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Chris DeMuth Jr.
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"It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a misplaced bet - that they can occasionally find one." - Charlie Munger I look... More
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  • Seeking Alpha Book Club 16 comments
    Dec 2, 2013 5:00 PM | about stocks: BRK.A, BRK.B, GD, GHC, TDY, LINTA

    Welcome to the Seeking Alpha Book Club. We read The Outsiders this past month and will discuss it this month.

    "Who is the greatest CEO of the last 50 years?" the author writes in the beginning of the preface to The Outsiders. Let's begin there. Who is the greatest CEO of the last 50 years? One of the eight identified in this book or someone else? Any examples that fit Thorndike's criteria that he left out?

    Do any of the remaining companies profiled - BRK.A/BRK.B, GD, WPO, or TDY still have the virtues described in the book?

    Was this book practically useful? Was it inspiring?

    Focusing specifically on the Outsider's Checklist (pages 218-220 in my copy), which questions do you use?

    What questions would you like to ask the author?

    (Please answer these questions or ask your own in the comments below)

    Stocks: BRK.A, BRK.B, GD, GHC, TDY, LINTA
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Comments (16)
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  • toddro
    , contributor
    Comments (165) | Send Message
     
    One thing the book opened my eyes to was the effective usage of debt as leverage. I am very frugal and very conservative financially. I have zero debt and owe no one a dime. Often when researching companies I see debt on a balance sheet and it is a negative to me.

     

    Obviously there are ways to asses a healthy balance sheet versus one where debt has become problematic, but how do you view a company's debt when you research? Is there a debt/equity ratio you like to see or a limit at which you are comfortable? How does it maybe relate to other metrics?

     

    By the way, I did think it was interesting that the author kind of glanced over the fact that General Cinema crumbled under the weight of its own debt without going into detail as to what went wrong there.

     

    Great read, I really enjoyed the book. Thanks,

     

    Todd
    3 Dec 2013, 12:09 AM Reply Like
  • MOSMan
    , contributor
    Comments (27) | Send Message
     
    Hi Toddro, I would tend to agree with you. I also love to see a clean Balance Sheet. The CEO's in the Outsiders had the luxury of consistent cash flows. That being said, they certainly found themselves in situations where they were concerned. Their main strength was they were adaptable and did not allow preconceived ideas or conventional wisdom to lead them astray. Also good observation on General Cinema. I thought the same thing. I think they went to the well perhaps once to often, but it easy to criticize in hindsight. All in all, they are still a good case study. Using debt wisely, is a practice few do well over long periods of time. I would like to hear Chris's opinion on General Cinema.
    3 Dec 2013, 12:32 PM Reply Like
  • Terrier Investing
    , contributor
    Comments (77) | Send Message
     
    One interesting difference between personal and corporate debt (and government debt, though that's a separate discussion) is that corporate debt does not necessarily have to be repaid. For big, large-moat, financially strong companies that generate good cash flow (ex. Coke), borrowing money usually tends to be pretty cheap. Obviously, it's extremely cheap right now, but even in normalized interest rate environments, it's not extraordinarily expensive. So if a company like this can borrow at say 7-8% and invest it at 10-15%/yr, they're generating value for shareholders. When the debt comes due, they can simply refinance it, and all they ever really pay on it is the interest. It becomes a permanent part of their capital structure. Especially with long-term interest rates so depressed right now, you're paying in nominal dollars for investments that will hopefully return inflation-indexed dollars. What's not to like?

     

    From a manager's perspective, a prudent amount of leverage is good; there's been some academic work done on the "ideal" amount of leverage, I think, but I can't claim to have read it. However, as a shareholder, having leverage already in the capital structure means that there will be less opportunity to add leverage going forward, hence the general preference for companies that do not have much debt in their capital structure (and therefore have the flexibility to add it).

     

    I don't feel comfortable with relying on some specific magic ratio, whether it be debt/equity or interest coverage or debt-to-EBITDA. I think it should be viewed on a sliding scale. Coke, which has relatively inelastic demand for its products, can afford to take on more leverage than a highly cyclical company. Beyond that and other similar generalizations, I think sensitivity analysis might be a useful tool - imagine the worst-case scenario, then imagine it gets worse than that. Is the debt too high then? Does the company run the risk of insolvency? If the answer is no, then it's probably not "too much debt" for me to consider looking at it, though all other things being equal, firms that are cash-rich are preferable than firms that are highly indebted.
    3 Dec 2013, 02:01 PM Reply Like
  • toddro
    , contributor
    Comments (165) | Send Message
     
    Nice thoughts, Terrier. Thanks! I appreciate you taking the time to lay that out in a clear and concise way. Cheers,

     

    Todd
    3 Dec 2013, 03:16 PM Reply Like
  • connellybarnes
    , contributor
    Comments (306) | Send Message
     
    A potential loophole for individual investors:

     

    "In all states, if you form an LLC to operate your business, and don’t personally guarantee or promise to pay its debts, you will ordinarily not be personally liable for the LLC’s debts. … Many creditors, however, don’t want to be left holding the bag if your business goes under so they will demand that you personally guarantee any [loans]." - Nolo.com
    20 Jul, 10:16 AM Reply Like
  • Ruerd Heeg
    , contributor
    Comments (410) | Send Message
     
    Another observation from this book: many investors look for companies with constant earnings or constant earnings growth. With this type of company you won't find it, earnings growth is lumpy.

     

    An obvious question to the author: which clearly undervalued companies satisfy his criteria today?
    3 Dec 2013, 03:29 AM Reply Like
  • MOSMan
    , contributor
    Comments (27) | Send Message
     
    Chris, did you consider adding POST to the list? I know it's a different company, but the CEO remains the same.

     

    On best CEO, I would have to say Warren Buffett. Given his longevity, and outstanding record and consistency of growing returns are remarkable. Plus he deserves credit for mentoring Katherine Graham. Graham deserves credit for embracing Warren Buffett from the get go.

     

    The book is inspiring on many levels. All took difficult situations and created masterpieces without a lot of fanfare. One main theme in the book reminds me of another book called "Quiet" which was written by Susan Cain. Warren Buffett is featured in her book too.
    3 Dec 2013, 12:48 PM Reply Like
  • Chris DeMuth Jr.
    , contributor
    Comments (4040) | Send Message
     
    Author’s reply » Good point on POST; that was simply an oversight on my part. I agree in regards to Buffett.
    3 Dec 2013, 01:04 PM Reply Like
  • MOSMan
    , contributor
    Comments (27) | Send Message
     
    Thanks Chris.
    4 Dec 2013, 12:07 AM Reply Like
  • Terrier Investing
    , contributor
    Comments (77) | Send Message
     
    Entirely related to the book and somewhat related to your proposed questions, here is a collection of assorted thoughts that may or may not be helpful/useful/interes...

     

    1) Contrarianism is often helpful but should never be engaged in for its own sake. The book provides many strong examples of how a contrarian mindset can be helpful; when others were selling, the outsider CEOs were buying, and vice versa. Buffett's borderline-overused quote about fear and greed comes to mind. However, I think it's important to realize that the value in straying from the herd comes from having a central "strategic insight" as the author refers to it at several times. Otherwise, you're just being disagreeable for its own sake.

     

    Most investors and people in the finance industry tend to be somewhat smart and well-educated. This doesn't make markets efficient, in fact, I'd say they're far from. But it usually means that inefficiencies have some specific reason - a specific characteristic of the security or industry or company that is poorly understood or poorly interpreted. There could be others. From an investor's point of view, it also means that there are not very many "obvious" investments - meaning there are not very many well-known large companies growing at double digits with a pristine balance sheet and a single-digit valuation multiple. If there were, we could all quit and go home. Companies that make good investments are usually missing one or more of these characteristics.

     

    Sometimes the crowd is smart. If you're on the highway and you notice that everyone in your lane is trying to merge into the next lane, it might be a decent bet that there's an accident up ahead, or perhaps the lane just ends. In this case, being contrarian might lead to you running into a brick wall headfirst. But sometimes the crowd is stupid. If you have a specific strategic insight - ie, "people are merging out of this lane because it says it's exit-only, but I live here and I know there's actually a mile before this lane ends" - then you have reason to be contrarian.

     

    All that to say, if a lot of smart people think X is true, and X represents consensus, then there's probably a good chance X is true. This is why markets tend towards efficiency over time; at any given time, many stocks will be somewhat overvalued or undervalued, but very few are drastically misvalued (say 40-50% or more). However, X is often not true. If you disagree with X for the sake of disagreeing with X, you'll probably bat less than .500. If, however, you engage in analysis of situations where you have a theory that X may be wrong, and you treat X as a neutral hypothesis - ie, you don't go in trying to prove or disprove X, just trying to collect information about it and determine whether the truth lies above or below X on the value scale - then you have a good chance of making value-accretive capital allocation decisions.

     

    One-line summary: contrarianism can be profitable, but only when based on specific strategic insights.
    3 Dec 2013, 05:38 PM Reply Like
  • Terrier Investing
    , contributor
    Comments (77) | Send Message
     
    2) Formulas are only vague. The Outsider checklist is quite useful, and undoubtedly something to consider. However, you'll notice that even within the group, their approaches to certain fundamental issues (dividends, buybacks, M&A, etc) varied to a fairly significant degree. Similar to the thesis expressed above, my takeaway is that history can be instructive, but strategies need to be shaped for the situation. The only universal truth is that capital allocation is important and that investments (and by proxy divestitures) should be made to maximize risk-adjusted return (although this is easier to justify ex ante than ex post facto, as you can generate quite a high IRR by tweaking assumptions in your favor).

     

    Again, if there was a silver bullet, everyone would be using it. Many of the concepts in the book are brilliant and I strongly believe reading The Outsiders has made me a better investor and manager. That being said, there's a reason sequels are never as good as the originals. Be a student, not a copycat.
    3 Dec 2013, 05:43 PM Reply Like
  • Terrier Investing
    , contributor
    Comments (77) | Send Message
     
    3) Bureaucracy is bad; creativity and innovation are good. This needs no explanation.
    3 Dec 2013, 05:45 PM Reply Like
  • Joshua Heller
    , contributor
    Comments (194) | Send Message
     
    If everyone follows the same investment strategy does that negate that strategy? There has been a ton of talk about The Outsiders yet very little about the ramifications. In this bull market, investors are buying high quality companies, regardless of valuation.

     

    The example that comes to mind is SBUX. A great high quality company (could Schultz be an 'outsider') but trading at 25x forward PE. 10 years from now, SBUX is higher than today, but is the investment return sufficient? I doubt it.
    3 Dec 2013, 08:39 PM Reply Like
  • MOSMan
    , contributor
    Comments (27) | Send Message
     
    Hi Joshua, you have a valid point. Price is always important. However, I don't believe the book is advocating finding a CEO who has the uncanny ability to allocate capital and for anyone to buy his or hers company stock at any price (at least that wasn't my take). I think you should use patience as you should or would with any investment. That is what the Outsiders do as well. So, I would advocate following CEO's who you believe have these innate abilities and buy if and when the price makes sense invest. The trick will be to find the CEO's who have these traits and also stick with them long term. It's not as easy as it may sound, but I'm sure you're aware of that. I also don't believe it's a strategy most will follow because most people who call themselves investors are really traders. But of course, I could be wrong. P.S. Schultz is a good recommendation for a future Outsider. Do you think the track record is long enough yet for him to be considered? Does he allocate capital well enough? It wasn't that long ago when he was closing stores and the stock was below $10. I like Starbucks (the coffee and cafe's) but not the stock.
    4 Dec 2013, 12:06 AM Reply Like
  • Ruerd Heeg
    , contributor
    Comments (410) | Send Message
     
    And therefore I don't invest in Transdigm yet, see page 35. The stock is too expensive.

     

    I think the track record should be at least 15 years to be sure. A good track record over 15 years filters out the managers that were just lucky.

     

    Michael Smith of MFC Industrial has this track record. He has delegated many operational responsibilities but unfortunately not all. He has used spin-offs to enhance shareholder value as well.

     

    If you do a lot of reasearch, having the privilidge of meeting the manager in person and so on then 8 years of track record might be sufficient.
    4 Dec 2013, 04:06 AM Reply Like
  • toddro
    , contributor
    Comments (165) | Send Message
     
    Interesting point on MFC. I agree that Smith should probably not be Chairman, CEO and CFO. That is too much responsibility. I have been studying them for a few months and I think there is a lot of value to be unlocked there. The stock currently trades at a significant value to its TBV, with a nice portion cash/share and little debt. This may be a good "in" point on that stock...
    4 Dec 2013, 07:39 AM Reply Like
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