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A Dissenting Review of 'The Outsiders' by Thorndike

May 23, 2013 | About:
Chandan Dubey

Chandan Dubey

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"The Outsiders" is a book which was published at the end of 2012 and has been recommended by Charlie Munger.

The book is the result of a flawed research method. The method goes as follows. Say you are interested in finding what makes people self-made billionaires. An obvious (and wrong) way of doing this is to do the following:

- Compile a list of self-made billionaires.

- Read about them and find how they are similar to each other.

- If you want to be more “thorough” you also find out how they differ from each other.

- Write a book in which you underscore the similarities and spend as little time as possible on the dissimilarities. If the similarities make sense, for example, hard working, having a vision, drive, etc., the book will come out rather well.

"The Outsiders" and "The Millionaire Next Door" both fit in this category. I am sure there are others. It is not to say that these two books are not useful. They might give you some good tips and ideas on how to select good investment opportunities or become a millionaire, but they don’t tell the whole story.

The questions that needs to be answered at the outset is the following: What is the usefulness of such a book? If one is reading it to learn tools and techniques which make a successful CEO, then I have bad news for you. While it is good to know, it is quite possible that the tools will be useless to you, depending on the situation you are in.

The flaw of the method lies in a simple misunderstanding of implications. If successful people have property A, then will cultivating property A make you successful ? The answer is not clear. In fact, it is a totally different question that I am asking. The research I did is useless in either confirming or disproving my hypothesis.

If my hypothesis is that “being a good capital allocator” leads to “good shareholder returns” then I need to conduct the research in a very different way.

- Find CEOs who are good capital allocators.

- Confirm if they have done well for the shareholders.

The book does the opposite.

- Find the CEOs who have trounced the S&P and have performed exceptionally well compared to the competition.

- Observe their similarities and extol them as virtues.

The book arrives at the following characteristics which they had in common.

- Running a decentralized organization with thin management layers.

- Concentrate on cash flows and not reported earnings.

- Concentrate on increasing the per share value of the company and not growth in revenues.

- Acquire when odds are in your favor -- even if the size of the bet is huge. Be patient otherwise.

The book also points out some of the similarities that these CEOs had. For example, they were frugal, analytical and humble. They did not give guidance and spent a very small amount of time talking with analysts. They were wary of investment bankers and lawyers and usually made acquisition and spin-off decisions on their own.

In one word, they were: iconoclasts. Someone who does not follow the crowd.

Let us look at a company which could have been a great example of shareholder returns if the price had appreciated. The relevant data for this company (whose name I am going to reveal later) is as follows:

-xqkiXTPz5PrmzmrRkYylSetI3snemng7cjebBpQ

It has flat revenues, good and predictable cash flows and has used the cash to buy back a lot of shares. This is how the shares have performed.

lYmvJirR-VFtXp2EbL9xozhOwi_GTtLL81XdydDn

You might think that they have taken on a lot of debt in the process, but you will be wrong. Here are the net debt figures for them:

2kC_MtBc-PS_jj05grQRqOIgWrUaJytdrubVUjl_And the interest cover:

tHHJQyGO-AB-2p-mShQzdP-RePaxmb0nhj-4WjMn

The company is: KPN (KKPNY).

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.5/5 (6 votes)

Comments

Enjoylife
Enjoylife premium member - 10 months ago
Chandan,

Thank you for the article very interesting view point. I have read the Outsiders and enjoyed it.

You make several good points about the methodology being a little weak. I have felt the same way about some of the Jim Collins books like "Good to Great" and "How the Mighty Fall".

That said I don't think your example is very good. All of the companies in the book had strongly increasing revenues not flat ones. And their earnings (net income was increasing) This company has pretty strongly decreasing net income which speaks to it not having a good moat to keep competitors out.

I think KKPNY has done their share holders a service by buying back stock. Without that capital allocation decision the picture could be much worse.

Dec 2003 guru focus shows share price for KKPNY at about $7.71 per share and Dec 2011 it is at $11.90. That is a total gain of over 54%. For a 9 year period CARG of about 5%.

That is not bad performance for a company that doesnt grow its earnings at all. So the stock price yield is solid. It also paid an average dividend of over $0.59 per share for the 9 year period. That is a 7.6% annual dividend.

So if we add the 5%+ 7.6% = TOTAL CARG of 12.6%

The S&P 500 went from 1070 in Dec 2003 to 1260 in Dec 2011. That is a total of a 18% gain. That is less than a 2% CARG for the 2003 to 2011 period. The S&P also pays about a 2% dividend so for the period a total CARG of less than 4%.

SO 10,000 invested in KKPNY on Dec 2003 becomes over $29000 on Dec 2011.

And 10,000 invested in SPY on Dec 2003 becomes less than $14,000 on Dec 2011.

Not spectacular but pretty impressive out performace for a company that didn't grow earnings.

My point is not sure how this disproves anything in the book. If anything I think it strengthens the argument.

Thoughts?

cdubey
Cdubey premium member - 10 months ago
Thank you for your comment. You do offer good evidence as to why the example was not great. My point about the flawed research still stands - even when there are no examples.

I will like to defend my example though.

First, at least one example was of a company that actually had flat revenues. I think that was Ralston Purina. The CEO did acquire new companies to boost the revenue but that was not the point. In any case, the whole argument of the book is exactly about not trying to measure a company by revenue but cash flows. In this regard, my example still stands.

In a similar vein, net income is not a good measure for profitability. Especially for a company with large cap-ex and good cash flows. Such a company can take on debt and manage the interest expense quite well. An example of such a company will be National Grid. They have huge debt but very predictable cash flows. A similar situation was in play with fixed line operators. They were regulated and each country had their own incumbents. France Telecom, Deutsche Telecom, Swisscom to name a few. It was hard to argue that they did not have a moat. You need a huge amount of cap-ex to even start competing with them. So, I do not accept the argument that decreasing net income do not show that they had a defendible moat.

About the performance of the stock - KPN is in trouble. The share price has plunged to $3.65 as of today. They sold a lot of shares to raise equity and diluted the existing shareholders. Picking Dec 2011 is not exactly correct. It assumes that you exited. If you didn't the returns are quite bad. We can wait a year and check back on Dec 2013 or calculate using Dec 2012 price.

I am not sure what I am arguing anymore :)

To recapitulate: With the benefit of hindsight, it is obvious that KPN should have retired debt instead of buying back shares. A great CEO on the other hand would have bought back shares - given the predictability of the business they have been in. The ground has literally shifted under their feet. No one could have foreseen that they will be fighting for survival. These CEOs obviously will not appear in Thorndike's book because even though they made correct decisions looking forward, it turned out to be a bad one looking back. So, the argument in the book is backwards.

Great CEOs might be good at capital allocations but it does not mean that great capital allocators will turn out to be great CEOs.
Enjoylife
Enjoylife premium member - 10 months ago
Hi Chandan,

Again thanks for the fast response.

As far as the dates ending in 2011, you did that not me.

I didn't pick the dates. I used the dates of your data. You showed financials and an earnings chart from 2003 to 2011.(Above) If you want us to look at a longer period then please include those numbers in the data.

I strongly disagree that net income is not a good measure of profitability. It is flawed like all measures but it is what Ben Graham used in valuing businesses along with price to book. And P/E has been proven over and over again to be a good predictor of future returns. Price over earnings where earnings is just net income per share. You can actually get the P/E of any business by dividing the market cap by net income. There are always exceptions to any predictive metric but I believe earnings determine stock price. (I know nothing about National Grid so will not comment on that example.) You can argue there are better measures now but growing NI is still pretty damn important to any investments long term performance.

Your KKPNY example again shows this net income concept as the earnings drop, so do the price. My point was the falling net income looked better on a per share basis because of the buybacks. However I still see it as a huge indicator of lacking pricing power and moat. FCF also shows the same trend with 2003 being $3.4B, 2007 being down to $2.7B, and 2011 being $2.4B. This downward trend is alarming any way you look at it.

The book also never says that good capital allocators always buy back stock and ignore debt. Perhaps with KKPNY reducing debt should have been a bigger priority over repurchases. But that is the CEO's job to decide what is best. In the book, John Malone TCI CEO, bought back stock when it was cheap but issued stock to make aquisitions when it traded at a premium. When it traded at an average level he paid down debt. So their point was that a good CEO making the right decisions about allocation has a strong positive impact on return. That part I think is true and driven home by the book.

Now let me be up front and say I know very little about the KKPNY company or their situation. But I do agree with the book concept that companies who use capital to repurchase shares and pay dividends are shareholder friendly and this behavior generally leads to better returns for shareholders.

However if you see your business shrinking and your ability to pay debt waning then clearly survival through paying down debt becomes a more important place to allocate. If the CEO ignored this need and spent all the money on dividends or repurchases then the book would say that was a terrible allocation choice. Buffet who is given a chapter in the book, openly admits misallocating capital by keeping the weaving business open too long at Berkshire. If KKPNY is failing then the money should be directed at other businesses or given back to shareholders and discontinue as an ongoing concern.

.

You are wrong about any example in the book having Flat net income. Some companies choose not to focus on net income but all of them had impressive gains in net income during the CEO's tenure.

For Ralston that you mention, the book doesn't say specifically what the net income did but on page 132 it states "During his (Stiritz- Ralston CEO) tenure, the business grew dramatically with operating profits increasing fifty fold through a relentless program of new product introductions and line extensions." So you take out the interest expense and operating income becomes Net Income. 50 fold increase is far from flat.

Not trying to fight and I still agree the method is flawed. I agree with you in that: Not all management that is shareholder friendly will produce above average results. Especially if the business or industry are bad or in a phase of obsolescence. But if you find a company that has a durable moat in a good industry, how management allocates capital will impact your investment return. And if they allocate it by giving back to share holders as dividends or share repurchases when prices are low, that generally will enhance your investment returns.

Thanks again for your contribution.

Sincerely
cdubey
Cdubey premium member - 10 months ago
You have convinced me that KPN was probably not a great example. I don't have an example to replace it either.

I repeat the lines (from you) which I completely agree with.

>Not trying to fight and I still agree the method is flawed. I agree with you in that: Not all management >that is shareholder friendly will produce above average results. Especially if the business or industry >are bad or in a phase of obsolescence. But if you find a company that has a durable moat in a good >industry, how management allocates capital will impact your investment return. And if they allocate it >by giving back to share holders as dividends or share repurchases when prices are low, that >generally will enhance your investment returns.

And add some more lines.

Being great at anything involves a lot of luck. It takes ability for sure -- but luck is pretty important too. The book underplays its contribution.

*Any* decision has a chance of looking wrong at the benefit of hindsight. And I mean *any*. Should you acquire, or not acquire a company. Should you pay debt or buyback stock. Should you pay dividend or not. Should you spinoff, sell for cash or sell for stock. Every one of these decisions may come back to bite you -- even if you made them correctly depending on the information you had at the time.

There are times when you make the wrong choice -- even when you had the necessary data to make the correct one. These are avoidable and might contribute positively to your performance.

But there are times that a decision which was correct soured because of changing conditions. If a CEO does not need to make these kind of decisions often -- he might be better off than the one who had to. Because sooner or later the luck turns.

It is true that the virtues extolled by the book may lead you to find good CEOs and better investment candidates -- and probably that is the major contribution. But there is no discussion on how the ability of the CEO is only part of the picture. And even a great CEO may fail if luck turns against him.

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