In a previous post, I made a list of investors and CEOs who were once considered great capital allocators but aren't any longer. Steve Odland and Guido Dumarey are two glaring omissions from that list.
Odland was the CEO of Autozone from 2001-05 and CEO of Office Depot from 2005-10. He used an Outsiders-style capital allocation strategy at both companies, with wildly different results. While he was CEO of Autozone, its earnings surged and the stock tripled. While he was CEO of Office Depot, its earnings sagged and the stock lost 75% of its value.
Odland's career suggests that Outsiders strategies amplify a business's characteristics. They produce "beta" rather than "alpha." Leveraging up to buy back stock worked well at Autozone because it was a good business in a good economic environment. Office Depot, not so much.
Dumarey was the CEO of Punch International, a Belgian conglomerate with investments in industrial technology and real estate.
Like Chad Wasilenkoff at Fortress Paper, Dumarey followed the Outsiders playbook of using leverage to enhance returns, buying back stock, making opportunistic acquisitions, and having "skin in the game." A VIC writeup from 2007 describes Dumarey as follows: "[Punch's] CEO is one of the smartest and deal-savvy persons I know and on June 28th bought back even more shares on the open market (even though he already controls 38% of the company)."
Unfortunately, that was written near Punch's all-time high. The company's stock fell 98% from peak to trough during Global Financial Crisis and has yet to recover.
It's easy to ridicule passages like that with the benefit of hindsight, but the VIC author had a point: at the time of his write up, Dumarey's track record was enviable. As with Odland, Dumarey's success before the crisis and subsequent reversals demonstrate the risk inherent to Outsiders strategies. They enhance returns during a bull market, and they may produce higher returns on average, but they can be disastrous during periods of financial stress.
Punch also demonstrates the limits of incentives. Since Dumarey owned 38% of his company, he had a strong incentive to avoid bad investments and excessive risk, but that didn't prevent Punch's collapse. The same can be said of Golden West and Bear Stearns. The Sandlers owned a large stake-- nearly all of their wealth-- in Golden West, and that didn't stop it from making bad loans. Jimmy Cayne owned almost a billion dollars of Bear Stearns stock when it collapsed, and other Bear Stearns execs were also big shareholders at the time.
Incentives can be very effective at resolving agency-principal problems, but agency-principal problems aren't the only things that lead to bad decisions. There are several reasons why incentives can fail:
• People's willingness to take risk is partly innate. Some people are very ambitious and will take big risks regardless of financial incentives. The prospect of glory motivates them more than abstract ideas like risk-adjusted return. The Lehman Brothers bankruptcy examiner's report claims that envy of Goldman Sachs motivated Lehman executives to take excessive risks.
• People can make poor decisions if their careers have given them constant psychological reinforcement to make a certain kind of decision. I think this explains the executives at Golden West and Bear: their whole careers had rewarded them for taking risk, so they continued taking the same kinds of risk past the point of diminishing returns.
• Everyone has certain intellectual and psychological limitations that even the best incentives can't overcome. Not everyone gets to be an astronaut when they grow up.