Tag Archives: Capital Allocation

A Reader’s Question on BDX

BDX was first mentioned here:http://wp.me/p1PgpH-1c6

Reader: “Should I buy BDX?”

Reply: The penalty for asking this question-the gauntlet: http://www.youtube.com/watch?v=j1BoNgCR8NU

You would be insulted if I told you whom to marry. Why should investing be any different? You have to think for yourself and apply principles through your own skills, interests and the opportunities in front of you today and (perhaps better) tomorrow.

Don’t end up like this (click on 4o second mark): http://www.youtube.com/watch?v=fPV2L2CGWdQ.


The lesson with BDX is that sometimes the stable, slow growth franchises with management that has the proper capital allocation plan might be able to generate above market returns for those with weak stomachs.

This is not an earth shattering insight. Look below at BDX compared to the S&P 500. Note the much lower price movement down in 2009 and up in 2009-2012. the company’s results are much more stable and better than the average company.

Look at page 3 in the BDX annual report, BD_2011ar. BDX’s stock price returned 3.66% compounded annually over a five-year period from 2006 compared to the S&P 500.  Will that condition continue? No one can know with 100% certainty, but I am betting my largest risk is boredom.

Note this Morningstar Video on market expectations: http://www.morningstar.com/cover/videoCenter.aspx?id=566021

Don’t fear nor expect too much. But if you can find an investment with a larger discount to your estimate of intrinsic value or, more likely, you require higher returns, then avoid BDX.

Asking ME whether YOU should buy is absurd. What YOU need to do is develop an investment process that will help you search, find, value and size the best portfolio for yourself. No one can do it for you. It’s a lonely but interesting road.  Embrace it.

Have a Great Weekend!

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


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!

Corporate Finance: Dividend Policy, Strategy, and Analysis

Earlier we analyzed stock repurchases. http://csinvesting.org/2011/12/08/an-insiders-view-of-capital-allocation-corporate-financie-valuation-case-studies/

Now we beat the subject of dividends to death from all angles especially from an insider’s perspective. Munger, Buffett, Peter Lunch and others discuss dividends http://www.scribd.com/doc/75491721/Dividend-Policy-Strategy-and-Analysis-Value-Vault

Please refer to the charts of the companies mentioned in the document:

WDFC_30 year chart

MO_50 year chart

MRK 50-Yr chart

An Insider’s View of Capital Allocation (Corporate Finance and Valuation Case Studies)

This is includes an important reading found here: http://www.scribd.com/doc/75125923/Capital-Structure-and-Stock-Repurchases-Value-Vault.  Also in the Value Vault.

The 58-page document will start with buy backs from a corporate finance (an insider’s) perspective as described by Mr. Louis Lowenstein, the CEO of Supermarkets General and a Law Professor at Columbia University. Then you will read what the masters, Buffett and Graham had to say on the subject. If, when and how a company buys back its shares says a lot about the business and capital allocation skills of management as the Case Studies of Teledyne Corporation and others will show. You will learn the importance of context and circumstance as the principles of good and bad capital allocation are applied. I hope you find the lessons instructive.

From the introduction

Whether the business is a franchise or not, management has two major jobs: operate the business efficiently which is critical in a non-franchise business since earning the company’s cost of capital is the best outcome and allocating capital effectively. Growth is only profitable in a franchise business, therefore capital allocation is critical for shareholder returns.  If a franchise’s core business is unable to grow, often free cash-flow can’t be redeployed at the same high returns. Capital might need to be returned to shareholders but how much and in what way?

Thinking about what management will do with excess cash is important for your valuation work. Should the excess cash on the balance sheet be discounted heavily because management tends to make poor choices (Greenblatt) or will management buy-in shares, causing the per share value to rise (Duff & Phelps valuation case study)?  You will be given a corporate insider view on these issues.

Share repurchase programs should be an integral part of a company’s capital allocation process, one in which management weighs reinvestment opportunities not only against the alternative of cash dividends but also both of those alternatives against a third alternative, the buyback of common stock. Management has several capital allocation alternatives:

Business Needs: Working capital, Capital expenditures, and Mergers & acquisitions

Return Capital to Shareholders: Dividends, Share buybacks, and Debt repayment

You will gain many insights from your reading.

Supplementary materials from a reader:


Dividends from an investor’s perspective:

More on Capex

Please refer to the prior post. A reader generously sent me this analysis of capex from Sanjay Bakshi (Fundoo Professor). Go to his blog (recommended) http://fundooprofessor.wordpress.com/. The more contributions from readers, the more we will all learn about specific aspects of investing. Thanks!

Capex is given in cash flow statement in the investing section. All capex which is not growth capex must necessarily be maintenance capex. So if you can estimate growth capex, since you know total capex, you can estimate maintenance capex.

Estimating growth capex is sometimes easy because one knows that the company is expanding capacity from x units to y units and its capex plans are known. Even when we don’t know exact capex plans, sometimes to we know how much money is needed in an industry to expand capacity from x to y.

Sometimes we know that almost all the capex is maintenance capex because of competitive pressure. For example what happened in the “Shutdown of textile industry” example, or in the petrol pump example i gave in class. The functional equivalent of these examples are very very common in the business world so one must not take the accountants’ definition of capex as sacrosanct. Accountants don’t like to make estimates. They would rather have something precise even if its wrong. You don’t have to be like them.

When you look at capex numbers you must ask the following questions:

1. Is this expenditure likely to result in a sustainable rise in economic earnings in the future? This is not the same as asking if margins will improve or not – they may improve temporarily but the nature of the business may be such that such gains would be temporary and the cost savings will flow through to the customers instead of the owners. So what may look nice on DCF analysis in an excel model, will not translate into sustainable economic earnings jump. You really need to do this “second step analysis” by asking how much of the benefits of the capex will go to the owners and how much to customers. If the benefits will go to customers, then its NOT Capex for US. For US its and EXPENSE. something we reduce from operating cash flow to arrive at owner earnings.

2. How competitive is this industry? If its extremely competitive or has a lot of foolish competition, then its very likely that capex won’t result in improvement in long-term sustainable earning power. In some businesses, you just can’t be a lot smarter than your dumbest competition. And there is plenty of DUMB competition in some industry. Witness for example, what’s happening in the airline industry in India right now…

3. Is there a lot of inflation? Historical cost accounting and inflation result in under provision of depreciation in accounting books.

4. Are there substantial productivity improvements? Inflationary effects are sometimes offset by productivity improvements. This was discussed in class in detail.

5. Is the plant really old and dilapidated and probably needs replacement? Sometimes there are very old plants chugging along for a long time but ultimately they have to be replaced. The plant may have almost zero value in books because they have already been written off. But they need to be replaced and replacement cost could be a bomb. When you spent that money, should you record it as Capex? Well the accountants will ALWAYS record it as capex. But they key question you have to ask is this: will this money spent improve long term earning power, or only help the company maintain current earning power. If the consequence of the money spent is going to be mere maintenance of earning power, then its NOT CAPEX FOR US. Rather its an EXPENSE.

6. Whats the rate of Obsolescence in this industry? Industries with very high obsolescence rates require frequent capex just to keep up with the competition which keeps on inventing new applications of technology making old technology obsolete. We talked about what happened to Moser Baer and Samtel Color. Well the unfortunate people who invested in those companies learnt the hard way that essentially these companies made NO REAL PROFITS because when you CORRECTLY TREAT the money spent on frequent capex programs of such companies not as CAPEX but and MAINTENANCE CAPEX, you would have figured out that essentially there were NO OWNER EARNINGS. And when there are no owner earnings there is NO VALUE. This is true even though interim value in the market may end up being BILLIONS OF DOLLARS!


Sanjay Bakshi

Analyzing Capital Expenditures-Buffett and Sears Case Study

A reader asks about calculating capital expenditures and Buffett’s owner’s earnings.  I believe only maintenance capex is deducted in determining owner’s earnings not growth capex because maintenance is mandatory while growth capex is discretionary.

This document is 11 pages and it includes other links.


Henry Singleton and Teledyne: A Study in Excellent Capital Allocation

Warren Buffett probably borrowed much from Dr. Henry Singleton while building Berkshire Hathaway from a money losing textile producer to a multi-billion dollar conglomerate.

The article below is an excellent study in what a great capital allocator can accomplish.  I find it ironic that courses in corporate finance at business schools neglect this study.


After ruminating on the above article, think about what you might use in your investing.