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!

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