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.


  1. I appreciate your work here--will be following.

    Guess I would add Sardar Biglari as an additional "control" to the outsider group--he would fancy himself so, at least. He's young too. He's had decent returns with CBRL, but he borrowed/raised a lot of money to do it.

  2. Hi widemoat,

    Thanks for commenting. I agree that Biglari is an interesting comparison-- he follows the Outsiders capital-allocation playbook but has also done a lot of things to enrich himself at the expense of BH's outside shareholders. He's probably worth a post of his own.
    - James

  3. Considering how many people have touted this book, I was very pleased to find someone whose impression of it was similar to mine (uh-oh, confirmation bias!).


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