Capital Allocation & Capital Management – What is good and what is bad
Everyone who has read Thorndikes book “The Outsiders” clearly knows that capital allocation& capital management is one of the most important factors in creating long term shareholder value. After I watched Thorndike give a briliant talk at Google on this topic, I decided to write down my own thoughts on the topic.
What is CAPITAL ALLOCATION & CAPITAL MANAGEMENT anyway ?
CAPITAL ALLOCATION is simply what you do with your profits/cash inflows once they are in your account. You can do a lot of things with it. Thorndike in the talk above uses 5 uses, I would add another 2 (in bold)
1. Reinvest: Maintain your existing assets/infrastructure/operations
2. Grow organically: Expand your business by buying more machines/outlets/opening stores etc.
3. Expand your business by M&A
4. Pay back liabilities (debt, payables, pension liabilities etc.)
5. pay dividends
6. buy back shares
7. just leave the cash on your account and wait for better opportunities
If we expand the framework to include additional outside capital, we would speak of CAPITAL MANAGEMENT, there is even more you can do:
8. Issue more debt (and use it as described above)
9. Sell assets (subsidiaries etc.) or do spin-offs
10. Issue more shares (and allocate it as described above)
What is considered GOOD capital allocation
I think at least within value investing circles, three persons stand out as great capital allocators/managers: Warren Buffett, Henry Singleton and John Malone.
Warren Buffett as capital allocator
Buffett clearly uses many of the instruments above, with exceptions/modifications:
– he never pays out dividends as he deemes them to be tax inefficient
– he never bought back shares in larger quantities as he thinks he can allocate into better opportunities. Although he made a “pledge” at one point to buy back below 1,2 times book
– he issues a lot of debt in the form of Reinsurance contracts, he uses non recourse debt at subsidiary level
– although he had sold stocks, he has never sold a fully owned business to my knowledge
– he always seems to be able to find good opportunities to deploy capital
– he grows both organically (for instance utilities) but also does a lot of M&A
– he accumulates cash for some time to be able to strike when things are cheap
– he focuses on return on capital metrics and per share growth, not absolute growth or (smooth) accounting income
– his interests as big shareholder and CEO with a tiny salary are well aligned with shareholders
– he allocates capital across many industries
– his time horizon is very long term
Henry Singleton master allocator
The founder of Teledyne is less know but his track record was a least as good as Buffet’s. There is a very good summary to be found on CS Investing.
His success can be contributed mainly to the following
– he used his expensive stock in the beginning to pay for acquisitions
– he didn’t reinvest that much into existing businesses but used the cashflow to acquire other businesses or stocks
– when his own stock became cheap he bought back most of the outstanding stocks, also using leverage
– used spin-offs often
– he never paid cash dividends
– he did accumulate cash balances before he then allocated them opportunisitcally
– used Insurance float similar to Buffett
– focused on per share value not earnings
– owned significant stake in his company, didn’t pay himself a large salary
John Malone “Capital Cowboy”
– he never paid dividends, not even showed accounting profits
– maximum amount of leverage
– allocated capital within a narrow range (cable and media)
– existing business “stripped to the core”
– Master of the stock swap and “spin-off”
– long term horizon
– owned a signifcant stake in his company (Liberty)
Is there a common theme ?
There are clearly fundemantal differences. Berkshire and Teledyne were conglomerates, Malone had a more focused cable & media empire. Buffett started with stocks and moved to buy complete businesses, Singleton the other way round. Nevertheless, I think there are somecommon themes here to be found:
– all three had a long term focus
– in every case the CEO was/is a significant owner and fully aligned long term with outside shareholders
– Cost conscious: No fancy headquarters, no company jet fleet
– active use of different funding sources (debt, equity, Float)
– they are/were not focusing on smoothly growing accounting incomes, or even completely ignore the GAAP results
– they were all active in the M&A market
– all showed countercyclical behaviour
– return on investment/ Return on capital employed as major management target
How to identify bad Capital Allocation / Capital Management
Identifying bad capital allocation is actually a lot easier (and more common) than good capital allocation. The list is almost endless but let me list a few cases I had covered in my blog:
- Buying back shares at peak prices financed by debt (Fossil)
- Building lavish new headquarters at the top of the cycle (EVS)
- Investing into “trophy assets” (IVG, Swatch)
- M&A at the top of the cycle (Siemens, Dresser Rand)
- Issuing new shares in a crisis situation (Italian banks, Imtech etc.)
- Trying to transform the business via a series of M&A transactions (Bilfinger, TUI, HPQ)
- Paying “strategic prices” for acquisitions (SAP)
- Reinvesting in “dead assets” (E.On, RWE)
- Paying high dividends fincanced by debt (E.ON, RWE)
- M&A as only growth strategy (Valeant)
- using hybrid debt to replace equity capital (almost all banks, some corporates)
- starting massive investment programs at the top of the cycle (Volkswagen)
- Market share / sales / EBITDA as success measure for management (E.On)
- Fire sales of assets because of too much debt (Valeant)
Special case: Share buy backs vs. new share issuance
These days, in for many investors the following equation seems to be a no-brainer:
Share buybacks = great capital allocation
In a presentation on Henry Singleton, Leon Cooperman has nicely sperated 4 different types of share buy-backs:
Cooperman classifies share buybacks into four categories: o
Type I: Combats the impact of option dilution
Type II: Assists executives that are exercising options
Type III: Company has no opinion on value but the buyback is done to return capital to shareholders
Type IV: Company believes the stock is undervalued and repurchases share
Clearly Type IV is the most value enhancing but also the rarest form. So beware of Type I and Type II buy backs and don’t get too enthusiastic about Type III !!!
On the flip side, any issuance of new shares is considered “bad capital management”. But again, this highly depends on the situation. If you issue expensive stock to buy cheap assets, then it is clearly value enhancing. If you issue stock to settle managemnt’s options, then most likely not.
Capital Allocation skills vs business environments
Capital Management alone will not guarantee success, this is clear. You can have pretty bad capital allocation /management skills and still make a lot of money if you happen to be in the right industry at the right time (for instance technology).
You can also show good capital alloctation skills and suffer a huge down turn because of a crisis in your industry (TGS Nopec, Kinder Morgan, Leucadia, Loews).
In the long term however, I do think there is a very strong correlation between capital management skills and company success.
One grain of salt here: Books like “The Outsiders” which look (only) at successful companies are always subject to a certain “survivorship bias”. We do not know how many companies maybe used similar ways of doing things and were not successful. In Malone’s case for instance there was clearly some luck at play as he almost went bankrupt in the very beginning. If this situation would have happened in an environment like 2008, he might not have survived it.
In my opinion, the two most important aspects of capital allocation are the following:
- Long-term alignment of managment and shareholders
- “Walking the talk”
Without proper alignment, capital management will be in the best case random but far more often harmful. CEOs with huge cash settled option packages that mature in 1 or 2 years often do things that are harmful in the long term.
On the other hand, the fact that a CEO owns a certain percentage of the company also doesn’t guarantee success (see Dick Fuld at Lehman or Globo) but clearly increases the probabilities. But beware of shares being pledged against personal loans and other “shananigans”.
And finally, talk is cheap. Over the last years many CEOs started to quote Warren Buffett or other great capital allocators but actually doing those things is still hard. So pay attention if someone is really doing what she/he is claiming to do.
Do check if the made M&A transactions on 2009 and 2012 or if they bought as everyone else in 2007 or 2015.