239 · From the Vault: Choosing Your Management Team

In one sentence: A rerun of 123 (Danielle introduces it as "episode number 123" in a new intro), so read that note for the full story and use this one for what is added.

Key ideas

• This is a rerun of 123. Same content: BP at $27 as a counter-example to "price equals value", jockey versus horse, the idea that a moat lets Munger hedge on management, the GM and Chicago Bridge & Iron examples, and the debt rule (one to two years of free cash flow, three at most). [01:00–25:00]
• Worked ROE versus ROIC example. With $1,000 of equity and $100 of income, ROE is 10%. Pay out $500 as a dividend and borrow $500 to replace it: ROE jumps to 20% with no more earnings, but ROIC (income divided by equity plus debt) stays at 10%. So watch whether ROIC falls relative to ROE as a sign that debt is rising. [28:00–31:00]
• Debt isn't automatically bad. Danielle challenges whether a new CEO's borrowing could be justified; Phil says it can be, but only if you understand the business well enough to judge it, and if it is a gray area, skip it. [19:00–25:00]
• Cal-Maine as a debt-light example. About $500 million cash and $40 million debt, with Phil's explanation of why a cash-rich company might still borrow cheaply to pay a dividend. These figures are Phil's recollection. [24:00–27:00]
• A dated news hook. The episode ends by teasing a Wall Street Journal piece (July 2017) on DryShips, whose reverse splits wiped out shareholders. In the 2019 rerun it is just a time-stamped teaser. [31:00–33:00]

How it maps to RuleOne

• As in 123: debt divided by free cash flow, ROIC and ROE are on the stock page, so the leverage check is a real test.

Buffett, Munger and Graham links

• See 123: "an idiot will run it someday" and Munger's four filters in 001.

Words to know

• Nothing new. See 123: jockey versus horse, ROIC, years to pay off debt.

Try this

Repeat the exercise in 123 on another company: compare five-year ROE and ROIC on /stock/TICKER/, and if ROE runs clearly above ROIC, compute debt divided by free cash flow.

Check yourself

1. In the worked example, why does ROE double but ROIC not move?
   Answer

   Swapping equity for debt shrinks the equity base so ROE rises, but ROIC divides by equity plus debt, which hasn't changed.
2. When can a CEO's borrowing be acceptable?
   Answer

   When you understand the business well enough to see what it buys, and the debt stays within about three years of free cash flow.

Short quotes

"It's the debt that kills." (Phil, ~16:30, auto-transcribed)