Buffett’s One Test, That Most CEOs Fail

In Quality of Management — 3 — The BS Filter, I made the case that pattern recognition — the BS Filter — is the only reliable way to assess management when you can’t sit across the table from them. But pattern recognition needs raw material. You need something to observe. Something that management actually does, repeatedly, over years, that you can track from the outside without ever meeting them. That something is capital allocation.

In my earlier post titled, Quality Of Management — 2, I had argued that Capital Allocation decisions made by the management are directly and positively correlated with the returns we intend to make on our investment. The company you own needs to be run by someone who is genuinely good at deciding what to do with the cash it generates.

There is a concept in management theory called the Peter Principle. It says that in most organisations, people get promoted because they’re good at their current job — not because they’d be good at the next one. A brilliant engineer becomes a mediocre manager. A great salesperson becomes a terrible VP. The promotions keep coming until the person lands in a role they can’t handle — and there they stay. Over time, every position in a hierarchy tends to be occupied by someone who is incompetent to carry out its duties.

While this may appear to be a bit satirical — it is what actually happens in real time. Now, pair this with the seminal observation that Buffett has made decades ago: After ten years on the job, a CEO whose company retains earnings equal to just 10% of net worth will have been responsible for deploying _more than 60% of all the capital at work in the business.

The CEO — the management — ends up ‘rebuilding’ the business we have invested in, one capital allocation decision at a time. The business you own after a decade is primarily the product of how the CEO allocated capital, not what they inherited.

And if that CEO rose to the position through the Peter Principle — promoted for being a great engineer, a great salesperson, a great operations head — they’re now playing a completely different game. One they never trained for — With 60% of your capital.

When we invest, we have no say in how the CEO or top management is appointed. But Munger gives us a shortcut — ‘Invert, Always Invert.’ Don’t ask what makes a great capital allocator. Ask what kind of appointment virtually guarantees a terrible one. Buffett answered this decades ago. Here he is in a 1999 Nightline interview (transcript):

“We talked about a couple of these issues many years ago and you told me for one thing, yes, you would leave a little bit of money to your kids — you’ve got three kids — but the idea that you would leave all this money to your kids is just silly as far as you’re concerned. Explain why.”

I don’t believe in the divine right of the womb. I see no reason why somebody that happens to win the ovarian lottery and come out of the right womb is entitled to fan themselves for the next fifty years — or command the resources of society.

If we’re going to pick an Olympic team in the year 2000, I don’t think we ought to take the eldest son or the eldest daughter of who won all the prizes in 1976 and put them on the team. I really believe in a meritocracy in athletics and I believe in a meritocracy in terms of who handles the resources of society. And we’re a better society because that’s the case.

Inherited leadership is the Peter Principle taken to its logical extreme. The Peter Principle at least requires you to have been competent at something before being promoted past it. Inheritance skips even that. When someone who never proved themselves at any level controls 60% of the capital at work in your business over a decade, the odds are stacked against you.

This is why capital allocation is THE test. Not a test. THE test. Everything else — the conference calls, the investor presentations, the stated strategy — is just talk. Capital allocation is what management does with your money when you’re not looking.

William Thorndike, in The Outsiders, strips this down to its essentials; I have already pointed at this in an earlier post — Quality Of Management — 2. His tool kit is basically pretty simple and full of common sense, and the five tools he mentions are:

1. Invest in existing operations
2. Acquire other businesses
3. Pay dividends
4. Pay down debt
5. Buy back stock

And, the quote he uses is: “Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions the CEO makes in choosing which tools to use.”… and he adds — “It’s the increase in a company’s per share value, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO’s greatness.”

Per share value. Not total value. That distinction sounds academic until you see what happens when a regulator takes one of those five tools away from management entirely — and what Indian investors have been losing because of it. That’s the next post.

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