#7 Rebel capital allocators (Part II)
A trilogy discovering the 10 basic principles for finding outstanding CEOs
This week we will keep digging into the principles that we should look for in our management when investing. This is an overlooked task most of the time. The fist big mistake of most investment processes, but hopefully, not anymore for you.
Let me start reminding the 10 Rebel Capital Allocator’s principles:
Treat shareholders as partners
Be obsessed improving the business with a long-term view
Be frugal and watch out non-value creating expenses
Focus on building sustainable competitive advantages
Operate decentralized organisations
Run conservative balance sheets
Think independently and full-time learner
Use simple model for complex problems
Have an out-of-the-box M&A approach
Capital allocation is king
If you missed the first 4 principles, you can read them here:
If otherwise you have them already settled in your brain, let’s move forward. We still have a lot to go. And remember, don’t distract and watch out, Mark Leonard is watching you.
5. Decentralised organisations release entrepreneurial energy and individual responsibility
Decentralisation is the cornerstone of the rebel capital allocator philosophy. The goal is to hire the best people they can and give them the responsibility and authority they need to perform their jobs. However, decentralisation does not mean having a structure of C-level executives for each area with infinite verticals of managers, but without execution capacity or responsibility for their actions.
But how to achieve efficient and functional decentralised structures? We are constantly bombarded with news spreading the benefits of centralised decision-making processes. Not only in government, but in many other social organisations. However, anyone understanding the Austrian School of Economics’ principles will know the superiority and agility over the long term of individual and dispersed organisation structures. To enable decentralised growth, rebel capital allocators assume things cannot be executed exactly the way they intend. Additionally, they are humble and perfectly aware they are not the most suitable person to carry out the day to day operations. Just the opposite to micro-management practices, our CEOs avoid constant supervision and focus on capital allocation and overall group strategy Thorndike, 2018).
Let’s now focus on real life. How do they do it? We bring here not one, nor two but three remarkable organisations to have a first grasp: Constellation Software, Embracer and, of course, Berkshire Hathaway:
Constellation Software acquires, builds & manages exceptional vertical market software companies. However, Constellation will not take over the day-to-day management of its businesses. They continue to rely on the managers and employees of their subsidiaries to run their businesses well.
Constellation overseas six "Operating Groups”. Each group essentially is a holding company for dozens of underlying software companies. Additionally, each operating group is composed of business units to serve a single vertical. Business unit managers are autonomous, often competing intensely with each other, and are held accountable only for their own results. Most of the operating decisions are made at this level, remaining only the bigger acquisitions, the overall strategy and culture in the Constellation’s headquarters.
The magic of the model is explained by Mark Leonard in his Letters to shareholders:
“I didn’t have complete confidence in a couple of the Operating Group Managers so the delegation process dragged on for a while. We eventually terminated two managers. It cost us some severance pay and time but we were able to find capable and trusted replacements from within CSI. There was a bit of a hiccup in our growth in 2006 and 2007 but the current Operating Group Managers - Barry, Dexter, Jeff, John, Mark, and Robin - have driven most of our capital deployment since 2006. They’ve developed their teams, put their own unique stamp on their groups and done a magnificent job of growing CSI’s revenue and FCF per share by more than tenfold. Each is now running a group of BU’s that is similar in size to CSI when I ran out of capacity. All of the Operating Group Managers have started the process of delegating their monitoring, coaching, and acquisition activities down to their Portfolio Managers, so the cycle begins anew.
When I look at the current generation of Portfolio Managers, I see some that have the potential to be exceptional managers and capital deployers. While that bodes well for continued growth, there aren’t enough of them to get us the ten-fold growth that we’ve had in the last eleven years. To generate that sort of growth, we need more Portfolio Managers and they need to be as competent as our current Operating Group Managers.” (Leonard, 2017)
Embracer Group is the parent company of businesses developing and publishing PC, console and mobile games for the global games market. The Group has an extensive catalogue of over 240 owned franchises. With its head office based in Sweden, Embracer Group has a global presence through its eight operative groups and 80 internal game development studios in more than 40 countries.
Similar to Tencent (another excellent company with a rebel capital allocator on top), Embracer Group takes a hands-off laissez-faire approach to operations management that allows each segment, publisher, and label to handle its own business.
Finally, Berkshire Hathaway. Where else could we find a better model? Buffett’s holding is run on the principle of centralization of financial decisions (capital allocation) at the top, and rather extreme delegation of operating authority to a number of key managers at the individual company or business unit level.
Serve as example what Buffett did as he took over the control of Berkshire in 1966 as chairman. Spoiler alert: he has kept doing the same in the last 50 years (Cunningham, 2016).
“Then Buffett explained to Chace (the new CEO in charge) the basic theory of return on investment. He didn’t particularly care how much yarn Chace produced, or even how much he sold. Nor was Buffett interested in the total profit as an isolated number. What counted was the profit as a percentage of the capital invested. That was the yardstick by which Buffett would grade Chace’s performance. To Chace, who had been reared, like most managers, to think of growth as an absolute good, this idea was new. But he grasped that it was pivotal to Buffett’s capitalist credo, and Buffett put it in terms that Chace could understand.
I’d rather have a $10 million business making 15 percent than a $100 million business making 5 percent,” Buffett said. “I have other places I can put the money.” He flew back to Omaha that night.
Buffett was serious about having “other places” to put the money. He leaned on Chace to keep the inventory and overhead as low as possible. As Chace said, “One thing Buffett wanted was to come up with cash quickly.”
Buffett also followed through with his promise of autonomy. He told Chace not to bother with quarterly projections and other time-wasters. He merely wanted Chace to send him a monthly financial report and to warn him of any unpleasant surprises. Indeed, Buffett sculpted the relationship to get the most out of it with a minimum of personal contact.
Chace’s freedom had one boundary. Only Buffett could allocate capital. And as most of the previous capital that Seabury had poured into textiles had gone for naught, Buffett was extremely reluctant to put in more. (Lowenstein, 2008).
To sum up, rebel capital allocators don’t run business operations. They have resolutive managers with better skills than them. However, they take most of their time to study and focus on capital deployment in the most effective areas. They give vast autonomy to their different operating units and demand only appropriate returns on capital and FCF to keep feeding the compounding effect.
6. They run businesses with conservative balance sheets
Our rebel CEOs believe a company's balance sheet should be handled conservatively, even if it means slower growth. They know there's a redundancy to carrying extra cash and very little debt. But we have two kidneys for a reason-increasing our chances of survival. In the business case. We're talking about more than just the company's survival. Well-run corporations serve a critical social function. They need to be financially strong enough to act as economic shock absorbers to protect employees, suppliers, and customers from the volatilities of capitalism. Free markets can do strange things to find the right price level. It's unfortunate, but it's still the best system we have for coordinating human action. You need a conservative balance sheet to be a healthy shock absorber. Business done well actually protects the little guys from natural fluctuations.
I wanted to walk in the same shoes as my shareholders and have the owners of the Company know that management is equally sharing any gain or loss. This is also a key reason why we have elected to manage Abitibi Royalties’ balance sheet in a conservative fashion. The shares we own in the Company represent a high percentage of our net worth. Each decision we make at the Company is analyzed through a very small prism of whether it will enhance the value on a per share basis, even if the impact is not immediate. (Ball, 2019)
Charlie and I have pledged that Berkshire (along with our subsidiaries other than BNSF and BHE) will always hold more than $30 billion of cash and equivalents. We want your company to be financially impregnable and never dependent on the kindness of strangers (or even that of friends). Both of us like to sleep soundly, and we want our creditors, insurance claimants and you to do so as well. (Buffett, 2022)
7. They keep learning and take their time to think independently
Most CEOs are involved on a daily basis in the day-to-day operational aspects of the company, leaving little time for any other topic. Under these conditions, it is not surprising the vast majority of CEOs cannot take a long-term view.
Our rebel capital allocators love reading. Furthermore, they read, think and read again. No man steps in the same river twice, for it’s not the same river and he is not the same man (Jack Handy)
Warren Buffett credits his success to his voracious reading habit. He says he starts every morning by poring over several newspapers and estimates he spends as much as 80 percent of his day reading. “Read 500 pages like this every day. That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life.”
Mark Leonard conveys the importance of reading, but he also repeatedly points out that he greatly appreciates time. It may seem counterintuitive since reading takes a lot of time, but the value we can extract if we select our readings is incalculable.
We have to be honest. Our current society does not reward this kind of life. They are the philosophers of our time. No wonder why I call these types of individuals rebels. This monastic lifestyle links directly with our next point.
8. Simple models to outperform peers
We have seen our rebels spend most of their time thinking. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. But they are far from conventional. One of the main advantages of independent thinking is the capability to create personal mental schemes to rationalise our decisions, simplifying the complex reality into simple models.
Simple models thrive when (Taylor, 2018):
Problem is ill-structured and complex.
The information is incomplete, ambiguous, and changing.
The goals are ill-defined, shifting, or competing.
The stress is high, due to time constraints and/or high stakes.
Normally, when we listen to brilliant people, we are impressed by their ability to express complex situations in very simple and didactic terms. This doesn't happen by magic, because they're so smart, or because they just came up with this wonderful idea. It is the reflection and the result of a rational process, continuous learning and time. It is the process of ordering our set of anarchic thoughts in simple and ordered rational models. In this way, when we listen to Buffett, we always hear him repeat the same simple and masterly ideas. Hence his clear and simple investment style.
Buy businesses within your circle of competence with discretionary consumer products and wide competitive moats, run by honest and passionate managers where you can easily predict the future cash flows . As intrinsic value is subjective, pay a fair price for these businesses and keep a margin of safety in case you were wrong in your valuation.
This is magnificent! It even looks simple to replicate! Economy, financial markets and investing can not be so basic. However, it is actually not that difficult. The problem is that there is only one Warren Buffett.
Something similar can be seen if we review the Constellation model to acquire new businesses. They have done it already for over 500 companies, and numbers corroborate they have done it quite well. What do they like in a business
Recurring and sticky revenue. Mission-critical businesses have high switching costs and make up a small share of the customer wallet (typically 1%) so switching isn't worth the hassle.
Asset light - With no major capital investment requirements, companies have the capability to downsize in case business slows down.
High gross margins and minimum ROIC
A clear price hurdle rate
This principle is applicable for all of us against complex situations. Try to build a simple model of actions for a complex situation you face recurrently, and keep to them over the long term, fine-tuning if needed. You will see the outcomes are consistently better than just improvising.
This is all for this week. For the last release of this trilogy, we will touch upon the two most important principles: how the rebels allocate capital and how they deal with the always controversial mergers and acquisitions.
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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
Buffett, W. (2022). Berkshire Hathaway annual letter to shareholders 2021. https://www.berkshirehathaway.com/letters/2021ltr.pdf
Cunningham, L.A. (2016). Berkshire’s Blemishes: Lessons for Buffett’s successors, peers and policy. Columbia University Business Law Review (July 2016) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2807131
Leonard, M. (2017). Constellation Software letter to shareholders 2016. https://www.csisoftware.com/docs/default-source/investor-relations/presidents-letter/2017-presidents-letter-1.pdf
Lowenstein, R. (2008). Buffett: The Making of an American Capitalist. Random House
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.