Capital Allocation: Evidence, Analytical Methods & Assessment Guidance by Michael Mauboussin

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

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Capital Allocation: Evidence, Analytical Methods & Assessment Guidance - Mauboussin

  • [tACapital 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.
  • Capital allocation is always important but is especially pertinent today because return on invested capital is high, growth is modest, and corporate balance sheets in the U.S. have substantial cash.
  • Internal financing represented more than 90 percent of the source of total capital for U.S. companies from 1980-2015.
  • M&A, capital expenditures, and R&D are the largest uses of capital for operations, and companies now spend more on buybacks than dividends.
  • This report discusses each use of capital, shows how to analyze that use, reviews the academic findings, and offers a near-term outlook.
  • 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.

Capital Allocation

Executive Summary

  • 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, 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.
  • Capital allocation is always important but is especially pertinent in the United States today given the high return on invested capital, modest growth, and substantial cash on corporate balance sheets. Companies that deploy capital judiciously have a significant opportunity to build value.
  • Internal financing represented more than 90 percent of the source of total capital for U.S. companies from 1980-2015. This is a higher percentage than that of other developed countries including the United Kingdom, Germany, France, and Japan.
  • Mergers and acquisitions (M&A), capital expenditures, and research and development (R&D) are the largest uses of capital for operations. In the past 35 years, capital expenditures are down, and R&D is up, as a percentage of sales. This reflects a shift in the underlying economy. M&A is the largest use of capital but follows the stock market closely. More deals happen when the stock market is up.
  • The amount companies have spent on buybacks has exceeded dividends for the past decade, except for 2009. Buybacks did not become relevant in the U.S. until 1982, so you should treat comparisons of yields before and after 1982 with caution. Research shows that the overall proclivity to return cash has not changed much over the decades, but the means by which the payout occurs has shifted.
  • Academic research shows that rapid asset growth is associated with poor total shareholder returns. Further, companies that contract their assets often create substantial value per share. Ultimately, the answer to all capital allocation questions is, “It depends.” Most actions are either foolish or smart based on the price and value.
  • Divestitures are substantial and generally create value. If the buyers tend to lose value, it stands to reason that the sellers gain value. Selling or spinning off poor performing businesses can lead to addition by subtraction.
  • 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 value creation 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.

Capital Allocation

Michael Mauboussin - Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance - Introduction

Capital allocation is the most fundamental responsibility of a senior management team of a public corporation. Successful capital allocation means converting inputs, including money, things, ideas, and people, into something more valuable than they would be otherwise. The net present value (NPV) test is a simple, appropriate, and classic way to determine whether management is living up to this responsibility. Passing the NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the present value of the long-term cash flow from an investment exceeds the initial cost.

Why should value determine whether a management team is living up to its responsibility? There are two reasons. The first is that companies must compete. A company that is allocating its resources wisely will ultimately prevail over a competitor that is allocating its resources foolishly. The second is that inputs have an opportunity cost, or the value of the next best alternative. Unless an input is going to its best and highest use, it is underperforming relative to its opportunity cost.

The process of making inputs more valuable has a number of aspects. A logical starting point is a strategy. Properly conceived, a strategy requires a company to specify the trade-offs it will make to establish a position in the marketplace that creates value. A strategy also requires a company to align its activities with its positioning and to execute effectively.1

Since a company’s strategy is often already in place when a new chief executive officer (CEO) takes over, capital allocation generally becomes his or her main responsibility. While a proper and comprehensive discussion of capital allocation requires a consideration of intangible and human resources, our focus here is on how companies spend money.

The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to allocate the capital of the companies it controls. Buffett is worth quoting at length:2

This point can be important because the 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. The lack of skill that many CEOs have at capital allocation is no small matter: 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. CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it. In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you hear so much about “restructuring.”)

Intelligent capital allocation requires understanding the long-term value of an array of opportunities and spending money accordingly. It also includes knowing the value of a firm’s individual assets and being willing to sell them when they are worth more to others.

We believe that long-term growth in value per share should guide capital allocation decisions. A necessary corollary is that there is a time when shrinking the business is the most beneficial course for ongoing shareholders. In some cases, for instance, buying back shares is a wiser choice than expanding by means of capital expenditures or acquisition.

Capital allocation is a dynamic process, so the correct answer to most questions is, “It depends.” Sometimes acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and times to retire it. Because the components that determine price and value are changing constantly, so too must the assessments that a CEO makes. As Buffett says, “The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.”3

Buffett also discusses what he calls the “institutional imperative,” a force that is also pertinent.4 The force has multiple aspects as he describes it, but a pair of them are relevant here. One is that subordinates will readily create spreadsheets and studies to support the business craving of the leader. Another is that companies will “mindlessly” imitate one another, whether in M&A or executive compensation.

The message here should be clear. A decision isn’t good just because someone in the organization can justify it or because some other company is doing it. Proper capital allocation requires a sharp analytical framework and independence of mind.

In our experience, very few CEOs, and chief financial officers for that matter, have what we call the “North Star of value.” The North Star is not the brightest star, but it doesn’t move much throughout the night or year. As a result, it provides a reliable sense of direction. Likewise, companies that have a North Star of value have an unwavering view of value no matter what is going on. It is common for executives to solicit input from a range of stakeholders, hear varying points of view, and walk away confused and unsure about the proper course of action. This doesn’t happen to executives with the North Star of value, especially since they may have better information about their company’s prospects than the market does.

Incentives are another barrier to proper capital allocation. An executive who is paid to deliver a target based on short-term earnings per share may well act very differently than an executive who is focused on building longterm value per share. In assessing management, ask a fundamental question: If there is a conflict between maximizing a reward based on the incentive plan and creating long-term value per share, which route will the executive select?

William Thorndike’s excellent book, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, deeply inspired this report.5 Thorndike shares the stories of eight CEOs who created tremendous value per share during their tenures. One theme that comes out clearly in the book, and is explicit in the subtitle, is that these CEOs appeared out of step with conventional wisdom as they were building value. The North Star of value guided their decisions, and they had the independence of mind to make the best choices.

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