Capital Allocation and Compounding Machines

Readers’ Questions

Several readers have struggled with understanding the common success factors of the companies discussed in this post: http://wp.me/p1PgpH-Qw

Any company with exceptional returns has been able to generate returns above it cost of capital while being able to redeploy free cash flow at rates above its cost of capital (marginal returns on capital). See one poster child:WMT_50 Year SRC Chart.

Ok, its easy to look back at successful companies and say wow! But what can we know A priori that can help us in our search than just “good”management, “passion for excellence” and all the other corporate consultant buzzwords?   There may be no common theme between Altria, Aflac, or Danaher or Eaton Vance but we do know that all companies successfully generated above average returns for a long time.  Let’s try to think more deeply and test our assumptions.  The first place to start might be management’s allocation of capital because not all of these companies had barriers to entry (Leucadia comes to mind).

Allocating capital and operating the business are the main jobs of management. The two are intertwined.  Does the company retain its excess capital to reinvest in the same business, make acquisitions, pay a dividend and/or buy back stock (at what price?). There are no simple answers or one size fits all approach. And if it were that easy then there probably wouldn’t be as much opportunity for investors who do find good capital allocators.

The linked papers below will go in depth into the issues and problems around corporate capital allocation.  Take the time to read these because the readings should help you think more intelligently about a crucial aspect of investing–how management teams allocate YOUR capital.

Dividend Policy, Strategy and Analysis

High Dividends Research by Tweedy Browne

Dividends_Beautiful,_and_Sometimes_Dangerous_20111110

Corporate Structure and Stock Repurchases

Punishment and Prizes

For those who have not worked hard at understanding corporate finance and the implications of capital allocation while investing then you face a flogging: http://www.youtube.com/watch?v=W1Ipb0WpoGI

For those who feel they are experts at capital allocation then you win first place and a date with Sasha: http://www.youtube.com/watch?v=6a7Kf1e5lEI

Keep learning!

12 responses to “Capital Allocation and Compounding Machines

  1. As luck would have it, we have the opportunity to study Phillip Morris’ just announced $18 billion buyback plan which will be be implemented over the next 3 years.

    • That will be interesting to see – as an investor, I would be interested to see how their decisions change as the price of the stock moves around. If the price of the stock moves up 50%, do they continue buying it? If so, it may caution me.

  2. Dear Ankit:
    As you can see in this report, companies increase their buy backs as their stock price RISES. Not good.

    go to http://www.lmcm.com and click on Mouboussin’s research on share repurchases (on the right side of site.)

    • Just read it – thanks for pointing me there. I was looking at Dell today and just can’t comprehend the situation. On one hand, I see that Michael Dell owns a chunk of the company. On the other, their executives have lots of options to incent them to “create value.”

      They were buying back stock at 2-3 times the current price and have continued to do so as it fell, but this week they announced a dividend with the stock at a price far lower than where they began buybacks in significant volume.

      Unless they were just doing back of the napkin calculations that assumed every business line would work out great (“Well, our cell phones just need to grab 1% market share to make us $xB in income, and this line will make 4% on revenue, and so on”), I have a hard time seeing how those valuations could have been justified in their mind. All I can see is that they thought, “Well, if the Street values us at 16x EPS, then our stock options will only be worth more if we get that EPS up as fast as possible.”

      It moved just the exact opposite way and today, at a historically low price, they announce a dividend and have stated repurchases will continue. I’m sure they had some studies showing that dividends would attract institutional investors who will pay a higher price and so they figured it was better to pay a little out than try to reach for “100% purity at any cost.” Fine. I get that, but isn’t this the time for them to just keep quiet and buy back stock with both fists, if it is indeed undervalued?

      These guys work really hard to earn their net income, then pay taxes on it, and then send some back to shareholders. If they bought stock back at 3x the current price, then the same stock they felt was overvalued is sitting at a 66% discount today and they should want to buy back more.

      It just drives me crazy to understand it, but I guess I’m inclined to give them the benefit of doubt that they’ve thought it through, especially because Michael Dell has so much money on the line.

      • Dear Ankit Gupta:

        Dell is a case study in a business that is losing its competitive advantage (lower cost) compared to competitors. Go to Harvard Case STudy Library and buy/read several case studies on Dell. Everyone copied their low cost model but the market shifted from PC to tablets. Will Dell get a competitive advantage in their new markets–I am highly skeptical. Don’t be fooled by their high “FCF”. Dell is a perceived Franchise but it isn’t.

        Also M. Dell has a lot of stock but he gets issued absurd amounts of stock. I have been short Dell for about 6 years (not very much now–but still short) Yes, Dell will rally here and there but paying above reproduction value is a fool’s game. Their capital allocation is horrific. What does Southeastern see? Why did I short–even I could see that their advantage would go away.

        Also, don’t confuse increasing net income with increasing wealth. Marty Whitman has several discussions on this.

        • Southeastern publicly discusses that most of Dell’s business isn’t tied to a competitive advantage stemming from the consumer markets. Most of their profitable operations are in the business to business area and that is a key piece to their valuations. Chanos discussed the lack of tablets and shift to tablet computing in general as a reason to short Dell, and I think I disagree with him on that little piece of his public statements, because consumer computing is only a portion of what they do. The real profits are coming from the ongoing services and service business that they conduct rather than hardware sales.

          Creating a tablet isn’t *that* tough anyway… Apple iOS tablet? Yeah, that’s tough. But Microsoft is going to have more in the tablet OS space and Android is already there, so it appears to be largely a challenge of putting lego’s together unless they try to design proprietary/customized hardware.

          • In general, I think the focus is on the enterprise hardware/software sales combination. Dell is doing things similar to IBM, but catered to smaller businesses than the Fortune 100 clients. There might be short term pain, but it at least appears that the situation isn’t as dire as the markets make them out to be.

          • Sorry for so many messages here. Regarding the competitive advantage by going direct to consumer… I’ve seen discussion on how others can do it now, however I don’t think they can emulate it (at least within the US) to the level that Dell can, because Dell isn’t in retail as deeply as everyone else. For others to leave retail would be a big change. As it turns out, as the size of the products decreases, this advantage shrinks, and so it was more applicable to desktops where the retail storage requirements were greater. I think this moat is going away over time, but to the extent that desktop sales with a tower continue, Dell will have a small but decreasing advantage. I think the money is on their services and sales channel in an area where there aren’t too many others competing – smaller businesses than the fortune 100.

          • Dear Ankit: That may be true but if market expectations are too high, you lose as an investor. If the investor believes Dell’s returns will stay stable or INCREASE but they stay stable and DECREASE you lose. I will stay short.

            However, rather than my opinion, the best thing to do is see what is happening to Dell’s Marginal return on capital. What is the industry maps of the various business that they are in or wish to enter. Where are the barriers to entry and are the barriers getting strong or weaker. If you can’t find any competitive advantage then GROWTH in sales and earnings has NO VALUE.

            I encourage you to do a case that that we can post. And if my analysis is wrong, I certainly want to change.

            Best,

            John

  3. Hi John,
    It will be interesting to see when they make the first purchase. It would be weird if they did it now after the run up since 2009.
    To be fair, they did say “over the next 3 years”.

    • I am speaking about shaare buybacks in general. If you note the general action of management, buyback slowed in 2008/2009 then increased as prices rose. But what counts is if companies purchase BELOW intrinsic value over time.

      The master of this was Henry Singleton of Teledyne–read the case study if you haven’t. Type in Teledyne in the search box on this blog.

      Thanks

      • I just wanted to add 1 item here – for insurers, something to consider is that there are often 2 things at play.

        1) If their investments have fallen, and this is the source of funds with which they would repurchase stock, the decline in their investments may be such that a share repurchase doesn’t offer the same attractiveness because they would have to be sold at below intrinsic value prices.

        2) Depending on their capacity, lines of business, and so on, the insurers may be weighing the odds of a competitor going bust. In the E&S markets, AIG’s P&C insurance group’s (now Chartis) outcome wasn’t certain. It was in much better shape than the other activities at AIG and so if they had left the market overnight, things would have quickly hardened and many would have been better off holding the capital instead of repurchasing shares.

        Basically… I do like looking at what management did as prices fell especially around May of 2009, but there might be some instances where I can “forgive” them for not repurchasing shares, like those 2 items. Obviously requires discretion and careful study, but I caught myself wanting to rule out one or two until I looked more deeply into it.

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