“The root of my success is acting rationally about capital allocation”, Warren Buffett tell us. He looks for managers who allocate capital effectively, and in 2012, the Number 1 book on his recommended reading list was The Outsiders, by William Thorndike - a book which discusses the common characteristics of effective capital allocators.
Effective capital allocators are managers who excel at deploying firms’ resources to earn the best possible returns for shareholders. This is important because as investors, we think of shares as pieces of a business. We therefore buy shares in the hope that managers will use our money effectively to drive up profits and thereby cause share prices to rise. This is why we pay attention to firms’ Return on Equity and Return on Capital Employed.
#1 on Warren Buffett’s Recommended Reading List:
In his excellent book, The Outsiders, William Thorndike writes that the “most important” job of a CEO is capital allocation. He insists that managers should think less like administrators, and more like investors, constantly exploring for opportunities to use capital in order to generate larger profits. Thorndike presents his argument using eight CEOs as case-studies. He argues that each CEO:
- Focused on reducing costs and keeping corporate overheads to a minimum;
- Increased investment in promising areas of the business which drove profitability;
- Strove to improve per share value, partly through share buy-back schemes;
According to Thorndike, rational capital allocators had several other common characteristics. Most importantly, the outsiders sought to deliver long-term per share value, rather than organisational growth. This bucked the trend. Thorndike insists that “in American business, there is a deeply ingrained urge to get bigger”. However, this approach dissuaded managers from allocating capital effectively by, for example, closing an underperforming division.
In addition, the ‘Outsiders’ were foxes (multidisciplinaires) rather than hedgehogs (industry specialists). This enabled them to approach problems in ways which industry conventions may have otherwise prevented them. The ‘outsiders’ also delivered better returns to shareholders by focusing on a much more precise measure of profitability, namely cash flow, as opposed to earnings per share - the main benchmark used by City Analysts. Finally, rational capital allocators tended to favour decentralised organisational structures, which “release entrepreneurial energy.”
Buffett’s litmus test for good management:
So Warren Buffett highlights capital allocation as a key test of management’s capacity to…
