Book Review - Distant Force: A Memoir Of The Teledyne Corporation And The Man Who Created It

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 |  Includes: DHR, ZBH
by: Xinyun Hang

I first read about Distant Force, the biography of Teledyne and its founder Henry Singleton, in an article by Geoff Gannon titled "What Would Value Investing 101 Look Like?" Teledyne Corporation was a conglomerate founded in 1960 as an electronics company by Singleton and George Kozmetsky. The company would eventually diversify into such areas as aeronautics, steel, and insurance before breaking itself up into such successor companies as Allegheny Technologies (NYSE:ATI), insurance company Kemper (NYSE:KMPR), and of course, Teledyne Technologies (NYSE:TDY) through a series of spinoffs in the 1990s and early 2000s. During that time, the company's stock gave investors 17.9% annual returns for 25 years, causing Warren Buffett to describe Singleton as having "the best operating and capital deployment record in American business." The reasons for that record are in this book.

That said, Distant Force isn't one of those investing books that neatly gives each concept its own chapter before wrapping up with a nice summary at the end. The author began his career as a metallurgist, and the book focuses heavily on technology rather than finance.

Thus, it is necessary to read between descriptions of rocket nozzles and rolled steel, of managers and mechanics, to understand the basis of Teledyne's extraordinary performance. Once you do so, though, you discover that there were five key factors to this performance-stock buybacks, careful acquisitions, dividends targeted to reward the long-term shareholder, the contrarian ownership of publicly traded securities, and a focus on niche businesses. Studying these factors will help an investor find companies that can deliver returns like Teledyne's.

Stock Buybacks

As head of Teledyne Corporation, Henry Singleton is probably best known for his share buybacks. Between 1972 and 1984, the company bought back over 90% of its shares, or well over 60 million shares. In the same time period, the company's net income per share increased from $1.58/share to $37.69/share, a compound annual growth rate, or CAGR, of over 30%. In comparison, the company's net income had a CAGR of 20.83%. This difference of nearly 10 percentage points between the company's annual net income growth and its per share net income growth can be attributed to Singleton's buybacks.

However, what's important about Singleton's buybacks is not their size, but the attitude he took towards them. Singleton waited to buy back shares until they were significantly undervalued as a result of the economic turmoil of the early 1970s.

In contrast, many corporate managers buy back shares regardless of the company's share price or intrinsic value. They often do so when they feel the company is at its best, which is usually when the company's shares are at their most expensive. As a result, you see charts like the below one from FactSet's December 2013 issue of Buyback Quarterly. In it, you can see how buybacks rose from 2005 to 2007, peaking in the same quarter as the S&P 500. Afterwards, the rate of buybacks falls just as it would have made more sense to buy shares when they became depressed by the Great Recession.

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Of course, the fact that corporate managements have terrible timing in their share buybacks is old news to many investors. Rather, the takeaway from Distant Force is that investors should look for companies that buy back shares intelligently, because such buybacks add significant shareholder value.

One such company is Zimmer Holdings, Inc. (ZMH), a producer of tools used by surgeons in reconstructive surgery and treating degenerative diseases, as well as orthopedic reconstructive devices such as artificial joints. In 2012, the company made about $4,400 million in revenues and $755 million in profits, resulting in a net margin of about 17%. When that is combined with the company's return on equity of about 13% and its five-year revenue CAGR of 1.65%, an image is created of a good, but not great company in terms of financial performance.

And yet, Zimmer Holdings is extraordinary in one way-its stock buybacks. During the same period when its revenues only grew at an average annual rate of 1.65%, its diluted net income per share grew at nearly double that, 2.89%. This doesn't seem like much, unless you consider that the company's net margins over that period actually fell from over 20% to around 17%. What allowed Zimmer Holdings' earnings per share to grow despite this was the use of buybacks, which reduced the company's share count by 24%. Those buybacks were highlighted by a June 2013 Globe and Mail article appropriately titled "Looking for stock buybacks - done right."

Even more important than the raw size of Zimmer Holdings' buybacks from a capital allocation standpoint, though, was their timing. In the Globe and Mail article cited above, the company is ninth of ten companies in its reduction in outstanding shares in the past five years. And yet, it is the best illustration of Henry Singleton's lessons in share buybacks because of those ten companies, only Zimmer Holdings increased its share buybacks in 2009 when its shares were lowest, at the worst point of the Great Recession. Even better, the company made a significant amount of its repurchases during the first quarter of 2009, the lowest point of a low year for its stock price. The company even took on debt to do so, a tactic also used by Henry Singleton.

That said, Zimmer Holdings has also made extensive repurchase this past year, as its stock price rose to record highs. As a result, it is difficult to know if the company's actions in 2009 were a fluke. Also, it is possible that the company's prospects have improved so much this year that shares have become undervalued despite their rise. That said, one point in the company's favor is that the company's largest share repurchases in the past five years occurred in 2011, another year in which the company's shares saw weakness. Either way, the company is noteworthy for being willing to not only make significant stock repurchases during the Great Recession of 2009, but also to increase those repurchases to take advantage of falling stock prices.

Of course, just because Zimmer Holdings and its CEO David Dvorak were willing to increase their share purchases when prices were low, like Teledyne and Henry Singleton, that doesn't mean that they are going to give shareholders the same kind of returns. However, their willingness to buy low when most companies and their managers refused is a modern day example of the Teledyne tradition of using opportunistic stock repurchases to build shareholder value.

Careful Acquisitions

Another method by which Henry Singleton built value was through careful acquisitions. Like many conglomerates in the 1960s, Teledyne was awarded a high P/E ratio for its shares due to its rapid, acquisition-fueled growth. And, like many conglomerates, Teledyne used those richly priced shares to acquire less highly valued companies, thus increasing its earnings.

However, what differentiated Teledyne from those other conglomerates was that Henry Singleton stopped making acquisitions after the stock prices of target companies became inflated. One quote from Distant Force describes Singleton as being unwilling to pay even 12 or 14 times earnings for an acquisition target. As a result, Teledyne avoided diluting shareholders by using shares to make overpriced acquisitions. Moreover, unlike most of its conglomerate peers, Teledyne successfully integrated its acquisitions. As a result, once the acquisition spree ended, the company was not left with a disorganized collection of unrelated businesses, but rather a group of companies with real synergies between them.

Thus, to find a company that acquires like Teledyne today, it is necessary to find a company that not only avoids overpaying for acquisitions, but also integrates them successfully and uses them as a source of growth.

One example of such a company is Danaher (NYSE:DHR), an industrial conglomerate founded in its current form in 1984 by the Rales brothers. Since 1987, the company's stock has appreciated over 20% a year, excluding dividends, a truly incredible performance.

Much of this performance can be attributed to the company's acquisitions. The company's managers have demonstrated skill in not only choosing acquisition targets, but also integrating them into the overall company. All five of the company's major segments-Test & Measurement, Environmental, Life Sciences & Diagnostics, Dental, and Industrial Technologies-were either founded or significantly augmented through major acquisitions. In the company's own words, Danaher began as a collection of discrete, cyclical companies and has become an integrated group of companies in stable industries. This evolution has been driven in large part by buying companies in industries that the company wishes to enter.

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Source: 2013 Danaher Investor & Analyst Day Presentation

As another example of the importance of acquisitions to the company, roughly 85% of the company's growth in the past six years has come from acquisitions.

Danaher Growth

Compounded Total

2012

2011

2010

2009

2008

2007

Acquisitions

85.9%

2.0%

8.0%

10.5%

2.0%

32.0%

12.0%

Organic and From Currency Changes

15.0%

-2.5%

11.5%

17.0%

-23.0%

5.5%

10.0%

Total

100.9%

-0.5%

19.5%

27.5%

-21.0%

37.5%

22.0%

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Source: 2008, 2010, and 2012 Danaher 10-Ks

However, what sets Danaher apart isn't the use of acquisitions for growth-that's a strategy used by many companies. Rather, it is the way that Danaher manages the acquisitions. Danaher's targets go through the Danaher Business System, or DBS, a management system. The system combines fundamentals such as listening to the Voice of the Customer and the continual improvements of kaizen with a focus on Growth, Leanness, and high quality Leadership.

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Source: 2013 Danaher Investor & Analyst Day Presentation

At first glance, the characteristics of the Danaher Business System seem like meaningless management buzzwords-after all, what company doesn't say that it is working towards growth, leanness, and better leadership? And yet, DBS has produced concrete results for the company. According to a 2010 Fortuna case study, Danaher has traditionally purchased companies that are relative laggards in their fields. Having done so, the company reduces the assets necessary to achieve the same results and improves cash flows.

Moreover, Danaher focuses on acquiring underperforming companies, it has consistently managed to buy its acquisition targets cheaply. A 2010 Fortuna Advisors article about the company described how Danaher has consistently paid a 21% discount to market valuations for the companies it buys. In this, Danaher is somewhat different from Teledyne, which generally focused on purchasing companies, which did not need significant improvements after acquisition.

That said, Teledyne also improved the companies it purchased. Distant Force describes how subsidiaries became the subject of regular monitoring and strong, centralized financial controls. As a result, corporate management would always be aware of what was going on, even if it rarely chose to intervene in the decisions of segment presidents. Moreover, those segment presidents would also be subject to incentives that emphasized increasing cash flow and reducing costs, resulting in leaner, more efficient organizations.

Danaher's acquisition system involves buying undervalued companies, successfully integrating them into a larger corporation, and using them to create growth. This system is a modern day version of the Teledyne model of corporate acquisitions, and it is unsurprising that as a result, Danaher's share returns over the past two decades have been reminiscent of those of Teledyne.

An Addendum: Taking Advantage of Share Overvaluation to Maximize Shareholder Value

Another company, which came to mind while I was writing about Teledyne's acquisitions, was Facebook (NASDAQ:FB). To describe Facebook and its CEO Mark Zuckerberg in a section about prudent acquisitions seems like an odd choice at first. After all, Facebook is infamous for having paid a billion dollars in 2012 to acquire Instagram, a company with not only zero earnings, but zero revenues, a far stretch from Henry Singleton's refusal to pay even average valuations for an acquisition target.

And yet, Facebook has been noteworthy for one characteristic reminiscent of Teledyne-taking advantage of share overvaluation to maximize value for its owners. Just like Henry Singleton used overvalued Teledyne shares to acquire companies, Mark Zuckerberg has used Facebook's high valuations as an opportunity to raise cash and build corporate value. Probably the best known example of this is, of course, the Facebook IPO, in which the desire to sell shares at as high a price as possible caused share prices to drop precipitously after the IPO.

However, it was a more recent event that brought Facebook to mind while I wrote this section-the company's December 2013 share offering, which was designed to take advantage of the recent rise in the company's shares. As Bloomberg View columnist Matt Levine puts it, "[Facebook] is unusual among public companies in its desire and ability to sell stock at local maximums. Most issuers are more into buying high and selling low." Felix Salmon also commented on the deal (and Levine's article) by noting that Zuckerberg "was taking full advantage of the astonishing valuations which can be bestowed on companies…by public markets." Mark Zuckerberg seems to understand how the market allows a company to trade overvalued shares for something more valuable-in this case, cash to fortify Facebook's balance sheet for the future. In this taking advantage of market irrationality, he resembles Henry Singleton.

Contrarian Ownership of Publicly Traded Securities

Another way in which Henry Singleton took advantage of the irrationality of public markets was in his purchase of publicly traded securities when they were undervalued. Singleton's decision to begin buying partial stakes in other publicly traded companies was an offshoot of his decision to stop acquiring companies in 1969. In Singleton's own words, "there [were] tremendous values in the stock market, but in buying stocks, not entire companies. Buying companies tends to raise the purchase price too high."

Moreover, beyond the issue of rising valuations for acquisitions, there was another reason for Henry Singleton's decision to start buying large stakes in public companies. In 1968 and 1969, Teledyne purchased several insurance companies, diversifying the company into the financial industry. Singleton's goal was to create a source of persistent capital to fuel the company's future growth. Because Teledyne now owned several insurance subsidiaries, Singleton was forced to find a method of investing their float. Singleton's response, as described in Distant Force, is particularly relevant to today's market:

During the 1968-1974 period [Singleton] considered bonds as high risk and stocks as low risk, contrary to popular opinion, and he instructed his insurance companies to follow that advice in their investments. These companies did just that, moving their portfolios from fixed income securities to equities when the stock market was depressed…

The stock market is hardly depressed today. However, with interest rates as low as they are and set to rise, it seems likely that we're in another situation where it would be prudent to move from bonds to stocks.

Moreover, one method of finding good stock investments would be to search for companies like Teledyne that have consistently taken advantage of low valuations in investing in publicly traded companies. One company that has done so is Loews (NYSE:L), the conglomerate led by the Tisch family. Loews has several wholly owned subsidiaries, including Loews Hotels & Resorts and Highmount Exploration and Production. However, the company is best known for its publicly traded subsidiaries: drilling company Diamond Offshore (NYSE:DO), Boardwalk Pipeline Partners (NYSE:BWP), and insurance company CNA (NYSE:CNA), of which it owns 50.4%, 53%, and 90%, respectively. In total, as of early January 2014, the company owns about $16.7 billion in publicly traded investments versus a market capitalization of $18.3 billion.

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Source: Loews Website

However, what is important is not the size of Loews' holdings, but the process by which they were obtained. Like Henry Singleton, the leaders of Loews are value investors who have consistently shown discipline in their stock purchases. The company famously bought the drilling rigs that would later form Diamond Offshore for less than their scrap value in the late 1980s and early 1990s, taking advantage of weakness in the oil sector. The company's other acquisitions have also been made during downturns that allowed the company to get a good deal. The company bought most of CNA in 1974, after business mistakes nearly drove it to insolvency. Similarly, tobacco company Lorillard (NYSE:LO) was bought in 1968 as the first anti-tobacco advertisements began to air, while luxury watchmaker Bulova was purchased in 1979 during an oil crisis.

Beyond this judicious purchasing of publicly traded securities, like Teledyne, Loews has also aggressively repurchased its shares, taking advantage of chronic market undervaluation to buy back over two thirds of its shares between 1971 and 2012. Thus, in its approach to capital allocation and purchase of large stakes in public companies during periods of weakness, Loews under the Tisch family resembles Teledyne under Henry Singleton.

Dividends Targeted to Reward the Long-Term Shareholder

Like many companies run by a strong capital allocator, Teledyne avoided paying a significant cash dividend for most of its history, preferring to retain cash for future investments. However, unlike most such companies, Teledyne did pay a regular stock dividend, beginning it in 1970, just as the company ended its acquisitions.

Distant Force describes Singleton's rationale for this action. In his opinion, a stock dividend was the best of both worlds. It gave yield oriented investors a yield that they could access without selling the principal part of their investment. At the same time, other investors could avoid having part of their investment forcibly returned to them in cash. Moreover, a stock dividend was more tax efficient. Such a dividend would not be taxed unless its recipient chose to sell his or her shares, unlike a cash dividend, which would incur an automatic tax.

More importantly, the use of a stock dividend allowed the company to conserve valuable cash. It is unsurprising that Teledyne instituted its regular stock dividend at the same time as when it stopped its acquisition program. Once growth through acquisitions-which, it is worth mentioning again, were undertaken using stock instead of cash-was no longer an option, it was necessary to obtain all growth organically, thus requiring as much cash as possible to fuel that growth.

The one oddity of Teledyne's stock dividend, though, is that much of it occurred at the same time as Teledyne's share buybacks. On the one hand, this seems to make no sense-Teledyne was spending valuable cash to buy back shares at the same time it was printing new shares to give to stockholders.

On the other hand, this action had the effect of concentrating share ownership in the hands of long-term shareholders. Those who refused to sell any shares saw their holdings grow through buybacks and stock dividends. Because their holdings of company stock became proportionally larger, their returns were augmented once Teledyne share prices began to grow again in the 1980s. However, one downside of stock dividends was that yield seeking investors who did not sell their original shares but who did sell their stock dividends saw their holdings diluted by those dividends.

One example of a company that has chosen to follow in Teledyne's tradition of stock dividends is Spanish bank Santander (NYSE:SAN). Unlike many Eurozone banks, Santander has maintained its high dividend yield, which is 7.3% as of early January 2014. However, it has done so by offering its shareholders a choice between a stock (or "scrip") and cash dividend. Most investors choose the stock dividend because it is not subject to Spain's 21% dividend withholding tax.

This use of a stock dividend by Santander is reminiscent of Teledyne. Like Teledyne, Santander can retain additional cash by avoiding cash distributions, while also improving the tax efficiency of its dividend policy. Also like Teledyne, this method aids long-term shareholders who accept a share dividend and do not sell the shares they receive, because they gain a proportionally larger ownership in the company. It is too early to tell whether this approach will augment the returns of such shareholders like it did those of Teledyne. Such returns will require appreciation in Santander's shares, which probably requires an improvement in the Spanish economy. However, if Santander's shareholders do benefit in such a way from the company's stock dividend, it will be another example of the lesson learned by Teledyne shareholders-stock dividends can be a powerful source of value for long-term shareholders.

"Niche" Businesses

One source of Teledyne's performance, which has perhaps been underappreciated, is the company's ownership of businesses in highly technological niches. From its beginning, Teledyne focused on what Geoff Gannon calls "demon dust" businesses. In Gannon's words:

In a demon dust business - the per unit cost contributed by the capital good is a small part of the cost of the finished product; however, failure of the capital good results in failure of the finished product.

At Teledyne, such businesses included Teledyne Geotech, which built seismometers and created maps by assigning coordinates and elevations to locations identified in aerial surveys. Both of these services were a small part of the final product- a tiny seismometer used in a space mission or a set of coordinates and elevations overlaid on a map created from thousands of aerial photos-but their effect was critical. Teledyne Geotech labeled the US Army's comprehensive map of the entire nation of Iran, turning a set of photos into an important source of intelligence. Similarly, the company's seismometers were left on the Moon as part of the Apollo missions, providing data that remains useful today. In each case, the company's contribution, though small, was critical to the value of the final product.

One example of a company whose products are similarly small, yet critical to operations is Exelis (NYSE:XLS). Exelis is a defense contractor, which was spun off from conglomerate ITT (NYSE:ITT) in 2011. What differentiates Exelis from many other, larger defense contractors such as Lockheed Martin (NYSE:LMT) or General Dynamics (NYSE:GD) is that it generally does not produce comprehensive final products like Lockheed's F-35 fighter or General Dynamics' Abrams tank. Rather, Exelis produces small components that form a small part of a larger system, but which are nevertheless crucial to the system's successful function.

For example, according to the company's 2013 Annual Report, Exelis sensors "currently provide all of the commercial high resolution space-based imagery in the United States." The company's GPS payloads "have been on every U.S. Government GPS satellite ever launched." The company's weapons carriage and release systems have been in every major US fighter aircraft in the past 25 years, including the F-15, F-22, and F-35. Though all of these products are a physically small part of the missions they participate in, they are key to their success.

Even when the company does produce its own, finalized products, these products are still often "demon dust" products. For example, Exelis is the world's leading supplier of night vision goggles and military radios, and a major supplier of counter-IED jammers. In each of those cases, the equipment supplied by the company is a small part of the overall mission, but is crucial to ensuring mission success and the safety of military personnel.

In producing such products, Exelis is reminiscent of Teledyne, which also emphasized products critical to mission success, both military and civilian. Unsurprisingly, this emphasis was a key part to Teledyne's financial success. Between 1971 and 1981, Teledyne's margins were consistently greater than those of the S&P 500, in large part because its highly engineered products were often irreplaceable. Similarly, Exelis' products business, known as its C4ISR Electronics & Systems segment, commanded greater operating margins (at 14.1%) in 2012 than the S&P 500 as a whole (at 12.9%), despite the weakness in the defense market.

Thus, because of its collection of irreplaceable "demon dust" products, Exelis is reminiscent of Teledyne Corporation as a modern example of a company focused on producing niche products.

Conclusions

Teledyne Corporation's success as a long-term investment, as described in George Roberts' Distant Force, can be attributed to five key factors- stock buybacks, careful acquisitions, dividends targeted to reward the long-term shareholder, the contrarian ownership of publicly traded securities, and a focus on niche businesses. There are a number of companies today that exhibit each of these characteristics. However, I feel that there is one company that represents all of the characteristics that made Teledyne such a great investment-Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).

It's not very creative to describe Warren Buffett and Berkshire Hathaway as successors to the traditions of Henry Singleton and Teledyne. After all, effective capital allocation is just another name for effective investing, and Warren Buffett is widely considered the greatest investor of all time. Nevertheless, it is striking how many characteristics of Teledyne can be seen in Berkshire Hathaway. Buffett is famous for his ownership of large stakes in publicly traded companies such as Coca-Cola (NYSE:KO) and Wells Fargo (NYSE:WFC), holding them, like Teledyne, in insurance subsidiaries. Buffett is well known for using the term "moat" to describe the kind of niche businesses with unshakeable competitive positions that Teledyne acquired. Moreover, Buffett is renowned for his rational approach to capital allocation, including his careful use of stock buybacks and stock issuance and his very Singleton-like reluctance to offer cash dividends.

Of course, just because Berkshire Hathaway embodies all of the important characteristics of Teledyne doesn't mean that someone buying Berkshire Hathaway today will earn Teledyne's historical returns-or, for that matter, Berkshire Hathaway's historical returns. That said, it is interesting that two of the most successful investments in history have so much in common, a fact that offers important lessons for investors looking for the next Teledyne or Berkshire Hathaway today.

Disclaimer: The content here is not meant as investment advice. Do not rely on it in making an investment decision. Do your own research. The content here reflects only the author's opinions. Those opinions might be wrong. The writer(s) of this content may have positions in securities mentioned in this article. This content is meant solely for the entertainment of the reader and its writer(s).

Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.