Sunday, February 2, 2014

Review of The Outsiders by William Thorndike

The Outsiders by William Thorndike is a shockingly overrated book and I am alarmed that it is so popular among value investors [see 1,2]. It gets no one-star Amazon reviews, but it should! This dissenting review is the only one I've found that sees what is going on with this book.

We get that capital allocation by CEOs is important. And yes, there are CEOs who, for incentive or principal-agent reasons, do not make capital allocation a priority.

However, the book focuses on a group (and only a group) of CEOs whose capital allocation decisions were, in hindsight, good. The stories are interesting but the study is unscientific and sadly pretty bogus. The biggest thing the CEOs really have in common is that they were levered to the moon.

This "study" of CEOs has no control group! You need to compare unsuccessful CEOs and verify that they used different techniques. You also need to verify that there were no unsuccessful CEOs who did use these techniques.

In my "easy come, easy go" post I pointed out that business hagiography lavishes praise on people who get really rich by speculating on assets with all the leverage they can muster. But not every leveraged speculator gets really rich.

What The Outsiders really seems to do is define good share repurchases, asset purchases, and divestitures as ones that retrospectively turn out well.



Taylor Conant said...

Yikes, that was the only review you found?

What about this quality effort:


CP said...

Oops! I was only looking for adulatory reviews or reviewers who realized it was dangerous junk. You were kinda in the middle.

Taylor Conant said...

I know. I think when I was writing my review I was in a "You've been a cranky sourpuss ruining other people's parades lately... try to find something constructive to say before you let out a stream of piss..."

So what I would mean to say in a more sober mood is the book was an enormous waste of time and it serves as a litmus test for critical thinking if a person heaps praise on it.

I did learn a couple things from it, but they were minor.

CP said...

It's odd that no one even mentions the methodological issues.

There are certain situations where you can make valid conclusions from a sample size of one. If you said, "I saw this guy walk in front of a train and he got creamed. Don't do that!", I wouldn't quibble about sample size.

The fans of the book should be getting out in front and arguing why it doesn't matter, for example, that there wasn't a control group.

Or why it doesn't matter that the author never establishes a framework for when a share repurchase is "good".

CP said...

"a rather breathless, New Age-y, pseudo-philosophical and kinda-scientific handbook to basic principles of organizational management and business success. The recommendations contained within range from the seemingly reasonable to the somewhat suspect and the author and his research team take great pains to make the case that they have built their findings on an empirical foundation but I found the 'We had no theories or preconceived notions, we just looked at what the numbers said' reasoning scary. This is actually the opposite of science, you’re supposed to have some theories and then look at whether the data confirms or denies them. Data by itself can’t tell you anything and deriving theory from data patterns is the essence of fallacious pattern-fitting."

whydibuy said...

Here I have to agree with Cp.
At every turn there is someone "going for it" in any field you wish to use.
If the market goes up 100% this year, the msm will highlight to high leverage long speculator who "knew" this would happen. Likewise if the market plunges 70%, the msm will trot out a bear who "knew" the market was about to crash.

Funny how in places like Japan that has been in a twenty year depression, you don't get stories about financial geniuses. In that kind of backdrop, its hard to do.
But I'm sure there were plenty who went for it but failed. We won't hear about them.

Likewise in industry there are those who went for it and failed. Like the business owner I knew who " knew" the Wankel engine would be the next big thing. He exhausted a tidy personal fortune and his business pursuing this concept. He bought patents for improvements in the engine, made prototypes and spent huge sums trying to get the automakers to adopt it. And it may well have been a better concept than the piston engine but, alas, it flopped. And since it flopped, you never heard about him. If it succeeded, his name would have been trumpeted as a visionary who saw the future.

bjdubbs said...

It seemed like 98% of the "capital allocation" was buying back and screwing one group of shareholders in favor of another. Maybe "the outsiders" refers to all the stockholders who got shortchanged for their shares. Or maybe the authors might want to mention that buying back stock creates no value. This is especially the case with Mr. Teledyne. The real lesson of the book was, don't be too forthcoming about the value of your stock and then buy it back from unsuspecting shareholders. If you read The Snowball, Buffett did this far more often than his fans acknowledge.

Anonymous said...

This is a good review. It shows a good understanding of scientific method, i.e., ways to discover new knowledge.

In general, as a scientist, I discover new knowledge by noticing a pattern in some data or in some day-to-day life experiences.

Then I invent a story to explain the pattern.

Generally, I use the principal of Occam's Razor by inventing the simplest story that accounts for the observed facts. Next, I look at some new data or some new experiences to see if the story continues to hold true.

This is called, "cross-validation" when one is doing science. It is called "back-testing" when one is inventing a theory to predict the future price of a security.

If new data or new life experience disagrees with my story, I abandon my story and create a new story that agrees with the old facts and the new facts. Then I cross-validate, keeping my new story until I find exceptions.

Science is an iterative process of creating new stories and cross-validating them.

CP said...

Thanks everyone, great comments.

That’s a good point that you never hear about Japanese investment geniuses. You don’t hear much about Japanese markets at all, actually.

I’ve noticed that the effect of Japan central bank operations is wild, unpredictable stock market gyrations that have absolutely no effect on the slow decline of the entire JGB yield curve to zero.

The key to the cheap share repurchases is, as bjdubbs says, to sort of sandbag shareholders about the value of the company.

From Snowball, Buffett hates to disappoint people. But there’s a dishonesty in portraying a company as worse than it is.

Anonymous said...

It seemed like 98% of the "capital allocation" was buying back and screwing one group of shareholders in favor of another.

Share buybacks need to be ethical. Sandbagging about the value of the business is close to the line, and something like misrepresenting book value would be definitely unethical.