CAPITAL ALLOCATION BY
MANAGEMENT TEAMS
An Often Overlooked Driver of Stock Prices
Written by: Timothy Moore, CFA®
Portfolio Manager
INTRODUCTION
What makes a stock price go up?
Besides a general stock market rally or a specific sector outperforming, there
are several reasons. The simplest explanation is because there is more
demand for the stock than there are willing sellers. Taking that to the next
level, stocks go up because demand has increased due to higher expected
future cash flows. Drilling down even further, many experts would say
prices go up because the company is exceeding the expectations of investors
and sell-side analysts. Positive surprises on the news front also help.
Change in “expectations” of a company’s cash flows and profits is the most
enduring justification of stock price moves. Yet, surprisingly often
overlooked is what I deem the single most important driver of long-term
results: Capital Allocation.
This White Paper marks my fifth in a series of Business and Investing
Fundamentals (“Characteristics of a Good Company” in April 2011,
“Surviving Emotional Investment Mistakes” in July 2011, “The Secret
Sauce: Characteristics of Successful Investors” in October 2011, “Weaving
the Threads of Corporate Leadership” in July 2012).
The importance of capital allocation by management teams cannot be
stressed enough. When it is overlooked by investors, it often comes back to
haunt them later as the stock price suffers. Usually as a result of a lackluster
expensive acquisition that added too much debt or became dilutive to
earnings.
Capital allocation can often be the difference between a stock plummeting
20% over a few days or rising 100% over a few years. It can be the long-run
determinant of a stock outperforming the 9.1% average annual total return of
the S&P 500 (Bloomberg; last 50 years through 2011 including dividends).
Just as portfolio managers decide which stocks or asset classes to own or sell,
management teams of companies make decisions on how to allocate money.
Proper capital spending aligns the interests of shareholders, whether they are
clients of a firm like Cabot or the owners of the underlying stock shares of
public companies.
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I place tremendous importance on capital allocation because it speaks to the
quality of a management team. This is part of my risk management in stock
selection when deciding whether to buy or pass on an opportunity.
TYPICAL CAPITAL ALLOCATIONS
Compass needles always point north, but that is not helpful if one blindly
follows it in a straight line to only encounter impassable mountain cliffs,
brush wildfires or fast-flowing wide rivers. Not all decisions are created
equally for different industries or different phases of a company’s life cycle
or economic cycle. However, some specific attributes highlighted later on
can mitigate setbacks and mishaps.
Passion and self-interests can impair one’s capacity for suitable decisions.
The most reckless choices made by executives tend to be ones concerning
capital allocation. Biases, egos and the empire-building itch come into play
when top management goes on acquisition or geographic expansion sprees.
On the flip side, constant vigilance coupled with competent leadership is a
winning formula for value-adding capital decisions. Unlike nepotism,
tenure, inevitable time distractions or depleted resources to monitor and fix a
poor allocation choice – which impair progress for their other business units
or adequate funding.
Capital Allocation is defined as businesses (and people) spending their
financial resources on a variety of projects, processes or other usages, by
determining how much and in what manner money should be spent to
produce benefits.
Capital Allocations:
•
Acquisitions: easily the #1 landmine that management teams step on,
especially when the targets they acquire are outside their core
competencies and have inferior profit margins or require substantial
debt issuance to fund the deal. Culture clash, loss of key managers,
weak integration or aggressive prior accounting practices at the
target can derail the stock price. Conversely, there have been some
terrific acquisitions when the buyer capitalizes on negative market
sentiment, avoids a bidding war or gets the target on the cheap due to
some temporary distressed situation (like working capital constraints
or interest coverage issues). Sensible targets even tend to be a
retiring founder who wants their profitable legacy left in good hands.
•
Divestitures: a disposal of an asset or business unit, which can be for
a variety of reasons such as getting rid of a slowing unit or dilutive
margins. Better yet, finding a buyer willing to overpay!
•
Capital Expenditures: such as equipment, new plant, upgrades or
replacement of worn-out items
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•
Research and Development: funding for new products (like pharma
drugs or food), services or software
•
Marketing and Selling: promoting brand awareness, selling channel
support or expansion and reach
•
Geographic Expansion: entrance into or widening of a certain region
or country (emerging markets are very popular the past decade)
•
Entry Into a New Business Line or Service
•
Construction versus Leasing/Renting of an Office, Plant or Store
•
Buybacks of Their Own Stock or Debt: retiring debt after cash
accrued or refinancing it with rates 2-4% lower than prior terms
•
Issuance of Their Own Stock or Debt: typically to pay for an
acquisition, expansion or a special dividend
•
Regular Dividends: issue a recurring dividend or increase current one
•
Special Dividends: one-time and separate from regular dividend – a
bonus to shareholders. They even allows some companies to avoid
starting a regular dividend policy
Most of these are not easy decisions. Their success or failure cannot be
measured over a few months. Many decisions take 6-24 months before a
proper assessment and measurement can be made. Conditions in the
economic environment also play a large role, as does the phase at which a
company is in its life cycle (early, rapid growth, mature, decline).
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QUALITIES AND ATTRIBUTES OF EFFECTIVE CAPITAL
ALLOCATORS
1.
Have a Methodology with Criteria and Metrics: Surprisingly, I have
met two dozen companies during the past decade without specific
financial criteria for major investments. Without stringent hurdles,
you open yourself to nightmares. Measurable objectives such as
Return on Investment (ROI), Payback (months or years), Earnings
Per Share Accretion or improved Return on Assets are critical.
Some strategic acquisitions or expansion are sensible and call for
more leniency for hurdles if truly long-term enhancing.
2.
Free Cash Flow Mindset: To become convinced that an actual
management team is thinking deeply in terms of cash generation is
rarer than you might image. Instead of easily manipulated
accounting earnings, cash flows are what tell the true story over time.
I find that management teams with this mindset, along with properly
aligned incentives with shareholders, tend to create more value.
3.
Not Reliant on Revenue Synergies: Time and time again I hear a
CEO or CFO state that revenue synergies are large and a key reason
for their acquisition announcement. I instantly recall a McKinsey
Quarterly study which I read 6 years ago citing that only 30% of
companies capture their original revenue synergies stated and only
60% of companies meet their cost synergies stated at outset.
4.
Avoid Businesses They Do Not Understand: They stay within their
area of expertise and do not get tempted or greedy to enter a “hot
trend or niche” that is non-strategic.
5.
Be Mindful of Debt Situation and Leave Buffer Room: Many
companies have covenants on how much debt they can handle
(typically Net Debt/EBITDA and Interest Coverage). Cash spent on
any purpose is less cash hanging around to service debt and interest
payments. Management teams that leave a buffer or “rainy day
fund” available tend to outperform during a recession or macro
downturn. That is because they can still afford to spend on
Marketing, R&D, hiring top talent, and sensible cheap acquisitions.
EXAMPLES OF POOR CAPITAL ALLOCATION
Subjectivity can cloud one’s mind for proper decision-making. Whatever the
prevailing winds, a management team needs to be efficient and effective in
spending financial resources. Below are a few memorable failures:
•
Expensive and Distracting Mergers: Quaker Oats/Snapple,
AOL/Time Warner, Daimler/Chrysler
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•
Green Mountain Coffee Roasters: deciding to go on a capital
expenditure spree in 2011 & 2012 instead of leasing plants,
especially shortly before their major patent expiration
•
Netflix: deciding to split up its subscription service into 2 confusing
entities in August 2011 while simultaneously raising prices by nearly
60% on its combo offering and by 25% on other plans
•
New Coke launch in 1985 – a poor marketing and branding decision
with inadequate reformulation that cost it significant market share
and alienated loyal customers – but made Pepsi execs happy
•
Sony’s Betamax launch – had the lead on videotape players but did
not do enough research or rushed launch with an inferior product that
could only hold 1 hour of a movie (no one wanted to get up from the
couch to insert another videotape an hour into the movie)
•
Kodak’s refusal to launch digital cameras and properly adapt.
Instead, they allocated cash flow to waning print businesses
•
Apple Newton – too far ahead of its time (i.e. 27 years too early)
compared to their successful iPad launch
•
Countless banking mergers 2006-2009 (combining 2 sick companies
does not heal the patient). Ask Bank of America if they would buy
Countrywide again if they had a time machine!
•
Spinoffs or Divestitures that only needed better resources and
autonomy internally to flourish
•
Geographic entrances or expansion: nearly 33% of all attempts are
exited or failures 2 years later. Companies are better off piloting or
doing joint ventures instead of starting with a full entrance
Plenty of accounting distortions and gimmicks exist to make a company’s
track record look better than it really is for return on investment. Such items
as accelerated revenue recognition, capitalizing leases or Research and
Development, switching inventory valuation methods, releasing reserves,
ignoring/overlooking stock options or compensation incentives as an actual
expense or creating fictional one-time write-offs that really are recurring
every year or two, are all examples of distortions.
What Capital Decisions Do We Face in Our Own Daily Lives?
Any advice or suggestions are provided for informational
purposes only and is not a solicitation to purchase any
investments or services described herein. Please consult
your advisor to determine if an investment strategy is
appropriate for you. Past performance of either the
domestic or international markets or any specific
investments is not predictive of future results nor will
diversification alone protect from loss.
•
Rent versus Home Ownership: home ownership seemed like a nobrainer in 2005 but turned out to be a devastating decision anytime
2003-2008. Yet, renting appears to be the poor choice in late 2012 in
popular economically strong cities like Boston, DC, Dallas
•
Cars: buying a certified used car with low mileage tends to produce a
better return on investment
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Cabot Money Management, Inc. is a
wealth management firm based in Salem,
MA, with additional office space in Boston.
As a firm with nearly 30 years of experience,
Cabot has a national clientele and is a
frequent contributor to CNBC, Bloomberg,
The Wall Street Journal, The New York
Times, and other local, national and
international media. Cabot provides highly
customized global investment management
services coupled with tax, estate and
financial advice for individuals and their
families.
Contact us at (978) 745-9233 or send your
email to info@eCabot.com if you have any
questions regarding this white paper.
•
Credit Cards, Home Equity Loans, Auto Loans: I am always amazed
at how people do not pay down their higher interest-rate card or stop
using that one because of the points or rewards program. Credit card
companies know that customers tend to spend more if their spending
limits are increased. This is a parallel for management teams that
increase their revolving credit facilities – they also become triggerhappy to spend it!
•
College Education: community college, state school or private
•
Luxury Items such as a Second Home, Boat or Plane Ownership,
Condo Timeshares
•
Sports teams trading or drafting players to and from teams
KEY TAKEAWAYS
When it comes to capital allocation, think of Warren Buffett and how he
patiently awaits a fat pitch before swinging. I try to avoid management
teams that step up to home plate to get beamed in the head or only swinging
for the fence. Capital Allocation is unique because it requires avoiding both
financial and operational mismanagement.
The best capital decisions have a high return on investment (cash on cash)
and fuel faster cash flow growth or elongate a company’s growth cycle by a
few extra years. It is difficult to stay constructive on holding a stock if its
management team makes bone-headed decisions. Most stock prices have an
embedded expectation of future cash flow generation potential. Investors
eventually punish a stock price for management’s wasteful spending or pet
projects. To capture upside in a stock over the long term, a successful capital
allocation record with employed criteria are critical components.
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