I started reading The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success this weekend. The book, written by William N. Thorndike, Jr., and published in 2012, details eight CEOs' methods and why they led to outsize returns for their shareholders over a long period.
The central concept of this book is that capital allocation is the CEO’s most important job. Capital allocation is “the process of deciding how to deploy the firm’s resources to earn the best possible return for shareholders.” It’s investing to get the highest return, so CEOs are both capital allocators and investors.
CEOs need capital before they can deploy it. They can acquire capital in three ways:
- Generating cash from company operations
- Issuing debt (i.e., bank loans or bonds)
- Selling equity (i.e., selling part of the company to VC, PE, or public investors)
When CEOs have capital, they can deploy it in several ways:
- Investing in the company’s existing operations
- Acquiring other businesses
- Issuing dividends
- Paying down debt
- Repurchasing equity (i.e., buying back part of the company)
- Launching new businesses (as the sole owner or in partnership with others)
These options make up a CEO's capital allocation toolkit. Figuring out what tools to use, if any, and when, is the skill of capital allocation. The book emphasizes that no courses are taught on capital allocation (as of 2012), so it’s a skill many CEOs lack. Now, though, Columbia Business School apparently covers this topic in its Security Analysis course.
Core to gauging the effectiveness of a CEO’s capital allocation in the long run “is the increase in per share value, not overall growth or size.” Long-term per share value essentially measures long-term value creation.
When I ran my company, I was focused on two things: running the company efficiently and generating cash. Getting the operations right consumed much of my time, and I didn’t think in terms of being a capital allocator.
So far, the stories of how these CEOs thought about and executed capital allocation strategies to generate high returns have been thought provoking. I’m looking forward to finishing this book.