#6 Rebel capital allocators (Part I)
A trilogy discovering the 10 basic principles for finding outstanding CEOs
Don’t fool yourself. When we buy a share, we ultimately invest in people running a business. Better said, we invest in the integrity and culture of these people. But we rarely stop to think about it. Buffett has said several times that he invests in companies that could be run by a monkey, while using the example of Coca-Cola. But I do not believe him. A bad CEO in an incredible company will end up sinking it, and we have recent examples in Apple post Steve Jobs (1st tenure) or Microsoft after Gates. However, an excellent capital allocator running “mediocre” businesses can spark value everywhere. This is why I believe the analysis of the CEO and management team of a company is the most often forgotten and most important driver for long-term successful investing.
Harvard Business Review recently released an article titled: What Sets Successful CEOs Apart (Bothelo, 2022). Their key points: a) deciding with speed and conviction, b) engaging for impact, c) adapting proactively and d) delivering reliably.
Let me tell you. Don’t waste your time there. All bullshit. Sorry, maybe these are the key skills if you want to go unnoticed in history.
In this post we will articulate the clues to discover another type of individual, what I like to call a Rebel Capital Allocator. Rebels never follow the instructions given. They enjoy figuring things out for themselves. They are curious about the world around them and enjoy the liberating feeling that discovering brought them.
These are my Rebel Capital Allocator’s principles:
Treat shareholders as partners
Are obsessed improving the business with a long-term view
Watch out non-value creating expenses and frugality
Focus on building sustainable competitive advantages
Operate decentralized organisations
Run conservative balance sheets
Think independently and full-time learners
Use simple model for complex problems
Have an out-of-the-box M&A approach
Allocation of capital is king
I myself do not claim the ability to predict what will happen and the returns of this or that company. I am no economist, politician or fortune teller. Still, I'm pretty sure that by finding and investing in people who meet the following qualities, it won't be hard to outperform the market in the long run.
Join me and let’s begin to explore the qualities to be entitled as a rebel capital allocator.
1. They view shareholders as partners
Read again because the statement has strong implications. First, a CEO is appointed by the shareholders to accomplish a certain vision. Never forget it. Second, we are the CEO’s partners. We both have to share the same destiny. That is, the CEO has to have most of his wealth with us. We want aligned incentives. All of this is not obvious and it happens less often than we might expect.
If a CEO thinks of his shareholders as partners in the business, he would make better decisions on their behalf. Not everyone thinks this way. These CEOs serve as fiduciaries. They take full responsibility for their financial well-being with respect to the stock. The majority of CEOs and managers are like most investors and prefer the safety of the crowd. They have a penchant for buying back their stock in boom periods when all is rosy and the general market is going up (situation we see everywhere now in the market at the edge of an interest rates raise campaign).
At what price would a CEO want his company's stock to trade? Ideally, you'd want the price of a share to change hands at the exact intrinsic value of the business. That way, both the exiting partner and the new incoming partner are each getting their money's worth. And here we find the first problem: most CEOs have no idea what should be their intrinsic share price. A good CEO will buy back shares when the price is below the intrinsic value (if this is the best opportunity cost allocation at the moment), and will tell publicly that his stock is overvalued. You will hardly ever find a CEO wanting his stock to drop. This is a great indicator of a rebel capital allocator.
It might be difficult to find CEOs treating shareholders as partners and one might not know where to start. But it is not. Word choices impact our thoughts and actions, so letters to shareholders are great initial points:
“As many long-term shareholders know, I have been investing all my after-tax compensation into the shares of the Company since joining 4.5 years ago. It is my intention to continue with this practice. I would not ask you to become a partner in the business and then invest my own money somewhere else. My personal fortunes are tied to the Company. Our goal remains focused on becoming The Best Gold Company and for me, this is about generating the best long-term share performance. It is also about creating a company that shareholders are proud to own.” (Ball, 2018)
Ian Ball, former CEO and President Abitibi Royalties obtained an annualised compounded return over 80% during his tenure from 2014 until 2021. He ran a small gold royalty company with other 2 employees. The headquarter building was a prefab barrack.
2. They are obsessed improving their business with a long-term horizon
Wall Street dictates and make most managers focus on the next quarterly earnings and short term performance of the business. We live in a world where patience may be the least-exploited advantage in the game.
Rebel capital allocators don’t care about Wall Street analyst or short-term volatility. They strive for continuous incremental improvement. They seek to compound everything. If you think about it, a continuous small percentage improvement over long periods of time leads simply to crazy results. They test continuously to deliver extra value to the customers. Testing small to make sure they have adequate returns on capital before trying to scale up and grow.
Move first, experiment constantly, and fail fast.
The case of Amazon, Jeff Bezos, and now Andy Jassy in this dimension is absolutely paradigmatic. While Google and other firms spend billions researching artificial intelligence and machine learning, Amazon is interested in monetizing artificial intelligence and applying it in every aspect of the organization. The company will often invent something or develop some new capability for its own needs, only to find that it can monetize that invention for others (Tucker, 2018). These entrepreneurial dynamics have given birth to the success of the Kindle e-reader in 2007, the failure of the Amazon Fire phone, and eventually the best business of Amazon so far: Amazon Web Services.
“We think of iterative innovation in much the same way. Iterative innovation creates magic for customers. Constantly inventing and improving products for customers has a compounding effect on the customer experience, and in turn on a business’s prospects.
Time is your friend when you are compounding gains. Amazon is a big company with some large businesses, but it’s still early days for us. We will continue to be insurgent—inventing in businesses that we’re in, in new businesses that we’ve yet to launch, and in new ideas that we haven’t even imagined yet. It remains Day 1.” (Jassy, 2022)
3. They often embrace frugality
What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. Adam Smith
Our rebel allocators are different to the vast majority of CEOs out there. They do not need extra luxuries to feel happier. They simply love what they do and understand that money spent on the business has to create value and hence, have a return.
We could again use Warren Buffett and Berkshire as example. Not surprisingly, Buffett has lived in the same house for 60 years and Berkshire Hathaway's offices are extremely modest. But to make our point, we are showing that this is a quality commonly repeated among these exceptional individuals. Mark Leonard, CEO and President of Constellation Software, is almost 2m tall and weights over 120kg. He still travels in tourist class because he is aware his shareholders and partners are paying for it and furthermore, he acts as an exemplary role towards his employees. Compare it with policies in big companies where any of the employee traveling over 2h have the right to travel in business class.
For these reasons, our rebel capital allocators differentiate between non-strategic and strategic expenses. Strategic expenses advance the strategy of delighting the customer. They seek to outspend the competition by a long shot. They build moat around the castle so customers only want to do business with them. Non-strategic expenses don't create value and they have to be removed or reduced as much as possible.
Do Constellation software need a flashy and top-notch webpage? Will it create any value to customers? Here we have an example of a non-strategic expense. Therefore, unchanged in decades.
The same applies to all these companies with modern and shiny offices in the city centers. Large spaces whose ultimately value is to enlarge the ego of their managers. Does this generate any value for our customers? What is the return on this invested capital?
A transcendental point, which is worth a complete new post, is the zero base budgeting: normally, budgets are taken from the previous year and slightly modified. Adopting zero base budgeting means that any expense must be justified as strategic and value creating for the company. Good capital allocation means doing more with less to create happier customers. The pressure to continually deliver value is one of the wonders of the free market.
4. They focus on building strong competitive advantages, rather than ambition to grow:
“Growth is simply a component, usually a plus, sometimes a minus, in the value equation.” Warren Buffet
Growth can destroy value when the returns on capital invested are below the cost of capital or the opportunity cost. This is a concept overlook by many investors and management team. Distrust any CEO talking in terms of revenue growth or EBITDA margins. However, embrace the ones commenting about improving ROIC or ROCE over the time.
Some CEOs would make you believe ROIC is not such a huge deal, but a positive or negative ROIC is a huge deal when you look at the entire capitalistic ecosystem. Misallocation of capital is bad for a company because it has less profits to reinvest. It’s bad for the customers because the invested project has turned out in something the customer didn’t want. It’s bad for the environment because the company invested energy and materials to build something that will likely be torn down. And it is bad for the society because not making progress is a waste of everyone’s time and talent (Taylor, 2018). It is amazing how, when we view the world through this lens, capitalism puts everyone on the same team. Capital allocation done well is good for everyone at different levels. We don’t celebrate it enough.
In the end, it all comes down to the company culture and CEO’s commitment with the mission and building sustainable competitive advantages. As many other times, I can not find better words than Mr. Buffett’s to express it:
“Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term.
But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.” (Buffett, 2006)
Most CEOs won’t admit they have a commodity business. If you cannot increase prices without losing customers, you are providing a commodity. There is nothing wrong having a commodity business. You are often keeping the wheels of the world turning. But it does change what you should focus on: operational excellency to become the lowest cost provider. We have outstanding examples in traditionally catastrophic businesses (from a shareholder point of view), such as the airliners with Southwest Airlines or Ryanair.
Here we finish the first 4 points defining our rebel capital allocators. In the next two weeks, we will go deeper and explore other dimensions often forgotten, to finish our decalogue on rebel capital allocators.
References:
Ball, I. (2019). Annual letter to the shareholders of Abitibi Royalties. https://static1.squarespace.com/static/5e274a28cbaf5d0d3e29734b/t/5e46f294ec2173472dbbd079/1581707924239/Annual+Letter+dated+May+13+2019.pdf
Ball, I. (2020). Annual letter to the shareholders of Abitibi Royalties. https://static1.squarespace.com/static/5e274a28cbaf5d0d3e29734b/t/5ecd07e595a4d74aea75a23c/1590495205242/Letter+to+Shareholders+2020+%28Final%292.pdf
Bothelo et Al. (2022). Harvard Business Review: What Sets Successful CEOs Apart. https://hbr.org/2017/05/what-sets-successful-ceos-apart?utm_campaign=hbr
Buffett, W. (2006). Berkshire Hathaway annual letter to shareholders 2005. https://www.berkshirehathaway.com/letters/2005ltr.pdf
Jassy, A. (2022). Amazon annual letter to shareholders 2021. https://s2.q4cdn.com/299287126/files/doc_financials/2022/ar/2021-Shareholder-Letter.pdf
Taylor, J. (2018). The Rebel Allocator. 5GQ Publishing
Thorndike, W. (2012). The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Harvard Business Review Press.
Tucker, R. (2018). Forbes: How Does Amazon Do It? Five Critical Factors That Explain Amazon's Incredible Success. https://www.forbes.com/sites/robertbtucker/2018/11/01/how-does-amazon-do-it-five-critical-factors-that-explain-amazons-incredible-success/?sh=2723672141b9
PD: Regarding the book “The Rebel Allocator”. Charlie Munger loved the book. He actually called the author and encouraged him to make it a movie. I recently read it and motivated me to write this post to reflect about the key learnings.
I leave here an interview to the author.
Just stumbled on this piece. Great work!