The Intelligent CEO
Value Investing - Capital Allocation - Investor Mindset - Long Term Value for Shareholders
Hello, I am Nicolas Bustamante, and each week, I write about concepts and methods to build successful businesses.
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Surviving Capitalism with Competitive Moats
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This essay's title is a tribute to the book The Intelligent Investor written by the father of value investing, Benjamin Graham. I have previously reported that a small number of investors use value investing principles to beat the market over a long period. Most investors may prefer to be long-term passive index investors, which is the best way to compound wealth from a risk-adjusted-return perspective. There is one job that doesn't offer the two options: Chief Executive Officer (CEO). Every CEO is an active investor allocating the capital of his company. In the long run, the difference between a good and a great company is the CEO's capital allocation skills.
Chief executive officer is a multi-faceted job. When launching a company, the CEO is the doer-in-chief, deeply involved in building the product and acquiring customers. Delegation isn't an option; the CEO has to do whatever it takes to achieve product-market fit. Then, the CEO mutates to the company-builder-in-chief focusing on hiring people and setting the right framework for the company to scale. Once the company generates cash flows, the CEO goes on to become the capital-allocator-in-chief. The CEO has no choice but to become an Intelligent CEO.
The Intelligent CEO creates outstanding businesses that increase their intrinsic value over time by delighting customers. Maintaining the highest customer obsession is the Intelligent CEO's constant challenge. Intelligent CEOs build lasting businesses where the grandchildren of today's teammates will be happy to work. This way, they maximize value creation for shareholders such as founders, investors, employees, and, more broadly, anyone who bought the company's shares.
Intelligent CEOs build competitive moats. They know that it's not the size of the castle that matters but how defensible it is. Network effects, a meaningful brand, and the domination of distribution channels ensure the company's long-term prosperity. Long-term profits only exist if the company is able to maintain a competitive edge over its competitors. It's particularly vital in the tech industry, where there are increasing returns to scale.
The Intelligent CEO surrounds himself with talented and honest managers. They reveal the good, the bad, and the awful, not hiding challenging problems. Intelligent CEOs work with a small board of directors, of whom each has a significant portion of their net worth in the company. Preferably, external directors don't derive a majority of their revenue from the board position. Intelligent CEOs believe in the purchasing of ownership versus the granting of stock options. Being an owner requires assuming downside risk; it otherwise creates an asymmetry of risk. As Charlie Munger famously said: "show me the incentive, and I will show you the outcome."
The Intelligent CEO keeps costs under control. A great company must operate in the leanest way possible. Costs that are too high jeopardize the company's future. Costs reduce profit margins, meaning the company has less capacity for investment and a smaller margin-of-safety. Furthermore, Intelligent CEOs know that throwing more money at a problem often doesn't solve the problem. Frugality nurtures creativity. Any cost that doesn't drive long-term revenue has to be questioned.
Once the company has solid foundations, the Intelligent CEO transitions from being the company-builder-in-chief to the capital-allocator-in-chief. Intelligent CEOs delegate oversight of operations in order to focus only on long-term strategy and capital allocation. They think more like investors than managers. The Outsiders: Eight Unconventional CEOs, by William Thorndike is an ode to capital allocators. In it, he "profiles several Intelligent CEOs, including Tom Murphy of Capital Cities, Henry Singleton of Teledyne, Bill Anders of General Dynamics, John Malone of TCI, Katharine Graham of The Washington Post Co., Bill Stiritz of Ralston Purina, Dick Smith of General Cinema, and Warren Buffett of Berkshire Hathaway.
The Intelligent CEO leads the capital allocation process. Most distrust advisers and, as Bill Stiritz put it, avoid being at "the mercy of bankers and CFOs." They make multi-billion-dollar investments without investment bankers or M&A staff. Intelligent CEOs John Malone and Bill Stiritz were famous for showing up alone facing armies of corporate development staff, lawyers, and accountants. Intelligent CEOs are focused, so they are reluctant to speak with wall-street analysts, journalists or appear on magazine covers. Their unusual combination of conservatism and boldness, as well as their confidence in their analytical skills, allow them to act boldly when they see compelling discrepancies between value and price. Let's dig into the process.
The Intelligent CEO starts by determining the hurdle rate, which is the minimum acceptable rate of return, giving insights into whether an investment should be made. Warren Buffet uses a whopping ten percent rate. The key is then to calculate the risk-adjusted-return for all internal and external investment alternatives, using conservative assumptions. The Intelligent CEO has few options to deploy capital, including investing in the existing business, acquiring other companies, issuing dividends, paying down debt, or repurchasing stock. Warren Buffet complains that too many CEOs reinvest in their business at below-average returns and, worse, acquire expensive companies in an attempt to buy growth. Every dollar retained must create at least one dollar of market value. If not, the solution is simple according to Buffet: "If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained."
Intelligent CEOs know that the best allocation is often their current business. Such investment might create a better product, expand geographically, reach new customers or widen the economic moat. Intelligent CEO Katherine Graham of the Washington Post writes in her shareholder letter: "Our preference is to allocate capital into our existing businesses. We know the management, understand the businesses, and think our best returns will be found here because of those two things." Knowledge offers an excellent hedge that is a sharp contrast with investing in another company.
The Intelligent CEO knows how and when to acquire companies. They are always on the hunt for well-run, profitable businesses with good capital returns and strong, honest, and talented management. Expect Intelligent CEOs to buy what they know at a price below the company's intrinsic value. Don't be surprised if they stand aside when prices, driven by hot money, seem foolish. Fighting the institutional imperative and peer pressure requires Intelligent CEO to be fearful when others are greedy and greedy when others are fearful. They wait until the value-to-price ratio is favorable. This margin-of-safety provides them with higher returns and fewer risks.
The Intelligent CEO knows that stock buybacks create value for shareholders when the company's stock sells well below conservatively calculated intrinsic value. Buying a dollar for fifty cents is always a good deal. Repurchasing shares is a better way to distribute capital than dividends because it allows deferring taxes to compound more capital. Intelligent CEOs Henry Singleton of Teledyne and John Malone of Tele-Communications generated more than 40 percent compound annual return for shareholders with buybacks.
The Intelligent CEO is reluctant to pay dividends. First, it might not be the best allocation and, second, it creates tax consequences for all shareholders. In the words of Fairfax's CEO, Prem Watsa: "every one dollar retained by Fairfax (as against paying it out in dividends) has resulted in at least one dollar of market value, with no taxes paid by our shareholders. As long as this test continues to hold and we continue to earn 20% on our shareholders' equity, we won't be paying any dividends because it would be contrary to the interest of long-term shareholders." Intelligent CEOs, however, don't hesitate to pay dividends when they can't reinvest in the business, acquire a company, or buyback shares without generating above-average-returns for shareholders.
With such capital allocation skills, Intelligent CEO attracts long-term shareholders. Such CEOs are proud of the low turn-over of their company's stock. Needless to say that Intelligent CEOs never split shares because they know that increasing the number of slices doesn't increase the cake's size. Intelligent CEOs try not to raise money or pay acquisition in stocks knowing the punitive dilution cost for shareholders. They also fear the short-term inclination of most private equity investors. They prefer conservatively raising debt for value creation purposes. The level of debt is always low because Intelligent CEO loves a strong balance sheet.
Intelligent CEOs are conservative yet bold. They understand that the world is driven by rare, unpredictable, and high-impact events. They are on a mission to build robustness and anti-fragility to resist fat-tailed risks. It took AIG, a finance and insurance corporation, 90 years to build a $100bn dollars business, and one crisis in 2008 to lose it all. Often seen as paranoid, Intelligent CEOs are well aware that the key is to survive long enough to win. They embrace volatility that they perceive as an opportunity to deploy cash when short-term people panic.
When running a company, the CEO has no choice but to become a good investor. Intelligent CEOs disdain dividends, make disciplined acquisitions, use little or no leverage, buy back a lot of stock, minimize taxes, run decentralized organizations, and focus on cash flow over reported net income. Intelligent CEOs build value over time to push humanity forward!
Ps: the cover photo features Henry Singleton, the archetype of an Intelligent CEO.
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I agree mostly with your article, but I don't understand why "Intelligent CEOs never split shares". If a single stock is worth too much, it might be a problem for example to give shares to employees, so it might make sense to divide them in that case don't you think?