Value Investing

Michael Mauboussin: Capital Allocation Outside the U.S.

Michael Mauboussin: Capital Allocation Outside the U.S.

Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places, see his latest piece from Credit Suisse below.

Summary

  • Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.
  • In this report we examine the sources and uses of capital for Japan, Europe, Asia/Pacific excluding Japan, and Global Emerging Markets. This extends our analysis beyond the United States, which we discussed in a prior report.
  • Countries or regions with a high return on invested capital (ROIC) can fund a substantial percentage of investment internally whereas those with low ROICs must rely more on external financing.
  • Capital allocation is also determined by the largest sectors in a country’s or a region’s economy, the stage of economic development, cultural norms, and regulations.
  • We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

Executive Summary

We extend our analysis of capital allocation beyond the United States to other major world regions, including Japan, Europe, Asia/Pacific excluding Japan (APEJ), and Global Emerging Markets (GEM). For the prior report, see Michael J. Mauboussin and Dan Callahan, “Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance,” Credit Suisse Global Financial Strategies, August 5, 2014.

Capital allocation is the most fundamental responsibility of a senior management team of a public corporation. The problem is that many CEOs, while almost universally well intentioned, generally don’t know how to allocate capital effectively. The proper goal of capital allocation is to build long-term value per share. The emphasis is on building value and letting the stock market reflect that value. Companies that dwell on boosting their short-term stock price frequently make decisions that are at odds with building value.

Regions and countries vary in the source of funding for capital. In general, high return on investment is associated with an ability to internally fund a substantial percentage of investments. Countries that largely finance investments internally include the U.S., the U.K., and Germany. Countries that require a higher proportion of external financing include France, Japan, and China.

Academic research shows that rapid asset growth is associated with poor total shareholder returns in most regions of the world. Further, companies that contract their assets often create substantial value per share. But these findings are more robust in developed markets than in developing markets. Making investments that earn a return in excess of the opportunity cost is the key to creating value.

Ultimately, the answer to all capital allocation questions is, “It depends.” Most actions are either foolish or smart based on the price and value. Similar to investors, companies tend to buy when times are good and retreat when times are challenging, failing to take advantage of gaps between price and value.

Past spending patterns are often a good starting point for assessing future spending plans. Once you know how a company spends money, you can dig deeper into management’s decision-making process. Further, it is useful to calculate return on invested capital and return on incremental invested capital. These metrics can provide a sense of the absolute and relative effectiveness of management’s spending.

Understanding incentives for management is crucial. Assess the degree to which management is focused on building value and addressing agency costs.

The five principles of capital allocation include: zero-based capital allocation; fund strategies, not projects; no capital rationing; zero tolerance for bad growth; and know the value of assets and be prepared to take action.

Summary of Global Capital Allocation

Mergers and acquisitions (M&A), capital expenditures, research and development (R&D), and net working capital are the uses of capital for internal investment. How companies invest internally varies substantially by region. (See Exhibit 1.) Here are some of the main observations based on spending in recent decades:

-M&A is the largest use of capital in the U.S., Europe, and GEM, the second largest use in APEJ, and the fourth largest use in Japan. The rarity of M&A in Japan is of particular note.

-Capital expenditures are the largest use of capital in Japan and APEJ and the second largest use in the U.S., Europe, and GEM. The range in spending, measured as a percentage of sales, was twice as large for M&A as it was for capital expenditures.

-R&D is the second largest use of capital in Japan, the third largest in the U.S. and Europe, and the fourth largest in APEJ and GEM. Developed markets spend substantially more on R&D than developing markets do.

-Net working capital is the third largest use of capital in Japan, APEJ, and GEM, and the smallest use in the U.S. and Europe. This disparity likely reflects the differences in the businesses in the respective economies.

Divestitures play a significant role in each of the regions, constituting roughly one-third to one-half the level of total M&A. They are also larger than dividends and share buybacks in all regions but Japan.

Dividends substantially exceed share buybacks in all regions except the U.S., where they have been roughly equivalent on average. Buybacks are modest in Europe and fairly insignificant in Japan, APEJ, and GEM.

Share buybacks have been meaningful in countries that embrace the Anglo-Saxon model and inconsequential in nearly all other regions. This pattern reflects cultural and regulatory constraints.

Michael Mauboussin Capital Deloyment

See full PDF below.