Will Thorndike - How Skilled Capital Allocators Compound Capital - [Invest Like the Best, EP.36]

This podcast is sponsored by CFA Institute, the Global Association of Investment Professionals, whose mission is to lead the investment profession by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals, working to build an investment industry where investors' interests come first, financial markets function at their best, and economies grow. The Chartered Financial Analyst's Credential is the most respected and recognized investment management designation in the world. The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome everyone. I'm Patrick O'Shanasi and this is Invest Like The Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shanasi is a principal and portfolio manager at O'Shanasi Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shanasi Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shanasi Asset Management may maintain positions in the securities discussed in this podcast. This week's guest is Will Florendike, an author and investor whose book The Outsiders is an all-time favorite of mine. Our conversation is in two parts. First we dive deep into the lessons of his eight-year research project, studying CEOs who were master capital allocators. These CEOs include Henry Singleton, John Malone, Tom Murphy, Katherine Graham, and Warren Buffett. We discuss how these CEOs tended to be contrarians on topics like dividends, buybacks, acquisitions, and the use of debt. As we go through each of the tools in the Capital Allicators Toolkit, you'll hear several useful lessons for running or evaluating a business. In the second part, we cover Will's career in private equity. Will founded and continues to run Hussetonic Partners, investing in buyouts, recaps, and search funds. Will has been one of the most active search fund investors for decades, and given how much time I've spent in past episodes on the searchers or operators in the micro-cap permanent equity space, it was great to get the perspective of an experienced LP. As always, we also take time to survey the dangers and opportunities in today's private equity market. You can find show notes for this episode at investorfieldguide.com/thorndike, and now please enjoy my conversation with Will Thorndike. So Will, thank you very much for doing this with me. I always like to start somewhere a little interesting of a far field from what you're doing today, and I thought it would be fun for us to start with an origin story of sorts, and go back to maybe the first moment or the first experience when you knew that you were deeply interested in investing as an application. If you could bring us back and kind of describe the early setting, that would be a neat place to start. Great. Well, thank you, Patrick. So I did have sort of a light bulb moment as it relates to investing. I was on a vacation very shortly after I graduated from college in Maine, and I had brought, it was, as it can be in Maine, the weather was terrible, and I'd brought sort of a set of books with me, and I had made my way through those books, and so I was perusing the shelves of the house that I was staying in. And there was a book on those shelves, The Money Masters by John Train, which I pulled down, and Sarah's Read in the first chapter in that book, I'm not sure if you've ever read it, but it's a very good book. This is the original, you know, there've been subsequent additions with this, the original 1980 iteration in the first chapter is on Buffett, and still a very, very good description of Buffett's investment in philosophy. And I just read it and immediately realized that was something I wanted to learn more about and eventually do, and began it, and I sent off for the Berkshire letters, and that sort of began a process. One of the things I found interesting was that your book obviously talks a lot about public markets, CEOs, and allocators, but your firm is predominantly private equity. So what was the journey like kind of deciding from that first chapter reading about Buffett, how did you get from there to the founding of whose tonic in 1994, what drove you into the private equity space? So I had a serendipitous opportunity after business school to work with two high net worth investors who were looking to identify private equity opportunities for their personal capital. And so that it came about through serendipity, I actually had worked at T-Roll Price before that in the public equity area, but sort of a unique opportunity to work for an equity interest, for a profit interest very early on, which is what I was looking for. It was a very entrepreneurial, early-day situation, and why I sort of worked out of a closet as we built the business kind of deal by deal, but it just was sort of a circumstance that arose through an unpredictable opportunity. We'll spend the first chunk of time talking about some of the principles you explore in the book, the outsiders, and then we'll circle back to private equity. One of the things I was really intrigued in my research leading up to this conversation was that it did not begin as a book that it was a separate research project where you were looking at, I think it was one CEO per year. So some pretty intense, deep research on how very specific types of operators produced incredible results. So could you walk me through a movie that the first of those was, and why you began doing that in the first place, why spend a year investigating the career of one person of one CEO? So it began, the whole project began as a talk that I volunteered to give at our biannual CEO conference about a dozen years ago. So every other year we host a conference for all of our portfolio companies, CEOs, as well as alumni, people whose companies we've sold, and people who were wooing to run future businesses, future companies. And we typically have a headliner speaker at those, sort of a Jim Collins Michael Lewis type. And then we have a few more practically oriented, you know, pragmatic specific talks. And I volunteered to give one of those. And I had read about Henry Singleton. Actually it goes back to the first mention of Henry Singleton that I was aware of was in that book, the Money Masters, where Buffett sort of describes him as a uniquely talented CEO. And so I decided I'd do a deep dive on him and then present that to our CEOs. And I realized in order to do that, I needed some research help. And specifically I needed access to the Baker library at HBS, I'm not an HBS alum. And we happen to have an HBS student working for us between years in business school. And I asked that individual if you wanted to do an independent study in his second year, and he was a tennis player, he told me that he just committed to another independent study, but his doubles partner was looking for a project. So I called up his doubles partner, who is an extremely talented guy named Elim Chaudry and Elim agreed to do the project. And we did a first semester of Elim's second year, we did a very deep analytical dive on teledine and all of the comparable companies, sort of the 60's era conglomerate peer group. And in the second semester we interviewed everyone alive who had anything to do with the company. And as I was writing it up, Elim came to me and said, if you want to do another one of these next year, and it was really talented guy in the class behind me is looking for an independent project. And Elim by the way was a Phi Beta Kappa in physics from Stanford. That second guy was a guy named John Gilligan who actually was in here yesterday. He was in town on business and we caught up. He now works for Byron Trot. But John was a summa in chemistry from Harvard. And so just by, and we did, he had John Knight to Capitol City, so that was the second one. So I just got by happenstance into this really talented sort of layer of top HBS students who did these research projects as independent studies in their second year. And so it just sort of evolved over time. And after about the fourth or fifth year, I thought maybe this is a broader book type project. And after about the sixth year somewhere in there, it just became clear there was this pattern. A much clearer, stronger pattern than I anticipated. Again, one of the models being the money masters where there really is no discernible pattern. There are a variety of different successful investors, but they pursued different strategies to achieve long term performance. So anyway, that was, it evolved over a long period of time. So maybe we can dive into that archetype now of the pattern that started to emerge. The reason that I have used the book a lot and given it a way as a gift a lot is because it effectively comes out a major area of my own research, which is quantitatively modeling capital allocation decisions. And it describes them in a perfectly kind of fundamental, complimentary way. And what's neat about the way you describe capital allocation is that it's a relatively short menu on both sides of the ledger. So there's kind of three ways to get capital, maybe four, and there's five ways to spend it. And what you found was some common patterns in how some of these really successful CEOs and your definition of success, I think, is an appropriate one, which is the businesses that they led significantly outperformed the broader market over a fairly long tenure. So they delivered kind of per share results that were extremely strong. So I'd love to kind of go through those two menus and we'll really focus on the allocation side to pull on the thread of what worked and what maybe just is interesting what didn't what's more common that doesn't work from a capital allocation standpoint. So first, maybe you could list what those five are and then we'll kind of go one by one. The five alternatives you have as a CEO is a capital out. or you can invest in your existing operations. These are in no particular order. You can buy another company. You can pay a dividend. You can repurchase your shares or you can pay down debt. There really is a six, which is you can let cash accumulate on your balance sheet, but that's just a deferral of an ultimate position, right? So those are really the alternatives. - Let's start with an interesting one, which is dividends. - Yeah. - Dividends have always been popular, always a significant quoted source of total return, obviously. And part of the whole idea of valuation is discounting of future cash flows, leaving the business and the form of dividends. What did you find in common between these eight and maybe beyond the eight, very successful capital allocators as it pertains to their dividend policy, their view towards dividends, whether or not they paid them and so on? - So they were very unconventional in that regard, specifically they generally disdain dividends. They generally either avoided them, either avoided them altogether where they paid a substantially lower, their dividend yield was substantially lower than the peer group. And the reason for that in every case was tax inefficiency. So one of the common threads across the eight was a real focus on tax minimization, optimizing kind of after tax outcomes. Individends just are inherently deeply tax inefficient with the two layers of taxation. The exception to that across the group was the occasional use of special dividends. So as opposed to getting on the regular systematic quarterly dividend treadmill, occasionally some of these CEOs would pay large one time dividends when they didn't have other alternatives. And you often timed to coincide with favorable tax. The timing relative to tax bills being passed or about to be passed. So then we can talk more about that, but yeah. - I know you focus in your day job on private businesses, but I'm curious if you look forward at public markets, it's always mystified me in a hyper liquid market why anyone would really pay a dividend. People love them still because of the cash stream, but you can obviously sell shares at hawk as needed when you're willing to incur the tax hit and sort of create your own dividend. So any opinion on why that general strategy hasn't taken better hold, it seems as though buybacks make a lot more sense in terms of just clean return of capital to shareholders, 'cause it's opt-in for who's gonna sell. And I guess it sometimes indexes our force to sell in a buyback, which is another interesting dynamic maybe that we could dive into, but I'm curious what you think about the future of dividends, whether or not anything will change. - Well, so dividends, I mean, it's interesting. The dividends I think are as popular now as a capital allocation alternative as they've ever been. Corporate profits are very high and this mantra of returning capital to shareholders is just everywhere. It's everywhere you turn. And it's Wall Street, Cell Sight Analysts, or Front and Center in advocating for returning capital to shareholders by dividends. And so it's an interesting, and this is occurring at the same time as dividends have become substantially less tax-efficient over the last four years, right? So you basically had this period, this interesting period from the early 2000s when George W. Bush was elected until your end 2012, where dividends were the lowest they've been on record in history. And so there were actually tax-advantaged relative to history for that period of time. The dividends increased January 1st, 2013, and actually oddly, the popularity of dividends has grown since that event, right, so over the last four years, which was not rational behavior. Interestingly, you could look at a group of companies that decided to pay large one-time special dividends in 2012, and that would self-select for a group that was very, very conscious of tax impacts, and it's an interesting list. And it would include very prominently the Washington Post Company under-- interesting. - Catherine Graham's, you know, son Donald is the most CEO at that time. - Yeah, I think it's something to watch for sure, and one of the things that we monitor is the relationship between different factors amongst stocks, and dividend yield for most of its history was a value factor. You know, high-divine yield indicated pessimism or some sort of cheapness, some sort of out of favor indication from the markets, and that basically collapsed in 2009, and has remained very low sense, meaning the correlation between high yield and other measures of cheapness is basically nothing. It used to be, you know, 0.5, 0.6, 0.7, and now it's basically zero. So high-divine yield does not imply a low PE or a low price to book or a low price to cash flow, which I think is fascinating, that people in a very low interest rate world like these dividend-paying stocks, it's really interesting. Let's go to the pair along with dividends to buybacks. This is the area that I am most interested in. It's the factor when you model companies, capital allocation decisions, that seems to contain the most predictive information. And what I mean by that is that firms which have large, lumpy, kind of not dollar cost average, but I hesitate to use the word timed, but almost timed, big, sharey purchases, sometimes 10% or higher, tend to go on to do very well versus say the S&P 500 or the broad market. So I'm curious what you found when studying CEOs, and how they, obviously single-ten was sort of the godfather of all this. Maybe you could explain that, but how you think about buybacks as a tool. - Single-ten was the pioneer of this, and the pattern that you describe Patrick is effectively the pattern across this group of eight CEOs that are profiled in the book, which is sporadic, large repurchases, time to coincide with low points in the stock price. And you know, Singleton, you can look at his history, so Singleton's fascinating, because he had great ranges, a capital allocator when he started, and the Teladine was during the heyday, sort of salad days of the conglomerate era, and he issued a lot of stock to buy companies, and he typically issued, you know, for the decade of the '60s, Teladine's average PE was in the mid-20s, and he typically bought companies at 12 times earnings, right, so it was a very accretive activity. He stopped issuing shares literally in 1969, never issued another share. Stock market went through a lot of turmoil, in the early mid-70s, and as that was all occurring, he completely reversed course and began to aggressively repurchase shares, and so between '72 and '84, he repurchased over 90% of shares outstanding, so no one else has ever been close to that level. And he did it across, you know, a small number eight or nine tender offers, a very specific points in time, and the average PE he acquired at was high single digits, right, so just, you know, dramatically different. So he's the exemplar, but if you looked across this group, all of this, the seven of the eight CEOs repurchased 30% or more of shares outstanding during their 10 years, all fitting this pattern of sporadic large repurchases, as opposed to systematic quarterly programs, the exception, the, you know, the eighth CEO being Buffett, who weren't Buffett, who've had a variety of reasons has never been as aggressive on repurchases, and there's some specific kind of idiosyncratic reasons for that, but it's a very specific pattern. - I use the Singleton story nonstop, because as I was reading the chapter, which is the book's first, and one of my favorites, for sure Singleton had he not retired in the early mid 90s, would be mentioned in the same breath as the Buffett, says the Jack Watchers of the World, for incredible CEO 10 years. But the story read to me, like a fundamental long short equity manager, where his universe was his own stock, and a hundred whatever stocks that he purchased. It always makes me wonder, you know, you mentioned issuing at 25 times earnings to buy at 12, and then not issuing anymore and buy his own stock at eight. As I read through the book, it really sounds like good capital allocation is basically value investing, that it's figuring out, and obviously we'll get into growth in CapEx, which is the other side of the coin, but can still be viewed through the lens of value investing. I found that story just completely fascinating, and I wonder how much that will continue, and I think they asked Singleton in the 90s as buybacks were becoming more popular, whether what he thought, and he said, well, if it's becoming popular, it's probably not as good or opportunistic anymore. So certainly a fascinating guy, and for anyone that hasn't read the book, just get the book and start with that chapter. It's an amazing lesson in value investing. Maybe we could go to CapEx next, and that is one where, in my research, I've found that the highest rates of CapEx growth tend to predict bad future returns. So significant increase in the size of the asset base, and that's just a very broad statement. Obviously there's a lot more nuance than that, and this one might take the most time, because I'm fascinated with growth. Everyone kind of thinks of growth as a good thing, but it's a nuance thing. So what was the opinion of the HCEOs, and maybe your own opinion, on CapEx, on spending, on reinvesting in the business? - So as a group, if you are gonna describe the HCEOs in the book, you know, what's interesting is, they came from a wide variety of backgrounds before they became CEOs. So, you know, you get two high-level mathematicians, Singleton and Malau, Jamalau. You had a widow who hadn't been a Lord Force in 20 years. You had a former astronaut who entered the private sector and his mid-40s. It's a very fairyt interesting mix of people, but they shared some common traits, right? So all of them were first time CEOs. That's a very surprising finding. Half of them under 40 when they got the job. Only two of them had MBAs. Four of them had engineering degrees. Right? And so if you were going to describe them, right? If you were going to pick a group of agitives, you're going to select adjectives to describe them. You wouldn't choose the traditional CEO agitives, right? So this was not a-- Younger name experienced. Well, so if you were going to describe them, you-- so you wouldn't. So they weren't charismatic as a group. They weren't visionary strategists. They were not Elon Musk. I mean, they were not remotely Elon Musk. What they were, if you were-- they were pragmatic, analytically oriented, flexible, opportunistic, cool, agnostic, words like that would fit them much better. So as it related to CAPEX, they were very analytical about capital expenditure, organic growth-related decisions and investments, right? So they quantified things and they made decisions based on returns. Looked that very coolly, you know? So the best example of this is Malone, John Malone, who is the CEO of the largest cable television company for 25 plus years, which is the-- we focus in the book on his record running TCI, you know, the large cable company from the early '70s to the late '90s. He's had a wonderfully fascinating post TCI career and he's still active, basically 20 years later, but holding all that aside, if you look at what he did as a cable TV executive, fascinating because he had this interesting suite of options where he had very attractive internal organic growth-related CAPEX opportunities. And he also had very attractive and interesting, inorganic acquisition allocation alternatives. So he's constantly toggling between the two. And he would look at, you know, what is the cost of building more cable plant and what's the related IRR? You know, we make penetration assumptions. If we pass-- if we pass neighborhoods where the densities are greater than 20 homes a mile, and we have 60% or better penetration, IRR will-- you know, there was very, very quantitative and he was constantly toggling back and forth. He was an incredibly active acquirer and that's what he's best known for. But if you go back and read the, you know, quarter by quarter analyst reports, internal growth CAPEX was a big part of that and he was quantifying that very specifically. Basically, you know, he wasn't going forward with anything that didn't have a mid-20s IRR or better on the internal organic growth. There was just clear decision rules. So anyway, I think that general approach was widespread throughout the group and it led in some cases to decisions to shrink businesses. I wonder if this is the area where the idea of a checklist is the most applicable among the suite of capital allocation options where you see a lot-- I read a lot in the book about specific hurdle rates. Like, for example, our current Secretary of State Rex Tillerson had a hurdle rate when he was cheering Exxon mobile of 20% where if there wasn't an expected return of 20, it's just-- you moved on. It was a checklist item that if it was 18, you didn't do it. And that sort of discipline sounds easy from a safe distance. But when you are flush with cash, which I think is what drives-- and when you dig into why high-capac growth companies underperform, you often find very undisciplined spending in capital allocation. It's very easy to spend money once you've made it. And I think a lot of managers do just that. They spend recklessly. They're not disciplined about a hurdle rate. They don't think about opportunity cost as cleanly as they should. So it was really interesting to read, especially that chapter on the loan, of that intense discipline. And it seemed like maybe that hurdle rate was the way that people were successful with growth-capac. I think that's fair and accurate. And they set intentionally high hurdle rates. And then they enforce them. So it's a very common thing for hurdle rates to be set within an organization. And then mysteriously, all of the models that managers bring forward to justify CapEx show IRRs north of the hurdle rate. So the key thing is having an internal system that retroactively holds them accountable. How does that work? So it's tied into a rigorous annual budgeting process. In which, in all of these companies in the book had highly decentralized organizations, which is a model that can be very powerful. But it needs to be accompanied by a budgeting process that has accountability sort of front and center, so that where targets are enforced and there's an internal sort of audit function that's confirming numbers and making sure that benchmarks are hit and sort of maintained. I mentioned Elon Musk earlier and he's the present day best example of a guy with a grand vision, or more specifically several grand visions trying to happen all at once. One of the interesting aspects or common traits of the CEOs in the book was something quite different than that. That they didn't tend to be big, multi-year strategic thinkers. I think the phrase you used was flexible and opportunistic. So can you describe that difference and how these iconoclastic CEOs were different in terms of their planning? Yeah. Generally, as a group, they were not fans of broad long-term rigid strategic planning. They just fundamentally believed in a more opportunistic approach to managing their businesses. Singleton has the sort of best quotes in this area, but he basically believed in showing up to steer the ship every day. And fundamentally, you couldn't predict what the external environment would provide you with in terms of opportunities. And so you needed to be prepared to react to circumstances as they arose, sort of optimize the hands, the cards dealt. That would be true kind of across this group generally. And they were not visionaries. They were they prided themselves on the quality of their analytical work and the related processes internally. We're talking about Singleton, who is clearly one example in Malone, but that would be true of Bill Steritz at Ralston, Purina, Anders, you know, and his successors at General Dynamics, kind of across to that group, that sort of analytical rigor was, you know, very, very common trade. What about acquisitions and debt paydown, which were the last two and maybe debt paydown is the one that sounds the most boring, but maybe I'll let you convince me otherwise. We talked a bit about John Malone and acquisitions, but what was the general take on acquiring other businesses, which in aggregate seemed to have destroyed value for shareholders just in the broad market sense. They tend to kind of follow the market cycle. They peak when the market profits peak and don't seem to contain a lot of information and often are not a good strategy. So how did these CEOs think about acquisitions? So the general pattern across the group was occasional large acquisitions. Malone is actually an exception. He's the exception to that in the book, because he sort of had this central insight relating to the power of scale in the cable television business in the 70s and 80s. And so he was constantly acquiring to develop and maintain scale advantages. And he was doing that within clear discipline decision rules, but as a result, he had a constant pattern of acquisitions. If you hold Malone aside, all of the other CEOs followed this pattern where they would do very occasional, very large acquisitions. And each of them made at least one acquisition that was equal to 30% or more of enterprise value at the time it was made. So occasional large bets, which they perceived to be very high probability. In almost every case, those were acquisitions where they knew they could improve margins through cost side economies. That tended to be the common thread. The best example of that, and the largest example in the book actually is Capital Cities, media company. It was run by a guy named Tom Murphy in the 70s and 80s and into the early 90s. And in 1986, 85, 86 capital cities, which mostly to that point owned more rural TV and radio stations and operated them exceptionally well, agreed to acquire ABC, the parent company, the network and the largest operator of TV stations in the country. They had stations in all the major markets, New York, Chicago, LA, etc. And the entire logic of that deal rested on Capital Cities being able to take the margins of the TV station business that ABC owned, which were about, they were operating at about 30% cash flow margin and take them up to the median margin for the Capital Cities stations. It was about 50%. 20 margin percentage point, 2000 basis point improvement of margins and they were able to do that in about two to and a half years. But the whole deal rested on that and they had a very specific series of things that they knew they would be able to do to improve margins. But as a result, they were very comfortable making a very large bet, which they financed predominantly with debt. I don't remember if you get into it in the book, but what were the primary strategies to increase those margins by that much? At ABC. It's mostly headcount related. It's mostly head or Jesus. Mostly synergies. Yeah, and the network business, it was a business where the TV station business. I should say in the 70s and 80s was an unbelievably good business. It had exceptional economic characteristics. And so even mediocre operators with lots of extra costs were very profitable. Right? And so capital cities just really knew how to run stations super efficiently. Which didn't mean they actually did that while investing significantly in the on-air content, the on-air product. But they basically ran everything else very lean. And they were able to produce headcount very significantly. Reminds me of the FIFER book, the 3G guys use so much, the double your profits in six months or less. And there's the cost they bifurcate into strategic and non-strategic. And some spending on content, some of them would help you grow and increase your revenue. You should maximize that relative to competitors and then minimize all of their costs. And that basically sounds like that playbook. It's exactly the same thing. There's this great story from Tom Murphy's earliest days of capital cities where he got sent out by the largest investor at capital cities to go run their one TV station in Albany, New York, which was located in a dilapidated former convent. So the guy sends Murphy out there and he says, "Listen Tom, you go out there and you run this station, I'm going to leave you alone." You figure out how to make it profitable. The only thing that I'm going to ask you to do is to paint the building because it's an embarrassment. And no local advertisers are going to take us seriously. So Murphy's response famously was to paint the two sides facing the road. So it suggests that every single station manager in the history of the company from that point forward was told that story before that. Now he didn't economize on on-air talent or the quality of the production equipment, or the things that actually went into getting ratings. But everything else was run. Leant had to be rationalized. So what an awesome story. I don't remember that one. The lean idea makes me think of debt now and debt pay down. And actually you'll have a very interesting perspective on this giving your career in private equity. One of the things that I find appealing about the private equity model is the idea of making equity sweat, meaning companies that have a lot of interesting principal repayment coming down the pipe every quarter tend to be very smart about managing their cash flows. So they can make sure to meet those requirements. So I'm curious how you think about in public companies the use of debt, how the outsider CEOs thought about the use of debt, and whether or not it's a good or a bad thing. Or if there's a goldy locks kind of amount of debt. So basically all of them, again Buffett is a bit of an exception here, although we can talk more about that. But basically all of them used leverage pretty actively. And they all believed that there were real benefits to the tax shield that debt provides. And that there were just all of them, the pattern tended to be they would based on the economics of their business. And cable being the most predictable utility like business of the aid in the book. You know Malone looked at that and he said, you know, we given that, we believe the right level of leverage is four times cash flow. Cash flow in the cable business defined as EBITDA by Malone who invented that term. And he consistently ran his business in that, but he was very clear to equity investors, public markets, debt providers, that that was the band. To this day, you can look at all the liberty entities. And in almost every case, they have told you the exact band they're comfortable with. And they're very clear about where they think the right level of leverage is. They'll typically be a little more aggressive in their use of leverage than the other players in their industries. That's true in cable here in the US, you know, the Charter, which is now a liberty entity effectively. We'll run at a higher level of leverage than Comcast does. That's been true for 30 years in Malone at these versus Comcast. But they're very clear about that. That was true also for Dick Smith, the general cinema, which is very clear. He was going to run the business between three and four times cash flow, again, to find as EBITDA in that, you know, in his case. So they were in each circumstance, there was the CEOs knew their business as well and felt that they knew the level of leverage that their businesses could comfortably support across a business cycle. And they were clear with investors and the markets generally about where those levels were and then they adhered to them. But they all use leverage. So an interesting question really curious to hear this answer. If you could hypothetically choose one of the eight, so you've got a 20 year horizon, let's say. So you're making an AlumsoM investment today. You're not going to touch it for 20 years. You get to pick one of the eight outsider CEOs and you also get to pick one real current business. That'll be extra points. It could be a generic business too. Who would you pick and why? All right, so let me ask, I get the guys question back. Or clarifying questions. So this is at the point in time that they began their careers as a CEO in the book. Yes. Right? Right. So, okay. Okay. And are we talking about, so well, that's a difficult question. But a good question. So I'll focus. I'll do the CEO piece of that in a minute. I got to think about it. But then on the business question, that is from today looking forward. Correct. Correct. Yeah. Okay, also an interesting question. Okay. All right. So let's see. So, um, yes, so I think that's a really tough, that's a really tough question. So there are some unique advantages structurally to insurance businesses as compounding machines, right? So, Whoa. Yeah, because of the float. And so if you have someone who really understands that and combines that with unique investing ability, it's really hard to beat that as a compounding machine. Right. So if you had Buffett with his known abilities and his abilities were known, like he had the Buffett partnership record in place. The vast majority of it by the time he took over Berkshire. He had the first 10 years of it, anyway. It's very hard to beat that standard. I mean, he's an incredible, unique genius and he, you know, found a unique vehicle that was uniquely leveraged to that genius. So that's a hard, so I'm going to kind of hold Buffett aside. Okay. Because I think he's, I think the quite it's a good question. I think it gets a little trickier. And then I think outside of Buffett, if your goal, if your sole goal was 20 year per share optimization, so you're optimizing the compound only. It would be a horse race. And they, you know, with it would be a horse race, but I would probably go with, I'd probably pick John Malone. So was it his, that's what for some reason that's the guess I would have had for who you'd pick. And I'm assuming it's his extremely disciplined and opportunistic acquisition strategy that kind of has Buffett-like characteristics in terms of the discipline with which he, and Singleton too, right, the discipline with which he did the math and cleared hurdle rates. Is that kind of what drives that choice? Yeah. What makes Malone interesting is that he kind of, I mean, if again, in answering this question, so that, yeah, that doesn't, I mean, he's super talented and he is my answer to that, to that question, X, X Warren Buffett. But he just everything about his approach, he is the other high level mathematician along with Singleton in the group. And he came out of an operations research, electrical engineering, and an operations research background. So everything in his training was geared towards, you know, optimization, right, optimizing the signal through the noise or, you know, output for any given amount of input. And his entire approach is the CEO's the same way. So it's his ability, his, the factor you mentioned is the discipline around acquisitions combined with unbelievable acumen on tax minimization, right? And I think it's hard to underweight that if you're talking about a 20 year holding period. And prudently aggressive use of the balance sheet. Right? So across those three factors, and you just, and as with all these CEOs, you know, Catherine Graham being you know, you just know the probability of bad decisions is very low. You know, so it's a dynamic way, if they announce an acquisition, overwhelmingly likely that's an accretive positive thing. Not true with generically of public company CEOs. If the stock gets hit, it's almost relaxing because you know, if it gets hit and the IRR is attractive from purchasing it at the new lower level, they're going to purchase it aggressively. You know, so just the, and kind of all of those pieces, you know, alone, some active repurchase service shares, as well as an active acquireer as well. So he kind of has, he's sort of uniquely suited to optimizing per share price over a long period of time. So that's, but it's tough. It's, that's a, it's a horse race. What business would you give him? Business would I give? Business would I give John Mulone? Okay. So I would go back if you said, what business from today? I would, I, I'm holding Malone aside. Again, I, I think it would be hard to, the insurance business has some real advantages, right? So if, if you have an insurance business run by a CEO who really understands the value of underwriting profitability and flow generation and then as a talented investor, that is really powerful over long periods of time. Okay, so that, I would, I would be looking for a niche insurance company that had a history of, you know, sub-100 combined ratios. strong flow generation run by somebody who understood how to allocate that flow in an advantage way. So that would be my first default choice. So if the question specific to John Malone, I'd probably give John Malone, I would love to see what John Malone would do with a cellular tower business that has these wonderfully predictable long-term cash flows that had a mandate outside the US, where you had sort of a combination of organic growth and that predictability of cash flow and just watch him go to work. Go to work on that over a long period of time. That would be a fun exercise. My point on insurance reminds me of another theme in the book which was this partnership. So there tended to be the CEO who is the allocator and the strategic thinker and then like an operating partner. For both it maybe it's a Jane who runs the insurance operation and it gets credited in almost every annual letter as being a key part of the engine that allows Berkshire to do so well. Maybe touch a little bit on the importance of that kind of partnership sort of a wingman or a chief operating officer. Someone that effectively makes sure the cash flows are coming so that they can then be allocated in a productive way. So that is a common thread across the ACOs in the book. They all had very strong operations oriented number two COO types common thread across the group and I would say more generally it relates to the company. So if you're looking at the resources you need to allocate as a CEO we've been talking about capital which is a primary obviously critical resource but there's also sort of human resources and this group shared an approach to that which was you know these highly decentralized organizations. Very thin corporate headquarters and responsibility distributed out into the operating units. And then as it related to their own time another scarce and valuable resource they were very disciplined about their time. And the two common threads there were one the use of these very strong COOs who were responsible for overseeing these intensive budgeting processes we talked about and running the operations. You know so that piece could be sort of bulletproofed and that freed these CEOs up to focus on capital allocation and longer term projects. The other area was investor relations right so depending what study you look at in the US now typical public company CEO spends somewhere around 20% of their time on IR. Didn't that ballpark? Asset managers too. Asset managers too. They for sure. And this group as a group actively actively disdain investor relations. Like allocated substantially less time to it. In some cases ignored it completely and in every case they were they were unconventional in that regard. So they spent less time with Wall Street and the business press than their peer group did. And that freed up time that they could allocate in other ways that they believe create more value. So I would kind of group the COOs and the IR approach together in sort of this management time allocation prioritization bucket. Or again I think that a differentiated approach. I've seen that as a couple people have mentioned that to me as an interesting screening criteria for companies for public companies is to look for ones who spend either don't do the quarterly rat race they completely opt out of it or they do as little as possible on the investor relations side. It's a really I don't know if you could you know perfectly screen for that but it's it's an interesting starting point right to find like your special dividend in 2012 you know some people that are that have a different mentality than the norm. Yeah for sure. Yeah. I'd love to hear a little bit about the experience of the book itself. So I think I saw you writer and an interview somewhere say that you know that the success of the book which has been very large and it become a well-known very well-known book in investing circles was surprising you didn't expect it. So I'd love to hear what the experience has been like. Do you think it's been received or used in the right ways? What was the experience of going from kind of a one-off project to a best seller in the investing space? I mean so that was you know wildly surprising and dramatically dramatically see it in any expectations certainly that I had or that the publisher had so that you know it's been it's just been a very fun for me personally since the book came out. The most fun thing is that it's led to a lot of interactions with really talented investors and through them with some very interesting CEOs. So I you know much more than I would have anticipated so that's been really that's been really fun I've really enjoyed that. I enjoyed that quite a bit and then you had there was something else embedded in your question that I'm no you've got it just sort of the unexpected maybe an unexpected positive experiences that came from it sounds like meeting some you know interesting people CEOs etc. that you might not have otherwise is worth it alone for the for the research effort. What would you do if you had to write one more book what would you write about totally unrelated to that project? So I don't have a I mean what I found is I'd never written anything before and this took me a very long time so slow writer but I really enjoyed that process and so I I don't have a clear answer you know Patrick there's nothing right now that's sort of on the horizon but I find that process invigorating and I look forward to finding other things to write about and there's some business things I'm interested in I'm not sure their book projects probably more in the form of articles and some non-business things. What are some of the non-business things that really have interest? Well so I you know I did for instance I'll give you an example I wrote a I wrote a short article on a my high school football coach who had a you know I had a phenomenally talented high school football coach who had extraordinary results with very poor material. What made it so I thought it's a combination of things but he was he was ahead of his time strategically would be one thing so he was running a I can go into detail in this. He was a pioneer in running the running shoot type of offense which is now widely popular in NFL but he was running that he read he read some early material in the late 60s so he was running we were running when I was there in the early 80s a offense that would you know in the early 80s where there were probably five places in the country running it you know so he was just ahead you know he and it was suited to the small wimpy people he had playing on his team but he got great results and he was just very talented guy so you know what I find is it's interesting to write if you're trying to figure something out that's the that's the intellectual sort of engagement part of it's fun to try to solve an interesting problem and then to write about it. He sounds just like an outsider CEO right? In a weird way he sort of was yeah yeah doing something against the grain sort of independent thinker. Very very much so yeah so that's a good bridge into your day job which is in private equity and I think kind of specializing in maybe we could touch on each in three buckets so one being traditional buyouts one being recaps and one being search funds and this is an area that I've just started to understand and explore and I was reading a Harvard business case study and I was this was just a couple days ago and I was kind of surprised to see your name pop up as someone that had done a ton of these I think north of 50 of them over the last 20 or 30 years so maybe we could start with we'll start with search funds since it's an interesting topic how did you get involved early on obviously I think you must have been a pioneer as an investor in people going out to acquire a business and run it so tell me the origin story there how did that get started? I went to Stanford Business School graduated you know in the early 90s and search fund idea was really invented and fostered shepherded by a professor who started at HBS in the mid 80s and then moved to Stanford to the GSB where he's been for the last 30-ish years his name's Irv Grossback so I had exposure to Irv when I was out there and when I was tapped to start whose tonic partner is the private equity firm very early on I realized this was a potential differentiated source of deal flow for us because what search funds do is small or growth buyouts that's that's what those transactions are and so we were involved very actively for the first eight to ten years of who's tonics existence investing in search funds because it was a proprietary source of deals for us and that are those very productive activity our returns were were quite good from that and then as our fund sizes grew it got harder to invest in search funds which tend to intentionally focus on smaller transactions so I began to invest personally in them and I've been doing that for 15 plus years now what was your first search fund investment my first search fund investment actually was in a company called Asurian which is just completely by absolute happenstance the most successful of of all the search funds it's been a wildly successful company run by very talented CEO who was a classmate of mine in business school guy named Kevin Tweedle so that was actually our our first one and we still own some of our original shares there we've sold the number of them the majority of them over time and some recapitalizations but 20 coming up on 22 years later we still on some of our shares you just grabbed the business maybe what it looked like back then yeah well yeah it's full what it looked like then was it was a provider of roadside assistance services through cellular phone companies to their end subscribers so you know you would hit star help on your start-take phone right 90's air cell phone and these guys would send a truck to come help you if you were broken down by the side of the road and at that point in time cellular penetration had gotten to the point point where the incremental users were signing on in many cases for safety and security reasons. So this sort of fit perfectly with that. And so it was a service sold through the channel of cellular companies to their end subscribers. And it was sort of a $3 a month charge embedded in a $60 a month cellular bill. So it was a recurring revenue stream attached to cellular penetration starting in about 1995. And then they've branched off of that into other businesses. Their largest business now is handset insurance. They're the largest provider of handset insurance here at the U.S. and they've done a phenomenal job over a long period of time. So how I'm curious of, I haven't seen good detailed data on search funds and for my understanding in a conversation I had last week was that there are probably several hundred searches going on in a given time, which may sound like a lot, but there's hundreds of thousands of companies and it's really a needle in a haystack game. So of the 50 plus searches that you've funded, whether it be Housetonic and Bridging into personally, what's the base rate like? How many of those were good, accretive, good investments, maybe cleared some sort of hurdle rate, how many failed completely? What does that distribution of outcomes look like? Yeah, so our experience and my experience mirrors, so there's a, I would recommend the Stanford Business School on their website has a search fund sort of repository of data and I would recommend going there and pulling down their information. They've got excellent returns data. It's far away the most comprehensive survey and they put it out every other year and the most recent survey came out, I think last fall. And what it shows is that across search funds generally, very, very, you know, the IRRs are very high mid 30s, but most interestingly over long holding periods, an average holding period of seven to eight years, so very high multiples of capital. If you look at the distribution of returns across that portfolio that generated those returns, there's a concentration of alpha in the top desial, top quartile outcomes, but there's some reasons for that. And you know, over again, the search fund is 25, 30 years old now as a, as a concept, as a vehicle and over the last 10 to 15 years, the economic criteria that searchers use and identifying industries and companies has been significantly tightened. And although the data is still emerging, it appears as though the returns data has also tightened. But the version, not the level of the, the dispersion, right, but not the level. So the overall level of returns appears to be holding, but the dispersion has shrunk. So it's very interesting. And then the number of search funds has exploded. And there's been sort of logarithmic growth there in the last dozen years. So it's absolutely, it's just fascinating. It's a very dynamic area. Do you see anything like that today in the entire investing landscape of a new category of sorts that like search funds were 25, 30 years ago? It's just a whole new concept, a new interesting way of compounding capital. I don't see anything that's a perfect analog. But I do think there appears to be more energy, interest, particularly among sort of high net worth family office, sophisticated endowment, sovereign wealth type pools of capital. So you know, the more, more stuff, what I would call more sophisticated pools of capital in finding more permanent, permanent capital type vehicles, true evergreen structures seem to be, seem to be growing. And I think there's, that's going to be very interesting category to watch going forward. It seems like everyone wants their equivalent of the holding company that there's no, obviously everything, I say this all the time, everything has a price, right? So you'll sell certain things under certain conditions. But when you think about taxes, when you think about some of the perversions in the private equity world, four sales, one fund to another, you know, I call it permanent equity as a category. And it's the, it's certainly the thing that is popping up everywhere. And maybe it's because I'm kind of looking for it. And so you know, I find what you're, you know, I'm going to say, you know, I find what you're at, what you said out to find, but that does seem to be a broad category that's increasing in popularity. What about the, since search funds are so small and you've grown, your capital base has grown? What about recaps and buyouts? What's kind of the state of those two strategies today relative to, to history when, you know, private equity's done really well, typically, for allocators in this cycle. So it's become more and more popular, a lot more scrutiny, some people's digging into the fees a little bit more. What do you think kind of the current state of more traditional private equity is today? Yeah, so I think private equity is, you know, as you suggest is, is sort of in, it's, as in favor as it has ever been among the larger institutional allocators, you know, this sort of this. So for the last 24, 36 months, there appears to be this sort of conventional wisdom that as it relates to the public markets, you know, passive versus active has shifted in favor of passive. And if you're looking for active management and our performance, you're better off focusing in private equity, right? So there seems to be a lot of dollars sort of being allocated around that. I think long term, the private equity asset class will continue to make sense based on ability to earn, you know, a premium to the public markets. But that'll be very, that's averaged across a long period of time. It'll be very, very cohort dependent. And we're in a very frothy time now. So no question about that. It's, you know, we, our firm has been pretty significant net sellers for most of the last three or four years. And we're very focused on proprietary sourcing and that's just gotten harder and harder to do. So we've had to work, you know, harder to find new things. In our experience, recap transactions are interesting because they provide more of an opportunity for that sort of long, long gestation proprietary, proprietary sourced opportunity with the right sellers. Can you describe that in a little bit more detail exactly what that means? So what a recap is and why that might be a longer term advantage than a traditional buyout. So recapitalization, as I'm using that term is basically a minority investment, right? So where we would make an investment and own less than a controlling interest in the firm, two thirds of the time in our history, we've been doing control investing through buyouts. Not a third of the time we've done minority recapitalizations and the way those work is we come in and we buy anywhere from 10 to 48 percent of a company, often in combination with some relevering of the ballot sheet. And then we tend to, we partner with the usually founder, the incumbent management team, which is usually a founder CEO, to continue to grow the business over a longer period of time. We do have historically had long, you know, somewhat longer holding periods than the norm and private equity. But those, because it's a situation where the investors are automatically riding with the founder CEO, that relationship with the founder CEO is critically important. And that's the opportunity to develop a differentiated relationship. And so that's, as opposed to the sale of an entire company, a control transaction, it's just rare that an intermediary investment banker doesn't get involved in selling those sorts of businesses, those are, you know, is involved in those sorts of opportunities. So that's been our experience. When you say frothy, is that primarily defined by valuation multiples that properties are trading at or there are other things beyond just, you mentioned maybe less proprietary, deal flow may that means more auctions, which is the reason for higher valuations. What are the components of frothyness? Yeah, I think it's, it's overall valuation multiples certainly fed by active auction processes, but, you know, there's a high correlation between overall transaction multiples and availability of leverage. Right. And so we just remain to time where there is plentiful debt available for these sorts of transactions. It's in your debt financing and layers of mezzanine and seller financing. There's just a lot of debt. Yeah, it's a, it's a hard thing to contend with with low rates and maybe returns being pulled forward. That's a concept you hear about a lot and certainly seems to be reflected in all asset valuations kind of across the board. I don't really know anybody that does quantitative type work that has high return expectations for kind of the world's assets. So it's going to be an interesting 10 years looking forward. I'm curious if there are particular industries that have the kind of economic characteristics that you, that you screen for or look for. And maybe the inverse of that question is the things that no matter how great everything else looked, we'd really scare you away from it from an industry or potential investment. Yeah, so we tend to let, we like three basic economic characteristics. You know, we like current revenues. So a consistent pattern of repeat business from existing customers. We like growing end markets. So threshold there of a minimum, minimum sort of secular long term market growth of two times GDP. And then we like businesses that aren't capital intensive and we track that through returns on tangible capital. And we're looking for after tax returns on tangible capital of 20% or more. And so you put all that together, that sort of our, so if you, the two businesses that in the long term have been the sort of best exemplars of that combination of traits for us have been the records management business, business that iron mountain dominates here in the US and globally and the cell tower business, you know, which is dominated, dominated. But the public companies here are American, tower and crown castle and SBA. And in both cases, we've found, and this is, we've been investing in those businesses for 20 plus years in the case of records management. 15-ish years in the case of cell towers. In both cases, the US market has matured over the last five years or so. So the market growth trait, you can no longer check that box here. Multiple have gone up, reflecting the predictability and the lack of capital intensity and growth has come down. That's a tough combination. So in both cases, we've worked to back management teams we knew well to look outside the US in those industries where growth rates are higher and you have the same economic characteristics as it relates to stickiness of revenue and capital intensity. - One of the things you said earlier, struck a chord where I think a lot about performance chasing and maybe there's components of private equity that are resulting from a performance chase. But I also think about just the US market broadly speaking that it has done so incredibly well relative to international indexes. I don't know if that's as true on the private side but certainly in the public markets, S&P has trounced everything. And I find it fascinating that in the trend to buying passive and the billions a day that go to Vanguard, and I think Vanguard does a fantastic job and has provided a fantastic service to markets in general. But it's amazing how expensive things have gotten and that if your anti-performance chasing, you're actually inherently anti- maybe a Vanguard as in P500 fund. So the international comment is an interesting one. I would like to ask people what their most memorable individual day of their career was. So I'm curious what your most memorable day was. (laughs) - That's an interesting question. So I have to think about that. So the series of conversations that I had with CEOs, so if you had to highlight one, it would be the phone conversation I had with Buffett or the most in most cases they were in person meetings. With the CEOs in connection with the book, we're just fantastic. We had extremely, you know, we went through this very deep analytical process to arrive at a package of material that was successful in every case in having leading to substantive conversations with these CEOs who were generally famously reclusive. So those conversations were just incredibly invigorating and actually energizing one. - And the early days, the early days at whose atonical, similarly, you know, were sort of finding a niche that was differentiated in private equity, you know, along several dimensions. So sort of the sorts of deals we were doing. Sort of, we were the first institutional investor to invest in search funds. It would be one example, but also sort of longer holding periods and proactively focusing on sophisticated high net worth investors, you know, who sort of were aligned around proprietary sourcing longer holding periods and then a very specific business model, the business model I just described. It was fun, that was fun. - Has that remained your capital base? Has the profile of your limited partners evolved or changed? - It's evolved, we have, and we have a great group of institutional LPs now as well, but we still have a solid core group of long term, high net worth families and individuals. - That seems to be the unheralded, underrated ingredient in any investment firm's success is the quality of their investors. It's very hard to get good ones, and oftentimes it's that same profile, right, of long high net worth individuals, long term thinkers, entrepreneurs themselves, long forward thinking institutions, which don't exactly grow in trees. - That was true, and it's true for the CEOs and the book all found their way over time to shareholder bases that were highly aligned with their differentiated approaches. - Yeah. - And that was critical in allowing them to be successful. - You're pointing about the early days at whose atomic makes me think about how you approach a business. So if you are looking at, first of all, what are you looking at? What are the actual raw material you're using in your first approach and opportunity, whether it's in a well known industry like cell towers or maybe something totally new, kind of what was in the early days, your process for going through and evaluating business. What were the key things you looked at? - They actually haven't really changed meaningfully. I mean, we like these businesses growing or current revenue businesses basically, and the material that we're looking at is often, again, if you're sourcing things proprietary, that means you're not seeing perfectly produced PPMs offering memoranda. So you're seeing raw outputs from financial systems and often the financial systems are not, they're often they're running on QuickBooks still. That has not been the focus in many of these businesses. So often the material is pretty rudimentary, but it's, again, if you're really focused on growth and quality of revenue first, and then understanding the inner economics and the margins, and that's a, there's sort of a, and these types of businesses are reasonably straightforward set of metrics that pretty quickly allow, it's one of the beauties of that focus is, it's a pretty tight screen, and pretty quickly you can identify whether something's a fit or not. So it leads to early nose, which are very, very valuable in any investing business. - Yeah, so what percent make it to pass that first stage of if you're sure in a hundred businesses, what percent look interesting or worth pursuing at a deeper level? - Yeah, so if you looked at the generic hundred businesses in the US economy, probably one or two percent, as we've refined, as we've gotten known for a certain sort of deal, and the hundred deals we see, 100 companies we see are pre-selected to have some of those characteristics, so a higher percentage than the one or two percent, but make it through the filter, probably 10 to 20 percent? - Yeah, still relatively low. - I've heard quite a lot about this idea of recurring revenue long-term, especially in the private equity world, long-term contracts, established customer base, maybe growth but not crazy high growth, 'cause that's hard to service and fund, which makes me think of the blind spot, which is there's plenty of businesses that don't have recurring revenue that have uncertain futures, that have hyper growth rates. Do you think that there's anything, and obviously some of those businesses can and will do well, right, not every business can look one certain way? Do you ever think about that? Do you ever think like, wow, we've kind of narrowed in on this, you mentioned even two particular industries, to think, I wonder if anything's changed about, you know, what everyone seems to kind of ignore, at least in the people, there's a self-selecting sample problem, a selection bias problem on my part, that I tend to be the value quality type guy, so I find like-minded people, but I'm always curious about like that, am I missing something significant in the volatile, deep cyclical, highly levered, high growth businesses or something like that? - Without question those other categories that you describe have huge opportunities and inefficiencies, but I think it's again, it's sort of buff its circle of competence idea. I mean, I think you really need to know where the perimeter of the circle is, in every case, but there are investors who really understand the various, you know, sort of the super high growth bucket is very different than what we do, and the cyclical, levered, often troubled piece is also, there are lots of people who are very effective investing there, it's just we, we're not- - It's just not really a game. - It's not in our game. It's not a game where we think we have an edge. My closing question always is to ask people the kindest thing that anyone's ever done for you. - Yeah, so I mean, I, you know, in the early days of our firm, I had two partners who were primarily investors, you know, they were investors and it was their capital that we were investing. They had involvement in the business, but not nearly full-time involvement, I was full-time. You know, there's a clear division between capital and labor in the group. (laughs) And they very generously kind of, as things went along and returns sort of came in pretty well, they proactively very generously shared economics with me in a way that they didn't have to, in a way that was just very sort of set a certain tone for the culture of our firm. So I'm very appreciative of that, still. - Fantastic. Well, this has been enlightening, as I knew it would be. Again, highly encouraged people read the book if they haven't, and I really appreciate your time. - Thank you, Patrick. (upbeat music) - Hey everyone, Patrick here again. To find more episodes of Invest Like The Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up to receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter, @Patrick_oShag_oshag. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like The Best. Thanks so much for listening. (upbeat music) [BLANK_AUDIO]