A couple nights ago, I was scrolling through my feed and I had a visceral reaction to this tweet:
Overrated? No! If anything, capital allocation is underrated by investors when they analyze a business and its management. Too often, an analyst looks at a quality business model and then makes no attempt to ascertain how well the person in charge is going to steward their investment. In one extreme, they might find a great business whose C-suite is hellbent on lining their own pockets instead of rewarding shareholders; in another, management may be in the empire-building business and acquisitions will be done without regard to industrial logic. The ability of managers to distribute resources to their highest and best use is, along with operating the business, one of the two roles of CEOs. Over the long run, capital allocation will significantly alter the investment outcomes that one can expect to achieve. Poor capital allocation can drive even excellent businesses into the ground.
The lack of skill that many CEOs have at capital allocation is no small matter: After 10 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.Warren Buffett, Berkshire Hathaway 1987 Shareholder Letter
So, there are two broad questions I wanted to address in this post: 1. What do we mean by capital allocation and what are the tools that companies use? and 2. Why is capital allocation ability so important when assessing the quality of a business?
The Capital Allocation Toolbox
When we talk capital, there are a only three moves that a business can make (if you can name a fourth, please comment below):
1. They can raise capital;
2. They can invest capital;
3. They can return capital.
1. Raising Capital
Managers can gather capital from investors in the form of equity, debt, or a hybrid. This gathering can occur at any stage of a company’s lifecycle. Most are familiar with a startup raising multiple rounds of funding with venture capital before coming public through an IPO (initial public offering). Companies might also raise capital in equity or debt offerings to fund investments into capital projects, acquire other companies, recapitalize, de-leverage, pay employees, and any other use that you might find in the “Use of Proceeds” section of any prospectus.
2. Investing Capital
Once, a company has some capital, they have to make decisions on what to do with it. Most companies will invest it into assets and resources that will generate a return. For example, a retailer may decide to open a new store using some capital to acquire real estate and equipment along with money spent to hire employees and advertise. Oftentimes, a company will do what is commonly called a build vs. buy analysis and use their capital to acquire another business if those returns are projected to be higher than doing something in-house. A company has capital to deploy either from raising capital, as above, or through retained earnings from prior investments that have borne fruit.
3. Returning Capital
The last piece of the puzzle is returning the capital to shareholders. As a company matures, management should be thinking about how best to reward the owners of the business. This might take the obvious form of dividends or buybacks but may also involve repurchasing debt or, in rarer cases, liquidation. Ultimately, the promise of the return of capital is why investors take risks in the first place.
There are some nuances between public and private business but for the most part the same tools are available. Given the structure of capital markets, public companies have an easier time taking advantage of using stock for issuance and acquisitions and also doing buybacks. It’s not impossible for a private company to do the same but the transactions tend to be more negotiated – think real estate transaction (private company) vs. stock market transaction (public company).
Why So Important?
So, that’s our toolkit. Now, let’s look at how important these decisions are and how they drive the value of a company. But first, here’s another Buffett quote from that 1987 shareholder letter to drive the point home.
… (T)he heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.
Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly- talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.
For each option – raise, invest, return – I want to provide an example of good and bad capital allocation and how it can drive large changes in intrinsic value. But, before allocating any resources, management must decide on the capital structure that is optimal for the business – should the business be funded by debt or equity and in what proportions? Many companies have been crushed under the weight of too much debt while a similar amount have squandered returns by issuing too much costly equity. I will save the discussion for another time but as a general rule of thumb: the more predictable your cash flows are, the greater the amount of debt your capital structure can support. e.g. if you own a profitable subscription business such as a cable company or an electric utility, you can lever that much more than a discretionary goods retailer. Now, let’s look at some examples of each capital allocation category:
1. Bad Capital Raise – SiriusXM
In 2009, satellite radio got caught in the wrong place at the wrong time. Unable to refinance a convertible note coming due, Sirius had to go with hat in hand to Liberty Media for help. Liberty extracted (more than) a pound of flesh. They offered them a package of $530mm in debt securities with rates as high as 15%. In addition, they demanded a 40% equity interest as a kicker and got it. SiriusXM shareholders got diluted terribly. To add insult to injury, less than three months later, CEO Mel Karmazin proclaimed “Satellite radio is now a cash flow growth story(!)” So, good operator, bad allocator. Of course, on the flip side, Liberty’s investment in SiriusXM is one of the greatest capital allocation maneuvers of the last few decades; the loan was paid off easily and that 40% stake is worth $12 billion today.
2. Good Capital Raise – Sycamore Networks
You can have a garbage company and still do things that are quite value accretive when it comes to capital allocation. During the 1999-2000 tech bubble, Sycamore Networks came public with no profits and barely any revenues or customers. At one point, the CEO was among the richest people in the United States as mania captured most investors. The company issued stock opportunistically and despite the bubble bursting, they had so much cash in the bank that they were able to survive for another 12 years before finally being acquired in 2013 after paying out a few special dividends. Not a great result but much better than Pets.com or Webvan.
3. Bad Capital Investment – Berkshire Hathaway
Even the best make mistakes. In his 2008 shareholder letter, Warren Buffet discusses his worst capital allocation decision – the acquisition of Dexter Shoe Co. He paid $433 million but did so by issuing equity in Berkshire. In his words: “What I had assessed as durable competitive advantage vanished within a few years. By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6 percent of a wonderful business — one now valued at $220 billion — to buy a worthless business.” As Berkshire has grown, this cost has grown, too.
4. Good Capital Investment – Berkshire Hathaway
This is the textbook example of re-allocating capital to its highest and best use. Buffett took control of Berkshire Hathaway in 1965. The business produced cotton textiles and was competitively disadvantaged while also required large amounts of capital to just to keep up. Buffett made the decision to reinvest earnings elsewhere and thus proved that even a terrible business with a great allocator can become a very successful investment.
5. Bad Capital Return – Apple
I’ll apologize in advance for using another Buffett-related example. You might be wondering how Apple could be an example of bad capital return given the astronomical returns that its shareholders have earned over the years. Well, here’s how. In 2012, Buffett described a conversation he had with Steve Jobs about what to do with Apple’s huge cash pile.
Many many many billions of dollars were left on the table by Jobs’ refusal to repurchase shares. Great operator, bad allocator. As an aside, similar concerns have been raised about Google recently. Sure, it’s a money machine but how can I be sure you are going to do something smart with the money when it comes in and not plow it into another moonshot?
6. Good Capital Return – AutoNation
Before the GFC, AutoNation’s stock price was $22.44 and by 2009 it had traded as low as $3.97. This is a disaster, right? Well, let’s see what management and the board were doing. They were focusing all their operational energy on making sure their dealerships continued to function during the downturn despite the bankruptcies of large automakers General Motors and Chrysler and simultaneously allocating free cash flow to stock buybacks and debt repurchase. The table below shows shares outstanding, net income, and earnings per share by year.
|Year||Shares Outstanding at Year End||Net Income||Earnings Per Share|
We can make a few observations: 1. During the financial crisis, net income at AutoNation predictably declined but the company continued to generate cash. (Revenues declined over 40%!) 2. Shares outstanding were reduced by over 40% during this period. 3. Because of these buybacks, earnings per share, which we are using as a proxy for free cash flow per share, returned to 2006 levels by 2010 and were up 82% by 2012 even though net income was essentially unchanged. That’s a pretty good performance by a company in one of the hardest hit sectors of the economy! The S&P 500 including reinvested dividends was up 14.6% from Jan 1, 2007 until December 31, 2012. How did AutoNation do? It was up 86%. Not bad. Good operator, good allocator. (By the way, AutoNation current shares outstanding have now declined further to ~89mm in 2020.)
Capital Allocation Conclusion? Underrated!
Operating a business efficiently is extremely important but those dollars you make have to go somewhere. If you’re printing money at the restaurant you own and then flushing it down the toilet playing Powerball every week, you’re a good operator but a bad capital allocator. Be both and look for both in your managers. Capital allocation is just as important if not more so than operations. Leave a comment if you have questions or disagree with me! Also, am interested in your favorite examples if you can think of any.