Talk Is Cheap: Why CEOs' Actions Speak Louder Than Their Words

When you think of any famous CEO, you probably think of the great products or services that they’ve championed. CEOs that build great businesses become very famous, and justifiably so. But building a business that generates tons of cash flow is just step one. The less interesting—but equally crucial—job of any CEO is allocating their capital. Capital allocation is not glamorous, but capital allocation choices have had a huge impact on stock returns historically. The bottom line is that disciplined, shareholder-oriented capital allocation plans produce great results—for both companies and investors…but reckless spending, acquisitions, and cash-raising lead to weak results.

How to Use Capital

When it comes to allocating (or raising) capital, CEOs have a fairly limited toolkit.  As William Thorndike, author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, summarizes in his book:

CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Let’s look at each option and how they affect stock returns, on average.

Investing In Operations

“CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations.”

— William Thorndike

The first group is companies that have lots of new capital expenditures. I consider the 10% of companies every year[i] that are growing their capital expenditures by the greatest percentage year over year. These are the big spenders. How has this group done historically? They’ve delivered an annual return of 5.4%[ii]. That is roughly half the return of the market’s 10% return over the same period. Rapid growth may sound good, but these results indicate otherwise. Overzealous expansion has led to weak stock returns. These stocks are also more volatile than the market (22% annual standard deviation vs. 15.5% for the market).

Acquiring Other Businesses

The easiest way to find acquisitive companies is to look for those companies whose “goodwill” has grown by the greatest percentage in the past year. Goodwill is a balance sheet account that grows when one company buys another, but pays more than the book value of the company they are acquiring (the difference is added as an asset called “goodwill,” which ostensibly measures the value of things like brand name, patents, etc.).  There have been a number of studies which show that big acquisitions tend not to work out for shareholders.  The evidence from companies with the largest growth in goodwill supports these findings.  This group has delivered an annual return of 6.5% (18% volatility), again significantly lower than the market’s 9.1% (14.8% volatility) return over the same period[iii].

Issuing Debt and Raising Capital

A third group is companies raising lots of cash through debt or equity issuance. These companies have been a disaster historically. The best way to measure this option is using financing cash flows.  Financing cash flows come in different flavors, and are basically the “capital allocation” options listed above.  Positive financing cash flows (money coming into the company) result when a company raises cash through new debt or equity offerings. Negative cash flows (money leaving the company) result when a company pays back creditors, pays dividends, or repurchases shares. This group is the 10% of companies that have the largest positive financing cash flows relative to their market cap (meaning they are raising cash). The stocks of these companies have grown at just 5.71% (21% volatility)--which is a little more than half the market’s 10% return (15% volatility) over the same period[iv].

Dividends, Share Buybacks & Paying Down Debt

The last category—and the one that delivers great outperformance versus the market—is the 10% of companies that have the most negative financing cash flows. These companies are sending cash back to stakeholders by paying dividends, repurchasing shares, or paying down debt. Their historical returns have been 15.4% per year (17.6% volatility), which is 5.4% better than the market’s 10% return (15% volatility)[v].  Sometimes these companies are referred to as having high “shareholder yields.” Owning these companies has worked great in the past.

The data from these four groups shows that you can do very well as an investor by following a CEOs actions. If they are spending like crazy, or raising tons of cash—look out. If, instead, they are sending cash back to stakeholders, then you should take notice.

Discipline Is Key

Back to The Outsiders. The author distills the lessons he’s learned down to 10 rules, the 8th of which is very important:

8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate [hurdle rate being some minimal acceptable return on investment, say 20%].

The discipline implied by this eighth rule is rare. CEOs awash in cash often spend overzealously on projects with lower than acceptable rates of return or on projects/acquisitions that are simply too risky. The successful CEOs described in The Outsiders had a disciplined process for spending on new projects. If there are no projects available that can earn a high rate of return, the best CEOs instead pay dividends, repurchase shares, or pay down debt.

Just like with investing, disciple is key for CEOs to be successful—and true discipline is rare. As Thorndike points out,

This outsider approach, whether in a local business or a large corporate boardroom, doesn’t seem that complicated; so why don’t more people follow it? The answer is that it’s harder than it looks. It’s not easy to diverge from your peers, to ignore the institutional imperative, and in many ways the business world is like a high school cafeteria clouded by peer pressure. Particularly during times of crisis, the natural, instinctive reaction is to engage in what behaviorists call social proof and do what your peers are doing. In today’s world of social media, instant messaging, and cacophonous cable shows, it’s increasingly hard to cut through the noise, to step back and engage Kahneman’s system 2 [thinking with your head instead of with your gut], which is where a tool that’s been much in the news lately can come in handy.

One example is with share buybacks. In general, they’ve led to solid returns for investors. But you’ll often read stories that buybacks are mistimed and stupid uses of cash. This is partly true. Look at the below table, which takes the 20% of stocks in the market that are buying back the most shares.  It then splits this group out into give groups by valuation. You can see that when CEOs and their companies buyback shares at cheap prices[vi], their stocks tend to do very well in the next year, beating the market by 5% on average. But when they buyback stock while valuations are expensive, they get killed by the market, losing by 5% on average. The key lesson is that the best CEOs buyback shares when it’s smart to do so, not just because all the other kids are doing it.

1963-2013

Ultimately, choosing what to do with a company’s cash (or how to raise it) is one of a CEO’s most important decisions.  By avoiding the big spenders, and buying cheap companies that are disciplined with their cash and rewarding their shareholders, you can outperform the market over the long-term.

[i] Rolling annual rebalance

[ii] 1963-2013

[iii] 1989-2013

[iv] 1972-2013

[v] 1972-2013

[vi] Cheapness measured by p/e, p/sales, ebitda/ev, etc

Beware Experts Bearing Predictions

You should ignore experts making predictions, you should avoid making predictions of your own, and you should definitely avoid any investment decision that is predicated on a subjective prediction. Predictions are everywhere in investing (price targets, GDP forecasts, S&P 500 earnings, EPS estimates, and so on), but they are usually worthless.  

Our brains evolved to recognize patterns, which creates the side effect that we are pattern junkies. Whenever we see two of something, we automatically expect a third. This pattern-addiction makes us obsessed with the future. We usually turn to experts for predictions about the future, and the stock market is chock full of more forecasts than any other arena of interest or speculation. But the evidence below shows that economic and market forecasts are crap: in most cases you may as well flip a coin. I’ll explain why instead of relying on expert predictions, you should do your own research, focus on process, and always stick to your strategy.

Why We Love Experts

“If you make people think they’re thinking, they’ll love you; but if you really make them think, they’ll hate you.”

— Don Marquis

Experts are surrogate thinkers. They do the thinking so you don’t have to! We love experts because they allow us to outsource our thinking but also because of the psychological bias known as the “halo” effect. The better known, more intelligent, better looking, or more respected an expert forecaster is, the greater the confidence we have in their predictions.

So what is the record of expert forecasters? The most comprehensive study on the topic was conducted by Philip Tetlock, whose book Expert Political Judgment is a must read. In the book, he assesses 28,000 forecasts made by hundreds of experts in a variety of different fields. He finds their abilities lackluster:

These results plunk human forecasters into an unflattering spot along the performance continuum, distressingly closer to the chimp than to the formal statistical models. Moreover, the results cannot be dismissed as aberrations…Surveying these scores across regions, time periods, and outcome variables, we find support for one of the strongest debunking predictions: it is impossible to find any domain in which humans clearly outperformed crude extrapolation algorithms, less still sophisticated statistical ones. (my emphasis)

A similar study was conducted specifically for investing/market forecasts. The CXO Advisory group gathered 6,582 predictions from 68 different investing gurus made between 1998 and 2012, and tracked the results of those predictions. There were some very well-known names in the sample, but the average guru accuracy was just 47%--worse than a coin toss. Of the 68 gurus, 42 had accuracy scores below 50%.

Another study of analyst estimates conducted by David Dreman showed that across 400,000 different estimates, the average error was 43%! (It is interesting to note that Dreman was was of the "gurus" from the CXO study--but he was the 5th best overall with an accuracy of 64%). 

Back to Tetlock’s study, which uncovered one variable that did effect whether the expert was more or less accurate:

It made virtually no difference whether participants had doctorates, whether they were economists, political scientists, journalists, or historians, whether they had policy experience or access to classified information, or whether they had logged many or few years of experience in their chosen line of work. The only consistent predictor was, ironically, fame, as indexed by a Google count: better-known forecasters—those more likely to be fêted by the media—were less well calibrated than their lower-profile colleagues.

The problem isn’t that these experts are dumb—indeed, they are usually very smart. The problem is that it is nearly impossible to predict outcomes in complex, adaptive systems like the stock market or the economy. J.P. Morgan (the original) had the only appropriate and accurate market forecast: “it will fluctuate.”

A Forecast Free Investing Process

Instead of basing your investment decisions on subjective forecasts, base them on simple rules or models. Many people don’t like models because they are impersonal and “backward looking.”  We want insight and prediction; models just spit out an answer. Of course models aren’t perfect, but they can be really helpful.

Simple models almost always beat experts. They are consistent, data driven, and easy to apply. From wine prices (Orley Ashenfelter), to political elections (Nate Silver) to individual stock returns—models work; and they use information that is already available instead of relying on forecasts about the future.

Ben Graham was the father of investing models—his checklists for the defensive and enterprising investor were decades ahead of their time. Similar systematic approaches are gaining popularity in the form of smart/strategic beta. These tend to be watered down applications of great ideas like value, momentum, or quality, but they can be a good start. The key with a modeling approach is to be consistent and stick with it. It is always most tempting to abandon a model when it’s suffering through an inevitable period of underperformance—but that is the worst time to leave (think of a value strategy in 1999).  

Quants are the heaviest model users, but the important point here is that you should have rules and a consistent process.  Many of the most famous investors aren’t quants, but they often have a system: a set of rules consistently applied when buying and selling. Here are a few examples of model or rules based projections that have worked quite well for the market.

•  Shiller CAPE ratio (as Ben Carlson recently pointed out, CAPE is a strategic tool, not a timing tool)
• GMO’s seven-year forecasts (based on simple principles like mean reversion)
• Individual stock selection factors including value, momentum, yield, and quality 
• Altman’s Z score for bankruptcies

One frequent criticism of models is that using them is like driving by looking in the rear-view mirror.  They only look backwards—at what has already happened—and never look forward to what will happen. But anyone making this objection is planting the axiom that others can successfully look out the windshield and accurately see what is coming.  The evidence above suggests otherwise.

The CAPE ratio, for example, is very “backward looking,” because it uses data from the past 10-years. One of the most common criticisms of the CAPE ratio is that 10 year old data is irrelevant in today’s market environment (“it’s different this time!”) Yet as Meb Faber has shown, a simple strategy that buys markets with the lowest CAPE ratios does very well (read this). The beauty of the CAPE model is that if forces you into terrible situations where the forecasts for the future are dire. Low CAPE ratios result from very bad news, fear, and forecasters whose consensus is that the market is going to hell (think Greece, or Russia today).

We rely on stories and circumstances when we should care more about price. The story about each cheap market is always different, but the psychology that creates each attractive market opportunity is always the same. That is why investment models like CAPE work: they prey on the mistakes of fallible human investors and don’t get caught up in trying to figure out each new, market circumstance.  A CAPE ratio tells you nothing about what will happen to any given country in the future, but it identifies markets that may have been mispriced.

Ignore Experts, Think For Yourself

Jiddu Krishnamurti, a great thinker and writer, spent his life urging others to investigate things for themselves rather than rely on experts.  Two passages from his book Freedom from the Known urge us to step up our game:

Jiddu Krishnamurti

For centuries we have been spoon-fed by our teachers, by our authorities, by our books, our saints. We say, ‘Tell me all about it—what lies beyond the hills and the mountains and the earth?’ and we are satisfied with their descriptions, which means that we live on words and our life is shallow and empty. We are second-hand people. We have lived on what we have been told, either guided by our inclinations, our tendencies, or compelled to accept by circumstances and environment. We are the result of all kinds of influences and there is nothing new in us, nothing that we have discovered for ourselves; nothing original, pristine, clear.

Krishnamurti highlights the importance of thinking for yourself and, often, standing alone. He could have been writing about many famous investors. In the passage below, if you replace “society” with “market,” and “a comfortable spiritual life” with “strong investing results," then you’ve got yourself one fine investment philosophy!

The traditional approach is from the periphery inwards…and [yet] when at last one comes to the centre one finds there is nothing there, because one’s mind has been made incapable, dull and insensitive. Having observed this process, one asks oneself, is there not a different approach altogether—that is, is it not possible to explode from the centre? The world accepts and follows the traditional approach. The primary cause of disorder in ourselves is the seeking of reality promised by another; we mechanically follow somebody who will assure us a comfortable spiritual life [strong investment results]. It is a most extraordinary thing that although most of us are opposed to political tyranny and dictatorship, we inwardly accept the authority, the tyranny, of another to twist our minds and our way of life. So if we completely reject, not intellectually but actually, all so-called…authority, it means that we stand alone and are already in conflict with society [the market]. (my emphasis)

Standing in conflict with the market is hard because it means you have to fight the popular opinion, which often built by experts making forecasts. But there is no evidence that expert opinion is worth listening to. Avoid expert forecasts, do your own research, focus on process (models/rules), and stick to your strategy. These rules are a solid foundation for a good investing process.