We’ve just been re-reading Michael Mauboussin’s great paper on capital allocation titled – Capital Allocation Evidence, Analytical Methods, and Assessment Guidance. At the end of the document Mauboussin provides his five principles of good capital allocation and his conclusions. Here’s an excerpt from the paper:
Five Principles of Capital Allocation.
In their book, The Value Imperative, James McTaggart, Peter Kontes, and Michael Mankins describe four principles of resource allocation that apply readily to our discussion about capital allocation. We added one to expand the list to five and believe that these principles are a sound benchmark that you can use to measure management’s mindset regarding their capital allocation practices.
1. Zero-based capital allocation. Companies generally think about capital allocation on an incremental basis. For example, a study of more than 1,600 U.S. companies by McKinsey found that there was a 0.92 correlation between how much capital a business unit received in one year and the next. For one third of the companies, that correlation was 0.99. In other words, inertia appears to play a large role in capital allocation.
The proper approach is zero-based, which simply asks, “What is the right amount of capital (and the right number of people) to have in this business in order to support the strategy that will create the most wealth?” There is no reference to how much the company has already invested in the business, only how much should be invested.
Research by McKinsey suggests that those companies that showed a zero-based allocation mindset, and hence were the most proactive in reallocating resources, delivered higher TSRs than the companies that took more of an incremental approach. Further, academic research shows that those companies that are good at internal capital allocation tend to be good at external allocation as well.
2. Fund strategies, not projects. The idea here is that capital allocation is not about assessing and approving projects, but rather assessing and approving strategies and determining the projects that support the strategies. Practitioners and academics sometimes fail to make this vital distinction. There can be value-creating projects within a failed strategy, and value-destroying projects within a solid strategy.
Another reason to be cautious about a project approach is that it is easy to game the system. It is common for companies to have thresholds for project approval. For instance, a plant manager can approve small projects, business unit heads larger ones, the CEO bigger ones still, and the board of directors the largest investments. But at each level, analysts can manipulate the numbers to look good.
One of the aspects of the institutional imperative, as Buffett describes it, is, “Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.”
The key to this principle is recognizing that a business strategy is a bundle of projects and that the value of the bundle is what matters. The CEO and board must evaluate alternative strategies and consider the financial prospects of each.
3. No capital rationing. The attitude at many companies, which the results of surveys support, is that capital is “scarce but free.” The sense is that the business generates a limited amount of capital which makes it “scarce,” but since it comes from within it is “free.”
The primary source of capital for companies in the U.S. is the cash they generate. The patterns of spending on the various uses of capital indicate the attitude of managements. Capital expenditures, R&D, and dividends receive priority, and M&A and share buybacks are considered when economic results are good. Internal capital allocation tends to be very stable from year to year, and inertia plays a large role.
Business units may jockey for more capital but, as we have seen, the changes in year-to-year allocation tend to be modest. These observations are consistent with the “scarce but free” mindset.
A better mindset is that capital is plentiful but expensive. There are two sources of capital that companies can tap beyond the cash generated internally. The first is redeploying capital from businesses that do not earn sufficient returns. Management can execute this inside the company or sell the underperforming businesses and redeploy the proceeds. The second is the capital markets. When executives have value creating strategies that need capital, the markets are there to fund them in all but the most challenging environments.
The notion that internally generated capital is free is also problematic. Thoughtful capital allocators recognize that all capital has an opportunity cost, whether the source is internal or external. As a consequence, managers should explicitly account for the cost of capital in all capital allocation decisions.
Too frequently, companies select actions that add to earnings or earnings per share without properly reckoning for value.
The limiting resource for many companies is not access to capital but rather access to talent. Finding executives with the proper skills for success, including an aptitude for allocating capital, is not easy. This is a valid challenge but relates to recruiting and development, not access to capital.
4. Zero tolerance for bad growth. Companies that wish to grow will inevitably make investments that do not pay off. The failure rate of new businesses and new products is high. Seeing an investment flop is no sin; indeed it is essential to the process of creating value. What is a sin is remaining committed to a strategy that has no prospects to create value, hence draining human and financial resources.
Executives who follow this principle invest in innovation but are ruthless in cutting losses when they see that a strategy is unlikely to pay off. Many companies have the opportunity to create substantial value by exiting businesses where they have no advantage. This reduces cross-subsidization within the organization and allows for the best managers to work for the businesses that create the most value.
5. Know the value of assets, and be ready to take action to create value. Intelligent capital allocation is similar to managing a portfolio of stocks in that it is very useful to have a sense of the difference, if any, between the value and price of each asset. This includes the value of the company and its stock price. Naturally, such analysis must include considerations such as taxes.
With a ready sense of value and price, management should be prepared to take action to create value. Sometimes that means acquiring, other times that means divesting, and frequently there are no clear gaps between value and price. As we have seen, managers tend to prefer to buy than to sell, even though the empirical record shows quite clearly that sellers fare better than buyers, on average.
As we mentioned in the introduction, the answer to most capital allocation questions is, “It depends.” Managers who adhere to this final principle understand when it makes sense to act on behalf of long-term shareholders.
Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage behaviors that are not in the best interests of long-term shareholders. We believe that the goal of capital allocation is to build long-term value per share.
In this report, we examined the sources and uses of capital. We found that U.S. corporations fund most of their investments internally and that M&A and capital expenditures are the largest uses of capital for operations. We then examined seven capital allocation alternatives, noting what the actual spending has been, how to think about that alternative analytically, what the academic research says, and the near-term outlook.
Finally, we set out a framework to assess the capital allocation practices of a management team. This framework includes examining past behavior, calculating return on invested capital, weighing incentives, and considering the five principles of thoughtful capital allocation.
You can read the entire paper here – Michael Mauboussin | Capital Allocation Evidence, Analytical Methods, and Assessment Guidance.
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