Checklist Series, Part 4: Capital Allocation
Follow the money!
Last year, Ricky made $200,000. He paid $50,000 in income tax. He paid $50,000 to run his household. With $100k left to spend, Ricky faced some “capital allocation” decisions.
This is his “free cash flow.” And how did Ricky decide to allocate his FCF?
He contributed $25k to his retirement accounts. This will earn him a return on his capital. This is productive capital allocation.
He directed $25k towards paying down his mortgage. Reducing debt is another way one can direct their income. This is a wise capital allocation decision.
He spent $25k on a family vacation. Although a current expense that doesn’t pay off financially, the expense allowed him to form stronger bonds and family memories which will surely pay off in the future. This is a reasonable capital allocation decision.
He paid $25k to trade in his year-old car for a newer model. He just decided that he didn’t like the particular shade of gray of his old car, and wanted a new, more current shade of gray. Not a great use of funds, but I guess it meant a lot to Ricky.
Show me your bank statement, I’ll tell you your values
How an individual spends their money tells you about the things they value. What can we infer about Ricky?
You will note that Ricky did not donate to charity or pay for a golf membership.
He did, however, invest quite a bit in a splashy family vacation (he either loves his family or is fishing for Instagram likes).
He is aggressively paying down his debt and saving for retirement, which tells you he is thinking about the future.
And he’s either a big car nut or just someone who obsesses over shades of gray paint.
You can tell a lot by just following the money!
Following the money in business
As Mitt Romney would remind us, Corporations are people! And just like people, their spending reflects their values.
After paying for all necessary capital and expense items to maintain current capacity, where do the profits flow?
Does the company invest in growth (expanding productive capacity)? If so, what is the payoff on these investments? What is it expected to be in the future, and is this justified by past experience?
Does the company make acquisitions? Every manager wants to rule over a growing empire. It means more money and resources for them. But that doesn’t necessarily mean that more profit finds its way to the shareholders.
Does the company pay dividends? If so, is the commitment to dividends hampering the company’s ability to grow, or to invest to defend it’s current market position? Dividends can impose spending discipline on managers, but they can also be a mature company’s downfall if management’s primary goal becomes appeasing income-oriented shareholders.
Does the company buy back shares? This is good! Less shares equals a larger percentage of the pie for every remaining shareholder. It’s nice to see a company buy back shares, but one must be careful of the tendency to buy back shares at high prices, and to pause buybacks when markets decline (this usually happens concurrently with a decline in FCF, so buybacks can be pro-cyclical, which is not good).
What I’m trying to get at here is that it’s not enough to say “I like a company that pays dividends” or “I like a company that buys back shares.” The money flows give us a synopsis, but we must dig deeper to understand the whole story.
Capital allocation tells a story
You can listen to a management team spout jargon every quarter… or you can just evaluate the evidence. Over the years, every public company leaves a trail of numbers that tell the story of how effective they are at allocating capital.
A pattern of making shitty acquisitions, underinvesting in growth, overpaying dividends, or buying back shares at price peaks becomes readily apparent over time.
Don’t just tell me that a management team is “good.” What does the quantitative evidence say about them?
Ultimately, when I buy a stock, I am hiring the management team to allocate capital on my behalf. The evidence tells us whether they have done a good job. It is often (but not always) reflected in the stock price.
Will they be good stewards of our capital? It’s impossible to tell for sure. But the best guess is based on the evidence of past experience. Studying a company’s capital allocation isn’t just a number-crunching exercise, it’s a peek into how owner returns are prioritized. Follow the money. It never lies.