This conversation is part of our “Wisdom in Books” series and podcast.
We had the pleasure of speaking with James Emanuel, author of Fabric Of Success: The Golden Threads Running Through The Tapestry Of Every Great Business. James discussed the book with Alex Gilchrist of MOI Global.
A lawyer turned investor, James improves the fortunes of the companies in which he has a financial interest. His book captures the essence of a great investment. James is also the author of the highly recommended Rock & Turner substack and a contributor to Latticework.
In this exclusive interview, James shares insights from his book, Fabric of Success. Drawing from his extensive experience as a long-term equity investor, James provides a unique vantage point on what differentiates truly exceptional businesses from the rest. He delves deeply into the common traits shared by standout CEOs — those visionary leaders who consistently deliver extraordinary long-term value.
James argues that investors frequently overlook the crucial role played by top executives, often distracted by fleeting narratives or superficial metrics. He illustrates his points with compelling examples, including stories of Sam Walton at Walmart, Steve Jobs at Apple, and the striking contrast between short-term managerial thinking and genuine long-term stewardship.
Throughout the discussion, James emphasizes the importance of looking beyond conventional measures of success — highlighting why aspects like company culture, capital allocation strategies, and alignment of incentives can be pivotal to long-term outperformance. By identifying what he refers to as “golden threads” woven through history’s greatest companies, James provides valuable tools for investors aiming to spot hidden gems and avoid costly pitfalls.
Experienced investors and fund managers will find James’ insights deeply thought-provoking, challenging traditional investment paradigms.
Discussion overview:
The Critical Role of Leadership
Common Traits of Exceptional CEOs
Long-term Thinking and Incentive Alignment
Unconventional Approaches to Capital Allocation
Dividend Policy: Myths and Realities
Spotting Hidden Gems and Red Flags
Why Location Matters in Business
Culture as a Competitive Advantage
Learning from History's Greatest Companies
Enjoy the conversation!
The following transcript has been edited for space and clarity.
Alex: Today’s guest is James Emanuel. He is an investor with a multi-decade career in the finance and banking industry who runs a private long-only equity fund that aims to have permanent capital invested in exceptional businesses. James is here to talk to us about his second book, Fabric of Success, which is available on Amazon. Welcome, James.
James: As part of my investing career, I regularly engage with C-suite executives, and I raise constructive challenges where decisions or a course of action makes little or no sense to me. This has happened countless times over the decades.
It often feels like Groundhog Day. I raise the same challenges again and again, albeit with different CEOs and CFOs. The interesting part is the response I receive. Most of the time, they’ll say something like, “Wow! I’ve never looked at it like that before,” or “That’s an interesting perspective.” Even more interesting is that this kind of discourse often brings about change and a beneficial pivot in the direction of the company. Don’t get me wrong: I don’t claim to be a guru of business administration. Everything I know, I have learned from others – from reading, from watching, from discovering what success looks like.
The advantage an investor has over a corporate CEO is peripheral vision. A CEO knows everything about their own company, is – one would hope – an expert on the industry, and may have limited knowledge about the business of their competitors. Think about that for a moment. That’s an extremely narrow field of focus. Now, contrast that to an investor like myself who constantly analyzes all sorts of businesses in different industries and countries. As an investor, I’ll be reading quarterly and annual reports and engaging with other investors. I come to learn what success looks like, what works and what doesn’t work. My field of focus is far broader, so I can introduce these challenges from what I’ve learned from others.
It’s no surprise that an investor can introduce new perspectives to corporate management. That’s when I thought to myself, “How valuable would it be to capture these perspectives in a book that I could share with corporate executives, particularly those running the companies in which I myself am invested? That way, I can see the benefit.”
I thought about the structure of the book. One of my favorite books is The Outsiders by Will Thorndike, who focuses on eight exceptional CEOs. He takes them one chapter at a time. What I have done instead is look thematically in 53 chapters at various aspects of running a business – whether it’s cost management or capital allocation, decentralization of operations, avoiding bureaucracy, succession planning, dividend policy, aligning the interests of insiders and outsiders, and so on. Each one of those themes is dealt with in its own chapter.
Then I look at how each of these exceptional CEOs have dealt with each of those themes, and I compare and contrast the approach. What I found fascinating is that these fantastic CEOs – I focus on about 150 of them in total – despite being located in different geographies, working in different industries, and some operating in very different eras, they all seem to converge on a strikingly similar approach to dealing with each of these topics.
Even more importantly, while they didn’t all start with a similar methodology, that’s where they all ended up. They all learned what worked throughout their careers. They learned from each other as well. Some have the same mentors and the same people who inspire them. They all seemed to converge – through trial and error – on a very similar approach. It would be silly for anybody running a business today to ignore this approach. By reading the book and learning a little more about how these people have achieved such outstanding success, a CEO can almost skip a few stages in the evolutionary process and hone in on some of those things.
One of the key things is that none of these people are afraid to break from convention. They understand that being better means doing things differently. Yet, despite being unconventional, they’ve all converged on a remarkably similar operating model. When writing the book, the objective was to pull on these golden threads running through the fabric of every great business, and I am exceptionally pleased with the result. Crucial to our discussion today, by identifying these golden threads, it becomes possible for me as an investor to spot them in other companies, which is how I find hidden gems in which to invest.
Alex: You mentioned the importance of the leaders of a company. Why do you think this is so often overlooked by other investors?
James: It’s interesting. Too many investors buy into a narrative. They don’t ask about the quality of the business and its management. By way of example, let’s consider the dot-com boom at the turn of the millennium.
Every top tech company back then was considered golden. As long as it had dot-com after its name, people were happy to throw money at it regardless of the fact that it wasn’t profitable, and a lot of them were highly unlikely to ever be profitable. Very few investors considered the ability of the CEO to deliver. To me, that’s back-to-front, upside-down thinking. They invest blindly, and, frankly, they deserve to lose money when the bubble bursts. There are parallels to be drawn with what’s happening today in the AI sector. Everybody’s throwing money at AI. Evaluations have gone crazy. A lot of it makes absolutely no sense.
Rather than investing in a theme, investors need to learn what ingredients make a great business, and then look for those ingredients. Some of these are in very dull, unfashionable industries. For me, the key ingredients – I’ll call out five of them now, though there are certainly more – are people, culture, capital allocation, time scales, and aligned incentives. I could certainly speak for hours on all this stuff, and that’s why I’ve written the book, but I’ll try and narrow it down.
Let’s start with people because I see that as the most important factor. It goes to the question you just asked me. The person steering the ship is so much more important than the ship itself. How many equity analysts value a business based on peer comparisons or peer company multiples? In my opinion, they’re barking up the wrong tree. Just because Company X trades at 30 times earning doesn’t mean that every company in its industry can justify the same multiple. It’s flawed logic. There are lots of e-commerce businesses, but there’s only one Jeff Bezos.
Let me give you some historical examples that hammer this point home. Consider Sam Walton, who created Walmart – probably the most successful grocery store on the planet. If you don’t know much about his life and career, I highly recommend his book Made in America – it’s a fantastic read. He set up his first store in Newport, Arkansas. It was running for about five years, and it was the most successful grocery store in the state, but he made a critical error, which he calls out in the book. It was a regret throughout his life.
The error was that he didn’t include a lease renewal clause in his rent agreement for the store premises. The landlord was a greedy man. He noticed how successful the store was. At the end of the five-year term, he told Sam Walton, “I’m not going to renew your lease.” Sam Walton had all of the key ingredients that had made the store such a huge success, and he lost everything because the landlord wouldn’t renew. Instead, this greedy person gifted the store as a going concern to his son. Sam Walton was knocked down, but he got back up and set up other stores in other states and locations. It wasn’t until 10 years later, when he got to his eighth or ninth store, that he came back to Newport, Arkansas. He opened that eighth or ninth store there.
What’s critically important here is that Sam Walton got knocked down, the first five years of his career were effectively wiped out, but he got up and built the incredibly successful franchise we know today as Walmart. The store he opened eight or nine years later in Arkansas also cleaned up. Now, the critical thing is that the hugely successful store the landlord had gifted to his son came to absolutely nothing. What does that tell you? It’s exactly the same business in the same location; all the key ingredients Sam Walton had introduced were there, but the change in ownership made all the difference. One was a failure; one became incredibly successful.
There are other examples. You can look at the McDonald brothers – Dick and Mac McDonald. They were happy with a single restaurant location. It wasn’t until Ray Kroc came along and persuaded them to scale up that McDonald’s became what it is today. Had it not been for Ray Kroc, McDonald’s probably wouldn’t have been anything except for one diner in San Bernardino, California. Again, it’s the person that makes a difference, not the business.
Warren Buffett, who’s a great example, says the single most important decision in evaluating a business is the management. He said he looks for people with talent, character, and a high degree of integrity. He says that if you have those three things, you’ve got a tremendous business. However, most equity analysts don’t put any kind of thought into the quality of the leadership. They become obsessed with quantitative analysis. They plug numbers into DCF spreadsheets and miss the most important qualitative part. Don’t get me wrong – I use a host of models and spreadsheets, but they’re never my starting point. I need to identify the quality of the business first before I waste my time analyzing the numbers.
Let me give you one other fantastic example. Consider a company we all know well – Apple. Steve Jobs is what I call a circumstantial CEO. If you look at his academic background and what he did before he started Apple, he never set out to be a businessman. That wasn’t what he was all about. He never set out to be the CEO of a public company, either. It happened by chance. He was pursuing his passion, which at that time was to democratize technology by creating accessible and user-friendly digital tools that could change the world. He didn’t set out to create a trillion-dollar company. Apple was simply the vehicle he established with Steve Wozniak to realize his dream.
The fascinating thing is that at an early stage, the writing was on the wall about how successful he was likely to become. We’re all very familiar with Henry Singleton. He’s one of the great CEOs that Will Thorndike wrote about in The Outsiders. Not many people know this, but he was a very early-stage investor in Apple. This is when personal computers were just coming into being. Hundreds of computer company startups appeared, but very few of them succeeded. Most withered and died. Singleton was subsequently asked how it was that he chose to invest in Apple over all of the others and how it happened that Apple turned out to be the winner. His response was simply that he’d been hugely impressed by Steve Jobs. It was the person, not the company. To Singleton, Jobs appeared to be a man on a mission. He was evidently committing everything he had to achieving that objective, and this distinguished him from all the others.
To hammer the point home about him being a circumstantial CEO, establishing a company and raising seed finance was the easy part, but the skill set to create a successful business is rarely the same skill set required to drive the company forward. None of us would jump behind the wheel of a car without taking driving lessons, but many people jump behind the steering wheel of a company equally ill-prepared, which obviously leads to poor decisions – particularly in relation to capital allocation and corporate strategy – and this is where most businesses falter. They essentially have the wrong person steering the ship.
Handing over control to someone else is never easy, especially for somebody who built the business themselves from scratch, with a major portion of their personal wealth invested. To Jobs’ credit, he recognized that he knew nothing about business administration, so he brought in a seasoned executive – John Sculley from Pepsi. The problem was that he selected the wrong man. Sculley clashed with Jobs and fired him. We know the story. The most valuable asset the company had was Steve Jobs. Scully disposed of that asset, which was one of a host of bad decisions he made during his tenure.
Apple’s fortunes declined under Sculley, taking it almost to the brink of bankruptcy in 1997. Allegedly, it was 90 days away from running out of cash, but Sculley was removed from the board, and Steve Jobs was brought back in, rescuing Apple from the jaws of insolvency and putting it on a trajectory to where it is today – a trillion-dollar company. What does that tell us? Same company, same target market, same industry – the difference was the person steering the ship. The outcome could not have been more different.
As an investor, the first thing you need to look at is the management. Who’s in charge? How passionate are they? What’s their mission? What’s incentivizing them? The lesson to be learned is that, as investors, we are not looking for the next Apple. We’re looking for the next Steve Jobs.
Let me take that a stage further. After Sculley kicked him out of Apple, Jobs founded the software business, which eventually became the Apple iOS operating system. He was also instrumental in the success of animation studio Pixar. Later in his career, when Pixar was acquired by Disney, Jobs became Disney’s largest shareholder. He joined the board and helped transform Disney’s fortunes as well. He influenced its strategy and also played a role in the appointment of Bob Iger as CEO. If you’d been able to invest in everything Steve Jobs touched, you would have done incredibly well.
Once again, the takeaway here is you’ve got to invest in the people, not the narrative. It’s not about the ideas. I don’t know if you’ve read the book Creativity, Inc. by Ed Catmull, the CEO of Pixar. He insisted that ideas come from people, so the people are always more important than the ideas. He always said that getting the team right is the necessary precursor to getting the ideas right. He stressed that a good idea in the hands of a mediocre team is like giving a bottle of champagne to a child. Didn’t we see that with Apple and Sculley? It was a fantastic idea, a fantastic company, but Sculley was a mediocre manager and nearly crashed the company. However, if you give a mediocre idea to a brilliant team, they’ll either fix it or throw it away and come up with something better.
This repeats again and again through history. Think about Intel under Bob Noyce, Gordon Moore, and Andrew Grove. They initially started a memory business in a commoditized market, which was a mediocre idea, but they realized it was mediocre, so they discarded it and came up with something better. That resulted in a pivot into semiconductors, and the rest is history.
To hammer the point home with one more example, consider Xerox PARC, PARC was the Palo Alto Research Center, which was established by the Xerox Corporation in 1970. It was responsible for pioneering many groundbreaking computer technologies. Those included the GUI (graphical user interface), the computer mouse we all use today, Ethernet networking, laser printing, and even the first personal computer, which was called the Alto.
However, Xerox failed to capitalize on many of PARC’s inventions commercially. The GUI is a great case study. I focus on this in the book, but I’ll tell you a bit about it. The graphical user interface was introduced at a time when everything before that was command line DOS. Introducing a graphical interface made computing more approachable for the average person, but Xerox didn’t do anything with it.
Steve Jobs was inspired by the work that had been done at Xerox PARC. He developed the first commercial GUI at Apple for his Lisa computer. That was in the early 1980s. He was focused on hardware sales rather than software and didn’t commercialize the operating system and the GUI. He made it available exclusively on Apple machines as a means to propel sales of the hardware. That very much opened the door for Bill Gates to come along, but it wasn’t for another five years.
Bill Gates had witnessed the power of Apple’s GUI, so he developed Windows. He took a very different approach. He wasn’t interested in selling hardware. Instead, he was focused on software. He made Windows available to anyone, whatever computer system they were operating on, and that opened the floodgates for widespread adoption of Microsoft’s operating system. By 1994, it had grabbed 90% of the market.
The GUI was a springboard for both Apple and Microsoft to succeed, albeit they were pushing in different directions. Apple used it as a means to sell hardware; Microsoft used it to succeed in software. The critical thing here is that you have three CEOs. The CEO of Xerox developed the technology but failed to commercialize it and do anything with it. On the other hand, Bill Gates and Steve Jobs built fabulous trillion-dollar companies on the back of that GUI idea developed by somebody else.
Once again, it’s not the idea, and it’s not the narrative. It’s the person. It’s all about the captain of ship. It’s all about the CEO.
Alex: You’ve mentioned these different characters. Can we pull on some of these golden threads, particularly from an investor’s perspective?
James: Sure. One of the other golden threads is time scales. This links up very neatly with people and also with incentives. Let’s talk about time scales for a bit.
As the famous saying goes, Rome wasn’t built in a day. Decisions need to be made with a bias towards the long term. Perhaps you’re familiar with the semi-reclusive investor Anthony Deden, who’s based in Switzerland. He has deliberately almost cut himself off from the financial world because he doesn’t want to be corrupted by all the white noise. It’s probably why Buffett is out in Omaha.
Anthony Deden tells a wonderful story. In the course of his investing career, he meets up with all sorts of businesses. On one particular occasion, he was traveling to meet with an Arab date farmer who was happily planting saplings in his orchard. Deden asked him, “How long will it be before these trees yield commercially valuable fruit?” Much to Deden’s surprise, the date farmer told him it was going to be 40 years, and it was almost certainly not in the lifetime of this farmer, who was already in his late 50s.
The important thing to bear in mind is that this date farmer was happily planting trees that weren’t going to benefit him in his lifetime. He could instead have extracted today’s earnings to enrich himself and chosen not to invest in these saplings, but his mindset was that his job, his duty, was to protect, preserve, and enhance what he was given to manage – effectively the date farm. He saw his role as being the trustee of assets owned largely by others. In this case, it was a family, but in the case of a public company, it’s clearly the shareholders. That was his mission. He was deeply grateful to the generations before him that had planted the trees yielding the fruit that was providing him with a living today, and he saw it as his duty to do the same. He was making decisions based on multi-decade outcomes. Isn’t that the kind of business you would like to apply permanent capital to?
Think about great CEOs we’re more familiar with, people like Jeff Bezos at Amazon. You can read his inaugural shareholder letter from back in 1997, in particular a section under the heading “It’s All About the Long Term.” He said there, “We believe that a fundamental measure of our success will be the value we create over the long term. We make decisions and weigh trade-offs differently from other companies. We make investment decisions in light of long-term market leadership considerations rather than short-term Wall Street reactions.”
Isn’t that the same kind of mindset as the date farmer’s? Just like Apple from day one, the clues were there. Amazon had the key ingredients. That letter was written in 1997, the year of the IPO. Henry Singleton realized Steve Jobs was someone exceptional, someone he wanted to invest in. Similarly, in that inaugural shareholder letter Bezos wrote for Amazon, the clues were all there. He had those key ingredients to build a great company, and so it was.
Essentially, whether you’re looking at Bezos, Jobs, Sam Walton, or even Thomas Edison, none of them were in it for the money. They were all on a mission, and wealth was an indirect consequence of a job well done. Unfortunately, these great leaders are in the minority. Most CEOs are mercenaries. They’ve got no passion for what they’re doing. They’re in it only to enrich themselves, but chasing wealth is the wrong way to do things, and it leads to making poor decisions and to unfavorable outcomes.
The best example I could probably give you is Twitter. Look at what happened to Twitter. It had an IPO in 2013 and was taken private by Elon Musk a decade later at almost exactly the same share price. Bear in mind that Twitter never paid a dividend throughout its existence. In real terms, accounting for inflation, the price paid per share by Elon Musk was lower than the IPO price, so it was a miserable time for investors. They had invested for a decade with a negative total return on their investment. Meanwhile, Jack Dorsey – the CEO – propelled his personal net worth over the period from zero to $4.5 billion. That was all on the back of stock-based compensation and all sorts of other means of extracting value from the business.
Twitter was the right idea. It launched at the right time with a huge addressable market, but it failed commercially because it was being driven by the wrong people with the wrong mindset and the wrong incentives. That’s probably why Mark Zuckerberg described Dorsey as driving a clown car into a gold mine. That’s effectively what he was doing.
Too many investors bought into the narrative. Twitter launched at a time when social media was truly coming into its own. They bought into the narrative, invested in Twitter, and put their money on the wrong horse. They paid no attention to the quality of the jockey. However, the writing was on the wall all along. The stock-based compensation was egregious. It was outrageous. You can see the company was making absolutely no progress. It ended where it ended, and investors suffered as a consequence.
A company in the right hands would compound in value; in the wrong hands, time would simply afford more damage to be done. That was summed up nicely by Buffett when he said, “Time is the friend of the wonderful company but the enemy of the mediocre.”
That’s one of the key ingredients. We’re talking about time scales – looking not to appease Wall Street and fixate on short-term metrics like earnings per share but instead investing for the long term. A lot of people misread Jeff Bezos. He took a very similar approach to John Malone, who reinvested most of his earnings back in the company and deliberately tried to keep earnings as low as possible because earnings attract the taxman, and taxes are a bleed on corporate capital.
Instead, Malone resolved that you’re far better off reinvesting as much of your earnings as possible into growing the business, and you’re effectively growing at the expense of the taxman. Bezos did exactly the same. There were so many equity analysts over the years who said, “I can’t invest in this company because the earnings multiple is way too high.” The earnings multiple was only way too high because Bezos was deliberately suppressing earnings. He was deliberately reapplying all of the capital he could into the growth of the business. Over the course of the last 20 to 25 years, we’ve seen the results of that.
Alex: You mentioned all these amazing CEOs. What would you say are the traits they share?
James: They are all on a mission. They are all focused on the long term. Interestingly, McKinsey did a piece of analysis where it resolved that the most successful CEOs have an average tenure of about 11.5 years. Contrast that to the average tenure of a public company CEO in America at the moment – it’s little more than four years.
Think about that. Why should it make such a huge difference? Think about what Charlie Munger always used to say. He was always so focused on incentives. He would say, “Show me the incentives, and I’ll tell you the outcome.” Most companies are run by what I call career CEOs. They jump from one company to the next every few years, collecting big payouts along the way. They’re very much like coaches of sports teams but with one critical difference.
If you think about it, a sports coach is focused on the short term. They’re only looking at the current season. They want to win a trophy this year. Building a company is a long-term endeavor for a CEO. It’s completely different. This is what I spoke about when we discussed the date farmer and Jeff Bezos. To put that in context, if the average CEO is only in office for four years, do you think they’re motivated to do what’s best for the company and its shareholders for decades to come, or do you think it’s more likely they’re focused on doing whatever’s necessary to hit short-term remuneration targets to enrich themselves?
I’d like to lean into this and give you a fantastic example. You’re probably very familiar with Lou Gerstner – the CEO of IBM over the turn of the millennium. He’s always praised for being such a wonderful CEO, but I think the narrative around Lou Gerstner is completely wrong, and his tenure was completely misunderstood. Let me give you an example because this truly hammers home the point about incentives and why this is so important when evaluating companies.
Thomas Watson effectively founded IBM after leaving the NCR – the National Cash Register business – which was another wonderful business well worth studying and one Charlie Munger was always very focused on. Watson moved from NCR to what became IBM (International Business Machines) around 1924. For the best part of a century, he and his son built IBM into the most valuable company in the world. By 1991, its market cap was approximately $105 billion, which then was about as big as you could get.
What’s critical – and why I would like to focus on Lou Gerstner – is that all of that success built over 80 years was undone in the next nine. Lou Gerstner was appointed CEO of IBM in 1993. Like Sculley at Apple, he was the wrong man for the job. He’d come from RJR Nabisco – a biscuit company. Sculley had come from PepsiCo – a soft drink company. What do these people know about technology companies? They don’t know anything. It’s a completely different skill set. Still, Gerstner was brought in, and his incentives were all wrong. The incentives he was offered were pegged to the share price of IBM.
So many companies do this, and it’s completely wrong. The focus of the CEO becomes boosting the share price, even if that’s at the expense of the long-term prospects of the business. Under Gerstner, debt ballooned from $10 billion to $29 billion. More importantly, that debt was primarily used for share buybacks, not for investing in the growth of the business.
During his tenure, he repurchased 25% of the shares of IBM, mostly at overinflated prices, which destroyed shareholder equity. As the share price inflated through this forced demand through all the repurchase activity, shareholder equity was being destroyed. Investors were focused on completely the wrong things and were reaching the wrong conclusions. Of course, as the number of shares goes down, earnings per share inflate. It’s not because the earnings are necessarily going up. It’s not the numerator in the equation that’s changing – it’s the denominator. Similarly, the return on equity will be boosted because by buying back shares at overinflated prices, he is effectively destroying shareholder equity.
Once again, you’re looking at return on equity. It’s the denominator that’s contracting. It’s making these metrics look great. All the while, sales decline. Between 1998 and 2001, IBM’s sales declined significantly, but the share price doubled over that period. Go make sense of that. Again, it’s because investors focus on the wrong metrics. They’re looking at EPS and return on equity. The foolish investors were ignoring fundamentals. Fear of missing out resulted in herd mentality. People jumped in and were chasing the share price. It was all about momentum, which was very similar to what we saw with Tesla over the COVID period.
During Lou Gerstner’s tenure, the dividend yield fell from 7.2% in 1992 to 0.4% by 2000. Blinded by share price gains, investors completely overlooked the collapse in dividends. Gerstner also sold core assets at IBM. He effectively asset-stripped the business. The data delivery network was sold to AT&T. Lexmark – the printer division – was sold to a private investor. The iconic ThinkPad PC division was sold to Lenovo in China. Software assets – including Lotus Notes and Domino – were sold to HCL Technologies. All the while, Gerstner slashed research and development.
He was selling off core assets, and there wasn’t much research and development going on, so the company wasn’t developing anything new in-house. Tax credits from stock options flattened net profits. Then he set up a special purpose vehicle called IBM Global Financing to securitize all of the debt he had taken on. This allowed IBM to move a lot of that debt off the balance sheet, which was naughty. It wasn’t the right thing to do. He was effectively disguising what was happening there. Now, more of the debt was being used to finance customer spending with low interest loans, but Gerstner booked all of that revenue and profit upfront, and he was using off-balance sheet debt to boost revenue and profit numbers. He leased lots of equipment to customers, which was a major source of revenue, but that also was effectively debt financing which, again, was concealed off balance sheet.
Pension plan value changes were counted as income. Accounting irregularities eventually attracted the attention of the SEC, which summoned IBM top brass to Washington. One of the things they looked at, for instance, is when the data delivery network was sold to AT&T for $4 billion, instead of that sale income being booked as extraordinary income, which is how it should have been, what they did was reduce SG&A opex by $4 billion. They were playing with the numbers. Gerstner’s tenure at IBM was more about financial engineering than about computer engineering.
There were many more things he did, but you get the idea. All of these things provided a short-term financial boost at the expense of the long-term prospects of IBM, which had taken 80 years to build under Thomas Watson. It was all about the poorly devised incentive scheme, which encouraged Gerstner to think short term in order to qualify for huge bonuses. When he left IBM, his personal wealth had ballooned to $630 million, but IBM was a shadow of its former self. He caused irreparable damage that continues to this day.
Gerstner left IBM in 2003, if I’m not mistaken. The company’s market cap had reached $208 billion because of all of the accounting alchemy he engaged in. After he left and it became clear what he’d done, the market cap collapsed to $98 billion. Two decades later, it still hasn’t recovered. The market cap is now only $128 billion – almost half of what it was at its peak. All of that was because of the way Gerstner managed IBM. Meanwhile, you pick up umpteen books written about Gerstner being a model to be followed as a CEO. I simply don’t understand it.
It’s all about incentives. It’s all about the long-term objective. It’s all about acting as a trustee of the assets you’re handed to manage as a CEO. It’s all about being on a mission. You can’t be a mercenary. If you’re invested in a company and see any evidence of the CEO being a mercenary, my advice would be to get out fast and transfer your money elsewhere.
Alex: What do you makes the CEO care about what happens to other shareholders and not just themselves?
James: It’s self-interest. If somebody dangles a carrot under your nose and offers you the opportunity to make hundreds of millions – if not billions, as in the case of Twitter – it’s very tempting for some people to take that.
Others see shareholders as an inconvenience. You might be a software engineer, for instance. You create a fantastic app that goes viral. You decide to build on that success. You want to expand and hire other software developers. You sell part of your company’s equity. Lo and behold, you find yourself the CEO of a public company. In that context, you see those shareholders as a necessary evil. You needed to sell some of your equity to raise capital – you didn’t do it because you wanted those shareholders to be partners.
If you look at Berkshire Hathaway, its investor manual is effectively its constitution. The company says that although it’s effectively a body corporate, it considers itself to be almost a partnership, and it considers its shareholders partners. Munger is no longer with us, but both he and Buffett invested most of their personal wealth in Berkshire, so that their fortunes would move in lockstep with shareholders. That’s the right way to go about it. Most other CEOs do see shareholders as an inconvenience, as a necessary evil, and they’re focused on themselves.
Alex: Do you think the CEO is almost more important than the business itself?
James: The CEO is absolutely more important than the business itself. I have given you many examples today of the same company in the same market with the same product effectively having an entirely different outcome in the hands of a different person. The person is the key to success.
Before researching anything about a company, a deep dive on the CEO is the most important thing. It’s one of the reasons why some of the most successful companies in history have founder CEOs who are passionate and have stuck with the business for the long term. It was always their intention to stick with it for the long term, which is why they always made decisions that were in the long-term interests of the company itself.
Alex: I found it particularly interesting when you said that good managers are willing to either make good use of an idea or chuck it away if it’s the wrong idea. It makes me think that a good CEO will be willing to abandon projects that don’t yield enough return and favor those that do and think outside of the box.
James: It’s not always the way. Effectively, what we’ve been talking about is the exception rather than the rule. Exceptional leaders will recognize that they’ve got a mediocre idea and that it needs to be improved.
I gave you the example of Intel, which is a textbook case study. If you want to look at others as a contrast, look at Kodak. It was the market leaders in silver halide film. Wherever you went in the world in the 1970s or the 1980s, you could be sure you’d see billboards for two companies – Coca-Cola and Kodak. It was one of the biggest brands globally and a hugely successful company. It was one of the Nifty 50 as well. It went bankrupt. Why? Because it didn’t recognize what was happening in its industry. It rested on its laurels. It knew it was doing very well in silver halide film, so it didn’t embrace digital photography. That was the death knell for the business.
It was a similar thing with Blockbuster Video, which was a rental business. It saw streaming coming over the hill, but either didn’t see it as a threat or didn’t want to disrupt its own business model. If you analyze any of the financials from Blockbuster, you’ll notice that the lion’s share of its earnings came from late fees.
For those young enough not to remember movie rental businesses like Blockbuster, before streaming, we had to go to a local store, select a movie from the shelf, and take home either a video cassette or a DVD. We’d have that movie for 24 hours. We had to return it the next day, and if we were late, we’d have to pay a late fee – very much like a late fee on a book borrowed from a library. Blockbuster made a lot of money on those late fees. It saw that streaming was a threat to this revenue stream. For that reason, it didn’t want to embrace it, which enabled Netflix to come in and claim its crown. Blockbuster effectively died.
There are countless more examples, but most companies and most CEOs are so married to a successful idea, even if it is mediocre or becoming mediocre. It may have been successful in the past but is becoming mediocre, yet they won’t relinquish that idea.
Another fantastic example is Blackberry. It was enormously successful. Anybody in the financial sector in the early 2000s had a Blackberry. It was not only a status symbol; it was also an immensely useful tool because, for the first time, you could pick up emails on the go. You didn’t have to be sitting behind your desktop. It had a tiny keyboard that most of us used with our thumbs. When Steve Jobs introduced the concept of a touchscreen, Blackberry refused to accept it. Of course, the iPhone took over and claimed all share in that particular market from BlackBerry.
I’d say most managements are mediocre, and they’re not prepared to discard bad ideas or cannibalize their existing business. The problem is that if you are not prepared to cannibalize your own business, somebody else will come along and cannibalize it for you.
Alex: If managements don’t recognize these threats despite operating in that business and doing that every day, how should investors – who are, in a sense, a step removed – recognize them?
James: The themes are there for all to see. You don’t have to be inside Kodak to see that digital photography is gaining traction and that it presents a threat to silver halide. You didn’t have to be a genius to see that streaming movies could be a threat to video rentals.
One of the primary drawbacks in video rentals was limited supply. You go down to your video rental store and it may only have one or two copies of every movie. If both have been rented out by someone else, that’s a movie you can’t watch. With streaming, there are no such limitations. It’s quite obvious that kind of thing is likely to be disruptive. I think investors can spot these things, certainly raise them with management at shareholder meetings and try and gauge the response. If management don’t want to listen or don’t want to change, then perhaps it’s time to bail out and put your money somewhere else.
Alex: In some sense, it seems to be coming back to the idea of the mission. Is the company out on a mission to make things better for its customers? If you’re Blockbuster and live off late-fee payments, it seems inherently bad for your customers. Not only won’t they be fans, but you’re doing something wrong. If you were interested in seeing how to use whatever new technology is coming along to improve things for customers, that might be a better way to approach it.
James: Absolutely. Customer-first is so important. Anybody who has studied the retail industry and read anything about Sol Price and Sam Walton will know they always put the customer first. Jim Sinegal at Costco is exactly the same. They have all said in the past that the boss is the customer. The customer has the ability to effectively fire everyone in the company – from the chairman down – by taking their business elsewhere and spending their money elsewhere. You have to be customer-centric and customer-focused.
All of the super successful businesses put their customers first. That’s another theme in the book, and I dedicate a chapter to that one as well.
Alex: Could you share some of your thoughts on other key ingredients for success?
James: Absolutely. Let me throw in a curveball, something that a lot of people perhaps don’t think about. Location is another key ingredient that many investors will never consider. It’s critical.
Let’s think about Walt Disney. He established his first animation studio in Kansas City, which is where he grew up. It failed. It became insolvent. Did that mean Walt Disney was no good at animation? Absolutely not. Did it mean animation was a bad idea? Again, no. Did it mean you shouldn’t have invested in the nascent animation industry? Again, the answer is no.
Anybody who does gardening knows that some plants will thrive in full sunshine. Others like the shade. Some like wet conditions, while others prefer drier, arid conditions. It is the same with businesses – the same business in different locations will lead to an entirely different outcome. Kansas City wasn’t fertile soil for animation in the 1920s and probably still isn’t today, but as we know, Walt Disney was on a mission. He had a passion for animation, so he moved to California, where all the big movie studios were located and where venture capital focused on animation and movies was looking to put money to work in this new, rapidly-evolving industry. As they say, the rest is history. You’ve got the same person with the same company and the same idea in a different location. The result was totally different.
Another example is the automotive industry. We all think that the electric car is a relatively new invention, but – believe it or not – Robert Anderson of Scotland invented the first-ever electric carriage in 1832 in an attempt to move away from horsepower. Up until then, human beings were reliant on horses pulling carriages along. Effectively, the first car was invented in the UK in the 1830s. The roads in Britain were second only to those in France. Britain also had plenty of skilled mechanics and engineering ability. In essence, the automotive industry ought to have been dominated by the British. They had the first car, they had the roads, and they had the engineering ability, but that’s not what happened. Karl Benz in Germany and Henry Ford in the US effectively captured the market decades later.
What went wrong for the car industry in the UK? The answer is the UK government. It stifled all innovation. It effectively enacted legislation designed to protect vested financial interests in the railways, which were the dominant means of travel back then. Of critical importance here is that many government officials were personally invested in the railways, which helps us understand why they were against competition from road travel.
As far as the invention of the car, it was certainly a case of having the right idea, the right technology, and the right people, but it was all in the wrong location because the UK at that time was hostile to automotive technology. Karl Benz invented the petrol engine in the 1870s or 1880s, about 50 years after the car had been invented in the UK. Henry Ford didn’t start his first car company until 1904. He set up Cadillac and then went on to found Ford a few years later.
Another wonderful example is Silicon Valley. Its fascinating history is explored in more detail in the book, so I won’t go into that here, but there’s an extremely high concentration of skill, expertise, and knowledge in one place that makes wonderful things happen in technology. If two technology companies were identical in every way, but one was being established in Silicon Valley and the other in Europe, the odds would be very heavily skewed in favor of the US-based business because that’s where the skill set, the expertise, and the technology exist at the moment.
As a result, if I were an investor who knows nothing else about these companies, I would be more tempted to put my money into the same technology company based in Silicon Valley. Again, location is critically important, but when analyzing companies, how many people factor that into their equity analysis? Very, very few.
Alex: Maybe they think more about where their sales are than where their operations are.
James: Yes, absolutely. I could give you another example.
Think about Coco Chanel. She was in Paris at a time when couture was prevalent there. She had all the couturiers, very technically skilled with needlework. She had access to the most luxurious fabrics. Chanel established a fashion empire because the soil was fertile in Paris at the time. Had she tried to establish a fashion empire anywhere else, it would have almost certainly failed. Location is so critically important.
Alex: It seems that part of the idea of the CEO falling in love with the mission is that they need to have the right ingredients around.
James: That’s really a chicken-and-egg type thing. In my mind, having the right CEO will lead to the other ingredients being right. Walt Disney was the right CEO for Disney. He founded the company. He realized that he was in the wrong location and that because of his passion he had to move, so he did. The rest is history.
Similarly with Jeff Bezos at Amazon. He’s certainly the right man for the job. He knew he would have to make decisions that were in the long-term interests of the company. If that didn’t make Wall Street happy, he was prepared to take it on the chin. In that inaugural shareholder letter, he said to investors, “I just want to set up my store. This is how I’m going to be effectively steering the ship. If you’re aligned with my thinking, great – you’re welcome to get onboard. If you’re not, there are plenty of other places you can invest.” He made it clear from the outset.
It was all about quality. You can read plenty about Steve Jobs and the number of times he rejected technology being developed in-house because it didn’t quite meet his criteria of quality, esthetics, and usability. He told his design team to go away and change either the user interface or the look and feel. He was always searching for inspiration from others. If you look at Apple Stores and the way they are laid out, they have got a very Japanese feel to them. That’s no coincidence. Jobs was greatly inspired by Akio Morita – the founder of Sony – and often traveled to Japan because Morita was one of his mentors.
As an aside, the black turtleneck Jobs always wore was designed by Issey Miyake, who was the designer for Akio Morita at Sony. After the Second World War, when Sony was founded, Japan was on its knees. Not only was it in recession, but almost half of Japan was homeless. The country had been absolutely destroyed in the war. It wasn’t a great time to launch a tech startup, but Akio Morita did it anyway.
Back then, if companies wanted to employ people, they had to provide clothing for them to wear because people didn’t have the means to pay for their own work attire. They were literally on the breadline. Even today, a lot of Japanese companies still provide workwear for their staff, and Sony is no exception. Sony has Issey Miyake – the fashion designer – design all of its in-house workwear. It was Akio Morita who introduced him to Steve Jobs. That’s why Jobs always wore that turtleneck.
All I’m saying here is that if you find the right CEO, if you’ve got the right person steering the ship, all of these other things should flow. If the other things aren’t flowing and any of these other ingredients appear to be out of place, chances are that you’ve got the wrong person steering the ship. These aren’t separate components. They’re all inextricably linked.
You’ve got to look at long-term decision-making. You’ve got to look at incentives. You’ve got to look at whether decisions are being made in the long-term interests of the company. Is the location of the business optimal for success? Is the company evolving? Is it prepared to cannibalize its own business to evolve with the changing landscape?
There are so many other factors. A lot of the most successful companies nurture talent within. That’s a hugely important factor as well. If you are looking to promote internally, ultimately to the top of the shop, that changes your mindset on the kind of people you’re recruiting for entry-level jobs. The Taylors, who developed Enterprise Rent-A-Car, only promote internally. As a result, the people they hire to sit at the front desk and hand over the keys to a rental car are the caliber of people they believe will ultimately be able to progress through the hierarchy and perhaps one day run the company. This means that even in entry-level jobs, the person serving the customer will be of much higher than at a rival company, which gives you a competitive advantage.
You see similar themes at Costco. It does exactly the same. All three of its CEOs started at the bottom. In fact, Jim Sinegal – who was co-founder – started as a bag packer. At Gen Elec, one of the most recent CEOs was a forklift truck driver and worked his way up to CEO 30 or 40 years later.
You see these patterns emerging time and time again. Even Mark Leonard at Constellation Software – which is an entirely different kind of business because he’s a serial acquirer – says that his hit rate hiring externally is no better than 50%. He says, “Why would you roll the dice and take a risk with a 50% success rate and hire external people when you could promote from within?” He always tries to promote from within for that particular reason.
I pull these golden threads out in the book in these vastly different industries. We’ve spoken about serial acquires in the vertically integrated software business. We’ve spoken about Costco, which is a grocery-type store. We’ve spoken about car rentals with Enterprise. They all gravitate towards the same kind of model. It’s all about nurturing talent from within, giving people a career path, allowing employees to think like owners so they have to believe that they’ll benefit from the success of the business. It involves all other types of incentives – profit-sharing and that sort of thing.
These are golden threads that run through every successful business. Only the kind of golden CEO you want to invest in will understand these subtle nuances that have to be introduced to a business. It’s all about culture. I gave the example of Lou Gerstner. He was the opposite kind of CEO. He wasn’t interested in the well-being of IBM and its shareholders; he was only interested in hitting short-term remuneration targets. He became very wealthy as a result, and his shareholders suffered. I think these are the most important things to focus on when making long-term investments.
Alex: You told me a story about Patagonia earlier. I thought that was very interesting, especially given how it departs from the conventional idea about ESG.
James: Yes, Patagonia is a wonderful company. Yvon Chouinard – who founded Patagonia – wrote a book called Let My People Go Surfing. It’s well worth the read. Even when Chouinard has achieved incredible success, he has always put the planet, the environment first. It’s the way he runs his business.
He very famously ran an advert in the New York Times on Black Friday with a picture of one of his jackets and a big caption above it saying, “Don’t buy this jacket.” What kind of person tells consumers not to buy their products? He did, and it was an incredibly successful advertising campaign. He was very much against consumerism, against people buying cheap clothes and disposing of them. He believed in making quality garments that people could use effectively over a lifetime because that’s so much better for the environment. Although they would cost more, he saw it as more economical because you’re far better off paying a bit more for a quality item than buying cheap items which need to be replaced very frequently.
The critical thing with Yvon Chouinard is that he refused to take his company public. One of the reasons was that he didn’t want to be answerable to shareholders. He wanted to be focused on long-term objectives rather than quarterly earnings targets. More importantly, he was laser-focused on the environment and the planet. Bit by bit, he has put the company into a trust, and all of the profits that flow from it now go to environmental causes. Critically important is that he never publicizes that. It never features in his advertising material. He’s not looking for a pat on the back. He’s not looking to win customers necessarily because of his own environmental ambitions.
Contrast this to the crazy wave of ESG investing we’ve seen in recent years. Most CEOs regard ESG as a tick-box exercise. They want to tick the right boxes because they know there are all sorts of managed funds out there that will only invest in companies meeting ESG criteria. These companies aren’t particularly interested in doing the right thing for the environment. It is just a tick-box exercise. Their approach is in stark contrast with the approach of Chouinard at Patagonia.
I could call out Elon Musk as an interesting example. He holds himself out as being a champion of the environment. He introduced Tesla cars. It wasn’t his company. He acquired it, but he built it up into what it is today. He’s always pushed that environmental line, selling electric cars as being fantastic for the environment. Meanwhile, what else is he doing? He’s got SpaceX. He’s almost gratuitously launching rockets. God knows what that’s doing for greenhouse gas emissions.
Moreover, he was a huge promoter of Bitcoin. Bitcoin mining is an activity that consumes more power than Belgium or Austria. The carbon footprint of Bitcoin is enormous. How does someone like Elon Musk square that circle? How does he hold himself out to be a champion of the environment, pushing Tesla and while at the same time promoting a technology incredibly detrimental to the environment? I can’t reconcile that. I find Elon Musk to be a very difficult character to understand. Personally, I would never invest in his companies for that reason, among others. However, Yvon Chouinard is truly a model for other CEOs to aspire to. If anybody hasn’t read his book, I would highly recommend it.
Alex: You have some strong views about capital allocation and dividend policy. Would you like to share some of your thoughts?
James: So far, we’ve been discussing – from an investment perspective – how the people running the business are more important than the business itself, but the question becomes how to identify a great CEO. This is where the golden threads identified in the book become so valuable.
Essentially, when all the best CEOs do something in a particular way, you can look for others who adopt a similar approach. In answer to your question, capital allocation is arguably the most important task for a CEO, but most make awful decisions without fully grasping the implications.
Take dividends. Many CEOs feel compelled to pay them, not understanding that doing so is often harmful to their business. Compounding this issue is a widespread myth that a large part of an investor’s return on equities stems from reinvesting dividends. Shareholders demand dividends unaware of the flaw in their logic. In combination, these two factors cause many companies to fall short of realizing their full potential.
Capital allocation decisions should always be guided by opportunity costs. That was something Charlie Munger always harped on about, and I believe that’s quite right. A business is subject to a large number of outside influences, and the vast majority of them can’t be predicted. Henry Singleton always preached about remaining flexible. He said he deliberately avoided making plans. Instead, he would steer the boat each day based on prevailing circumstances, which has to be the right way to run a business. Yet, most CEOs default to blindly following some kind of a playbook regardless of circumstances and without any critical thinking. Effectively, they’re replacing management discretion with a codified approach that avoids the need to make difficult decisions. Do you want someone like that running a company in which you’re invested? I certainly don’t.
Dividends sit at the heart of the capital allocation issue. As you’re aware, neither Warren Buffett nor Jeff Bezos pays a dividend. Ask yourself why. If you’re not sure of the answer, allow me to offer some insights and explanations.
Back in 1972, there was a group of 50 top-performing US stocks, including McDonald’s, Coca-Cola, Walt Disney, American Express, Gillette, and General Electric. Collectively, they were known as the Nifty 50. They were heralded as the best investment opportunities. They were considered elite companies one could buy and hold almost forever. Half a century later, many of them remain industry leaders.
Here’s the really interesting part. If an investor in 1972 had evenly distributed $5,000 across all 50 companies – $100 in each – and held them until the end of 2022, that $5,000 investment would have grown to $609,000 through a combination of capital growth and dividends – not a bad return. However, instead of investing in the Nifty 50, that investor back in 1972 could have put the $5,000 into Berkshire Hathaway. The amusing thing here is that back in 1972, Berkshire Hathaway was a turnaround situation. It was emerging out of a failed textile business and wasn’t considered worthy of being included in the Nifty 50. Yet, over time, $5,000 invested in Berkshire Hathaway would have grown to a cool $28.7 million. The Nifty 50 – $609,000; Berkshire Hathaway – $28.7 million. I’m sure you’ll agree it’s quite a difference.
This demonstrates the magic that Buffett discovered very early on in his investing career. That’s the extraordinary power of compounding retained earnings. Buffett achieved an astonishing annualized return of just under 19% on a CAGR basis, while the Nifty 50 compounded an annual rate just over 10%. The key truly is in optimizing growth by avoiding the payment of dividends. It’s not rocket science; it’s just basic mathematics. Let me give you an example.
If a company achieves 20% return on invested capital and reinvests all of that back into the business, then – all else being equal – the value of the business will compound at that same 20% rate. However, if the company distributes 50% of its earnings as dividends, the compounded growth rate is cut in half to just 10%. To put numbers on it, $5 million invested in a business with a 50% payout ratio compounding for 15 years at 10% will grow to $23 million, plus $16 million in gross dividends – a total of $39 million on a $5 million investment. Without dividends, compounding at the full 20%, it will have grown to $77 million.
The only difference is that in one scenario there was a dividend, and in the other scenario there wasn’t. The outcome is almost double. This is why Buffett realized that paying dividends is foolish. He explains why Berkshire Hathaway outperformed the Nifty 50 by a factor of 47 times over that 50-year period. The longer the compounding period is, the more pronounced the effect will be. This is probably why Albert Einstein famously referred to compounding as the eighth wonder of the world. He said, “He who understands it earns it.” Buffett certainly understood it.
Those who don’t get it underperform, which is why I said earlier that it’s foolish, but a lot of CEOs just don’t get capital allocation properly. They pay out huge dividends, sometimes because shareholders demand it. Again, shareholders lose out. Not only are you underperforming, but by not reinvesting all of your capital in growth, you’re allowing competitors to capture market share that remains unclaimed due to the slower growth rate of your business. This doesn’t make any sense at all.
Alex: Given this, why are companies and investors so often fixated on dividends?
James: That’s an interesting question. To answer it, we need to look back in time.
Prior to the 1950s, there was a prevailing belief that if a company generated regular cash for its investors, that signaled its quality and reliability as a business. During that era, companies were heavy with tangible assets, meaning that organic growth was slow. Acquisitions were rare at that time, and share repurchases weren’t yet a thing. With excess capital accumulating, returning it to shareholders became a default choice. It made a lot of sense, and it was ethically sound.
We now live in a completely different world. Many of the leading companies today have an intangible asset base that’s very easy to scale. Mergers and acquisitions are commonplace, and share buybacks done properly are incredibly accretive to shareholder returns. Despite changing times, so many CEOs are still using their grandfather’s playbook and still doing it the way it was done back in the 1950s.
Although I’ve framed it in a historic context, the debate about whether or not to pay dividends isn’t new. We’re going a long way back now. In the 1870s, Sam Andrews was an early investor and a director in Standard Oil. He believed the consistently high dividend payouts would make Standard Oil’s stock a hugely attractive investment, but JD Rockefeller disagreed. He argued that profits should be reinvested to fuel growth and to strengthen the company’s competitive position. This disagreement was a source of ongoing tension within Standard Oil. It culminated in Andrews being ousted. Rockefeller went on to become the richest man on the planet at one time, and his approach was fully validated by the success of Standard Oil.
From an investor’s standpoint, unlike other asset classes, a company can compound in value. This is what makes equity investing so attractive. By reinvesting earnings, it becomes possible to create a long-term reinvestment spiral that accelerates growth. It amazes me that so many CEOs and investors simply don’t get it.
The next person to consider in this narrative is John Malone – the legendary CEO of TCI. He served there from 1973 until 1999 – just over 25 years. It’s important to understand that when he joined in the 1970s, the prevailing trend among public companies was to focus on the optimization of net earnings. To be honest, that mindset continues today, but Malone recognized back then that this approach was fundamentally flawed. He recognized that earnings are taxed, which drained capital from the company. He asked himself, “Why bleed capital to the taxman when it can instead be reinvested in a tax-efficient manner that will compound for the benefit of both the business and its shareholders?”
With little or no net earnings, there would be no dividends. Still, under Malone’s leadership, TCI became a financial powerhouse. He delivered remarkable returns for shareholders, averaging over 30% year-on-year for a straight quarter of a century. In fact, every dollar invested in TCI at the beginning of his reign grew to be worth $900 by the time he stood down. As an investor, if you’ve seen a dollar of your investment turn into $900, would you be bothered about not receiving a dividend? By comparison, over the same period, the S&P 500, which comprises companies mostly fixated on maximizing quarterly earnings – the opposite to Malone – and favoring dividends over reinvestment, turned the same dollar into $22. Talk about a stark contrast.
Back in the 1970s, Malone created a real headache for Wall Street analysts. They struggled with his approach, which was so novel. They’d always valued businesses on earnings multiples, so optimizing earnings was the holy grail. Malone tried to help them through their malaise. He was doing the complete opposite. He emphasized that they needed to divert their attention from the bottom line and instead focus on the earnings power of the business. Reinvested capital is not a cost of running a business. It’s a means of optimizing future cash flows through investment, which is where the real value of the business could be unlocked. Reinvested capital reduces bottom-line earnings, which makes net earnings an unreliable indicator of the true worth of a business.
The important metric is how much cash the business is capable of generating in the absence of that reinvestment. What Malone advocated was that analysts ought to look further up the income statement, which is the way to reveal the true earnings power of the business. This is how John Malone introduced the now ubiquitous term EBITDA into the business lexicon back in the 1970s. Effectively, “earnings before interest, tax, depreciation, and amortization” is a variation on operating earnings right the way up the income statement. Unfortunately, EBITDA is used today for all sorts of nefarious purposes, which is why Charlie Munger referred to it as bullshit earnings, but its purpose is entirely legitimate if used properly, the way John Malone intended it to be used.
Like Buffett and Bezos, Malone understood that the intrinsic value of the business lies in the net present value of future cash flows, not the current earnings. That was reinforced in Amazon’s 1997 inaugural shareholder letter. In it, Bezos emphasized that his was a long-term approach prioritizing future cash flows over short-term Wall Street earning expectations. That strategy – combined with his refusal to bleed capital in the form of dividends – saw Amazon’s market cap grow from $438 million around the time of the IPO in 1997 to $1.7 trillion by the time Bezos stepped down in 2021. It’s worth even more than that now. While Bezos was in office, he achieved a 43% compound annual growth rate. That’s quite incredible.
It also explains the danger of using earnings metrics to screen investments. How many investors look for PE ratios as a means of screening investments? For this reason, it’s flawed. How many investors were deterred from investing in Amazon over the years because its PE multiple appeared to be high in the 70s? It only appeared high because of the incredibly high levels of reinvestment in the business, which distorted the denominator. That’s a critical mistake. It caused so many investors to miss out on one of the greatest investments of the century. Even today, Wall Street obsesses over earnings metrics and earnings per share. Analysts still don’t seem to get it. This leads me to an incredibly interesting story.
There’s a lesson to be gleaned from the Federal Republic of Germany. After World War Two, the German economy was in ruins. In 1947, industrial output was only a third of its 1938 level, and a large percentage of Germany’s working age men had been killed in battle. However, a mere 20 years later, Germany’s economy had transformed into a powerhouse and become the envy of the world. It was referred to as the German economic miracle. In fact, Germany’s economy has consistently remained Europe’s strongest economy since the 1980s – even before the reunification of East and West – but the real relevance here is how they achieved it.
Germany introduced a 95% corporate tax rate. You didn’t mishear – that’s 95%. It’s not clear whether this was done to raise public money to be used to rebuild Germany after the war or whether it was devised by an economic genius who was thinking about second- and third-level consequences of the policy, but it worked out well.
Think about this for a minute. How might a 95% tax rate influence corporate behavior? If you were running a company at that time and knew that your profits would be taxed at 95%, why maximize earnings when almost all of it was going to be taken away in tax? What happened instead is that every company sought to minimize earnings by reinvesting heavily in growth. With little or no corporate earnings, investors were neither motivated nor distracted by dividend income. This approach led to rapid economic expansion, the German economic miracle.
The country effectively achieved great success in exactly the same way that Berkshire Hathaway, Amazon, and TCI achieved their own economic miracles. It’s all about taking the long-term view and preserving corporate capital, reinvesting in the business, and enjoying the power of compound growth instead of bleeding capital in the form of dividends.
A stark example of what happens when a truly great company deviates from this approach is the unfortunate story of what went on at Intel. Once a darling of the stock market, it was the undisputed leader in the semiconductor industry. It was known for its cutting-edge microprocessors and continuous innovation. However, Intel saw its competitive edge diminish due to a shift in the management strategy. This decline can be traced back to the leadership of CEO Brian Krzanich, who took over in 2013.
Instead of focusing on long-term growth – as Buffett, Bezos, and others do – Krzanich prioritized short-term financial metrics, particularly those related to earnings, because that’s what his poorly designed remuneration package incentivized him to do. To boost earnings per share, Krzanich made a controversial decision to cut opex, particularly in research and development, which is absolutely incredible and even more remarkable since Intel’s co-founder Gordon Moore famously observed that the number of transistors in an integrated circuit doubles roughly every two years, which we now refer to as Moore’s law and underscores the rapid pace of innovation required in the industry.
Against that backdrop, Krzanich decided to cut R&D, which makes absolutely no sense at all. Rather than investing in R&D to maintain Intel’s leadership, he redirected resources towards share repurchases, which does nothing for the underlying business at all, but it artificially inflates earnings per share. All of this was at the expense of the long-term prospects of the business. The other thing he did was to delay transitioning to a more advanced manufacturing process in order to reduce capex. This decision allowed competitors like TSMC and Samsung to surpass Intel in manufacturing technology, leading to a loss in Intel’s market leadership.
The delayed innovation resulted in a talent drain as top engineers left Intel to join its more advanced rivals. Compounding these strategic missteps, Intel adopted – relevant to our discussion – a progressive dividend policy. Not only was Krzanich deliberately restricting reinvestment in the business, but he chose to distribute the capital that should have been reinvested as dividends instead. What he did throughout his term was increase the dividend payment sequentially, regardless of opportunity cost. The sum paid as dividends per share more than doubled throughout his tenure despite the fortunes of the company declining over the same period.
He inflicted such damage on the business that by 2024, its market cap stood at $84 billion versus $108 billion when he was named CEO over a decade earlier. It was a disastrous 11 years for Intel investors; they’d been receiving dividends all the way through, but taking a huge capital hit as a result. Intel has since been working to reverse course under the leadership of Pat Gelsinger. The company has seen the error of its ways and has begun scaling back its dividends. Whether it can ever recover from the setbacks of the Krzanich era remains to be seen, but its efforts to refocus on the long-term strategy is certainly a step in the right direction.
Before I wrap up the answer to this question, I’d like to contrast the strategies of two companies – Publix and McDonald’s. US listeners, particularly in the southern states, will be very familiar with Publix – the grocery chain founded back in the 1930s. It is a challenger to Walmart, particularly in those southern states and its domestic market. The company owes its phenomenal growth to the power of retained earnings.
Ed Crenshaw – the CEO and grandson of founder George Jenkins – affirmed that profits were the fuel for rapid expansion and helped it to succeed. He confirmed that it was years before they ever even considered declaring a dividend. Had Publix opted to pay dividends from the outset, it couldn’t have grown as quickly as it did, and it wouldn’t have been as successful as it has been. Shareholders may have received regular income, but the investment would have resembled a high-yield bond rather than a growth-oriented equity, which is how it turned out.
In stark contrast – in recent years, at least – McDonald’s took the high-yield bond approach, and its business has stagnated as a result. Quarterly revenues in 2024 are pretty much at the level they were in 2010. In a 14-year period, quarterly revenues have pretty much been stable. There’s been no growth at all.
Why has this happened? During that period, McDonald’s dividend payout ratio has been as high as 80%. If you’re giving away 80% of your earnings rather than reinvesting them in the business, you have cause and effect, which is why the business has stagnated. Metaphorically, if you consider Publix a thoroughbred racehorse nurtured for high performance, McDonald’s is a cow that’s been milked to the point of exhaustion through the payment of dividends. I hope that answers the question.
Alex: Although there are strong arguments in favor of not paying dividends, how do you serve investors who require income?
James: That’s interesting. It goes back to what I said at the beginning about investors who don’t see the flaw in their logic when demanding dividends.
Many corporate boards will argue that they must pay dividends because a significant number of their investors require income, but that’s flawed thinking on two counts. First, it misunderstands the real issue. Second, it proposes an ineffective solution.
I accept that some investors require income, but I would also state – and it will be difficult to refute – that many other investors don’t want income and would prefer instead to optimize capital growth. Why should a company favor one group of investors over another? Additionally, why should a company dictate the timing and the amount of cash distributed to investors? Not all shareholders have the same needs at the same time. On that basis, it’s an undeniable truth that dividends are an attempt to provide a “one size fits all” solution, which is inherently impossible.
Ironically, not paying a dividend actually offers the flexibility to meet the needs of all shareholders. I’ll explain why. Through the liquidity of the stock market, those who need income can choose if, when, and how much cash to draw down from their investment instead of relying on dividend income. If the amount they withdraw from their investment is less than the growth rate of the business, their investment still continues to grow in value. If they choose to draw down large sums, causing the value of their investment to stagnate, it’s without prejudice to the growth aspirations of the other shareholders. This is much fairer than the way McDonald’s has done it and paid out 80% of its earnings regardless, which has punished anybody looking for growth.
Not paying dividends and letting instead shareholders manage their own needs through drawing down their investment allows them to manage their income streams more efficiently and control better the timing of their cash flows to mitigate personal tax liabilities. Interestingly, this is why Warren Buffett has always advocated for this approach when questioned about why he refuses to pay dividends.
Another common argument from corporate boards is that dividends are necessary to attract institutional investors. It’s certainly true that pension funds and the like do favor dividend-yielding stocks for income generation and liability matching purposes, but income-chasing investors aren’t the ideal shareholders a company should seek to attract. The reason is that they tend to prioritize their own commercial objectives and often switch investments based on prevailing dividend yields, and they show little commitment to the long-term goals of the business. Allowing self-serving shareholders such as those to influence capital allocation decisions reflects poor management, in my opinion.
To give you a good example of this, back in 2008, Microsoft explored acquiring Yahoo. It was a deal valued back then at around $44 billion, but the acquisition ultimately fell through for various reasons. Following that, pressured by income-seeking shareholders, Microsoft distributed the capital that had been earmarked for that deal as dividends. The decision prevented the company from using those funds for another strategic acquisition or, indeed, reinvesting in its own search technology development.
As a result, Microsoft struggled to compete in the search and online advertising markets, which is where Google came to dominate. Crucially, many of the shareholders that pressed Microsoft to pay that dividend when the Yahoo deal fell through received a huge windfall, but they soon exited. They moved on to the next company paying out a big dividend. They had no interest in the long-term prosperity of the business. They viewed Microsoft purely as an opportunistic source of short-term income. Microsoft suffered because it arguably allowed the tail to wag the dog.
You must never lose sight of the fact that the company will always have shareholders. This is a given in the stock market because for every seller, there’s a buyer. The real challenge lies in attracting the right type of shareholders, which is those aligned with the company’s long-term objectives. This is why Charlie Munger once said, “Run a company well, allocate capital intelligently, and the business will attract the shareholders it deserves.” The example of Microsoft sums that up very well.
The other interesting thing to point out is that despite not paying dividends, companies like Berkshire Hathaway and Amazon have never struggled to attract institutional investors. Some will say, “Their size and provenance afford them a unique status,” but it’s extremely important to remember that both of these companies started small and both achieved their success without the payment of dividends from the outset.
Does that answer the question?
Alex: Yes, but if companies do take this approach and move away from paying dividends, what’s the best way for them to convince their investors that this approach is indeed in their best interests?
James: That’s interesting. I think Henry Singleton addressed this issue. He was another outstanding CEO. In fact, Warren Buffett once referred to him as the best capital allocator of all time. He always resisted paying dividends as well. We’ve got this golden thread again. We’ve got Jeff Bezos, Warren Buffett, John Malone, and now Henry Singleton. They all resisted paying dividends. JD Rockefeller was another one.
When Henry Singleton was questioned on the matter, he responded, “What would stockholders do with the money? Would they spend it? Teledyne isn’t an income stock. Would they reinvest it?” He noted, “Since Teledyne earns 33% on equity, we can reinvest it better for them than they can reinvest it for themselves.” Then he pointed out something crucial. He said the profits had already been taxed. Paid out as a dividend, they get taxed a second time as income. Why subject stockholders’ money to double taxation?
Singleton shifted the debate to the investor’s viewpoint, highlighting the numerous disadvantages of receiving dividends. He emphasized the issue of double taxation, which is highly significant. Consider this. You’re a company with a dollar of pre-tax earnings. That gets reduced to 75 cents after a 25% corporate tax rate. If those 75 cents are paid out as dividend, it may be subject to a 40% income tax in certain jurisdictions, leaving the investor with a net 45 cents of the initial dollar in their pocket.
It doesn’t end there. That money needs to be reinvested, and after factoring the market bid-offer spread, transaction fees, and all other frictional costs, the investor might end up with 38 cents in the dollar reinvested. In that scenario, the only real beneficiaries are the tax authorities and stock brokers. Why would an investor favor such an outcome? In contrast, if the company had optimized reinvestment and minimized taxable earnings – as John Malone and Henry Singleton did – almost all of that original dollar could have been reinvested to accelerate future compound growth. It doesn’t take a genius to work out which is the superior approach.
It’s essential to stress that there’s a prevailing myth that the lion’s share of an investor’s returns flows from the reinvestment of dividends, but let’s think about this mathematically. Dividends are reinvested by investors at stock market prices, which is often a multiple of book value, while retained capital is reinvested by the company at book value. This distinction is critical. What does it mean?
Essentially, the return on retained capital will be the same as the return on equity being achieved by the business because it’s being reinvested at book value rather than being only a fraction of that number if paid out to the shareholder and reinvested by the stock market at a premium – multiples of book value. The company can reinvest on behalf of its shareholders at a preferential price. It’s the reinvestment of those retained earnings – not the dividends – that drives exceptional shareholder returns, which explains why Buffett, Bezos, Singleton, and Malone have achieved so much.
As discussed earlier, a company is capable of compounding in value. This is what makes equity investing so attractive. By reinvesting earnings, it becomes possible to create a tax-efficient, long-term cycle of capital growth. Investors preferring income over capital growth should – with few exceptions – be active in other asset classes or else take Warren Buffett’s advice and invest in growth stocks that don’t pay dividends, then simply draw down on a stock that’s rapidly growing in capital value due to this reinvestment process.
From a shareholder’s perspective, one more point to consider is the administrative burden of reclaiming withholding taxes on dividends paid by companies in foreign jurisdictions. We don’t all invest in our domestic market. Withholding taxes could be a real nuisance. As I’ve found, trying to reclaim withholding taxes is a process that could be incredibly difficult, if not entirely impossible in some circumstances. That’s another reason to view dividends unfavorably. There are far more accretive means of allocating capital.
Alex: How do you think about dividend payments in the context of capital allocation more generally?
James: Let’s look at this through a slightly different lens. If a business becomes unsustainable or no longer economically viable, it will wind down its operations, pay off its debts, and distribute the remaining assets to shareholders – what we call liquidation of a business.
Similarly, if the return on marginal capital declines, the logical strategy might be to shrink the balance sheet, thereby reducing the business’s capital base back to a profitable core. This is what we’ve seen in some industries – for instance, the tobacco industry. It makes perfect sense in a declining industry. This is effectively a partial liquidation of the business where you’re liquidating some of the asset base.
Now ask yourself, “Is the payment of a dividend not a partial distribution of the company’s accumulated asset base?” Of course it is. Effectively, are the terms “partial liquidation” and “dividend” not entirely synonymous? They both refer to exactly the same process. Both involve the reduction of a company’s net assets, shrinking the balance sheet, and decreasing the capital deployed by the business. This raises the question of why a company with opportunity to grow should intentionally shrink its asset base through the payment of dividends. Why partially liquidate a business with good growth prospects? It makes no sense at all.
To make matters worse, some CEOs deplete cash reserves through dividend payments and then seek to raise growth capital via the debt or equity markets. In my mind, that’s not only irrational but borders on complete incompetence. Borrowing money to deploy in the business in order to generate returns on investment makes sense, but borrowing money to facilitate the payment of dividends is plain stupid. Many CEOs would not have previously contemplated dividends in these terms before, but they’d be well advised to do so in the future because it shifts the perspective and could lead to a more coherent capital allocation strategy.
In terms of capital allocation strategies, the process you can see in the most successful companies is structured like a waterfall. Decisions are made in a specific order of priority. First and foremost, a good company will always focus on reinvesting in the business or building cash reserves for future investment. If no profitable reinvestment opportunities are foreseen, the next step is to consider reducing debt or repurchasing undervalued equity – both of which benefit the business and its shareholders. Only when all of these options have been exhausted and cash reserves start to accumulate to the point of excess should the company consider distributing surplus capital as dividends, which implies the return of capital to shareholders will at most be an ad hoc activity, that is, special dividends. It makes no sense to have regular dividend policy and still less a progressive dividend policy.
Let’s explore each section of that waterfall in some more detail. Even when investment opportunities are not immediately apparent, building a cash reserve in anticipation of future opportunities is a valid reason to refrain from paying dividends. A cash war chest provides flexibility for strategic initiatives and maintains the ability to weather economic downturns. Berkshire Hathaway is the perfect example of this. It has built a cash war chest which – at present, given its recent sell down of its Apple stake – stands at over $250 billion, and the company still has no intention of paying dividends. Crucially, shareholders have such confidence in Buffett’s ability to allocate that capital accretively that they don’t even demand a dividend.
As Buffett explained, “We have no interest in cash – except to the extent that it gives us opportunities,” which is how he’s grown the business so successfully. He says, “The only reason for having cash is if you think you’re going to need it.” He says that cash combined with the courage in time of crisis is priceless. He has proven that time and time again. He allocated his excess cash extremely well after the dot-com crash and the credit crisis of 2008, and it’s paid huge dividends. He’s always said – as have most other good investors – that you’ve got to be courageous when all others are fearful. That’s exactly what he’s done. He’s only been able to do that by having these big cash reserves he can deploy strategically when the opportunity presents itself.
He runs a conglomerate. He’s got those acquisition opportunities, and not all companies work on that basis. If you don’t have those kind of reinvestment opportunities, the next level of the waterfall involves considerations around debt and equity financing. Share repurchases are a huge topic in their own right. I won’t go into too much detail here, but it’s important to briefly touch on them.
We all know that debt is typically a cheaper form of financing because lenders face lower risks. There are repayments scheduled at regular intervals, and debt holders also have a senior claim on assets in case of insolvency. On the other hand, equity financing involves offering investors a stake in the business’s future success, leading to a perpetual dilution of earnings on a per share basis and of the value of the business across a broader base of owners, which arguably makes equity financing less desirable.
Yet the peculiar thing is that many companies will focus on paying down debt while showing less urgency to reduce the more expensive and less desirable equity financing, which has never made sense to me at all. The situation becomes even more puzzling if one considers that a dividend is a one-time payment to investors – the short-term windfall – while reducing the share count through buybacks will provide remaining shareholders with a larger share of future earnings and capital appreciation on the basis of the value of the business, benefiting them in perpetuity. Share reductions are far more beneficial and accretive to shareholders than dividends. Meanwhile, most CEOs will favor dividends over buybacks, which doesn’t make a whole lot of sense to me.
There’s also a paradox to consider. A CEO will spend a significant amount of time presenting to investors – in person, by video link, through publishing written reports. The aim is to retain existing investors, to give them reassurance, and to attract new ones. In that context, does it not seem contradictory for a company to promote itself as a sound investment when it’s opted to distribute its capital rather than investing it in itself through buybacks? It doesn’t make any sense at all.
Buffett, Bezos, Singleton, and Malone never seem to exhaust in this waterfall approach the first four steps. They’ve never exhausted their primary options for accretively allocating capital. They’ve never found themselves in a position where the distribution of assets as a dividend made any sense. In other words, they never reached the bottom of their waterfall, which explains why they’ve never paid dividends. Arguably, it’s why others shouldn’t pay dividends, either.
Eventually, CEOs see the light. Let’s take another great CEO – Mark Leonard of Constellation Software. He’s an exemplary CEO. I’m sure everyone will agree. In his 2021 shareholder letter, he said, “One of our directors has been calling me irresponsible for years. His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI shareholders. Hence, we should stop paying dividends and invest all of the cash we produce. We have paid three special dividends. For the last decade, we’ve also paid a regular quarterly dividend.” Then he said, “I’ve stopped arguing. I’ve converted, and with the fervor of the newly converted, I’m busy demonstrating my newfound fate.” He came around to the same way of thinking as the other great CEOs.
Wrapping up, I will ask you, “Is it not uncanny how all of the best CEOs eventually see the light and converge on a very similar approach to capital allocation and dividend policy?” These are CEOs who operated over completely different time scales. We saw Mark Leonard convert in 2021. We had Singleton and Malone deploying this strategy back in the 1960s, 1970s, and 1980s. Bezos didn’t start until the early 2000s. Back in the 1870s, this was exactly the strategy Rockefeller deployed. In my mind, this is no coincidence. This is one of the golden threads that runs through all great businesses. This is why I pull this one out in my book, in the chapter on dividends.
Ultimately, companies that pay dividends typically either lack viable reinvestment opportunities – possibly due to operating in a declining industry – or they have management that lack the creativity and financial acumen to fully realize the company’s full potential. That explains why many high-performing investors – I like to include myself in that number – use a company’s approach to dividends as a leading indicator of its quality as an investment. When I’m analyzing a business, one of the things I’ll look at in detail is its approach to dividends. If I see a company paying regular dividends, having a progressive dividend policy, and ignoring the opportunity cast, that’s usually a huge red flag for me.
Alex: James Emanuel, thank you so much for taking the time to talk to us today about your new book.
James Emanuel lives and works in London, England. He is happily married and has three children. He qualified in English law having achieved a Bachelor of Laws degree with Honours (and several academic prizes along the way). He subsequently secured a post graduate Legal Practice Certificate from the Law Society of England and Wales. However, having enjoyed the academic side of law, practicing law was not what excited him. Sharing a family aptitude for mathematics and economics — his father, being a retired stockbroker and his brother an actuary — he was drawn into the world of finance, particularly investing in businesses. As an investor in some of the world’s leading businesses, he has engaged with corporate leaders and learned what success looks like. He constantly introduces constructive challenges to inform corporate decision making and has improved the fortunes of the companies in which he has a financial interest. He has also served as a special advisor to the U.K. Government in matters relating to business policy.
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