How to identify great CEOs for success in long-term investing

Thorndike says while running an organisation, an exceptional CEO does unorthodox things to get exceptional results, while an ordinary CEO performs the same tasks as his peers, which restricts a business’ potential and performance.

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During his research, Thorndike found that each CEO shared some common traits and virtually identical patterns in their management styles
Renowned author and investor William Thorndike says the goal of an investor should be to invest in companies with great CEOs early, because that often translates into great stock performance in the long run.

Thorndike is the founder of Housatonic Partners, a private equity firm in Boston, and currently serves as its Managing Partner. He has also served as a member on the Board of Directors for LeMaitre Vascular since 2008, and previously from 1998 through 2005. A graduate of Harvard College and the Stanford Graduate School of Business, Thorndike is the author of a famous book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.

How to spot exceptional CEOs

Thorndike says while running an organisation, an exceptional CEO does unorthodox things to get exceptional results, while an ordinary CEO performs the same tasks as his peers, which restricts a business’ potential and performance.

“In assessing performance, what matters is not the absolute rate of return, but returns relative to peers and the market. You only need to know three things to evaluate a CEO’s greatness: the compounded annual returns to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market,” Thorndike said in a presentation at Talks at Google.

What separates great CEOs from ordinary ones
In his book The Outsiders, Thorndike explores the journey of eight unconventional CEOs who during their tenures amassed extraordinary returns for shareholders. Thorndike finds these CEOs to be unorthodox in their approach and lists out the qualities that separate them from the rest of the pack and the reasons for their extraordinary success. These 8 CEOs were:
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  • Warren Buffett of Berkshire Hathaway
  • Thomas Murphy of Capital Cities Communications
  • Richard Smith of General Cinema Corporation
  • Bill Anders of General Dynamics
  • Bill Stiritz of Ralston Purina
  • John Malone of Tele-Communications
  • Henry Earl Singleton of Teledyne
  • Katharine Graham of The Washington Post
During his research, Thorndike found that each CEO shared some common traits and virtually identical patterns in their management styles, which helped them outperform their peers and gain a larger market over an extended period.

These CEOs, whom Thorndike calls ‘The Outsiders’ were distinct from the typical CEOs as they didn’t follow conventional wisdom and acted contrary to popular beliefs. They were not contrarians just for the sake of it, but they identified areas in which divergence from the norm enabled them to generate superior returns for shareholders.

Also, he found that personalities of these outsiders weren’t extravagant, and they didn’t particularly like the outward-facing part of their role as CEOs. On top of that, they were generally frugal and none of them ever had lavish company headquarters.

“The outsider CEOs were also distinctly unpromotional and spent considerably less time on investor relations than their peers. They did not offer earnings guidance or participate in conferences. As a group, they were not extrovert or overly charismatic,” says he.

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Thorndike outlines three areas where these outsider CEOs' approaches were different from common wisdom. These are-

  • Approach to Capital allocation: The primary job of the CEO is to run the operations of the business and deploy the capital generated by those operations. Mostly the typical CEOs focus on the former, but outsider CEOs usually excel at the latter.
Thorndike says rather than seeing themselves as business operators, the outsider CEOs see themselves first and foremost as investors and capital allocators.

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Businesses can deploy cash in five basic ways like investing in the existing business, acquiring other businesses, paying dividends to shareholders, paying debt, or buying back stock and raising money by issuing debt or raising equity. Specific usage of these capital allocation tools determines a company’s performance.

Thorndike believes ‘Outsider CEOs’ tend to allocate capital differently compared with their peers. They choose their options wisely and make rational and profitable choices by calculating the return on each investment project. They ignore conventional wisdom and what their peers are doing.

Outsider CEOs tend to aggressively buy back company stocks when they are cheap, which increases earnings per share and, consequently, price per share. They rarely issue shares to raise funds, preferring to avoid dilution and also rarely issue dividends as they find it a tax-inefficient way of rewarding shareholders.

They are also judicious about making acquisitions and buy companies only when they feel it is a good deal and they never let their ego come in the way of making the right decision for the company.

“These CEOs thought more like investors than managers. Fundamentally, they had confidence in their own analytical skills, and on the rare occasions when they saw compelling discrepancies between value and price, they were prepared to act boldly. When their stock was cheap, they bought it and when it was expensive, they used it to buy other companies or to raise inexpensive capital to fund future growth. If they couldn’t identify compelling projects, they were comfortable waiting, sometimes for very long periods of time. Over the long term, this systematic, methodical blend of low buying and high selling produced exceptional returns for shareholders," he says.

Thorndike feels typical CEOs issue shares to fund costly acquisitions, prefer not to buy back stock or raise debt, and pay dividends frequently. Also, they aggressively acquire companies believing they can improve profits through scale or synergies. In most cases, all these activities result in lower business performance.

  • Distinct Management Practices: Thorndike says along with making wise capital allocation decisions, the outsider CEOs also run their businesses in a unique fashion.
a) Decentralization of authority:Thorndike says outsider CEOs generally believe in decentralization while dealing with management of staff and its business units. They believe in hiring the best managers for their business lines and do not interfere in their way of running the business and they make sure to have minimum staff at headquarters which reduces overhead count and anxiety about office politics.

Typical CEOs tend to hire many resources at the headquarters, featuring layers of vice-presidents and MBAs. Not only does this increase overhead, but it also encourages office politics.

b) Frugality:Thorndike says Outsider CEOs give utmost importance to cash in running business operations, since it can be redeployed in their capital allocation strategies. Therefore, Outsider CEOs believe in cutting operating expenses to a minimum and avoiding typical corporate perks like private cars and expensive airline travelling and keep headcount lean and efficient. They also encourage this culture when they acquire new companies.

c) Focus on cash flows : Outsider CEOs resist the temptation of focusing on reported earnings, which often presents a confusing picture of a business performance. Instead, they focus on cash flow and metrics like Ebitda helping them to make better financial decisions. This relentless focus on cash flow can help avoid costly acquisitions for the sake of growth that may later prove unprofitable.

d) Enhance shareholders wealth: Thorndike says one of the top priorities of Outsider CEOs is to enhance shareholder value for which they don’t even hesitate to shrink the company size for better returns to shareholders.

e) Spend less time on investor relations: Outsider CEOs see investor relations as a wastage of time and spend little time talking to market experts and managing market expectations and rather prefer to spend time on their business.

f) Luck not the reason behind success: Thorndike feels Outsider CEOs outperform their peers not because of any stroke of luck, but because of how they efficiently manage their businesses whose credit can be attributed directly to their management and capital allocation strategies.

g) flexibility: Outsider CEOs also show tremendous flexibility according to the circumstances while handling the business operations. Instead of adhering to a fixed strategy, they evaluate all possible options before choosing the best option available.

h) Personal negotiations: Outsider CEOs also negotiatedirectly instead through layers of advisers, he says.

i) Avoid complicated financial models: Thorndike said Outsider CEOs avoid complex financial models and pages of quantitative analysis when making capital allocation decisions as they feel these are imprecise. Instead, they simplify understanding of the business to a few key assumptions like market growth trends, competitive dynamics and cash flow. This allows them to make fast decisions when an opportunity arises.

  • Exceptional personality traits: Thorndike says the outsider CEOs also show similar personality patterns which is even evident in how they run their businesses.
a) Independent Thinkers: Outsider CEOs are independent thinkers and prefer to deduce their own conclusions instead of following the herd. They are analytical and rational about their businesses which often leads to unusual practices, such as buying back shares or ignoring traditional measures of value like reported earnings and book value.

Thorndike believes they also care little about skeptical critics and never fall into the trap of imitating other CEOs. They are mostly very learned and knowledgeable and are familiar with a variety of industries and disciplines, which helps them to use new perspectives and approaches to create value.

b) Humble: Outsider CEOs are very humble and do not have any inclination to hog the limelight. They avoid public talks and live seemingly boring lives. They are also very patient and are ready to wait for long periods for compelling opportunities to arise.

Thorndike says when Outsider CEOs see a great opportunity, they act boldly and decisively.

“These geniuses are the Isaac Newtons of business, struck apple-like by enormously powerful ideas that they proceed to execute with maniacal focus and determination. Their situations and circumstances, however, are not remotely similar (nor are the lessons from their careers remotely transferable) to those of the vast majority of business executives,” he says.

(Disclaimer: This article is based on William Thorndike's The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success and his presentation at Talks @ Google).
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