Capital Cities, Capital Allocation

How David crushed Goliath...

THERE's a terrific story about Tom Murphy, who became the CEO of Capital Cities in 1966, writes Tim Price of Price Value Partners.

At the time, this media company, which owned five TV stations and four radio stations, all in small markets in the US, was dwarfed by CBS, which had a market capitalisation 16 times the size of Capital Cities.

By the time Murphy sold his company to Disney 30 years later, Capital Cities was three times as valuable as CBS. David didn't just beat Goliath, he crushed him.

Shortly after Murphy arrived at the company's Albany studio, the board begged him to do something about the premises, which were located in a ramshackle former convent building and were discouraging advertisers. Murphy's response? He painted the two sides of the building facing the road, leaving the other two sides untouched. This was a CEO determined not to waste money, even on paint.

Under Murphy, this obsessive focus on keeping costs under control permeated down throughout the entire organisation. Whereas CBS and ABC executives would routinely travel by limousine, Murphy would go to downtown meetings only by cab. When he was asked whether this was a case of leading by example, Murphy replied, "Is there any other way?"

David closed the gap on Goliath by doing things differently. Whereas CBS spent the 1960s and 1970s converting the cash flow from its network and broadcast businesses into an aggressive series of acquisitions into unrelated businesses like toys and baseball teams, Murphy had one single, over-arching goal: make the company more valuable. Whereas CBS was content to build a trophy headquarters in Manhattan at vast expense, displaying what Warren Buffett's business partner Charlie Munger called "a prosperity-blinded indifference to unnecessary costs", Murphy rejected diversification and the general tendencies of the conglomerate era, in order to focus like a laser on profits, costs and corporate efficiencies.

In an interview with Forbes, Murphy put it as follows: "We just kept opportunistically buying assets, intelligently leveraging the company, improving operations and then we'd...take a bite of something else."

Where rivals sought diversity, Murphy went for concentration instead, moving slowly to gain genuine operational expertise, keeping his attention on a small number of potential large acquisitions that he knew would carry a high probability of success: "The business of business is a lot of little decisions every day mixed up with a few big decisions."

Murphy became CEO of the business at the age of 40. He quickly appointed his colleague Dan Burke, a Korean War veteran, as president and chief operating officer. Burke maintained that his job was to create the free cash flow and Murphy's job was to spend it. Burke would take control of day-to-day management of the business, and Murphy would be responsible for acquisitions, managing relations with Wall Street, and overall capital allocation.

And during the prolonged bear market of the mid-1970s to the early 1980s, Murphy became a keen purchaser of his own stock, buying back close to 50% of the outstanding shares, most of it at single-digit price/earnings multiples.

In the summer of 1995, Buffett suggested to Murphy that he meet with Michael Eisner, the CEO of Disney, at a media gathering in Sun Valley, Idaho. Murphy, now 70 and with no obvious successor, agreed. Over the next few days, he negotiated a $19 billion price for his shareholders, equating to a multiple of over 13 times cash flow and 28 times net income. He had done an outstanding job. A single Dollar invested into Capital Cities in 1966 would have been worth $204 by the time the company was bought out by Disney. That equates to a 19.9% annual rate of return over a period of 29 years, versus 10.1% for the S&P 500 over the same period, and 13.2% for an index of the major media companies over the same time.

Over a ten-year holding period, Buffett, in owning Capital Cities, earned Berkshire Hathaway a compound annual return of over 20%. In his 29 years at the company, Murphy outperformed his media peers by almost four times and outperformed the S&P 500 by over 16 times.

Times have admittedly changed. The media landscape is now completely transformed from that of Murphy's day. The internet is up-ending everything and also allowing a handful of IT and media quasi-monopolies to dominate much of the market. The media market has fragmented, and the tyranny of programme planners has been replaced by on-demand consumption across multiple media platforms, including terrestrial TV, cable, the internet, YouTube, Netflix and Amazon Prime.

And valuations are also rarefied. The Shiller p/e – a 10-year smoothed average price / earnings ratio for the S&P500 stock index – trades at 41 times. In 1929 it peaked at 31 times. Its long run average stands at just 17 times.

Shiller is not the only one to be worried about a probable bubble. A similar warning came some time ago, when James Tisch of Loews Corporation voiced a warning that investors currently bidding up the prices of stocks and bonds are doing so without paying any attention to the rising global uncertainties around taxes, regulation and free trade:

"The movement of these markets is in stark contrast with many unknowns of our current economic and political landscape, both here and abroad. It's a major disconnect, and it concerns me...Key credit metrics such as leverage and coverage ratios are showing signs of weakening. The leveraged loan market has been overrun by such massive inflows of capital that you could probably get a loan to buy a fleet of zeppelins at this point."

Loews can be compared quite reasonably with Capital Cities under Murphy's leadership.

Loews is a family-run investment vehicle for the Tisch family, founded by Preston ("Bob") Tisch and Laurence Tisch.

The Loews business started in the form of a hotel in New Jersey in 1946. Loews Theatres followed as an acquisition in 1959, and from there the company has grown to incorporate businesses including natural gas pipelines (Boardwalk Pipeline Partners), packaging (Altium) and insurance (CNA).

In common with Murphy, the Loews family, which owns roughly 17% of the listed business Loews Corp, has consistently bought back stock. The majority of stock buybacks – especially in the US – destroy shareholder value. Company management will likely parrot the line that buybacks are earnings accretive, which they are; but every time companies buy back stock above book value, they are in fact lowering the return on equity of the company.

We actively look for companies that buy back their stock when it trades below book. Buying back stock below book value is value accretive to the shareholder because it increases the company's return on equity.

And Loews is an excellent example of this trend. Management regularly buy back shares using free cash flow when the shares trade below book value.

The focus on costs and on not overpaying for acquisitions is also something the company has in common with Capital Cities. Tisch has refrained from splurging on corporate purchases, especially given current market valuations. He points out that the valuations that private equity firms have been willing to pay for leveraged buyouts have essentially "crowded out" the Tisches in their search for takeovers – James Tisch once said the firm will continue to "kick the tyres" when looking for potential targets, even if it becomes physically gruelling: "One of our shareholders recently asked if my foot is getting sore. I have to admit it is."

As the company takes pains to point out, its primary focus is on effective capital allocation. Repurchasing stock – at the right price, without overpaying – is a cornerstone of this approach. It also looks to invest in its subsidiaries. It is always on the lookout for strategic acquisitions but, again, will never consciously overpay and the company and its management are willing to be as patient as required. Finally, it looks to build its capital position, so that it can weather any uncomfortable storms and again make opportune acquisitions as and when they arise.

The formula for long-term success that the company uses comprises four ingredients in total:

• Efficient capital allocation
• Financial strength
• Conservative management
• High quality and profitable underlying businesses.

Loews' previous investments in offshore drilling and the maintenance of gas pipelines have been something of an anchor on the business during a period of commodity market weakness, and it's possible that a sustained bear market for energy – not that we foresee one – will weigh on the company's prospects. And as with any individual business there are always unforecastable risks. Suffice to say, we believe that prospects for commodities and real assets in general have rarely looked more favourable.

Faced with the challenges of running a business, CEOs have five fundamental choices when it comes to investing their capital. They can invest in existing operations; they can go acquiring new businesses; they can issue dividends; they can pay down debt; or they can buy back their own stock. Both Capital Cities and Loews have proven themselves adept at buybacks, using discipline only ever to engage in that activity when shares can be bought at a discount to book value.

Both companies have also proven themselves adept at managing existing operations, and at exercising extreme discipline when it comes to considering acquisitions, choosing to stand by rather than effectively waste capital on expensive corporate purchases. Sometimes you want your CEO to be active. At times like today, with markets at frothy levels and rising uncertainty in politics and economics globally, you probably want your CEO to be inactive, but with an eye open for opportunities wherever they might exist.

The two most important words in investing? Capital allocation. Whether you're contemplating an investment in a fund, or an investment in a listed business, the ability of the manager (or fund manager) in question to be an accomplished and disciplined allocator of capital will ultimately make all the difference between lousy investment returns and tremendous ones.

The requirement for disciplined and patient capital allocation then comes down to you – so once you've found a standout investment opportunity, the onus is on you not to sell it prematurely. In the context of generating superior long-term returns, capital allocation is just about everything.