What Matters More - The Jockey or the Horse?
Let’s consider the following Buffett-ism: “Invest in a business any fool can run because someday a fool will.” Berkshire Hathaway itself is a contradiction to this rule. What would Berkshire be without Buffett and Munger? A failed textiles business and nothing more? How would Nebraska Furniture Mart perform in a parallel universe without Buffett’s guidance? Most of Berkshire’s annual reports celebrate outstanding execution by the managers of the company’s most important units (e.g. Ajit Jain, Greg Abel, etc.). Did Berkshire succeed because of its jockeys or because of its stable of horses? Did the horses overtake the jockeys at some point?
These are questions that arise when we are evaluating new and existing research targets, and the short answer to us is that both are important, but on different horizons. Personally, I find myself drawn to companies with great leadership and I strongly prefer them to good businesses with mediocre leadership. However, I couldn’t care less about terrible companies with great leadership. In fact, this scenario almost never happens because greatness is magnetic, and great managers seek great businesses to exploit the full extent of their talents. The cream rises to the top.
Who’s the Jockey?
While of course there is deep talent across organizations, public company CEOs wield tremendous power within their companies and are responsible for directing strategy around product, marketing, customer service, internal resource management, and capital allocation. With the board’s blessing, they can turn their companies at their whim. This is the blessing and the curse of their positions. If they manage by building consensus, they’ll go slowly and likely will not take enough risks. If they manage authoritatively, they might take some wrong turns and ignore dissenting opinions, leaving their companies worse off. CEOs require strong conviction to choose their companies’ paths and strong leadership to rally their companies behind their decisions and drive strong execution.
In practical terms, a company’s CEO matters the most. CFOs, COOs, EVPs of Sales, and others are important, of course, but they must all fall in line with the CEO’s vision, or else they won’t last long. This makes the CEO the topic of our discussion.
CEOs have many important jobs that are unique to their positions:
They set the vision and the culture of the company. They may have help from their direct reports, but make no mistake – the buck stops with the CEO and he must behave beyond reproach internally.
They create the go-to-market strategy and communicate it internally, with customers, and with investors and the board. Setting a clear go-to-market strategy to compete and win share is essential. Doing so with a clearly articulated financial model, supported by strong internal dashboards and controls also is extremely important.
They are responsible for raising and allocating capital, including capex investments, mergers and acquisitions, divestitures, and other strategic alternatives. Most CEOs rise to their positions by being very good with #1 and #2 above for smaller divisions. They do not have as much experience allocating excess capital, and perhaps not as much experience allocating internal opex and capex dollars with strong discipline.
We are drawn to many founder-led Builder Companies after they have established themselves as leaders in the markets because they have shown excellence in all three important dimensions, and because they tend to obsess over creating long-term value, not over beating the next quarter’s expectations. However, any competent management is welcome and we own a mix of founder-led companies and those with high-quality owner-oriented managers that are willing to make the right tradeoffs in the business to maximize long-term shareholder value. It’s also important to have corporate boards that are thoughtful about aligning the company’s strategic vision with executive compensation and with shareholders.
What’s Your Time Frame?
The jockey vs. horse debate depends a lot on an investor’s time frame and investment horizon. If you care about the next 1-2 years, the horse is probably the biggest swing factor – how the company will perform in the economic cycle, how it performs relative to competitors, etc. Of course, management can alter the near-term path, but most organizations change direction more slowly and incrementally unless they are in an extraordinary macro environment.
Over longer horizons, say 5-20 years, jockeys start to matter more. How will a CEO guide a company through a cycle, two cycles, three cycles? How is he at taking advantage of opportunities in the market operationally and strategically? Will she avoid significant pitfalls?
But zooming out even further, over the longest horizons, the horses matter again – but only if properly guided by the jockeys until a company has achieved escape velocity when building a long-term defensible moat. Berkshire Hathaway today should survive reasonably well without Buffett and Munger, but it would be very different if Buffett and Munger exited in 1980. Netflix has been able to continue after Reed Hastings’ exit from the CEO role, but he was critical in positioning the company for success, navigating the company through a period of extreme change in media and technology.
At Recurve, we try to invest in great businesses with great managers, hoping to win on both fronts and form an enduring long-term investment partnership with them. We believe an underappreciated superpower in the market is the ability to invest patiently, allowing capital to compound naturally in the hands of great managers running great companies. Masayoshi Son allowed Softbank’s original $20 million stake in Alibaba to become over $100 billion at peak. How many stakeholders pressured him to sell at lower levels? How much criticism has he taken for not selling at the top?
When Jockeys Falter
We find that many founder/owner/operator CEOs with large ownership have an other-worldly influence over their organizations which magnifies their impact relative to “professional” CEOs. Within our portfolio, Gary Friedman at RH has this. Dave Schaeffer at Cogent. Ernie Garcia at Carvana. Brunello Cucinelli. There are many others as well. The Mendelsons at HEICO. Steve Jobs. Elon Musk. John Malone. Tobi Lutke. Their companies are an expression of and an extension of their strategy, vision and culture.
Dave Schaeffer is famously parsimonious. Despite being a billionaire, he flies Economy class everywhere he goes around the world when traveling for Cogent. That quality and culture permeates Cogent and is essential for the company to maintain and fervently defend its status as the low-cost provider of connectivity in its end markets. Elon is famous for sleeping on the factory floor in the depths of “manufacturing hell,” showing Tesla’s employees that he was in the trenches with them. This is in stark contrast to companies that have executive-only floors, executive-only elevators, and other perks that separate leadership from employees. We prefer CEOs that inspire customers, employees and stakeholders by being in the trenches.
While we want to maximize the “alpha” from these inspiring and effective founder/operators who are blessed with magnified influence over their organizations, we also recognize that they do sometimes make decisions that investors dislike in the near term and/or decisions that hurt their companies for periods of time. Of course, not everything goes to plan. Let’s go explore some of those decisions.
1. Ernie Garcia guided Carvana to one of the greatest growth stories in the last decade…and then he almost drove it into the ground. He made a big, bold bet when buying ADESA in early 2022 at a time when capital was tight, demand was shrinking, and Carvana had acquired too much inventory, all of which led to massive deleverage in the operating model and significant cash burn. The company’s position was exacerbated by high financial leverage and liquidity draining from capital markets rapidly. Carvana’s stock fell -99% and there were many articles about its imminent bankruptcy. It has since recovered some of its losses, but the experience scarred many analysts and investors. Most likely, it will take years to rebuild trust. Ernie’s mistake was that he was far too aggressive, pursuing a mandate of growth above all else despite managing a business that was not yet self-funding and which had significant short-term liquidity needs. If liquidity dried up in the ABS or auto loan markets , Carvana could not finance its auto loan originations with only its own cash on hand.
Thankfully, Ernie’s resolve never wavered and he re-oriented the company around operating efficiency before allowing the company to pursue growth again. Though a very difficult lesson to learn and a very difficult path to travel for equity investors, we believe Ernie has guided the company to superior profitability at every volume level of retail unit sales compared to the “super growth” mode prior to 2022.
2. Gary Friedman has bet big on RH several times, essentially executing a public company LBO over the last decade. RH levered up to repurchase shares in 2017 and did so again in 2023. Each time, he pushed the company’s debt loads to levels that raised the risk profile of the company. He bet big on the company’s product and go-to-market strategy, execution, and financial performance. These capital allocation decisions have caused major volatility in RH’s stock during these periods, but ultimately he has created significant equity value for shareholders.
We believe Gary has created the best business model in furniture and décor and has created a brand that will endure for a long time. He is highly analytical and does not make big bets without supportive data. It doesn’t mean he will get everything right, but we like our chances betting alongside him.
3. John Malone is famous for his building his Cable Cowboy empire via TCI and the Liberty companies. He pioneered the levered buyback model, whereby cable companies grow subscribers moderately, raise prices moderately, and generate EBITDA growth faster than revenue growth, and free cash flow growth faster than EBITDTA growth. Malone’s companies deploy excess free cash flow and incremental borrowing capacity into buybacks and always carry high financial leverage to enhance equity returns and reduce their cash tax burdens. This model worked beautifully in an environment with blue skies for market share gains.
Malone and his companies were too slow to adapt to higher competitive intensity which significantly hurt broadband growth and valuations. Most of his cable companies are well underwater on their tens of billions of buybacks. Altice US (NYSE: ATUS), of the same levered buyback lineage, also followed this model and has lost over 90% of its equity value, and now has over 7x net debt/EBITDA leverage.
In our opinion, every single wireline telecom CEO should operate at very conservative leverage ratios and should allocate capital flexibly enough to deleverage rapidly if needed.
4. Jay Brown at Crown Castle directed the company through more than a decade of massive capex and acquisitions in dense urban fiber footprints, deploying seemingly all excess capital into one large “small cell” densification bet. That bet has played out far slower than anticipated, and he came under fire from Elliott Management, an activist investor. We happen to agree with Jay’s vision longer-term, but it’s also true that the bet has produced a bad IRR any way we slice the numbers. He had a solid long-term vision, but he got near- and medium-term demand wrong. Having strength in conviction in the longer-term trend but only moderate success in the medium-term creates a very difficult decision for investors and the board. Eventually the dream has to become a reality, and unfortunately time ran out for Jay.
The examples above show the dangers of a fearless leader that uses capital to make big bets on the future. Big bets helped their companies achieve success. However, when they falter and use debt to fund those bets, it can cause potentially volatile situations. If they bet big and use equity, the dilution is painful as well.
Some of these volatile situations create opportunities for attractive entry points. Others signal wrong steps that result in an impairment in value. Sorting through which is which can be difficult, so it’s important to be diligent and selective. The “easy” answer for most investors is to assume the worst, which often leads to pessimistic overshooting. We think there can be great opportunities to generate significant returns by finding great leaders who make bets that are underappreciated by the market in the near-term, but are highly accretive longer-term.
Conclusion
Jockeys (CEOs) and horses (companies) both matter tremendously. Great companies are not created without great leaders, but great companies can be maintained by good CEOs. A great CEO in a bad company has a tough hand to play, but if he is Warren Buffett, he can create an amazing company from the scraps of the original Berkshire Hathaway. A bad CEO in a leading company can harvest the advantages the company built over time, but he also may put a company at risk of competitive disruption (e.g. Paypal?) or impairment of capital (Charter?).
We spend most of our time studying companies, but over time we’ve also seen how much long-term value can be swung by the proficiency (or lack thereof) of a company’s leader, so we care deeply about them as well. Great leaders who navigate well through different environments and who allocate capital with insight and discipline tend to bless their companies with higher valuations and cheaper capital. They build trust with employees, customers, and all stakeholders to pursue their strategic visions. Doing so creates a virtuous cycle that helps the business across many dimensions: improving stature with customers and prospective employees, enhancing competitive differentiation, and increasing optionality for accretive strategic capital allocation.
