coming from consumer packaged goods had risen to almost 90%.

This transformation had a remarkable effect on the company's key operating metrics. As the business mix at Ralston shifted toward branded products, pretax profit margins grew from 9% to 15%, and return on equity more than doubled, from 15% to 37%. When combined with a shrinking share base, this produced exceptional growth in earnings per share and returns to shareholders.

Throughout the balance of the 1980s, Stiritz continued to optimize his portfolio of brands, making selected divestitures and add-on acquisitions. Businesses that could not generate acceptable returns were sold (or closed). These divestitures included underperforming food brands (including the Van de Kamp's frozen seafood division, a rare acquisition mistake) and the company's legacy agricultural feed business, Purina Mills, which had become a commodity business with chronic low returns and limited growth prospects. His add-on acquisitions focused on the core battery and pet food brands, particularly in under-penetrated international markets. All these decisions were guided by a careful analysis of potential returns for shareholders.

Throughout the 1990s, Stiritz focused on continued opportunistic stock buybacks, occasional acquisitions, and, significantly, the use of a relatively new structuring device, the spin-off, to rationalize Ralston's brand portfolio. Stiritz came to believe that even with a relatively decentralized corporate structure, some of the company's businesses were not receiving the attention they deserved either internally or from Wall Street. To rectify this and to minimize taxes, Stiritz became an early user of spin-offs.

In a spin-off, a business unit is transferred from the parent company into a new corporate entity. Shareholders in the parent company are given equivalent pro rata ownership in the new company and can make their own decisions about whether to hold or sell these shares. Importantly, spin-offs highlight the value of smaller business units, allow for better alignment of management incentives, and, critically, defer capital gains taxes.

Stiritz began this program with the 1994 spin-off of a collection of smaller brands, including Chex cereals and the ski resorts, into a new entity, Ralcorp. He remained the chairman of the new entity, which had a separate board and two co-CEOs. Stiritz would continue to rationalize and optimize Ralston's portfolio with the 1998 sale of the company's remaining agricultural businesses (including the fast-growing protein technology business) for a record price to DuPont in a stock deal (again avoiding capital gains taxes).

His last move (and the largest by far) was the spin-off of Energizer Holdings in 2000, which at the time had an enterprise value equal to 15% of the company's total value. These spin-offs have all performed exceptionally well as independent publicly traded companies (Ralcorp, originally a collection of neglected assets, today has an enterprise value of $5 Billion).

This series of moves left Ralston at the dawn of the new millennium as a pure play pet food company, the dominant player by far in the US market. It did not escape Stiritz's attention that pruning unrelated businesses might make the company's core pet food brands more attractive to a strategic acquirer, and in 2001 the company was approached by Nestlé. After extensive negotiations (which Stiritz characteristically handled himself), the Swiss giant agreed to pay a record price for Ralston: $10.4 Billion, equal to an extraordinary multiple of fourteen times cash flow. This transaction was the capstone of Stiritz's tenure at Ralston.

During a period when all of his peers had excellent returns, Stiritz's numbers were exceptional. Over his 19 years at the helm, Stiritz's transformation of Ralston into a streamlined packaged goods company had a propulsive effect on the company's stock price. A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later, a compound return of 20%, comfortably surpassing both his peers (17.7%) and the S&P (14.7%).

William Stiritz’s strategy for reshaping Ralston Purina.

Michael Mauboussin, now a well-respected investor at Legg Mason, covered Stiritz and Ralston Purina as his first research assignment at Drexel Burnham in the mid-1980s. He became fascinated by Ralston's maverick CEO and did an early comprehensive research report on the company, building on the work of his mentor, Alan Greditor, a rare Wall Street analyst whom Stiritz respected. With Greditor's coaching, Mauboussin came to appreciate Stiritz's unique approach to capital allocation.

When asked to summarize what made Stiritz different, Mauboussin told me, "Effective capital allocation requires a certain temperament. To be successful you have to think like an investor, dispassionately and probabilistically, with a certain coolness. Stiritz had that mindset."

Stiritz himself likened capital allocation to poker, in which the key skills were an ability to calculate odds, read personalities, and make large bets when the odds were overwhelmingly in your favor. He was an active acquirer who was also comfortable selling or spinning off businesses that he felt were mature or under appreciated by Wall Street.

As longtime Goldman Sachs analyst Nomi Ghez emphasized to me, the food business had traditionally been a very profitable, predictable business generally characterized by low growth. Alone among public company CEOs, Stiritz saw this combination of characteristics and arrived at a new approach for optimizing shareholder value.

In fact, he fundamentally changed the paradigm by actively deploying leverage to achieve substantially higher returns on equity, pruning less profitable businesses, acquiring related businesses, and actively repurchasing shares. In doing this, he was echoing the techniques of the pioneering private equity firms, including Kohlberg Kravis Roberts (KKR), which had successfully targeted underperforming packaged goods companies (Beatrice Foods and later RJR Nabisco) for some of the largest early leveraged buyouts (LBOs).

In fact, Stiritz was an underbidder on both Beatrice and RJR. He also made unsuccessful bids for Gillette and Gatorade.

How William Stiritz optimized Ralston Purina’s cash flow, debt, and handled proceeds from asset sales.

The primary sources of funds at Ralston during Stiritz's tenure were internal cash flow, debt, and, particularly in the early years, proceeds from asset sales.

Operating cash flow was a significant and growing source of funds throughout Stiritz's time at the helm. Margins steadily improved under his management, reflecting both a shifting mix toward branded products and a leaner, more decentralized operating philosophy. By the time of the Nestlé sale, Ralston's margins were the highest in the packaged goods industry.

Stiritz was the pioneer among consumer packaged goods CEOs in the use of debt. This was heresy in an industry that had long been characterized by exceptionally conservative financial management. Stiritz, however, saw that the prudent use of leverage could enhance shareholders' returns significantly. He believed that businesses with predictable cash flows should employ debt to enhance shareholder returns, and he made active use of leverage to finance stock repurchases and acquisitions, including his two largest, Energizer and Continental. Ralston consistently maintained an industry-high average debt-to-cash flow ratio during his tenure.

Stiritz's approach to sales and divestitures evolved over time. He started by selling noncore businesses, like the mushroom farms and the hockey team, that did not meet his criteria for profitability and returns, and these asset sales were an important early source of cash for the company. In this regard, there were no sacred cows (including the ancestral feed business). "Stiritz knew what things were worth and would sell any asset for the right price," Mauboussin told me approvingly. During this period, he was focused on divesting noncore assets at the best possible prices and redeploying the capital into higher-return packaged goods businesses like Energizer and the Continental Baking brands.

However, Stiritz eventually developed an appreciation for the tax inefficiency of asset sales and, as we've seen, began to use spin-offs, which he believed released entrepreneurial energy and creativity while deferring capital gains taxes. From the outset, Stiritz had been a believer in decentralization, working to reduce layers of corporate bureaucracy and giving responsibility and autonomy for the company's key businesses to a close-knit group of managers. He viewed spin-offs as a further move in this direction, "the ultimate decentralization," providing managers and shareholders with an attractive combination of transparency and autonomy and allowing managers to be compensated more directly on their operating results than was possible in the larger conglomerated structure of the mother company.

Stiritz also proved to be a very astute seller. After his initial flurry of divestitures in the early 1980s, he made only two asset sales, both of them large. The first was the sale to DuPont of Ralston's protein business. DuPont paid a very high price for this business, and Stiritz opted to take stock, thus deferring capital gains taxes. The other divestiture was the Nestlé sale, which, as we've seen, resulted in a record price of over $10 Billion. While Stiritz acknowledges today that the price was very attractive, he regrets not taking stock, given the strength of Nestlé's business and the capital gains tax incurred by his shareholders.

Outside of the steady, year-in, year-out pattern of debt service, internal capital expenditures, and (minimal) dividends, Stiritz's two primary uses of cash were share repurchases and acquisitions. His approach to both was opportunistic in the extreme.

Stiritz was the pioneer in the consumer packaged goods business when it came to stock buybacks. In the early 1980s when he started to repurchase stock, buybacks were still unusual and controversial. As one of Ralston's directors said at the time, "Why would you want to shrink the company. Aren't there any worthwhile growth initiatives?"

Stiritz, in contrast believed that repurchases were the highest-probability investments he could make, after convincing his board to support him, he became an active repurchaser. He would eventually repurchase a phenomenal 60% of Ralston's shares, second only to Henry Singleton among the CEOs in this book, and he would earn very attractive returns on these buybacks, averaging a long-term internal rate of return of 13%.

He was, however, a very frugal buyer, preferring opportunistic open-market purchases to larger tenders that might raise the stock price prematurely. These purchases were consistently made when P/E multiples were at cyclical low points. Stiritz even personally negotiated discounted brokerage rat these buybacks.

Stiritz believed buyback returns represented a handy benchmark for other internal capital investment decisions, particularly acquisitions. As his longtime lieutenant, Pat Mulcahy, said, "The hurdle always used for investment decisions was the share repurchase return. If an acquisition, with some certainty, could beat that return, it was worth doing." Conversely, if a potential acquisition's returns didn't meaningfully exceed the buyback return, Stiritz passed.

In his approach to acquisitions, Stiritz always sought an edge and focused on buying businesses that he believed could be improved by Ralston's marketing expertise and distribution clout. He preferred companies that had been under-managed by prior owners; and, not coincidentally, his two largest acquisitions, Continental Baking and Energizer, were both small, neglected divisions within giant conglomerates. The long-term returns from these two purchases were excellent, with Energizer generating a 21% compound return over fourteen years and Continental generating a 13% return over an 11-year holding period.

Stiritz focused on sourcing acquisitions through direct contact with sellers, avoiding competitive auctions whenever possible.The Continental Baking acquisition was sourced from a letter he sent directly to ITT chairman Rand Araskog, thus circumventing an auction.

Stiritz believed that Ralston should only pursue opportunities that presented compelling returns under conservative assumptions. He disdained the false precision of detailed financial models, focusing instead on a handful of key variables: market growth, competition, potential operating improvements, and, always, cash generation. As he told me, "I really only cared about the key assumptions going into the model. First, I wanted to know about the underlying trends in the market: its growth and competitive dynamics."

His protégé, Pat Mulcahy, who would later run the business, described Stiritz's approach to the seminal Energizer acquisition: "When the opportunity to buy Energizer came up, a small group of us met at 1:00 PM and got the seller's books. We performed a back of the envelope LBO model, met again at 4:00 PM and decided to bid $1.4 Williamion. Simple as that. We knew what we needed to focus on. No massive studies and no bankers." Again, Stiritz's approach (similar to those of Tom Murphy, John Malone, Katharine Graham, and others) featured a single sheet of paper and an intense focus on key assumptions, not a forty-page set of projections.

Why and how William Stiritz pursued a leveraged buyout strategy with Ralston Purina.

Stiritz, aware of the early LBOs in the packaged goods industry, consciously adopted a private equity-like mind-set. His managerial worldview was neatly summarized by Mulcahy: "Stiritz ran Ralston somewhat akin to an LBO. He was one of the first to see the benefit to shareholders of higher leverage as long as cash flows were strong and predictable. He simply got rid of businesses that were cash drains (no matter their provenance) and invested more deeply in existing strong businesses through massive share purchases interspersed with the occasional acquisition that met our return targets."

Stiritz married nuts-and-bolts packaged goods marketing expertise with financial acumen, an unusual combination. He focused on newfangled metrics, like EBITDA and internal rate of return (IRR), that were becoming the lingua franca of the nascent private equity industry, and he eschewed more traditional accounting measures, such as reported earnings and book value, that were Wall Street's preferred financial metrics at the time.

He had particular disdain for book value, once declaring during a rare appearance at an industry conference that "book equity has no meaning in our business," a statement that was greeted with stunned silence by the audience, according to longtime analyst John Bierbusse. Mauboussin added, "You have to have fortitude to look past book value, EPS, and other standard accounting metrics which don't always correlate with economic reality."

William Stiritz’s fierce independence.

Stiritz was fiercely independent, and actively disdained the advice of outside advisers. He believed that charisma was overrated as a managerial attribute and that analytical skill was a critical prerequisite for a CEO and the key to independent thinking: "Without it, chief executives are at the mercy of their bankers and CFOs." Stiritz observed that many CEOs came from functional areas (legal, marketing, manufacturing, sales) where this sort of analytical ability was not required. Without it, he believed they were severely handicapped. His counsel was simple: "Leadership is analysis."

This independent mind-set translated into an innate suspicion bordering on distrust of outside advisers, particularly investment bankers, whom Stiritz once described as "parasitic." He was surgical in his use of advisers—using as few as possible, always in a carefully targeted manner—and he was aggressive in negotiating their fees, holding up the multimillion-dollar Nestlé deal when he felt the bankers were overcharging him. He made a point of using different bankers for various transactions so that none felt overly secure about his business.

He was well known for showing up alone to important due diligence meetings or negotiations where the other side of the table was crowded with bankers and lawyers. Stiritz relished this unorthodox approach. A then junior banker at Goldman Sachs told me of a late-night due diligence session during the RIR Nabisco sale process when Stiritz came to a conference room at the Goldman offices alone, armed only with a yellow legal pad, and proceeded to walk through the key operating assumptions one by one before making a final bid and going to bed.

How William Stiritz manages his time.

Stiritz jealously guarded his time, eschewing high-visibility, time-consuming philanthropic boards, and avoiding casual lunches as"mostly a waste of time." As he explained, "It got to the point where they were taking up too much time, so I stopped them completely." He did, however, make time to sit on other corporate boards, viewing this as a unique opportunity to expose himself to new situations and ideas.

He was always a fox-like sponge for new thinking regardless of its origin. John McMillin, a longtime industry analyst, once wrote,"Some people are innovators and some people borrow ideas from others. Stiritz is both (and that's meant as a compliment)." He consciously carved out blocks of time in his schedule to wrestle with the key issues in the business alone, without distraction, whether on a Florida beach or in his home office in St. Louis.

He avoided time-consuming interactions with Wall Street and retained, in the words of analyst John Bierbusse, "a certain Garbo-like quality," rarely speaking to analysts, virtually never attending conferences, and never issuing quarterly guidance.

4 Traits of Outsider CEOs

They always do the math.

The outsider CEOs always started by asking what the return was. Every investment project generates a return, and the math is really just fifth-grade arithmetic, but these CEOs did it consistently, used conservative assumptions, and only went forward with projects that offered compelling returns. They focused on the key assumptions, did not believe in overly detailed spreadsheets, and performed the analysis themselves, not relying on subordinates or advisers. The outsider CEOs believed that the value of financial projections was determined by the quality of the assumptions, not by the number of pages in the presentation, and many developed succinct, single-page analytical templates that focused employees on key variables.

As George Roberts, Henry Singleton's COO at Teledyne, told Forbes magazine, "Capital discipline is so ingrained in our managers that very few low-returning proposals are ever presented to us."

Under the leadership of CEO Rex Tillerson and his curmudgeonly predecessor, Lee Raymond, ExxonMobil has exhibited similar discipline, requiring a minimum 20% return on all capital projects. During the recent financial crisis, as energy prices fell, Tillerson and his team were criticized by Wall Street analysts for lowering production levels. They simply refused, however, to pump additional oil from projects with insufficient returns, even if it meant lower near-term profits.

They have a feisty independence.

The outsider CEOs were master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest, most local levels in their organizations. They did not, however, delegate capital allocation decisions. As Charlie Munger described it to me, their companies were "an odd blend of decentralized operations and highly centralized capital allocation," and this mix of loose and tight, of delegation and hierarchy, proved to be a very powerful counter to the institutional imperative.

In addition to thinking independently, they were comfortable acting with a minimum of input from outside advisers. There is something out of High Noon in John Malone showing up solo to face a phalanx of AT&T corporate development staff, lawyers, and accountants; or Bill Stiritz showing up alone with a yellow legal pad for due diligence on a potential multibillion-dollar transaction; or Warren Buffett making a decision on a potential acquisition for Berkshire in a single day without ever visiting the company.

They consistently apply a rational, analytical approach to decisions large and small.

These executives were capital surgeons, consistently directing available capital toward the most efficient, highest-returning projects.

Over long periods of time, this discipline had an enormous impact on shareholder value through the steady accretion of value-enhancing decisions and (equally important) the avoidance of value-destroying ones.

This unorthodox mind-set, in itself, proved to be a substantial and sustainable competitive advantage for their companies. It provided the equivalent of polarized lenses, allowing the outsider CEOs to cut through the glare of peer activity and conventional wisdom to see the core economic reality and make decisions accordingly.

There are numerous examples sprinkled throughout the book of the crispness and efficiency that resulted from this pragmatic analytical approach. These CEOs knew precisely what they were looking for, and so did their employees. They didn't overanalyze: or overmodel, and they didn't look to outside consultants or bankers to confirm their thinking—they pounced. As Pat Mulcahy, Bill Stiritz's longtime lieutenant at Ralston Purina put it, "We knew what we needed to focus on. Simple as that."

In a 2009 article, Barron's described ExxonMobil's "distinctive" corporate culture with its "relentless focus en returns at the expense of ego." Not coincidentally, this frugal culture produced exceptional results, and ExxonMobil has consistently led the oil and gas industry in return on equity over the last quarter century.

They have a long-term perspective.

Although frugal by nature, the outsider CEOs were also willing to invest in their businesses to build long-term value. To do this, they needed to ignore the quarterly earnings treadmill and tune out Wall Street analysts and the cacophony of cable shows like Squawk Box and Mad Money, with their relentless emphasis on short-term thinking.

When Tom Murphy insisted on a huge spike in capital expenditures for a new printing plant or when John Malone bought expensive cutting-edge cable boxes in the late 1990s, they were consciously penalizing short-term earnings to improve their customers experiences and defend long-term competitive positions.

This long-range perspective often leads to contrarian behavior. In contrast to its controversial decision to reduce production, ExxonMobil, alone among the major energy companies, resolutely maintained its spending on exploration during the financial crisis with a view toward optimizing long-term value. When other large players retrenched from the Canadian oil sands after energy prices plunged in early 2009, ExxonMobil moved forward with a large exploration project in Alberta even though it would penalize near-term earnings.

An Example: How Warren Buffett and John Malone Navigated the 2008 Financial Crisis

If you can keep your head when all about you are losing theirs... — Rudyard Kipling, "If"

As the Nobel Prize-winning chemist Louis Pasteur once observed, "Chance favors... the prepared mind," and speaking of prepared minds, let's conclude by looking at how the two remaining active outsider CEOs, Warren Buffett and John Malone, navigated the financial meltdown that followed the September 2008 collapse of Lehman Brothers.

As you would expect, both pursued dramatically different courses from their peers. At a time when virtually all of corporate America was sitting on the sidelines, shepherding cash, and nursing ailing balance sheets, these two lions in winter were actively on the prowl.

Buffett, after a long period of relative inactivity stretching back to the immediate aftermath of 9/11, has had one of the most active periods of his long career. Since the fourth quarter of 2008, he has deployed over $80 billion (over $15 billion of it in the first 25 days after the Lehman collapse) in a wide variety of investing activities:

  • Purchased $8 billion of convertible preferred stock from Goldman Sachs and General Electric
  • Made a number of common stock purchases (including Constellation Energy): $9 billion
  • Provided mezzanine financing to Mars/ Wrigley ($6.5 billion) and Dow Chemical ($3 billion)
  • Bought various distressed debt securities in the open market: $8.9 billion
  • In Berkshire's largest deal ever by dollar value, bought the 77.5% of Burlington Northern that he didn't already own for $26.5 billion
  • Acquired Lubrizol, a leading, publicly traded lubricant company for $8.7 billion
  • Announced a sizable ($10.9 billion) new investment in IBM stock

Over the same period, John Malone has been quietly conducting an extended experiment in aggressive capital allocation across the disparate entities that were spun out of TCI's original programming arm, Liberty Media. In the depths of the financial crisis, Malone:

  • Implemented a "leveraged equity growth" strategy at satellite programming giant DIRECTV—increasing debt and aggressively repurchasing stock (over 40% of shares outstanding in 24 months).
  • Initiated a series of moves across the former Liberty entities, including the spin-off of cable programmer Starz / Encore and a debt-for-equity swap between Liberty Capital (owner of Malone's polyglot collection of public and private assets) and Liberty Interactive (home of the QVC shopping network and other online entities).
  • Swept in and bought control of Sirius Broadcasting, the satellite radio service, through Liberty Capital, in a distressed (and extremely attractive) transaction at the nadir of the market in early 2009. He also bought back 11% of Liberty Capital's shares in the second quarter of 2010.
  • Through his international cable arm, Liberty Global, announced the company's largest acquisition ever, the purchase of German cable company Unitymedia for over €5 billion (less than seven times cash flow), as well as the sale of its sizable stake in Japan's largest cable business for over nine times cash flow (with all proceeds sheltered from taxes by the company's enormous pool of net operating losses). He also continued Liberty Global's aggressive buyback program (the company has repurchased over half its shares in the last five years).

Phew… so while corporate America generally stood frozen on the sidelines, these two wily CEOs engaged in an orgy of Keynesian "animal spirits." They were, to qualify Buffett's dictum, very greedy at a time when their peers trembled with unprecedented fear.

An Example: Deciding How to Expand a High-End Bakery

Suppose you own a successful high-end bakery, specializing in baguettes and fresh pastries. The key to your success is a special oven manufactured in Italy, and you have the high-class problem of more demand than you can keep up with.

You are faced with two choices for growing the business: expand into the space next door and buy a second oven, or open a new store, in a different part of town, which also requires a new oven. A competitor of yours in a different part of the city has recently expanded its store with great success, and you've recently read about a publicly traded baking company that has grown through carefully enlarging existing stores. Conventional wisdom points to expanding your store as the right path, but you sit down and do the math.

You start by calculating the up-front cost and likely revenues and profits for each scenario, using what you believe to be conservative assumptions. You then calculate the return for each, starting with the expansion option. You've decided your personal hurdle rate: you will go forward only if the project can produce at least a 20% return. You make the following calculations: a new oven costs $50,000; additional space in your existing building costs $50,000 to build out and would likely produce incremental annual profits of $20,000 after labor, material, and other operating costs. So, you have $100,000 in up-front costs (the oven plus the build-out) and an expected annual profit of $20,000, for an expected return of 20%—right at your hurdle rate.

You then turn your attention to the new-store option. The upfront costs include an oven at a cost of $50,000 and $150,000 in build-out expenses. The scenarios for the new store are harder to predict (it's in a different part of town, and so on), but you assess the potential annual profit at $50,000–$75,000. So you calculate that you would spend $200,000 up-front, and you would expect a return of 25-37.5%. This return, even at the lower end of the range, is clearly higher than the adjacent-space option; but before deciding which path to take, you ask yourself some important, qualitative questions:

  • The new store is in a different part of town, and there is greater risk that sales will be different than what you forecast—how comfortable are you with your estimates?
  • Is the higher return enough to compensate for this additional uncertainty?
  • The new store requires twice the investment of the expansion option. Can you raise the extra $100,000 for the new-store option (and if so, at what cost)?
  • Conversely, are there hidden benefits to the new store?
  • Does it, for instance, diversify your operations, so that if sales decline in your existing store, you have some protection?
  • Does opening a second store give you insight that allows you potentially to build a much larger company over time?

These are the sorts of capital allocation questions and decisions that managers and entrepreneurs have to wrestle with every day, regardless of the size of the enterprise (although larger companies will often hire consultants and investment bankers to help them with the answers), and the same methodical, analytically oriented thought process is essential to both the baker and the Fortune 500 CEO in making effective decisions.

The Outsider’s Checklist

Checklists have proved to be extremely effective decision making tools in fields as diverse as aviation, medicine, and construction.

Their apparent simplicity belies their power, and thanks to Atul Gawande's excellent recent book, The Checklist Manifesto, their use is a hot topic these days. Checklists are a particularly effective form of "choice architecture," working to promote analysis and rationality and eliminate the distractions that often cloud complex decisions. They are a systematic way to engage systematically, and for CEOs, they can be highly effective vaccines, inoculating against conventional wisdom and the institutional imperative.

Gawande advises that these lists are best kept to 10 items or fewer, and we will conclude with a checklist drawn from the experiences of these outsider CEOs, to aid in making effective resource allocation decisions (and hopefully avoiding value-destroying ones).

So, here we go:

  1. The allocation process should be CEO led, not delegated to finance or business development personnel.
  2. Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes). Comment: Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the mid-teens or higher).
  3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions. Comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low returns.
  4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark. Comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.
  5. Focus on after-tax returns, and run all transactions by tax counsel.
  6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.
  7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?)
  8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.
  9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
  10. When prices are extremely high, it's OK to consider selling businesses or stock. It's also OK to close underperforming business units if they are no longer capable of generating acceptable returns.

Whether you are looking back or looking forward, the outsider approach to resource allocation offers a proven method for navigating the unpredictable, untidy world of business, one that has generated exceptional results across a wide variety of industries and market conditions. This checklist is a tool that can help any business, from the neighborhood bakery to the multinational conglomerate, adopt this proven approach and embrace the inherent uncertainty of the business world with open arms... and fresh eyes.

For more, I highly encourage you to order The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success and read the entire book yourself.

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About the author

Daniel Scrivner is an award-winner designer turned founder and investor. He's led design work at Apple and Square. He is an early investor in Notion,, and Good Eggs. He's also the founder of Ligature: The Design VC and Outlier Academy. Daniel has interviewed the world’s leading founders and investors including Scott Belsky, Luke Gromen, Kevin Kelly, Gokul Rajaram, and Brian Scudamore.

Last updated
Apr 28, 2024

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