Tuesday, 11 December 2012 00:00

The Outsiders

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The Focus Investor Book 2nd Edition

The book revamp/rewrite/improvements are done. The next step is trying to find an agent or someone to publish it. Keep your fingers crossed! If the book doesn't find a publisher I'm looking at electronic publishing options.

Book Review: The Outsiders by William Thorndike

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Focus investors are always searching for those companies that have exceptional competitive advantages but the investment research process doesn't end when they are found. To earn outsized investment returns two other necessary components need to be present:

1. The company needs to be selling below its intrinsic value
2. The company must also possess management that understands how to properly allocate capital.

Management capital allocation skills can then become the determining factor on what kinds of investment returns the shareholders will receive. Management can sink investment returns by squandering excess cash by making bad acquisitions, failing to buy back stock at appropriate prices, and not taking advantage of tax efficiencies.

The Outsiders is of my favorite investment books of the year because it examines how excess returns can be created by a management team that approaches their job differently than most CEOs. It's well written, it has clear historical examples, in short there is a lot of lessons to learn, and apply, to a focused investment program.

What's the key insight to the book? Warren Buffett once related that the institutional imperative was a force in business that he never learned at business school. Well I've been in the investment industry now over ten years and I can say with confidence that the institutional imperative is alive in well both in the investment business and at the companies I follow. This book shows you how talented management team can break free of the institutional mindset and create real shareholder value!

It's rare to find a manager willing to differentiate themselves from Wall Street and not follow the normal Wall Street line. For instance many CEOs have to devote a large portion of their time meeting with money managers simply because most money managers won't even invest in their company if they don't speak with them. I'm sure the vast majority of this time could be better used by the CEOS instead of them having to deal with money managers trying to get a direction of next quarter's earnings or "advising" the management team of short-term behavior that might boost the stock price.

In a recent Wall Street Journal article (Investors Demand CEO Face Time, Nov. 29, 2012)the CEO of Gamestop said that "... investors and analysts take up an ever-larger chunk of his schedule. He estimates he now spends 25% to 30% of his time preparing for or attending meetings at the company's Grapevine, Texas, headquarters or investor hubs like New York, Boston, Chicago and San Francisco."

So finding a management team that can resist this institutional imperative is quite rare. To find one that takes the next step into the type of superior capital allocation as Mr. Thorndike discusses in his book is even rare but if they can be identified they can add lots of value to your investment portfolio over time.

Everyone reading this blog is familiar with Warren Buffett and he is featured in the book (along with other luminaries as Tom Murphy, Henry Singleton and Kay Graham , to just name a few) ins lauded for having created an incredible capital compounding machine at Berkshire but how many managers follow his example? Not many.

Do I know of any management teams that are following the formula described in the book? Well I would say Verisign since 2007 has followed quite a few aspects displayed by managers in the book.

The Verisign management team embarked on a new business vision in November 2007 and from that time to late 2011 the company decreased headcount from 5,000 to 1,000, went from 88 worldwide offices to approximately 10, and sold 13 business combinations. The team took the capital generated from this process and rewarded shareholders with attractive share buybacks and dividends. They bought back $1.3 billion in stock in 2008, $260 million in 2009, $449 million in 2010 and $550 million in 2011.

I would like to see the capital allocation done with a more opportunistic methodology but the company certainly has done better on this front then I have seen the vast majority of companies I have observed over the years.

Summary

Mr. Thorndike book provides many clear cut examples of managers that blazed their own trails, often in conflict with accepted financial practices of the times. He walks us through these examples and explains how they were able to earn outsized returns for their shareholders. These lessons can be used in your own investing process and will help you when you search for management teams of current companies that have the characteristics detailed in the book. The traits include a willingness to go against conventional wisdom, the ability to be flexible enough to buy stock when it's cheap and do acquisitions only when their return expectations can be attained.

This quote (page ix) contains the main theme of the book and it's something that most investors miss:

"The metrics that the press usually focuses on is growth in revenues and profits. It's the increase in a company's per share value (author italics), however, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO's greatness."

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