Investors and Operators: Lessons I’ve Learned from Both Worlds
Everybody reading this probably knows the Warren Buffett saying that he’s a better businessman because he’s an investor and a better investor because he’s a businessman. And I agree. Warren Buffett has proved himself to be pretty good at both.
But the converse isn’t necessarily true. Good investors aren’t always good business people and good business people don’t always light it up as investors. My experience has been that people can make a whole lot of money without knowing much about managing it and that others can know a whole lot about managing money without understanding how operating companies amass it.
The two, though, are related and the question is, When do the fields of investing and operating complement one another and when are they wholly disconnected?
PROGRESS AND PROBLEMS
I oftentimes feel like a business orphan. I straddle the two overlapping worlds of business operations and investment, but don’t quite fit into either.
I started my career as an entrepreneur and operator and made seemingly every mistake possible. For those who don’t know the history of Permanent Equity, what started as a collection of marketing firms became a holding company and then a private equity firm. Along the way I was the master of poorly conceived strategy and pivoted around unnecessarily. I mis-set expectations and misaligned incentives. I hired poorly. I fired poorly. I was overly frugal in some ways and lavish in others. It was a mess.
Then, perhaps despite me or perhaps because of the lessons learned along the way, the companies started producing free cash flow and it felt like I got my legs underneath me operationally. But now there was another (good) problem: profits to deploy. Out of necessity I began to learn about investing. But I never took for granted that because we could run a company, we could successfully buy one too.
RECOGNIZING THE OVERLAP
Here’s where I come clean: I’ve never taken a finance or investing class and I didn’t keep the Berkshire letters under my pillow growing up. In fact, I didn’t even know who Charlie Munger was until I was in my mid-20s, around the same time I learned there was an industry called “private equity.” Funnily enough, that was after I acquired my first company. I found Howard Marks, Teledyne, and the Marmon Group in my late 20s. Search funds caught my attention even later.
Needless to say, I’m no investing whiz. I struggle to navigate the Excel spreadsheets people send me and have a tough time understanding what most people in high finance even do everyday. Permanent Equity has been built on grinding execution and healthy fear, not on outcompeting or outmodelling the far more brilliant and highly educated.
But, I’ve come to realize that my experiences put me in an unusual position. Through it all, I’ve been fortunate to spend time with brilliant investors and top-notch operators in alternating settings, observing and learning from both. Depending on the week, I’ll be in board meetings, chatting with a seasoned executive about strategy, helping brainstorm about a new marketing plan, or discussing capital allocation. I love my job.
These interactions continually reinforce the distance between the worlds of investing and operating, so much so that I have to force myself to remember which type of person I’m with, so I can properly frame discussions. We’re all a product of our experiences and the experiences of operators and investors couldn’t be more different. Each group could learn quite a lot from the other. Here’s what I’ve learned from both:
WHAT INVESTORS CAN LEARN FROM OPERATORS…
ALL BUSINESSES ARE LOOSELY FUNCTIONING DISASTERS, AND SOME ARE PROFITABLE DESPITE IT.
At 30,000 feet, the world is beautiful and orderly. On the ground, it’s chaotic and confusing. Nothing ever goes to plan. Surprises lurk around every corner. Things are constantly breaking. Someone is always upset. Mistakes are made daily. Expecting anything less is being out of touch with reality. And remember, just because you’re now aware of it doesn’t change reality. It was that way before, you just didn’t realize it.
And the thing is, businesses usually get that way even with the best of intentions. While McKinsey may guide us all to think along the three horizons of current products, incremental innovations, and breakthrough innovations, the fact is that most small business owners are just trying to get to the end of the week. This manifests itself in all sorts of ways. Owners use too much debt or too little, they prioritize payback period over return, they pay different people vastly different amounts to do the same job, or they are constantly applying band-aids to systemic problems.
This is the challenge of running a business but also the opportunity available to investors. There are outsized returns available for solving these problems.
FORECASTS AND PREDICTIONS ARE EXERCISES IN GUESSING AND GUESSES ARE ALWAYS WRONG.
Precise spreadsheets are maps of a world that never existed and will never come to fruition, even if the numbers are hit. Business is about people and people are hot messes, capable of incredible feats of brilliance and stupidity. What’s more, they’re either optimistic or pessimistic, but rarely accurate. Some relentlessly strive to beat the numbers, while others have never hit a projection. Get to know the people and the business and the operations. That’s where the opportunity is. The numbers are the numbers.
OUTSIZED RETURNS REQUIRE DIVERGENT THINKING AND ACTION.
Every operator has a collection of moments that changed the course of their company’s fate. Almost all of them — on the surface — look absurdly risky, if not downright crazy. These stories of personal guarantees, accepting outsized orders without ready production capability, product offering pivots, and other bet-the-farm moments change trajectory, both for good and bad. As I know better than I’d like to, most LPs and by proxy most GPs struggle with anything that’s not 2-and-20, lever up, and flip. Investors generally should be open to innovative structures, creative incentives, and new ways of solving old problems.
RARELY IS THE PROBLEM STRATEGY.
Activist investors are some of my favorites to watch. They pontificate and prance about declaring how the current leadership are a bunch of cold ham sandwiches, while they have a brilliant and obvious plan that will undoubtedly lead to success. And occasionally they’re correct. But most often, that brilliant strategy has been considered and discarded, or tried and failed. Strategy is important, but for most businesses, it’s not rocket science. The best course forward is typically neither complicated, nor difficult to determine. What’s hard about strategy is execution and culture and systems-building and incentives and leadership. Companies most often languish for lack of execution, not poor strategy.
WHAT OPERATORS CAN LEARN FROM INVESTORS…
CAPITAL EFFICIENCY AND CAPITAL ALLOCATION MATTER.
It’s rare, especially in the lower end of the lower-middle market, to find operators even aware of their cost of capital or return on invested capital (ROIC). But capital has a cost and returns matter, particularly if your aim is to create sustainable long-term value. Business unit economics are the operating earnings minus the reinvestment necessary to hold the competitive position. Excess investment, in people or machinery or acquisitions, should be analyzed based on the return realized. Growth is meaningless and sometimes destructive without corresponding increases in the present value of future cash flows. Investments can be made, measured, and financed in lots of different ways. Sometimes it may make sense to get paid back quickly, but other times it makes sense to optimize for the long-term and there are ways to manage your balance sheet accordingly. Debt isn’t always bad, and more cash isn’t always good. Sometimes the answer is spending more, but sometimes the answer is spending less. It’s worth engaging someone with expertise to help you understand cash flows, cash management, and reinvestment.
CIRCLE OF COMPETENCE WILL LIMIT YOU, BUT KEEP YOU ALIVE.
Being an expert at something doesn’t make you an expert in anything else. Being a seasoned construction exec doesn’t make you knowledgeable about retail, or manufacturing, or any other business model. If it did, doctors would be notoriously good investors. Understanding your specialty and wading into new waters seem diametrically opposed, and they usually are. If something you’ve never done seems “easy,” or “simple,” or “obvious,” it’s not, you just don’t know why. Have humility and tread lightly, especially when it comes to areas outside your circle of competence.
GET A LIBERAL ARTS EDUCATION IN BUSINESS.
As someone who went to a liberal arts college, I can tell this joke, “What did the liberal arts major say to the engineering grad? Do you want fries with that?” The truth is that hard skills matter and many operators have an abundance. What they’re usually lacking is knowledge about the business of business. At a certain level, it all tastes like chicken. No matter if you’re building buildings, or manufacturing widgets, or developing a mobile application, a proper understanding of best practices across marketing, sales, technology, HR, finance, accounting, and operations will dramatically increase a leader’s decision making and performance.
One of the most common pieces of business advice is to play to one’s strengths, and we find it rings true, but only after a business has knocked down the table stakes stuff first. You could be the best widget-maker in the world, but if your org chart is a mess, or you don’t have access to capital, or you haven’t gotten around to putting up a website, or you’re still paying bills with paper checks, your performance is internally constrained.
What’s more, while it’s fashionable in white collar investing to believe that technology is eating the world, we’ve actually found that technology is among the most underutilized resources in smaller companies, partly because technology is developing so much faster than the typical business owner can implement it. But if you are an owner/operator, take some time to understand technology and the role it can play in different aspects of your organization. People resist change, but we find that it can be a huge area for opportunity and efficiency improvement.
In closing, here’s a fantastic quote from Sanjay Bakshi:
“If you’re going to make progress in the world you’ve got to have a clear sense, a realistic sense, an unsentimental sense, of how things really work: the mixed motives that compel some people and the high motives that compel some others. And the low motives that unfortunately captivate other people.”
More lessons for and from investors and operators in our newsletters.
