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

by William N. Thorndike Jr.

That exception, however, helps make an important point about capital allocation. The central event of Chabraja’s tenure was the Gulfstream acquisition. So, how exactly did he pay for this massive deal? His approach was opportunistic and unusual—in a radical departure from the Anders playbook, Chabraja sold stock. A lot of stock. This was a seemingly dilutive move. Closer examination, however, reveals its sophistication (and kinship with Anders’s principles). As figure 3-2 shows, the equity offering coincided with an all-time high trading multiple for General Dynamics’ stock (not unlike Buffett’s large purchase of Gen Re, also done with a stock currency then trading at a record premium). As Chabraja described it to me, “What drove me was the realization that the stock was trading at a significant premium to our historic norm: twenty-three times next year’s projected earnings versus an historic average of sixteen times. So what do you do with a high-priced stock? Use it to acquire a premium asset in a related field at a lower multiple and benefit from the arbitrage.”11 As Ray Lewis summarized, “Nick sold shares equaling one-third of the company to acquire a business that provided half of our consolidated operating cash flow.”

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.

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 percent 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.

There is an apparent inverse correlation between the construction of elaborate new headquarters buildings and investor returns. As an example, over the last ten years, three media companies—The New York Times Company, IAC, and Time Warner—have all constructed elaborate, Taj Mahal–like headquarters towers in midtown Manhattan at great expense. Over that period, none of these companies has made significant share repurchases or had market-beating returns. In contrast, not one of the outsider CEOs built lavish headquarters.

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.

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.

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 twenty-five hundred, 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.

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.”11 This attitude was very different from that of the leaders of other cable companies who regularly trumpeted their extensive investments in new technologies.

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.

Graham’s approach to deploying these earnings was influenced by Simmons, Buffett, and another director, Dan Burke of Capital Cities. All capital expenditure decisions were submitted to a rigorous approval process, which required attractive returns on invested capital. As Alan Spoon summarized it, “The system was totally federalized, with all excess cash sent to corporate. Managers had to make the case for all capital projects. The key question was, ‘Where’s the next dollar best applied?’ And the company was rigorous and skeptical in answering that question.”1 This discipline led Graham to a more cautious approach to physical plant investments than that of her peers. During the 1980s, other large newspaper companies spent hundreds of millions of dollars to install new printing and prepress facilities that allowed shorter lead times and color printing. Graham, alone among major newspaper CEOs, held back, eventually becoming the last major publisher to rely on old-fashioned letterpress printing, deferring the expensive investment in a new plant until costs had dropped and the benefits had been definitively proven out by peers.

With her board, she subjected all potential transactions to a rigorous, analytical test. As Tom Might summarized it, “Acquisitions needed to earn a minimum 11 percent cash return without leverage over a ten-year holding period.” Again, this seemingly simple test proved a very effective filter, and as Might says, “Very few deals passed through this screen. The company’s whole acquisition ethos was to wait for just the right deal.”

Buffett played a key role in this discipline, functioning as Graham’s allocation court of appeals and weighing in on all significant decisions involving capital investment. He was particularly involved with acquisitions. Buffett’s style, however, was not directive, according to longtime board member and Cravath, Swaine partner George Gillespie: “He would never say, ‘Don’t do that,’ but something more subtle, along the lines of, ‘I probably wouldn’t do that for these reasons, but I’ll support whatever you decide.’”4 His reasoning, however, was invariably compelling and usually encouraged restraint.

As we’ve seen, stock repurchases were another major capital allocation outlet for Graham. Once Buffett explained the compelling math of repurchases, she initiated a buyback program and pursued it with vigor. Graham would add enormous value for her shareholders by buying in a massive amount of stock (almost 40 percent eventually), most of it purchased during the 1970s and early 1980s at single-digit P/E multiples.

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.

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 percent of Ralston’s enterprise value, both of them largely financed with debt.

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 percent to 15 percent, and return on equity more than doubled, from 15 percent to 37 percent. 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).

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.

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, as figure 6-2 shows.

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, and after convincing his board to support him, he became an active repurchaser. He would eventually repurchase a phenomenal 60 percent 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 percent.

Stiritz believed that Ralston should only pursue opportunities that presented compelling returns under conservative assumptions, and 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 billion. Simple as that. We knew what we needed to focus on. No massive studies and no bankers.”5 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.

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.”

The CHH investment is an excellent example of Smith’s opportunism and his willingness to make sizable bets when circumstances warranted. The transaction was both very large (equal to over 40 percent of GC’s enterprise value) and very complex. It was also very attractive. Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH. As Ives summarized to me, “At the end of the day, we borrowed money at 6–7 percent fully tax-deductible while earning 10 percent on tax advantaged debt, plus we got a conversion option (which eventually allowed us to peel off the Neiman Marcus Group) and the option to buy Waldenbooks.”

When I met with Smith in his office, he showed me the 1962 annual report, his first as CEO, in which he refers repeatedly to cash earnings (defined as net earnings plus depreciation) as the key metric in evaluating company performance, not net income. This may well be the first use in American business parlance of that now standard term. As longtime General Cinema CFO Woody Ives said, “Our focus was always on cash,” and across Smith’s tenure, the company consistently generated high levels of operating cash flow.

Smith was a steady repurchaser of General Cinema’s stock over time, eventually buying back one-third of the company’s shares. His long-term internal rate of return on these buybacks was a very attractive 16 percent.

General Cinema maintained a disciplined approach to capital expenditures, with all capital requests requiring attractive cash returns on invested capital. The company’s early suburban theaters generated exceptional returns, and the beverage division also had attractive internal investment options.

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.

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 pretax income).

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 percent compound return on Berkshire’s investment over its first twenty-seven years.

(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 percent.)

Charlie Munger has said that the secret to Berkshire’s longterm success has been its ability to “generate funds at 3 percent and invest them at 13 percent,” and this consistent ability to create low-cost funds for investment has been an underappreciated contributor to the company’s financial success.

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 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 percent to $98.4 million and did not return to the $100 million level for twelve 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 percent as a percentage of premiums. In contrast, over the same period, the typical property and casualty insurer averaged a loss of 7 percent.

according to a study in Money Week magazine, Berkshire’s investment returns from 1985 through 2005 were an extraordinary 25 percent.

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’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 investments. The top five positions in Berkshire’s portfolio have typically accounted for a remarkable 60–80 percent of total value.

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.

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?

Since 1977, Exxon (and later ExxonMobil) has generated a phenomenal 15 percent compound return for its investors, dwarfing both the market and its peers, a truly remarkable record given its size.

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.

According to Kahneman, the key to using system 2 is often a catalyst or trigger, and for the outsider CEOs, these deceptively simple, “one-pager” analyses often served that function.

Under the leadership of CEO Rex Tillerson and his curmudgeonly predecessor, Lee Raymond, ExxonMobil has exhibited similar discipline, requiring a minimum 20 percent return on all capital projects.

Fundamentally, Stonecipher, Tillerson, and their fellow outsider CEOs achieved extraordinary relative results by consistently zigging while their peers zagged; and as table 9-1 shows, in their zigging, they followed a virtually identical blueprint: they disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.

Let’s conclude with an example that shows the outsider approach at work in a different setting. 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 percent 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 percent—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 percent. 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 o...

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.1 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 system 2, and for CEOs, they can be highly effective vaccines, inoculating against conventional wisdom and the institutional imperative.