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The masterful allocation of a company’s cash flow, over long periods, is the single greatest determinant of shareholder value for an investor. This is the conclusion in the 2012 book “The Outsiders” by William Thorndike.
Thorndike examined eight companies and uses the word “iconoclast” to define these CEOs who challenged conventional management norms and outperformed the S&P 500 by 20-fold and their peer groups by a multiple of seven.
For these “outsider” CEOs, growth in per-share value, driven by savvy capital allocation, was the key to superior investment performance. Another common thread was thumbing their nose at standard protocol, like avoiding communication with Wall Street and running their businesses with independent thinking.
A goal for many traditional CEOs is to make their companies bigger. These outsider CEOs sometimes shrank their companies through stock buybacks, spinoffs and closing underperforming divisions.
Capital-allocating CEOs think more like an investor instead of a manager and understand the difference between price and value. They are willing to buy back stock in large quantities when it is cheap. And, conversely, when their stock is overpriced, they use it as currency for value-accreting acquisitions. They avoid overpaying for acquisitions—a mistake made by many CEOs interested in growing the overall pie.
Thorndike notes that there are three sources of capital—cash flow from operations, issuing debt, or issuing equity. When allocating that capital, the CEO has five choices—invest internally, make acquisitions, pay dividends, pay down debt or repurchase stock.
Investors should periodically analyze the past capital allocation decisions of their portfolio CEOs and measure whether they are increasing per-share value. There are three simple ways to measure CEOs’ performance—the compound annual return to shareholders during their tenure, that return compared to a peer group of companies during the same period, and a comparison against a broad market index like the S&P 500.
Verisign, the provider of Internet infrastructure services, is a good recent example. In 2010, the company sold a large subsidiary for $1.2 billion. Since then, Verisign has bought back 41 million shares of stock at an average price of $32 per share and paid special dividends of $3 in 2010 and $2.75 per share in 2011. Verisign’s stock now trades for about $49 per share.
Travelers Insurance, since its first repurchase authorization in 2006, has acquired 362 million shares for a total cost of $18.8 billion at an average price of $52 per share. Even though the company has barely grown revenue, profit or total assets over that time, the per-share book value has advanced from $37 to $67, primarily due to share repurchases. Travelers stock has significantly outperformed the S&P 500 and the S&P Property & Casualty index.
Another example is Precision Castparts CEO Mark Donegan, who has been masterful with a series of value-creating acquisitions, despite keeping a low profile and shunning Wall Street’s desire for earnings guidance.
Identifying a CEO who possesses superior capital allocation skills can add exponential value to your portfolio.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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