Serial Acquirers

The Operator-Allocator Spectrum

Gustaf Hakansson
March 22, 2024
How can we justify benchmarking a CEO in a struggling industry against another in a thriving one?

Should we compare a CEO in an underperforming industry to competitors? Or to mavericks who successfully move into more profitable areas?

It depends on the capital-allocator allowance a CEO secures from their board, with all CEOs falling somewhere on the operator-to-allocator spectrum.

For example, Royal Little – a pioneering conglomerateur who beat Buffett by a few years in transforming a textile business (Textron) into a sprawling operation – had little in common with his initial peers.

As an aside, in his book, How to Lose $100,000,000 and Other Valuable Advice, Mr. Little wrote that believing that Pepsi bottlers don’t face varying pressures even in the same country could take you one step closer to losing that $100m. Munger would later make the same observation (as seen in the acquirer book).

In any case, CEOs are often evaluated on Total Shareholder Return (TSR). However, choosing peers to benchmark the TSR against and determining what it even was isn’t straightforward.

But how can we justify benchmarking a CEO in a struggling industry against another in a thriving one? We’ll see that we only need a slight push in our current direction for such benchmarking to make sense for select CEOs when evaluated over long periods.

Let’s start with operator evaluations and gradually move toward allocator measurements.

The only-an-operator CEO can be evaluated on similar metrics investors use to analyze operations.

Investors sometimes use return on tangible equity (ROTE) to understand underlying business profitability while also looking at how much capital that’s been reinvested at those rates. We get tangible equity by removing goodwill and other acquired intangibles from equity.

Awkwardly, we often use an adjusted ROTE, which, among other adjustments, includes guestimates for internally made intangible investments. Effectively, it’s a return on proforma organic equity (“ROPE”) based on the equity invested at cost (in "today dollars"), as though all subsidiaries had been part of a group since their inception.

The adjustments guard against the circular analysis that would result from mixing in value-accounting leftovers from M&A. Acquired intangibles already incorporate expected value from growth at excess profitability. And we need harmonized cost accounting to determine underlying profitability ourselves.

The operator CEO may have accounting remains from past acquisitions or a board that drives M&A, sets arbitrary buybacks to match share dilution, and fixes dividend payouts. Comparing “ROPE” developments and growth metrics with industry peers could be fair for such CEOs.

But a higher allocator allowance means more accountability.

For instance, my ROPE would be excellent if I raise capital to acquire Coca-Cola, but the return my shareholders get depends on how much I pay.

As such, we’re already used to excluding acquired intangibles when evaluating operations while including them when evaluating managers making both organic and M&A investment decisions.

However, allocator CEOs are accountable for all capital allocation levers.

Shareholders effectively reacquire their firm daily at the after-tax market capitalization they would have realized if it was sold. Naturally, the allocator opts not to sell at that price each day the firm isn’t put up for sale.

The M&A skill in that opportunity-cost decision can be treated as any other acquisition.

The allocator CEO, therefore, is also responsible for compounding economic goodwill.

“Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” – Buffett 1985 letter

The allocator’s job is to maximize shareholder value over the long term, not compared to their current industry but to the best available risk-adjusted opportunities. Notwithstanding that we can only expect a few allocators to exist.

And measuring that shareholder value leads us to Total Shareholder Returns (TSR).

TSR includes future expectations, often making it more complete than historical performance metrics based on growth, profitability, and economic-value-added estimates.

TSR is calculated as the returns a buy-and-hold investor would get in a stock when recycling dividends back into it indefinitely.

(Hypothetical minority interests are willing to be bought out at staggered levels from the share price. Buybacks, therefore, don’t need to be viewed as distributions for buy-and-hold shareholders.)

Beyond the non-practicality of all shareholders reinvesting dividends at the prevailing share price without any sellers, the dividend-reinvestment assumption shifts capital allocation responsibility from the CEO to the shareholder.

For example, suppose a CEO pays a massive dividend, whereas the same CEO in a parallel universe instead conducts aggressive buybacks. Both would share a similar TSR, even if the share price subsequently plummeted while stock indexes went up. So, TSR cannot be a perfect measure of capital allocation performance.

Publicly listed firms, ironically, need a TSR based on a public market equivalent (PME).

PMEs are used in private equity to supplement metrics such as the internal rate of return (IRR). Just like IRR, TSR only equals an investor’s return if distributions are reinvested at the TSR rate. But in contrast to regular TSR, an “Allocator TSR” treats dividends as a CEO signal that dividends create more value than buybacks.

Therefore, the Allocator TSR’s dividend accumulation factor isn’t based on reinvestment in the firm’s share but into an index (ideally after-tax) most resembling its shareholders' portfolio.

Lastly, you might have seen the study, Do Stocks Outperform Treasury Bills?”, which showed that only 43% of US common stocks have outperformed one-month Treasury bills.

Companies eventually die, liquidize, or get acquired, and not reinvesting dividends into an index in the meantime likely doesn’t do the value creation of many firms justice. While power laws still exist, a complementary study based on Allocator TSR would be welcome.

Note: While extreme, the following example illustrates why evaluating the net effect of a firm's returns can be interesting, which Allocator TSR is a proxy for.

Consider an index with a 95% probability of returning 1.2x and a 5% chance of 0.2x. We time travel a hundred years into the future and observe its successive returns, which happened to fall out as expected. The index rose 20% in ninety-five of the years and sank 80% in five of them. Its regular TSR equaled its geometric mean of 9.7%.

Conversely, a firm called the Hedge returns 0.0x with 95% probability and otherwise 10.0x. Any -100% return in a distribution of potential returns, regardless of any associated low probability, makes the geometric mean -100%. So, the Hedge CEO’s TSR will also be -100%.

“for time converts the improbable to the inevitable.” – Stephen Jay Gould

But the miserable TSR doesn’t necessarily tell whether its CEO created shareholder value. Because the Hedge happens to always perform well when the index doesn’t and vice versa. Every year, Hedge shareholders receive any dividends and then pay 3% of their net worth in new capital raisings, while allocating the rest to the index.

Their combined payoffs in the only two possible scenarios become 1.16x in 95% of the time and 0.49x otherwise. Consequently, adding a firm with -100% TSR increased their geometric returns from 9.7% to 11.5%. Indeed, the Hedge CEO performs exceptionally by counteracting the cycle.

Of course, this is a stylized example requiring the Hedge CEO to convince shareholders that a 3% allocation is the right annually rebalanced allocation beforehand. The Hedge is clearly an insurance instrument, but it does show a drawback of using regular TSR to measure shareholder value creation.

Unfortunately, our Allocator TSR doesn’t fare much better in this extreme example. Because if Hedge shareholders had allocated 9% to it instead, their geometric return would have suffered compared to the index.

However, Allocator TSR is at least a better capital allocation performance measure than regular TSR for the compounding assets that serial acquirers aspire to construct.

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Worth reading!
Chris Mayer
Author of 100-Baggers
PM & co-founder, Woodlock House Family Capital
Brett Kelly
Founder & CEO
Kelly+Partners Group