Thursday, May 29, 2014

Book review: "The Outsiders" by William Thorndike

"Capital allocator" is Wall Street jargon for someone who makes investments. It often specifically refers to people who control large companies but devote most of their time to making investment decisions while hiring other people to manage the business operations.

"Great capital allocators" like Warren Buffett and John Malone who have compounded their money at 20% or more per year for many years are widely admired on Wall Street. Many people claim that they have unique talents and a unique mentality that set them apart from other investors.

The Outsiders by William Thorndike is a great example of this attitude. The book describes eight companies that were run by "outsider CEOs" who focused on capital allocation, Buffett and Malone among them. All eight companies handily beat the S&P 500 in stock-market performance, and Thorndike offers fulsome praise for the CEOs and their capital-allocation decisions, which typically involved some mixture of a) cutting costs, b) leveraging up to make large, promising acquisitions, and c) buying back lots of stock, often using leverage.

In my opinion, this strategy is much less sound than Thorndike makes it out to be. It's the kind of strategy that's enormously successful during periods of sustained economic growth and increasing asset prices but usually fails otherwise.

One astute reviewer had the following to say about the book:

I'll say one thing about The Outsiders: Thorndike knows his audience.

Value investors want to live vicariously through the great successes who crushed it during the inflationary, low interest rate era by owning assets with a lot of leverage.

One can think of The Outsiders as a value-investing analogue of Jack Schwager's Market Wizards series. The Market Wizards books describe short-term traders who turned a few thousand dollars into a few million by leveraging up and aggressively riding a trend. The Outsiders describes the same thing in slow-motion.

Like Market Wizards, The Outsiders is popular because it's inspiring rather than because it's informative. The book doesn't provide nearly enough detail for readers to determine why the capital allocation decisions it chronicles were successful. It also has methodological problems reminiscent of Jim Collins' Good to Great but even worse-- Thorndike's approach involves a lot of survivorship bias, and he doesn't subject his outsider CEOs to any kind of control group. The only comparison he makes is to repeat ad nauseam that his subjects' companies outperformed General Electric in the stock market even though Jack Welch is better-known than they are.

The ninth outsider

As part of my investing research, I recently came across a CEO who's much younger than Thorndike's outsiders but uses the same capital-allocation strategy they did. One can think of him as an honorary ninth outsider.

This CEO built up an impressive company in a commodity industry even though he had no background therein. The industry is notorious for having poor aggregate returns, but the CEO bought a couple of niche operations that had high returns on capital. Then, like many of Thorndike's outsiders, he leveraged up to make a huge, transformative acquisition. The CEO was savvy enough to negotiate a subsidized government loan in order to finance the acquisition, improving his company's potential returns while limiting risk.

The CEO is Chad Wasilenkoff and the company is Fortress Paper. The new acquisition has been an unmitigated disaster: Fortress's stock is down 95% from its all-time high and trading near an all-time low. Wasilenkoff has had to sell one of his niche high-return businesses to keep the new acquisition afloat, while the other niche business has swung from large profits to large losses following an operational snafu.

Wasilenkoff followed the Outsiders formula to a T-- the only thing he did differently was lose money.

Wednesday, May 28, 2014

Book review: "Stock Market Superstars" by Bob Thompson

Stock Market Superstars is a collection of interviews with a bunch of Canada's best-known money managers. When it was published in early 2008, the investors that the book profiles had achieved compounded returns of 15%, 20% or more annually. Many of them got destroyed later that year during the Lehman crisis and have yet to fully recover. Rohit Sehgal had the best track record when the book was published, but his main fund finished 2008 down more than 70%. Tim McElvaine and Wayne Deans were down almost 50% in 2008 and have had middling performance since then. McElvaine's interview mentions that he'd historically earned high returns despite holding a lot of cash in his mutual funds, yet he only had 6% of assets in cash during 2008. In the interview he touted a leveraged radio broadcaster that later went bankrupt.

I think some of the interviewees, particularly Eric Sprott, were bull market geniuses who had achieved strong returns at the time of publication by riding a bubble in commodities producers and low-quality cyclicals. Others, like McElvaine, seemed like good guys who were naturally conservative but got blindsided by Lehman because nothing in their careers had prepared them for it.

Most of the interviewees talk about investments that had been significant to their career in some way-- big winners, big losers, or investments that had taught them some important lesson. I found it interesting to look up some of these investments online, reading old SEDAR filings and looking for old news releases as a way of getting a fuller picture about them. The book didn't impart any concrete lessons, though. My biggest takeaway is that many investors who achieve high returns do so by optimizing their investing strategy for a specific economic or financial environment. When that environment changes, so do their returns (for the worse).

Sunday, May 25, 2014

Alice Schroder takes questions on Reddit

Like her previous interviews, this one is very good. She mentions that Buffett is much more bearish in private than in public, which reaffirms my sense that his public persona and all the hype surrounding it don't help people become better investors.