This second post related to William Thorndike’s splendid book, The Outsiders, will address commonalities amongst the CEOs highlighted in the book and Sears Holdings’ CEO & chairman, Edward Lampert. As I read The Outsiders (twice), I was continually struck by parallels amongst the book’s subjects and Lampert.

As a starting point, there is a common set of tactics and attributes Thorndike ascribes to his illustrious set of CEOs:

• Significant share repurchases
• No dividends
• No Wall Street guidance
• “Same combination of derision, wonder, and skepticism from their peers and the business press.”
• Remarkable performance over very long terms (20+ years on average)

Each of these bullet points is manifested in Lampert:

• Share repurchases –  during the period of Lampert’s involvement with and investment in AutoZone, the share count has been reduced via repurchases by over 75%.  Over the same time period, the share price has appreciated roughly 1,075%, an IRR of around 18% versus the S&P 500’s IRR of approximately 2% (exclusive of dividends).  This AutoZone track record is analogous to Henry Singleton repurchasing 90% of Teledyne shares between 1972 and 1984.  Similarly, since orchestrating the 2005 Sears-Kmart merger, Sears Holdings has reduced the outstanding share count by over 35%.  While Lampert has taken much public flak for significant Sears Holdings repurchases above $130/share during 2006 and 2007, the final verdict on Sears Holdings repurchases should be withheld until the company’s values are ultimately determined.
• No dividends – enough said.
• No Wall Street guidance – Sears Holdings offers no guidance, and Lampert’s skeptical views concerning Wall Street and financial commentary are relatively clear.  Lampert offers no SHLD sales pitch – necessary information is disclosed and not much more.  These are not the actions of the average CEO who courts and coddles both the press, Wall Street and buyside analysts.
• Peer and business press derision and skepticism – read any article concerning Sears Holdings, and this Lampert-Outsider CEO analogy is made clear.
• Remarkable long-term performance – although not a precise comparison as Lampert has managed a private investment partnership rather than steered a publicly-traded company for the vast majority of his career, Lampert has compounded ESL capital at over 20% since its 1998 formation.

Beyond these common attributes, there are other aspects of the Outsider CEOs that conjure Lampert:

• Decentralization driving accountability – as Thorndike describes Teledyne: the company had a “wafer-thin corporate staff at headquarters and operational responsibility and authority concentrated in the general managers of the business units.”   Singleton “[e]mphasized extreme diversification, breaking the company into its smallest component parts and driving accountability and managerial responsibility as far down into the organization as possible.”  While Lampert inherited a bloated corporate organization, his efforts to divide Sears Holdings into five business units (brands, real estate, online, operating and support)  and the spinning off of businesses to drive increased accountability echo Singleton – in Lampert’s words: “The idea behind the reorganization is to drive decision-making down into the organization and to harness free-market forces to convert a centrally planned company into a more decentralized company.”
• Focusing on return on investment rather than sales or growth –  counter to the tendency of many CEOs to prize growth, often without appropriate focus on associated profitability or ROIC, the Outsider CEOs were of a different mindset.  In the words of General Dynamics Bill Anders who shrank the business dramatically – “Most CEOs grade themselves on size and growth . . . very few really focus on shareholder returns.”  Likewise, Thorndike’s own words on Berkshire Hathaway: “A critical part of capital allocation, one that receives less attention than more glamorous activities like acquisitions, is deciding which businesses are no longer deserving of future investment due to low returns.”  While the Sears Holdings story has yet to play out, Lampert has received an inordinate amount of negative commentary concerning SHLD’s “underinvestment” in its stores as the primary driver of same-store sales declines and overall poor operating performance.  In the face of such criticism, Lampert has consistently – from 2006 to 2013 – re-framed the issue as one of return on investment rather than top-line fixation.  Clearly, the company’s operating performance has been poor but is it also clear that heightened investment in poorly-positioned large format department stores would have been anything other than “throwing good money after bad”?  Whether – in the long run – Lampert’s capital allocation decisions prove correct is yet to be determined; however, what is clear is that contrary to most managers his focus is on return on incremental capital even if that means shrinking the enterprise.
• Optionality – the last aspect of the Outsider CEOs I want to discuss is a bit more amorphous – channeling optionality.  Many corporations have grandiose long-term plans that set their course well into the future.  While prudent planning is a necessity, plans should not be so rigid as to suffocate the ability and freedom to capture the optionality offered by Lady Fortuna – in Taleb’s vernacular, remaining antifragile.  As Thorndike quotes Henry Singleton: “I know a lot of people have very strong and definite plans that they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted. So my idea is to stay flexible.”  Similarly from Singleton, “[m]y only plan is to keep coming to work. . . . I like to steer the boat each day rather than plan ahead way into the future.”  Likewise – with SHLD – Lampert is dealing with a diverse, mixed  bag of assets.  It appears the company is tinkering with many different strategies and means of monetizing these various assets.  While many of these efforts will fail, the associated investment is low and the potential payoffs are high – intelligent tinkering is the womb of optionality.

To wrap, Thorndike’s The Outsiders does a tremendous job conveying common traits and strategies amongst a group of CEOs who generated vast amounts of shareholder value while marching to a different beat than their peers.  Upon reflection, many of these same traits appear in SHLD’s Edward Lampert, one of the most currently reviled corporate executives.  While only time will offer the ultimate verdict on Lampert’s helming of SHLD, it is worth noting he stands in good company in terms of his mindset and methodologies.

The Outsiders, by William Thorndike, is a great recent book that does a tremendous job highlighting eight unconventional CEOs – executives who marched to their own drummer, did not coddle Wall Street and pursued idiosyncratic strategies (relative to peers) that generated significant shareholder value. The illustrious group includes Tom Murphy (Cap Cities), Henry Singleton (Teledyne), Bill Anders (General Dynamics), John Malone (TCI), Katherine Graham (Washington Post), Bill Stiritz (Ralston Purina), Dick Smith (General Cinema) and Warren Buffett (Berkshire Hathaway). This wonderful read will provide fodder for several posts, including this one.

As part of discussing the beauty of Berkshire Hathaway’s model, Thorndike describes the importance of insurance operating liabilities (reserves) in funding BRK’s return generating assets. As Buffett habitually describes in his annual letters, these insurance reserves serve as leverage, increasing BRK’s assets, investment and operating income, and return on equity. In concept, insurance is a beatiful business model: start with equity capital, write insurance policies to generate reserves and invest the aggregate funds in return generating assets. The key, however – and where most insurance companies get in trouble – is underwriting profitably, which is something the insurance industry as a whole rarely accomplishes.

So how does Berkshire consistently underwrite profitably while other insurance companies do not? One key: A willingness to shrink the insurance business should the market offer unattractive pricing.

Thorndike does an excellent job of illustrating Berkshire’s atypical willingness to reduce the scale of its insurance operations should market pricing prove unattractive. Thorndike highlights that in 1984, National Indemnity – BRK’s largest PNC insurer at the time – wrote $62mm of premium. In 1986, premiums increased six-fold to $366mm. In 1989, premiums shrank over 70% to $98mm and did not return to the $100mm level for 12 years. Three years later, National Indemnity wrote in excess of $600mm of premium. This level of premium volatility is unheard amongst the greater insurance industry. Over this time period, National Indemnity generated an average underwriting profit of 6.5% as a percentage of premiums (even higher on a discounted basis) while the average PNC insurer generated an average loss of 7%.

Wow. Let that sink in – it’s the financial equivalent of a Mozart symphony. Thorndike’s vignette captures in a nutshell the beauty of Berkshire – (a) equity (b) leveraged with liabilities that actually pay Berkshire interest rather than vice versa (c) providing funds for investment to a great capital allocator. This is a harmonious recipe for significant compounding.

Very few insurance companies are willing to act accordingly. Such premium volatility is anathema to the typical insurance CEO focused on growing the business, facilitating predictability for Wall Street sell-side modeling and competing with the rest of the herd.

Buffet has a critically different mindset: protection of equity capital. His focus is not on premium volume and growth, but rather underwriting profitably to ensure insurance loss payments do not have to be funded from equity capital.

Insurance companies can represent tremendous compounding machines when focused on the protection of equity capital and leveraging that capital via selective underwriting to fund intelligently invested assets (versus the “return-free risk” assets that clog many insurance portfolios). This mindset is rare indeed amongst public insurance companies.

One example to the contrary is David Einhorn’s Greenlight Re. Although GLRE has had underwriting issues of late, the cause has not been recklessly pursuing premium growth in a soft market. The company has maintained a low level of premium relative to equity capital, waiting to scale premium until the right pricing dynamic emerges amongst the market generally or within a niche. Further, the entire intent of the operation is to fund an asset portfolio allocated by one of the better capital allocators of the past 20 years. This recent quote from GLRE’s CEO captures the company’s worldview:

“If we cannot find opportunities to deploy our capital profitably, we will continue to manage our renewal relationships and remain ready for a better underwriting environment. Our goal is unchanged. We aim to build long-term shareholder value by writing a concentrated underwriting portfolio with the best risk adjusted returns we can find and to utilize the float generated from these contracts to invest in our deep value long, short investment program.”

The point is not to advocate for GLRE, but rather highlight what is a unique mindset within the greater insurance industry.

That wraps this first installment of thoughts from The Outsiders. There will be more to come. Thorndike created a commendable work that serves as a great lesson to business and investment professionals alike. The devil’s in the implementation! Reading about the behavior is quite easy, implementing a contrarian process not so much.

Welcome to Beta Hater Blog (BHB).  BHB will offer commentary on investing, the capital markets and human cognition and action within these realms.  The primary tenet undergirding BHB and its content will be contrarianism, a differentiated view.  Contrarian is a fashionable word amongst the investing community.  Oft cited; rarely implemented.  What does it mean?  I don’t know precisely.  I could tether the concept to some Webster’s definition, but in the vein of Justice Potter Stewart’s definition of obscenity, “I shall not today attempt further to define it; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it . . . .”

BHB’s title should help capture my worldview – “beta hater.”  The doctrinaire concept of beta was derived in academia and has crept into the mind and practice of the average finance professional via the charlatanistic curriculum of undergraduate business and MBA programs across this world.

What a crazy idea that risk can be captured by a formula?  Oh . . . if only it were so easy.  I can see how this idea is attractive to the math-minded individuals who derived the concept.  Like Charlie Munger’s oft-referenced notion of every problem looking like a nail to the man with a hammer, these mathematically-inclined individuals sought to reduce the gauging of investment risk – an inherently nebulous and partly qualitative and quantitative matter – to a formula.  And how attractive is the formula to investment banks?  Beta in concert with CAPM is the perfect CYA mechanism – better than actually thinking about a complex issue, use a formula!  If everyone else uses the methodology, we cannot be held to account when it proves fallible.  How wonderful and easy.

Reality, however, is messier.  Risk cannot be reduced to a formula.  Furthermore, the false comfort derived from such simplifications creates dangerous effects resulting from the illusion of knowledge amongst market participants and increasing reliance on the false precision created by models.  Beta does not capture reality and is dangerous and unnecessary.  To borrow and quote from Taleb, practice leads to theory, and the reverse should not be true –

“Nobody worries that a child ignorant of the various theorems of aerodynamics and incapable of solving an equation of motion would be unable to ride a bicycle.  So why didn’t he transfer the point from one domain to another?  Didn’t he realize that these Chicago pit traders respond to supply and demand, little more, in competing to make a buck, with no need for the Girsanov theorem, any more than a trader of pistachios in the Souk of Damascus needs to solve general equilibrium equations to set the price of his product?”

“The market” is a manic cauldron of mixed incentives, algo-driven trading, retail day traders, etc. full of intelligence, ignorance, over and under reaction, emotion and many other competing drivers.  Utilizing the market as the barometer by which to gauge the risk of an individual security turns logic on its head.  I am reminded of a professor I once had.  This man had a very, very high IQ and multitude of degrees from several august institutions.  What’s worse he actually had commercial experience, having worked for both a nationally-revered law firm and like investment bank.  When challenged during class concerning the real world utility of a particularly academic concept he had just elucidated, the gist of his response was telling, paraphrased: “I don’t actually believe in a lot of this but in order to be successful and published in academia you’ve got to contort your analytical framework to fit the accepted structures and theorems.”  Oh heavens!  So rather than dealing with reality as it is actually encountered let’s contort reality in an effort to fit it within our preferred, unrealistic framework.  That moment was my clean and final break from placing the least bit of weight on any construct emerged from academic finance.  The entire insular academic finance world is a false reality with a near absolute dearth of utility.

I offer this explanation for the intent and worldview of BHB.  I hope you find my musings thought-provoking and entertaining, and I welcome your feedback, commentary and insults.

One other BHB facet I should mention: concentration.  Like sensible fundamental-based investing, BHB will seek quality of ideas over quantity.  BHB does not seek to be the equivalent of your average mutual fund that holds a hundred securities and of its own accord consigns itself to mediocrity (sub-mediocrity, net of fees).   There is a surfeit of trite financial commentary on a second by second basis.  BHB’s goal is not to add to this noise.  Rather, I will post as I develop thoughts that are of interest to me (and perhaps to you!).  Posts may relate to a book recently read with relevance to the psychology and process of investing; a news item or interview of interest either for substantively valid reasons or as an emblem of what is broken in financial journalism; or some other thought with tangential, if any, relevance to investing.

Given posting will be intermittent I invite you to sign up for email notification of new posts.  Such notifications will not clog your inbox in light of their infrequency.

In closing, I hope to offer ideas you will find interesting and atypical.  You may not agree with my notions, finding them shallow, ignorant or incomplete.  In either case – whether you are of like or opposed mind on a given topic – I would enjoy hearing from you.  Robust discourse on a topic – as suggested by Holmes’ “marketplace of ideas” – is the best mechanism by which to flesh out truth and insight.