In my investing journey, I've been learning and thinking more and more about good capital allocation. From my own standpoint, I am my own capital allocator with my portfolio. I have to determine where I'm going to put my capital. There are so many places to put it, but as Li Lu so elegantly pointed out in his great paper on value investing in China, the clear winner stocks, which is where I choose to spend most of my time researching.
As an investor, we are looking to invest in companies that are being led by great capital allocators. Look at Warren Buffett at Berkshire, or Prem Watsa of Fairfax. These guys are the cream of the crop of capital allocation. They have long histories of success in their respective companies, and if you invested in them early, you'd be very happy with your investment now.
The more and more I take in about investing, the more I am realizing how important investing in a good capital allocator is. Sure, some businesses can do well regardless of who is leading it, but if I had the choice of a great business with a mediocre capital allocator or a great business with a great capital allocator, I don't think anyone would choose the former!
So I wanted to try and distill what makes a good capital allocator? I like to think of the CEOs and CFO's of the companies I own and look at their decision-making and really try to grasp onto what they are doing and how it's affecting the company. I want to research other good capital allocators in companies I don't own so when their companies become attractively priced, or they move to a different company, I can have them on my watchlist to pounce on good opportunities.
The main points I've come up with in my research are:
- Does the CEO have a good-sized equity stake in the company? Did they purchase any of the stock themselves or is it stock-based compensation?
- Are they focused on short or long-term growth?
- What has the CEO done to provide value creation in the past and present?
- What smart capital allocation strategies have they done in the past and present and what was the outcome to the companies' economics? **Note how I used company economics and not share price, there is a difference here that should be expounded on**
- How does the CEO interact with analysts?
- What is the CEO doing with excess cash? If they have high retained earnings, are they actually putting it to good use?
- Have they done stock repurchases, or hinted at doing it in the future? Did they make these repurchases for the sake of doing it, or did they do it when the price was right?
- In contrast to the above, what decision did they make when their stock price was overvalued?
- Once you have some quantitative and qualitative metrics of what makes a good leader, you can invert. Look at the qualities of poor managers, and avoid those ones at all cost.
Let's discuss each of these points in a little more detail.
Is the CEO Owner Oriented?
Phil Town has talked extensively about the difference between an owner-oriented CEO and a "hired gun" type CEO. The owner-oriented CEO treats the business like he owns it and makes decisions that any owner would be proud of. They see the business as part of their character and wouldn't do anything to tarnish that character. They tend to be frugal as they understand large expenses are coming out of the pocket of the company and aren't a simple luxury of being in a specific position.
The hired gun CEO is the opposite of the above. They usually are hired and don't have the history and affection for the business that an owner-oriented CEO would. They treat the business as their personal bank account, spending on luxurious things like private jets and lavish parties, all on the dime of the business. They are the leaders of the company, the history of the company doesn't have any bearing on how they perceive the company. They have a board of directors who work for them rather than working for the shareholders.
You generally want an owner-oriented CEO. There are plenty of great CEOs who aren't the company founders, but you need to research what they've done in the past to see if they qualify as owner-oriented CEO.
Is the CEO short or long-term focused?
You'll often see CEOs who constantly talk about how well they've done in the last quarter, or how well they think the next quarter will be. They make decisions based on the next few quarters, looking to impress analysts, rather than actually making their business better in the long run. It can be hard to know if a CEO is long-term focused, as they refrain from making large predictions into the future, as they can get in trouble from the SEC and their own shareholders if they are wrong.
I think listening to their tone, and their general outlook when they discuss their company is very powerful. If your CEO is constantly mentioning all sorts of capital decisions that are happening now to lay the groundwork for the future, you know you have a long-term focused CEO who is making decisions that will bear fruit multiple years down the road, and not just next quarter.
You can also look at a CEO's history to see what work they've done on companies from the past. If they have a long history of being short-term focused, then you may want to stay away. If they have been with one company for 20 years and have grown with it, then you might be onto something.
How has the CEO created value in the past?
What decisions have the CEO done in the past to make the businesses they run better? Here is a shortlist of options they could've done to improve the economics of their business:
- Has the share price of their company gone up while they're in charge?
- Have they done intelligent share buy-backs?
- Have they issued equity when their company was underpriced or overpriced?
- When they have had excess cash, what do they do with it?
- If they are an acquirer, how have their acquired business turned out in relation to what they paid for them?
- Does the CEO make an exorbitant amount of money? Do they get bonuses when the company is doing poorly?
You could make an even more exhaustive list, but I think these are some of the most important things. We will cover many of these in the points below!
What is the CEO's capital allocation history?
When we look at a CEO's capital allocation skills, we want to see a good ROE or ROIC. A general rule I like is if a company issues equity, use ROE, if they use more debt than equity, use ROIC. You'll see the differences once you start playing with the numbers.
The point is, if the CEO is buying capital, they need to show that they can actually produce income with the capital they buy. If they use capital and it ends up producing no returns then you have a problem. It's up to you to decide if the problem is a secular reason, or if it has to do with a one-off event that is causing some short-term headwinds.
A lot of value can be found in companies that have a long history of high ROIC's, then an even happens (such as Covid) which greatly reduces their income, resulting in lower returns. The market may think these numbers are a sign of things to come or realize they are unlikely to change in the next 90 days and the share price will suffer. Looking for these when you're a long-term focused investor is smart!
What is the CEO's relationship with analysts?
This is an interesting point that isn't discussed much but was really hammered home to me when reading The Outsiders. Many of these great CEOs did not have much of a relationship at all with analysts. They simply performed and let the underlying economics of their business speak for itself.
I think this is a double-edged sword. Not talking to analysts can be a good thing, if you just don't care to spread the word of your company. I think this is smart for some companies, especially if the share price is cheap and you want to repurchase shares. Have as little exposure as possible at these times is very smart.
On the other hand, if you have a company that is heavily undervalued and don't have the funds for share repurchases, then getting your companies to name out there is smart. Two great examples of this currently are Micron and Bausch Health.
Micron is always on fireside chats and all sorts of conferences to help spread the word of the coming boom in semis. Their stock is trading a very low forward PE, and the incoming press is good for the share price. Bausch Health is a company where the sum of its parts is greater than the whole. Unfortunately because of poor prior management, they are digging themselves out of a massive debt hole. So they are at all sorts of conferences discussing the spin-off of their crown jewel and getting more attention on the aesthetic parts of the business instead of focusing on warts.
What does the CEO do with excess cash?
When a company has excess cash there are a few main things they can do with it:
- Retain their earnings for growing the company
- Pay dividends
- Repurchase shares
Your CEO must determine the best use of this cash. Here some big points to consider on each subject above.
Retained earnings are a great indicator of a good capital allocator. If a CEO can retain earnings, and improve their share price with those earnings, then by all means they should continue growing the company. In The Buffett Way by Hagstrom, he shares Buffets outlook on retained earnings: “‘Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated into at least a dollar of market value.'” For more info on this, read what the Oracle himself has to say on the matter on P2 of this annual report.
This metric shows you how talented management is at utilizing retained earnings and creating value for their company in terms of share price appreciation.
Let's go over an example. Let's use BABA as an example. As of December 31st of 2020, retained earnings were: $86.005B. The initial market cap was 191.66B, and it is now 605.73B. This is a growth of over 400B. BABA has reinvested 86B to increase their market cap by 400B. That's what you call good business economics!
Dividends are often misunderstood. I think it depends on your financial situation whether you should invest in dividend-paying companies or not. The reason for this is simple. If a company pays dividends, it reduces the companies ability to re-invest in itself. If a business can't re-invest in itself, it means it's no longer growing much. This is fine if you need dividend income, but if you are looking for companies that are going to grow, generally you want companies that can invest that money for you and get a better return.
For instance, if a company is only growing at 5% per year, then paying a dividend is probably smart. Why? Because they feel their owners, can probably use that cash and invest in something that makes more than 5%. On the other hand, if a company is growing at 30%, then why give cash to the owners? It's unlikely they'll be able to make 30% on any cash they distribute, so the company may as well keep it for themselves and grow it for their shareholders.
One thing to note on dividends is to look at the payout ratio. Some companies have over 100% dividend payout ratios. A dividend payout ratio is simply dividends paid out/net income. So if you pay $150 in dividends on an income of $100, your payout ratio is 150/100 = 150%. Does this make sense? Where can this other money be coming from to keep the dividend so high? Debt. Some companies literally use debt to pay their dividends. It's highly recommended that you stay away from most of these companies.
Repurchasing shares is another excellent way to increase spend excess cash. We will be covering that in more detail below.
When you are evaluating a CEO, look at what they are doing with their cash. If they have high ROIC's, then retaining it is generally the right play. They can invest the money, buy capital, and make good returns on it, which will compound for hopefully a long time. If they can't make a good return on their capital, then distributing it to shareholders or share buybacks is a great decision.
How effective have past share repurchases by the CEO been at increasing shareholder value?
Share repurchases are a hot topic. Many of the public hate that some companies are getting government handouts, then these companies are going ahead and repurchasing shares. Further grief can be found when these companies find themselves in dire financial issues due to having little to no cash on the books. I don't want to get much into this, but if you've heard of share repurchases, you've probably seen this issue and it does have bearing on good capital allocation.
Share repurchases should be made during a very specific time. The time is when the share price of a business is below its intrinsic value. If a company's intrinsic value is 100m, and its current market cap is 50m, this is when you want to see buybacks. Let's say 1 person owns 10 percent of 100m shares outstanding of the company. This means they own 100,000,000*.1 = 10,000,000 shares. These shares are valued at 1 dollar each.
Let's say the CEO has 10 million dollars to repurchase shares. They can then use 10 million dollars to cancel (50m market cap - 10 million of share repurchases) 20% of the shares outstanding. This leaves only 80,000,000 shares outstanding. This means our one person who owns 10,000,000 shares went from owning 10% of the company to owning 10m/80m = 12.5%. So this is a very intelligent move.
But let's say the company has the same value of 100m, but the market cap is 150m. They still have 10m to spend on buybacks. They can then cancel 10m of the market cap. But they are only decreasing the shares outstanding by ~7% instead of the 20% above. If the company can re-invest this money and grow at 15%, then they are actually doing a disservice to their shareholders.
So you generally want to see share repurchases being done when a company is below intrinsic value as this maximizes shareholder value!
What smart decision has the CEO made when the share price was intrinsically overvalued?
A good CEO has a few decisions they can make when their share price is high:
Dispositions
Equity Issuance
If a company is overpriced, it probably means they have overpriced areas of their company that the market is valuing too high. A good capital allocator, who maybe thinks a segment of their business is going to lag the business as a whole could create value for their shareholders by selling this segment to the highest bidder. In a hot market like today, if you can get a premium to the value of a segment, that's a smart move.
The other thing you can do when your shares are overvalued is issue equity in exchange for acquiring other companies. Buffett doesn't like to issue equity, one of the few times he did was to purchase General Reinsurance, a decision he later regretted because he diluted shareholders by 22%. He prefers paying cash for companies, a Buffett baseball analogy will suffice:
"For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event -- except when the team must trade a .380 hitter to make the deal.
Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better."
So in general issuing stock is a pretty bad idea, unless you are fleecing the company you are acquiring. You can definitely look at what acquisitions your CEOs have done in the past and evaluate how an acquisition ended up years down the road. For instance, Hideaki Shinohara of Shinoken fame bought Ogawa for ¥2.6 billion cash a few years ago and it now represents ~1.5 lagging 12 months earnings before interest and taxes. A pretty good investment indeed!
Inverted look at how a CEO destroys shareholder value.
Now let's invert and look at how a CEO would destroy shareholder value by having the poor characteristics of what we discussed above:
- The CEO is a hired gun who has a history of trying to increase his salary even in bad times. He doesn't own any shares of the company other than when the company issues him options, which he promptly sells for cash. The company jet? Yea, he uses that as much as possible.
- The CEO is best buds with analysts. He is regularly blowing smoke up his ass, discussing how good the next quarter is looking and how last quarter's blunders were a "short-term" tailwind. They have big plans last year, but after a few months of trying to execute that plan, it fizzles out and is no longer discussed. Don't bother asking where they see the company in the future.
- The crappy CEO will either maintain or destroy value. Let's say he started 5 y6ears ago and is somehow still with the company despite massive underperformance vs comps. The share price has plunged 40%. The few times the share price was past intrinsic value the CEO repurchased shares. He's constantly issuing equity, the share count since he started has gone up by 100%. At the end of each year, where shareholders have suffered, his crony buddies on the board approve him for 20 million dollar bonuses. They keep increasing size each subsequent year even tho the company is headed for Chapter 11.
- The CEO LOVES acquisitions. They are a shiny object that attracts media attention and grabs headlines. They try and make huge acquisitions regularly. When they do, they're always outbidding their competition and ending up paying the highest possible price. After a few years, the acquired company has shown zero revenue and income growth.
- The CEO sometimes pays dividends to shareholders if by some miracle they have spare cash. Or, they have no spare cash, yet want to keep the divvy going, so they borrow cash and use that to keep their dividends artificially high.
- When the market has propped up its share price, the CEO issues stock for his acquisitions. Why not get something from some poor sucker while the stock price is at unsustainable levels? A few years down the road, when the acquisition has failed miserably, shareholders are left scratching their heads wondering why they now own 50% less of the company, that is now worse than when the CEO started?
I'm sure you could find a load more information to analyze managements, but these are things that I think are most important. I know that I need to think more about these things when I'm analyzing potential investments, instead of passing them over. Complete, thoroughness is going to pay in the long run.
Keep Thinking!