Capital (Mis)allocators
The eternal appeal of finding the next Berkshire
I like to rub my nose in my mistakes. A quick story:
Eons ago, I was manager of a Technical Services department for a warehouse operation. Among other duties, I was responsible for the group that trained forklift drivers. One fine day, one of the trainers was driving in the warehouse with the forks raised on his lift. This is not something he was supposed to do. The best practice was to drive a lift with the fork at operating height only when needed and very slowly and carefully. Then, safely lower the load and drive with the fork at normal operating height. In this case, he hit a sprinkler pipe. Before the water to the pipe could be shut off, there was significant damage to the product in the warehouse. It took weeks to sort out and repair. Eventually, I asked him to come see me to talk about it. When he arrived, he was very nervous:
“You wanted to see me?” Driver
“Yes, come in. Sit down. You look upset. Are you ok?” Me.
“You are going to fire me, right?” Driver.
“Are you going to fail your drug test?” Me. It was our policy to drug test anyone who caused a severe accident.
“No.” Driver.
“Then you have nothing to worry about.” Me. He was visibly relieved.
“I can’t believe it.” Driver.
“Will you ever make that mistake again?”
“No”
“Exactly. You are a good driver. You made a mistake. And yes, it was a big mistake. But you will probably never, ever make that mistake again. I could send you into the most dangerous warehouse corner with sprinkler pipes all around you, and you would be the least likely person to hit a pipe. If I fired you, I’d have to hire a new driver, train them up, and then they would be just as likely as anyone else to hit a sprinkler pipe.”
Needless to say, he was grateful. And he never hit another pipe or even had any accident I know of. Investing is not like forklift driving. The feedback is not as immediate, and the mistakes tend to be less visceral. If I treat them like that forklift accident, I hope to learn from them and not make them again.
Despite my enlightened warehouse management style, I find that I continue to make mistakes in investing. In fact, I repeated the same types of mistakes MULTIPLE TIMES. I guess I am a slow learner.
One of the areas in which I have made repeated mistakes is the fabled “Capital Allocator.” These are investments where the investment's success lies with the management's capital allocation talent, often with the CEO. The theory is that they will use their talents to purchase cash-flowing assets to add to their kingdom and generate superior returns. I put these in two categories. The first is a company that focuses on one industry. Famous examples here include Danaher, Pool Corporation, and Constellation software. You will often hear the CEOs of these companies described as “The Buffett of Industrials” or “The Buffett of Software.” The second, and more insidious, is the generalist company. These companies often have diverse assets across multiple industries. Examples here include Markel Group and the most famous, Berkshire Hathaway. Unfortunately, I have fallen victim to “looking for the next Buffett.” And too often with disastrous results.
There are great examples of both types of companies that were very successful. I mainly invest in smaller companies, and the many, many disasters with smaller capital allocators are missing from the archives. I am particularly susceptible to the second kind. Generalist CEOs have the selection of a variety of significant assets to invest our cash in. I have a few observations and lessons learned from some of my mistakes in this area:
CEO is from PE or IB: Having a CEO who worked in an industry that functions to buy and value companies would be excellent training for a small capital allocator investment. The justification is usually something like “they will have access to great deal flow”. That may be true, but even the most active small capital allocators will only do a handful of deals, at least initially. Most of the time is spent running the business.
CEO is an investor: I can attest from personal experience that corporate operations are nothing like investing. Running a company requires a different skill set.
Small companies have hair: It is probably incorrect to compare a $10b market cap company buying a $500m company with a $100m company buying one for $500k. The smaller company most likely has “non-professional” management. There is often hair. I witnessed one capital allocator company buy a business that had operational problems. They spent the next several years dealing with operational issues at the acquired company and very little time focused on capital allocation. This is the norm with small companies. The idea that you can buy a handful of decentralized businesses in the <$10m range and let them operate autonomously is probably much more difficult than buying larger, more established companies.
I am now much more skeptical of capital allocator stories. It is easy to remember the great winners in this category. We often forget the unique challenges that small companies bring to this area. I am much more willing to wait and watch these companies before investing. I want to see a demonstrated ability to deploy capital and grow before I join. But on the flip side, if they showed that ability, even if it takes years, there should be an extremely long runway for growth.
Let me know if you have experienced anything similar in the comments! Maybe I can learn from someone else’s mistake rather than mine…
Experiencing this first hand (currently) with $IAC