Client Update, May 17, 2024: Management Qualities that Build Trust

“Everyone wants to just push a button and walk away, which is just plain lazy. The hard way is the way.”

Kate Bradley Chernis, CEO of Lately.ai

Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts can be rolled over into an IRA and are often an excellent fit for GDS Investment’s long-term investment approach. GDS manages separately managed accounts for retail investors at Charles Schwab. If you would like to invest with GDS Investments or connect with us, please email glenn@gdsinvestments.com.

This month, we want to talk about leadership and its relationship to capital allocation.

As we once told The Manual of Ideas, “[There are different] buckets of ‘I like to have’ companies, but the underlying ingredient is: I must trust management. I want to partner with people I respect and who understand capital allocation in a deep way.”

But what does all that mean in practice? What are the management qualities that build trust and reassure us that we are partnering with people who will handle capital allocation effectively?

To start, one key shared trait among leaders who are successful capital allocators is discipline. Consider Danaher (NYSE: DHR), a global conglomerate with interests in medical, industrial, and commercial products and services. Historically, Danaher has grown via acquisition, building up their newly acquired firms and then—if they feel they can get more value by separating—spinning them off. Repeatedly making the right judgment calls in the realm of mergers and acquisitions (M&A), however, is challenging in the extreme. Danaher beats the odds through its famously disciplined approach. As The Washington Post once put it, “Danaher thrives on discipline.”

“For us, staying disciplined is easy because that's the only way we know how to play the deal game," then-President Larry Culp told the Post.

That kind of discipline usually rests on a specific kind of temperament. Disciplined leaders tend to be rigorously intellectually honest about their capabilities to ensure they keep playing the game within their own circle of expertise. Warren Buffett, co-founder, chairman and CEO of Berkshire Hathaway (NYSE: BRK.A), is an excellent example here. He has developed a deep understanding of certain verticals while actively avoiding sectors he doesn’t know; he is intellectually honest with himself about his own limits. For example, he has said, “I don't worry about not buying Microsoft, though, because I didn't understand that business. And I didn't understand Intel.”

In contrast, there are plenty of cautionary tales of leaders who don’t or won’t acknowledge their own limits or the limits of their own best strategies.

Consider the tale of two The Home Depots (NYSE: HD). The first Home Depot is the one originally founded by Bernard Marcus, Arthur Blank, Ron Brill, Pat Farrah, and Ken Langone in 1978. They had an amazing concept, went out, and executed. They put a lot of smaller operators out of business because their model disrupted the space and offered customers benefits that they weren’t getting elsewhere.

But then comes the second version, after the founders stepped down and the Board brought in new CEO Robert Nardelli. He had been passed over to succeed Jack Welch as CEO at General Electric (NYSE: GE), and he seemed (on paper) to be an excellent candidate. Once installed at The Home Depot, however, he acted as a financial operator who tried to ride roughshod over the unique culture that made The Home Depot so special. It’s not that his approach was wrong exactly, but it was wrong for The Home Depot. Intellectual honesty is being able to say, “The way I did things before is not a good fit for the way things work here.”

Ultimately, even Langone, who had originally pushed for Nardelli’s hiring, began to advocate for his resignation. In his book I Love Capitalism, Langone wrote, “My first impression of Bob Nardelli—‘he’s a real people guy; we’ve got a great operator here’—had been exactly 50 percent right. The guy really was a great operator. But I came to realize—too damn slowly—that the whole people equation of Home Depot, the essence of our culture, had completely eluded him.”

Langone is an example of someone who does have the discipline and temperament needed of great leaders and investors—and the humility and willingness to course-correct when necessary. He’s also a lively speaker full of great stories and insights. He recently appeared on the Invest Like the Best podcast in an episode we thoroughly enjoyed.

Beyond a disciplined, intellectually honest temperament, the best capital allocators and leaders are also opportunistic (in a good way) and long-termist.

In other words, good capital allocators have a proven record of taking advantage of the opportunities in front of them. Yes, they are disciplined and discerning about these decisions. They don’t dive into areas where they don’t possess expertise, but they’ll be responsive to conditions that favor the forms of capital allocation they know best, especially when those activities serve the long-term interests of the business.

Google (NASDAQ: GOOG) and its leadership teams stand out here. They recognize that disruption/destruction cuts both ways and consistently seize opportunities to stand on the right side of that kind of change. Their most recent earnings report highlights their facility with capital allocation.

To start, all of their core operating segments are growing nicely: Search revenue is up 14.4%, YouTube Ads up 20.9%, Cloud up 28.4%. Importantly, this revenue growth did not come at the expense of profitability, as the operating margin for Google Services (Search + YouTube Ads, Network and Other) hit an all-time high at 39.6%. This, in turn, creates a free-cash-flow generating machine that can:

1. Enable the company to buy back $15-$16B in stock each quarter,

2. Fund $12B in quarterly CapEx (to protect their existing moat and develop new moats),

3. "Link” free cash flow to buybacks, so that net cash balance stays around $100B (going back four years, net cash balance has been remarkably consistent around $100B—$95M as of Q1 2024—which means they’re not mortgaging the future), and

4. Declare their first ever dividend at $.20/share.

This is why GOOG remains a Tier 1 position for us and has for a long time.

But GOOG is also unusually long-termist in its approach to its business. Too many others try to front-load rewards (usually earnings per share or some other per unit metric). Consider a turnaround situation: the Board brings in someone with a great resume, and the new outside CEO is pressured to grow fast, so he or she turns to “easy” ways, like acquiring more companies. It’s very easy to make M&A math look great on paper, but few companies are Danaher or Google, and few CEOs have the skills or devote the time to integrate new acquisitions successfully and produce earnings that are anything but short-term.

Sanford “Sandy” Weill, former chief executive and chairman of Citigroup (NYSE: C), was known for promoting financial supermarkets. Instead of just offering a straightforward commercial bank, they would do everything. To make that work, Weill acquired a lot of companies. On paper, his arguments made a lot of sense, creating a one-stop banking shop, but they struggled to integrate. With the benefit of hindsight, they would have been better off as exceptional in one or two verticals, instead of performing at an average level in seven or eight business areas.

This is a kind of corporate trap that gets sprung in the business world all the time, because it serves the CEO’s need to grow earnings today, and it’s a lot easier than growing brick by brick. Too many CEOs want to just push a button labeled “Make Revenue Grow” and walk away, but no one can ignore the factors that reflect on the long-term health of the business—valuation, culture fit, R&D, the right CapEx cycle—and expect long-term, sustainable success. The hard way is the way.

The positive impact of a long-termism outlook from business leaders isn’t just abstract or anecdotal either. A study reported in The Harvard Business Review found that business short-termism is negatively correlated with both innovation and positively correlated with higher cost of capital. Specifically: “Investors punish companies with a short-term orientation by applying higher discount rates to them, which increases the cost of capital for those companies. In contrast, companies with a long-term orientation are rewarded with a lower cost of capital, which allows them to afford more innovation—a virtuous cycle.”

The researchers also found that this increase in short-termism and lower innovativeness seems to be related to the increasing prevalence of “outside CEOs” (which we refer to as “renter CEOs”). They observe that from 1970 through 2004, “the percentage of CEOs hired from outside the firm increased from 12% to 39%.” As of 2022, there’s evidence that number is now closer to 75%, at least within certain market segments.

At the end of the day, follow the incentives. Particularly if you have people coming in from the outside—like Nardelli or Weill—and those people are rewarded based on things that happen on the income statement, those shorter-term incentives will drive their behavior. Often for the worse.

On the note of taking a long-term perspective, if you’d like some wisdom on the power of long-termism from one of the world’s greatest masters of it—Mitch Rales, the co-founder of Danaher—I’d strongly recommend a recent episode from The Art of Investing podcast. This might be one of the best episodes we’ve heard as it relates to thinking long-term in an increasingly short-term world.

Ultimately, leadership is key to any asset we own or consider. Favorable financial outcomes today cannot be sustained in the absence of disciplined, opportunistic, and forward-looking leadership; and given that our own philosophy of investing favors long-term outperformance, we need to have confidence that the leaders of the assets we own will be able to serve the needs of the business for years to come.

A few final notes:

Last month, we discussed the book Empire of Pain: The Secret History of the Sackler Dynasty by Patrick Radden Keefe about the opioid crisis and the Sackler family’s role in it. Since our comments, an interesting and potentially momentous update to the story has emerged: the Justice Department has announced that it is investigating McKinsey & Company for its role in advising Purdue Pharma and others in how to boost sales of opioids. As the expression goes, the wheels of justice grind slow but fine. This investigation offers another piece of evidence of both the severity of the crisis and the wide-ranging effort to put a final, just end to it.

Finally, we wanted to highlight another show/newsletter we’ve been enjoying: Scott Galloway, a clinical professor of marketing at the NYU Stern School of Business, writes a weekly newsletter, No Mercy / No Malice, that offers wide-ranging, thought-provoking content on issues like the economy, higher education, and more. Professor Galloway recently appeared on the Julia LaRoche Show to discuss his newest book The Algebra of Wealth: A Simple Formula for Financial Security—a  worthy watch.

With warm regards,

Glenn