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Thomas Macpherson
Thomas Macpherson
Articles (154)  | Author's Website |

Return on Capital Super Heroes

Managers who are frugal, both in their personal lives and in their compensation, generally run companies with higher returns on capital than those overseen by the most highly compensated managers

May 20, 2019 | About:

I remember watching cartoons as a kid where each character had a super power. Some could fly, some could see through walls, some shot sticky crap to catch the bad guys. They all had something that innately made them better than both the bad guys and the good guys. When I’m looking at a potential investment, I want my managers to have capital allocation super powers. I want the Superman of return on capital.”

- Allard Ross

“It’s interesting. I’ve never found a single test that can help you find a manager that – over the long term – has the uncanny ability to be an outstanding allocator of capital. Perhaps the one and only correlative factor I’ve ever seen (and I mean this quite seriously) is whether the individual does their shopping at discount or second-hand stores. That nearly always guarantees you’ve got someone at the helm that takes shareholder capital very, very seriously.”

- Pierre Pontet-Canet

There was a story about Bob Kierlin, the former CEO of Fastenal (NASDAQ:FAST), who used to buy suits not just at a mark-down suit store, but suits already used by the manager at the mark-down suit store. He said, “Luckily, we're the same size. I picked up six of those suits for 60 bucks each."

Another time, Kierlin and current CEO Dan Florness had to get to Chicago for a meeting. Since the meeting wasn’t until the next day, they decided to scrap the one-hour flight and drive instead – saving the company 78% in costs and eating at A&W because they had the cheapest hamburger on the route.

But it wasn’t just frugality that Kierlin built into corporate DNA. Fairness was another. When a recession hurt Fastenal growth in 2001, management were the first to cut their pay. Variable pay for management declined 30%. Kierlin’s salary was hit the hardest. His $121,000 pay was cut almost in half to $63,500. For other employees, variable pay increased 4%.

Cheap management generate high returns

In 2014, Nintai Partners did an analysis comparing corporate return on capital of companies with management compensation in the highest decile versus companies with management compensation in the lowest decile. We were interested in seeing whether there was a correlation between how much management was compensated and their respective company's return on capital.

We chose 36 companies from the top decile of the S&P 500 and 49 companies from the top decile of the Russell 3000 and calculated return on capital for the years 2009 to 2013. We chose the same amount for the lowest decile. In addition, we wanted to see if individuals who are compensated at either the highest or lowest decile had a different tenure within their respective companies. Last, we were interested to see what happened to the company’s return on capital after that management team had left. (The pool of candidates was smaller here simply because not everyone has left yet.)

It turns out there was a strong correlation. The numbers seen below show that management who are compensated the least have a dramatic – and positive – impact on ROC. I should note this applied in every industry sector listed (in the Corporate Sector Make Up). The lowest 10% in compensation achieved an average ROC from 2009 to 2013 of 17.3%. The highest 10% compensated managers achieved a ROC of only 11.4%. Additionally, the lowest paid managers stayed on in their CEO position nearly 10 years longer.

As an investor, not only does your holding managed by the lowest compensated managers generate a higher ROC, but it achieves it for a longer period of time. Last, the departure of the lowest paid CEOs had a slight greater negative impact than the departure of the highest paid (this is to be expected since the gap was so large to begin with).

Why this matters

Anecdotally, I’ve often heard that if someone manages your money like their own then you’ve found a good manager. It turns out the data show that managers who are frugally compensated have a tendency to generate much higher return on capital than those who are lavishly compensated. Nintai’s research can teach investors several lessons.

Frugality is a Lifestyle

It turns out frugality runs through many managers’ personal and professional lives. Whether it be Bob Kierlin at Fastenal or Ken Iverson at Nucor (NYSE:NUE), some individuals run a tight financial ship throughout their lives. This type of tight-fisted approach to spending can run through an entire business, creating extraordinary internal returns (such as return on capital, return on equity and return on assets) as well as investor returns.

Frugal managers are long-lived managers

During their research, Nintai Partners wasn’t able to measure the happiness or contentment of low-compensated versus high-compensated managers. But one thing was for certain – managers who faithfully showed up on the lowest compensated list year after year remained at their post far longer than those who were the highest compensated.

Frugal DNA remains within the organization

While return on capital decreased slightly after the departure of a lowest-compensated manager, generally the company continued to outperform companies with the highest compensated managers. This persisted over the next five to 10 years in nearly every case. The values of the cheapskate CEO had a lasting effect.

Conclusions

Over my investing career, I’ve always looked for companies with high return on capital because I believe these are organizations with the best chance at becoming (or already being) compounding machines. Partnering with managers whose personal and professional characteristics help drive high return on capital and receive low compensation can increase your chances of investing in one of these compounding machines. For instance, from 1987 to 2019, the S&P 500 has grown 989% while Fastenal’s stock has grown 49,000%. As an investor, you can’t ask for more than that. If you were Bob Kierlin, you simply didn’t.

As always I look forward to your thoughts and comments.

Disclosure: I own Fastenal in several accounts I personally manage.

Read more here:

Nintai Investments' 'Statement of Investment Partnership'

Disclosure and Performance: A Toxic Mix

Six-Word Portfolios

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (16 votes)

Voters:

Comments

haze.alon
Haze.alon premium member - 1 month ago

Excellent article.

Thank you, Thomas.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Thank you Haze.alon. I'm glad you enjoyed it. Best - Tom

batbeer2
Batbeer2 premium member - 1 month ago

Hi Thomas,

Yes, this is an interesting correlation I have observed at many companies. There are two thoughts I'd like to add:

1) Perhaps the correlation is not causation. At least not in the expected direction. Managers who understand the value of money will be good capital allocators and they'll also be frugal.

2) You don't need to pay a smart manager as much to work at a superior company. Just imagine what you would you have to pay James Sinegal to become CEO of say... Bed Bath & Beyond? Or Ajit Jain to work at AIG.

Just some thoughts, thanks for the article.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago
Hi Batbeer. I knew the correlation/causation issue was going to come back and haunt me. Several told me to take it out, but I decided - proving I was a very poor stats student - to leave it in. I certainly grant you your point! I agree with you on the idea of the pay issue. To use Warren Buffett (Trades, Portfolio)'s words, I tap dance my way to work every morning and I'm definitely in the lower quartile in terms of investment management compensation. I think that's why you see the lower compensation AND duration in their position. Thanks for your comment. As always, it is much appreciated. Best - Tom

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Great stuff Tom!

batbeer2
Batbeer2 premium member - 1 month ago

@Tom

LOL.

Stats aside, figuring out the causation that drives some correlations can lead to some interesting investment ideas. Someone recently wrote an article precisely about that here:

https://www.measuringthemoat.com/post/kone-oyj

If you have time I'd appreciate your feedback on that.

stephenbaker
Stephenbaker - 1 month ago    Report SPAM

I'll take a CEO who drives himself (or herself) to work in a nondescript car and suit any day.

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Batbeer. I will take a look at the article and send back my thoughts. I apprecate you giving me the link. StephenBaker. You said in roughly 20 words what it took me 3 pages to say. Next time you get to write the article! ;o)

asawhneyy
Asawhneyy - 1 month ago    Report SPAM

Wear any kind of clothes ok to me--

or they high on integrity treating employees right---

not self serving

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago
Asawhneyy. LOL. I need you on my Board. That was a Charlie Munger (Trades, Portfolio) type of response. Best. - Tom

Thomas Macpherson
Thomas Macpherson premium member - 1 month ago

Science. Thanks for the comment. I didn't see it come in. Glad you enjoyed. Best. - Tom

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