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We covered a lot of ground on the call this week, so instead of one, very long weekly email, I’m breaking it up into a few parts. This is the third post, and provides some perspectives on how I think about I think about managements actions related to capital allocation decisions.
The other posts related to episode 2148 include…
Capital Allocation
On the pod this week we broadly discussed the most important job for every CEO - Capital Allocation. Many CEOs (and board members for that matter) are skilled leaders, operators, salespeople, and administrators, but few are skilled capital allocators.
There are a number of ways businesses can allocate capital. The broad categories are…
Deploying capital
Investing in organic growth
Mergers, acquisitions
Returning Capital
Paying down debt
Share repurchases
Paying dividends
Dispositions
Anyone with an MBA will tell you that capital allocation is pretty straightforward (mathematically speaking). Deploy capital in projects that meet or exceed the particular project’s required rate of return (RRR). In the event that the company has more excess cash than projects that meet or exceed RRR, return that capital to shareholders. Additionally, manage your debt to equity ratio according to the Modigliani-Miller Theorems and minimize your weighted average cost of capital (WAAC).
In practice it is not straightforward. First, capital allocators don’t often deploy capital in a way that maximizes shareholder value. Humans are inherently selfish and make decisions based on their own set of outcomes - independent of the company to which they have a fiduciary duty. Second, all capital allocators are people, and people are not rational - we are subject to numerous cognitive biases that cause us to justify irrational behavior. Some common examples of this include…
Employees and executives of large organizations find that they can easily tweak assumptions to make their pet projects appear investible (i.e. project IRR > project RRR). Over time, successive failures are realized and make their way into the stock price, harming investors. Unfortunately, by that time, the purpetrator/executive has already moved on to another opportunity.
On a larger and more visible scale, a CEO may spearhead a large acquisition to expand the size of the business. Laden in the economic analysis are the supposed ‘synergies’ expected to be realized (they rarely are). The dirty little secret is that the growth in the size of the business (regardless of performance) ultimately increases the size of his/her comp package.
A company may load up on debt in a low interest rate environment and use that money to repurchase shares. This activity will enhance EPS and other metrics, potentially providing increased stock prices. However, in the long term there is risk of making the business fragile. Those low interest rates may not be available when the company must refinance that debt, or the market environment may move against the company - ex March 2020.
So what is an investor to do? One option is to invest in founder led companies, as founders typically have a very large equity stake that incentivizes rational behavior that is aligned with shareholders. However, for every Jeff Bezos, there is an Adam Newman, so there is no absolute certainty in this strategy. For insights in to one brilliant and one horrific capital allocator, check out Amazon Unbound: Jeff Bezos and the Invention of a Global Empire and The Cult of We: WeWork, Adam Neumann, and the Great Startup Delusion, respectively.
Another option is to invest in businesses that have CEOs with a good track record for capital allocation. A book I read last year provides a history of some of the great capital allocators, along with some similarities / differences that could be worth evaluating when considering in vesting in a company. Check out The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. It was #1 on Warren Buffett’s Recommended Reading List in his Berkshire Hathaway Annual Shareholder Letter in 2012.
Unfortunately, most business are not run by good capital allocators. Does that mean you should not invest in them? No. But, we should be aware of the unique biases and incentive conflicts that exist in every business.
On the podcast this week, Hunt suggested that a sustainable, growing dividend policy is a good indicator of quality management and sets a responsible policy that prioritizes rewarding shareholders and guides toward long term sustainable growth. While dividends are not the most tax efficient form of capital distribution, they are effective because of what is known as dividend signaling. Additionally, I think they act as ‘guardrails’ to minimize the negative impact of poor capital allocation decisions by management.
There are, however plenty of detractors. A few of the arguments against dividends include…
Dividends are not tax efficient, if capital must be returned to shareholders, tax efficient strategies like share buybacks and spinoffs/splitoffs are preferred.
Good managers should be focused on capital deployment, not capital return. As such, management should be employed to find opportunities for organic growth and M&A (to a lesser extent). In other words, if you can’t find good ways to deploy capital, you are not a good CEO.
Hunt suggested altering tax policy in order that dividends would be on a more level playing field with other forms of capital distribution, which would resolve #1. #2 is more of a Silicon Valley ethos that has crept its way in to public markets as a result of the recent boon in tech IPOs. I think, over time, this perspective will diminish when those growth companies mature.
Quite a few of the supercompounders we’ve discussed in the past have employed dividend policies and have sustained IRRs > 20%. In all but one case, the current dividend is many multiples of the initial IPO price.
All that is to say is that a company’s capital allocation decisions help us decide if a company will be a good compounder of capital.
Hopefully this post provided you with a little more color on how I think about capital allocation. Let me know what you think in the comments or feedback links below…
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