Michael Mauboussin: Capital Allocation Outside The U.S.

Michael Mauboussin on Capital Allocation Outside The U.S. – Evidence, Analytical Methods, and Assessment Guidance

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).

Capital Allocation Outside The U.S. – Evidence, Analytical Methods, and Assessment Guidance

• 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 most recent report, see Michael J. Mauboussin, Dan Callahan, and Darius Majd, “Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance,” Credit Suisse Global Financial Strategies, October 19, 2016.
• 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 wise 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, APEJ, and GEM, and the third 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 the second largest use in the U.S., Europe, AJEJ, and GEM. The range in spending, measured as a percentage of sales, was five times 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 APEJ and GEM, and the smallest use in the U.S., Japan, and Europe. This disparity likely reflects the differences in the businesses in the respective economies.
• Divestitures play a significant role in all of the regions except for Japan, constituting roughly one-third the level of total M&A outside of Japan. 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 fairly limited in Europe, APEJ, and GEM and insignificant in Japan.
• 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.

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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.”)

See the full article here.

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