In his latest paper titled – Capital Allocation – Results, Analysis, and Assessment, Michael Mauboussin discusses five principles of good capital allocation that can be used as a benchmark to assess management. Here’s an excerpt from the paper:
1. Zero-based capital allocation. Two empirical observations from the prior discussion are relevant here.
First, the vast majority of companies are below the threshold of optimal capital allocation among divisions, which means that some divisions get too much investment and others too little. Second, CFOs are by nature conservative. This aversion to change can put companies out of step in a dynamic world.
The zero-based approach asks the question, “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”. The answer is based on the future and does not rule out reducing net investment when appropriate.
2. Fund strategies, not projects. Capital allocation should support a company’s strategic goals. But that’s not what usually happens. Small investment decisions are usually made within a business unit, medium decisions go to unit managers, and large decisions go to the CEO or board of directors. These are processes to control how money is spent but can fail to put decisions into a broader context.
Capital allocation should start with an assessment and approval of strategies and then determine which projects support the strategies. This distinction is commonly overlooked. There can be projects that pass a rate-of-return test within a strategy that fails. There can also be projects that fail the rate-of-return test that support a winning strategy.
3. No capital rationing, but earn sufficient returns on the capital you use. Within most mature companies the practical attitude is that capital is “scarce but free.” Scarce because the amount of capital available to reinvest in the business is perceived to be constrained by the cash flow the business generates and the company’s payout commitments. Free because business leaders sometimes fail to associate an opportunity cost with the cash that the business generates internally. This is consistent with the conservatism and sticky decision-making processes that CFOs exhibit.
4. Zero tolerance for bad growth. An investment, whether made by a business or a money manager, will succeed only with some probability. Companies that aspire to grow will sometimes allocate capital to investments that do not pay off. New businesses and products fail at a high rate. For example, Amazon, a multinational technology company known for its e-commerce and cloud computing operations, has a long list of failed initiatives. The point is that companies should not remain wedded to a strategy or business initiative that has no prospects to create value. Doing so drains human and financial resources.
5. Know the value of assets and be ready to take action to create value. Great capital allocators always have a sense of the difference between price and value in all of their businesses. And, as important, they are willing to act to build value when those gaps become large enough to overcome frictions such as taxes and fees.
You can read the entire paper here:
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