This article is an excerpt from the Shortform summary of "The Outsiders" by William N. Thorndike, Jr. Shortform has the world's best summaries of books you should be reading.
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What is capital allocation, and how does it work? Why does a strong capital allocation strategy make for a great CEO?
Capital allocation is the practice of distributing and investing a company’s resources in a way that will make further profits. For the Outsider CEOs, an unorthodox capital allocation strategy was the building block on which they developed other strategies that resulted in higher profits.
What Is Capital Allocation?
In general, CEOs have to do two things to succeed:
- Run operations efficiently to generate cash.
- Deploy the cash productively.
Most CEOs and most management books focus on the former. In contrast, Henry Singleton of Teledyne and the other outsider CEOs in the book focused on the latter. Rather than seeing themselves as company operators, the outsider CEOs saw themselves as investors and capital allocators first and foremost.
Despite the importance of capital allocation, little training is devoted to it. Business schools don’t feature capital allocation strategy in curricula, and CEOs are promoted from functional roles (like product or marketing) without strong experience with investment in the business. Outsider CEOs saw it as their core job.
Unique Capital Allocation Strategies of Top CEOs
As a baseline, businesses can deploy cash in five basic ways—invest in the existing business, acquire other businesses, pay dividends to shareholders, pay down debt, or buy back stock. They can also raise money by issuing debt or raising equity. These are all tools in capital allocation, and the specific usage of these tools determines a company’s performance.
How to decide between these options? Universally, outsider CEOs were rational—they calculated the return on each investment project, then made the most profitable choice. They ignored conventional wisdom and what their peers were doing.
Compared to their peers, outsider CEOs tended to allocate capital differently:
- They aggressively bought back company stock when it was cheap (for instance, when price-to-earnings ratio was in single digits). This would increase earnings per share and, consequently, price per share.
- They rarely issued shares to raise funds, preferring to avoid dilution.
- They rarely issued dividends, seeing this as a tax-inefficient way of rewarding shareholders. Dividends are essentially taxed twice, first as corporate tax on earnings, then as personal tax on capital gains.
- They were judicious about acquisitions. They didn’t acquire companies out of empire-building ego, with little care for cost. Instead, they bought companies only when it was a good deal; many had hard rules for what to buy, for instance based on a maximum P/E ratio or projected rate of return.
- This didn’t mean timidness—outsider CEOs were capable of making large, bet-the-company acquisitions when they felt it was a high-probability bet. Every CEO in the book made an acquisition worth at least 20% of their company’s enterprise value.
Outsider CEOs thought about their companies as investors and made cool, rational decisions based on what provided the best returns. Ego and a desire to build empires were never part of the decision.
In contrast, typical CEOs issued shares to fund costly acquisitions, preferred not to buy back stock or raise debt, and paid dividends frequently. In the conglomerate era, they aggressively acquired companies believing they could improve profits through scale or synergies; this was often a mirage that never materialized. All these activities tend to result in lower performance by the author’s favorite metric—price-per-share.
Note that the optimal choices vary from company to company, from industry to industry, and between different time periods. The point is not to blindly mirror what the outsider CEOs did—it’s to examine all of the tools in your toolkit, and choose the best one based on rational analysis.
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- What great CEOs like Warren Buffett do that average CEOs don't
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