Capital allocation here refers to how a company’s management invests the funds they raise from investors and that they acquire through earnings.
Warren Buffett has often written about the crucial importance of capital allocation skills.
For example, in his “owners manual” for owners of Berkshire Hathaway shares he indicates that investors should assess management’s skill in that regard and he notes that capital allocation and the care and feeding of key managers is what he mainly attends to in managing Berkshire.
Buffett pointed out that even for large long-established companies each new CEO should be skilled at capital allocation. In his 1987 letter he pointed out the perhaps surprising fact that that “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.” (10% growth compounded for ten years increases capital to 259% of the original amount and the 159% gain is 61% of the resulting total.)
In his 2010 letter, Buffett explained that calculating the intrinsic value of Berkshire involved an examination of its assets and earnings. In regards to capital allocation he then stated:
There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.
This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
Given the importance of capital allocation skills, the InvestorsFriend analysis process for each company specifically comments on management’s apparent skills in capital allocation.
The four main categories of capital allocation or use of cash generated are: 1. To invest in the company’s assets to grow or maintain the business; 2. To use to make a corporate acquisition to grow the business; 3. To pay a dividend or; 4. To repurchase shares.
When it comes to choosing how to spend money within the existing business, almost all companies will undertake an analysis of the return on capital and will choose projects which appear to have the best return. However, few companies will explicitly compare that option to the alternative of repurchasing shares.
If capital was used to repurchase shares we comment, in each of our reports, on whether or not that appears to have been a wise use of funds. (It has turned out to be unwise if the share price has subsequently declined by a material amount).
We consider whether capital additions made to maintain or expand the business appear to have been wise.
We consider whether the company has made wise decisions if it has made acquisitions. Purchasing businesses that provide poor returns is unwise and even purchasing wonderful businesses can be unwise if the purchase price was too high.
The payment of dividends is not always wise if there were better uses for the money, or particularly if the payment is effectively being made from borrowed funds, and we consider if the dividend policy was rational.
In conclusion, the capital allocation skills of management can be the most important factor in determining the long term returns of a company. Before investing, it is important to consider if the management of the company has displayed good skills in allocating its capital.
END
Shawn Allen
InvestorsFriend Inc.
November 30, 2015 (edited on December 1, 2015)