#9 Rebel capital allocators (Part III)
A trilogy discovering the 10 basic principles for finding outstanding CEOs
The 3rd act of any play can hardly outlive the first two. But this is not going to be the case. We left the two the most important differentiators for a rebel capital allocator for the end. Additionally, we will run an experiment to actually apply our principles empirically on a potential rebel and see the outcome. I advance the result will surprise you.
If you missed the first 8 principles, you can read them here:
If otherwise you have already settled them for good, let’s move forward. We still have the most important ones to go. Focus and take notes, don’t disappoint them.
9. Out-of-the-box M&A strategy
In a business climate marked by escalating global competition and industry disruption, successful mergers and acquisitions are increasingly vital to the growth and profitability of many companies. Yet research shows most mergers fail, destroying shareholder value and costing companies billions in dollars. Over the decades, multiple studies have shown that most mergers and acquisitions fail to generate the anticipated synergies, and many actually destroy value instead of creating it. In other words, a significant percentage of M&As cause 2 + 2 to equal 3 instead of 5 (Fernandes, 2019).
However, surprisingly, our rebel capital allocators have consistently created value with their acquisitions. How is it possible?
We have seen that these people are essentially different to any of the Wall Street animals we can find out there. They simply approach M&A as an investment.
It is worth to differentiate two types of individuals in this case:
The serial acquirers: whose business model is based on constantly acquiring new smaller companies to grow and to reinvest the FCF generated into new acquisitions in the same industry or vertical. Clear examples already described would be Constellation Software or Embracer. These companies have internal M&A groups focused on developing the business.
The opportunistic acquirers: any other company whose business growth is not dependent on acquisitions. Here is where we can find most of the failures, as sporadic and big acquisitions tend to destroy shareholders’ value. But it is not always the case. Take a look at the immense value created after Instagram’s acquisition by Facebook or YouTube by Alphabet.
Nevertheless, even if the frequency of their activities in the M&A spectrum are different, both of them share the same principles, summarised in the following points (Taylor, 2018):
Motivation: the first thing to examine is the intrinsic motivations for wanting to do a deal. It could be surprising, but the CEO’s ego could be lacking a bit of thrill of action to be in the game (same similar human behaviour as many investors buying new stocks continuously). Masked in market share gain or economies of scale, many times we can find simply size, status and ego.
Synergies: there are two types of potential synergies: revenue and cost. You can basically forget about revenue synergies where two businesses sell more just because they are combined. It hardly ever happens, and never to the degree that is projected. Businesses are rarely complementary in that way. Cost synergies can be real, especially in the back office. It depends on how well each of the companies are run in their strategic versus non-strategic expenses before the merger.
Additionally, rebel capital allocators avoid acquisitions/mergers of companies with a similar size. A simple rule of thumb would be that there must be a 1/10 difference in the size to have the potential to create value.
Payment method: always watch out issuing shares for an acquisition, it is like printing your own currency (and we know the results of it). A good CEO will never issue shares unless they receive as much intrinsic value as they are giving up. If they are able to use your stock that’s priced at twice what you know it’s worth to acquire a company for half that’s worth, it doesn’t take a genius to figure out they stand to add a lot of value for their shareholders. But sadly, few think this way.
Acquirer overpays: often due to overoptimism. However, there is a first mover advantage to being early in the cycle because there are more higher quality targets, fewer competitors, and usually lower valuations early on.
Last, but not least, never trust pitch books put together by investment bankers. The incentives are simply different. They want the deal to be done, therefore, incentives dictate behaviour.
Treat this point as an appetiser on M&A operations. We would go further and deeper into M&A value creation. Subscribe so you don’t miss it.
10. Effective capital allocation requires evaluating all options
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 investing, 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. (Thorndike, 2012)
Same as with the M&A approach, we will discuss here some basics on capital allocation, but it is intended to dive way deeper in future posts. However, I would like to discuss a point many times misunderstood in the financial community: the dividends.
The magic of compounding can happen inside a company when a high ROIC strategy has a long runway to absorb a lot of capital and keep providing high returns. If you're an investor, you want management to unlock the compounding machine inside the business. Then you have to do all you can not to take any money out of it. You want to keep your money tied up in this machine that feeds itself and keeps growing. Taking money out would be a terrible idea, including to pay a dividend.
Paying a dividend should be the last resort for a rebel allocator. It's like a confession that they have a lack of attractive ideas. It says a lot actually: They can't reinvest back in our business and find profitable growth. There are no acquisitions that would be productive for their partners. There are no marketable securities they could buy on their behalf that are undervalued. The price of their own stock is high enough to be inappropriate to buy back. In essence, they're saying they can't find anything smart to do with this money, so they are giving it back to their partners.
When a company issues a dividend, it gets applied to all of the owners equally. That may sound like a good idea to treat everyone the same, but what if you're an investor who doesn't have any use for the money at that time? Too bad, everyone has to take the dividend when the corporation says so and pay taxes for it. Instead, the people who have expenses they need to pay can sell a little of their stock when they need the cash. For everyone else, they get to keep their money in and hopefully compounding. You get to self-select. A dividend takes away that freedom of choice and stops compounding. Never stop compounding.
One of the arguments in favor of fat dividends is you can't trust management to make smart decisions with the money. A dividend takes the money out of management's hands before they do something boneheaded with it. If that's the case, I'd rather just find more capable management (Taylor, 2018).
Lastly, on capital allocation we shall never forget our next best option is our opportunity cost. Important to not define the menu too narrowly. Imagine you own a restaurant franchise and you plan to acquire some land to build a new restaurant. How many ways could you proceed? You could buy the land, hire a construction crew and build one, right? But there are more strategies: a) buy the land and erect the building later, b) buy land and wait, c) buy a competitor’s store and convert, d) buy public stock e) buy back your own stock, f) just wait, g) … A rebel capital allocator considers not just the short-sighted options for capital deployment, but both the visible and invisible possibilities available to spark outstanding value.
Wrapping-up with Bruce
We've covered each of the 10 basic principles for finding a rebel capital allocator. As any investor, I like to see what my “competition” is doing. In Part I of this trilogy, we reviewed What Sets Successful CEOs Apart for the Harvard Business Review (Bothelo et Al, 2022). I came up lately with the following slide from McKinsey on the six elements for an excellent CEO (Dewar et Al, 2019):
Although infinitely more valuable than the ones from our colleagues at Harvard, I happen to miss the characteristics of our rebel capital allocators. No doubt a CEO with these skills must become a great operator CEO. But the same way extraordinary companies are not found everyday, there are only a bunch of rebel capital allocators. In our current dynamic, impatient and short-term society, the blossoming of these types of characters is scarce.
To finish this series of articles on capital allocators, I would like to review our principles by the hand of another exceptional CEO and rebel capital allocator: Bruce Flatt from Brookfield Asset Management. Bruce joined Brookfield in 1990 and became CEO in 2002. Brookfield focuses on direct control investments in real estate, renewable power, infrastructure, credit and private equity. During his tenure as CEO, Brookfield has multiplied its value by over 20 times.
I ran a simple experiment. I read a random interview given by Bruce. I took notes and compared his comments with my 10 principles. Here is the result:
1. Treat shareholders as partners
It is important to build a business and all relationships based on integrity as running a business for the long term needs strong relationships, both outside the company and with the people within the business.
2. Obsessed improving the business with a long-term view
First, companies should measure success based on total return on capital over the long term, which would prevent them from making the mistake of looking at short-term objectives within the business.
3. Watch out non-value creating expenses and frugality
It is necessary to treat the client and shareholder money like it’s their own before making a business decision.
4. They focus on building strong competitive advantages, rather than ambition to grow
Companies should seek profitability rather than growth, because growth does not necessarily add value.
5. Operate decentralized organisations
Companies should try to encourage its people to take calculated risks, which should be compared with the return that one might get out of the investment.
To be successful, it is also important to sacrifice short-term profit, if necessary, to achieve long-term capital appreciation.
It is also important to attract and retain high-calibre individuals who can grow with the company over the long term and ensure that these individuals think and act like owners in all their decisions.
6. Run conservative balance sheets
N/A
7. Think independently and full-time learners
Often our investments are longer term and are more illiquid than others. So, our advantage is that we’re willing to be longer-term investors, and we’re willing to have something that’s illiquid versus what others might accept. Often they’re larger in size, and that’s not attainable by others. And most of the time, when we’re making a investment , it’s not fashionable. Most investors follow fashion. If you cannot follow fashion and follow value, the returns will be much greater over the longer term
8. Use simple model for complex problems
It is crucial to keep the business model very simple. We try to utilise our global reach to identify and acquire high-quality real assets on a value basis and finance them on a long-term, low-risk basis. Further, we enhance cash flows and value of these assets through our leading operating platforms and source equity from clients seeking exposure to property and infrastructure returns. This strategy should be repeated over and over with assets with similar cash flow characteristics.
9. Have an out-of-the-box M&A approach
In 2016, we bought a graphite electrode company in the United States out of bankruptcy. And at that time, the steel market was incredibly under stress. But we were able to purchase it and it was really only because there was nobody else in the market that would put capital into the steel industry at that point in time. We've now taken it public at eight times the price that we paid.
10. Effective capital allocation requires evaluating all options
The wealth that can be generated through compounding of returns is significant. It's amazing what it accomplishes if you don’t make too many mistakes or lose capital on the way through and you just keep compounding a return. And it really is an amazing concept in the world of investing. Keep buying great investments and holding them for compounding returns. Don't pay taxes by selling them. And don't look for fashion when you make them. […] It most often indicates value because the competitive product that will ultimately compete against you will cost more than what you paid. So you should be able to either earn a higher return or out price your competition during the investment. And that's probably the number one thing, which is why in our business what you're always trying to do is to move your capital to the places where others are not.
9 out of 10 in one single interview. I am myself surprised with the result. Our framework is actually easily actionable and applicable. And the best of all, it works. Bruce Flatt is clearly another of our rebel capital allocators.
I hope you have enjoyed this trilogy discovering the 10 basic principles for finding outstanding CEOs. I intend to go deeper in some of the points I consider extremely important and I would like to think further on. Nevertheless, I have definitely clarified and organised my thoughts. From now on, I hope this framework helps you identify these outstanding individuals and make you improve your results over the long-term.
Subscribe and comment if you liked and share with your colleagues if you think any could be interested.
I leave you in good hands with Bruce.
References:
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
Fernandes, N. (2019). The Value Killers: How Mergers and Acquisitions Cost Companies Billions—And How to Prevent It. Springer International Publishing
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.
Dewar et Al. (2019) The mindsets and practices of excellent CEOs. McKinsey & Company. https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-mindsets-and-practices-of-excellent-ceos
#9 Rebel capital allocators (Part III)
One thing is saying (and PR) and another doing. If I remember well, Brookfield hasn't treated minority shareholders very well in some of their publicly traded partnerships/vehicles... Uses their position to go for buyouts at very lowballed offers. But that is from memories from articles, can't say for sure from my own experience