The Importance of Investing in Companies That Make Good Capital Allocation Decisions

Capital allocation is one of the most important decisions a company’s leaders have to make. Good capital allocation will enable the company to grow profits and maximise shareholder returns.

In this article, I will share what are some common uses of capital and how I assess whether management has made good capital allocation decisions. 

The different uses of capital

I will start of by describing some of the ways that companies can make use of their financial resources.

1. Reinvesting for organic growth

First, companies can invest their capital to expand the business. This can take multiple forms. For instance, a restaurant chain can spend money opening new stores, while a glove manufacturer may spend cash increasing its annual production capacity. Companies can also spend on research and development for new products or improving an existing product.

A company should, however, only spend on organic growth when there are opportunities to expand its business at good rates of return.

2. Acquisitions and mergers

Big companies with substantial financial strength might decide to acquire a smaller company. An acquisition can help a company by (1) removing a competitor, (2) gaining intellectual property and technology, (3) achieving vertical integration, or (4) increasing its market share and presence. 

Ultimately, acquisitions should lead to long-term financial gain for the company and shareholders.

3. Pay off debt

Another way that a company can use its financial resources is to pay down existing debt. This is most effective when interest rates on its debt are high and paying off the debt provides a decent rate of savings.

This is true for a company that has taken on a lot of debt to grow and needs to reduce its debt burden to keep its cost of capital low. Reducing overly high leverage may also be necessary for a company to survive an economic crisis.

4. Share buybacks

A company can also choose to buy back its own shares in the open market. This reduces the number of outstanding shares. What this does is that it increases the size of the pie that each shareholder owns. Share buybacks can create shareholder value if the stocks are bought back below the true value of the company.

5. Pay dividends

Lastly, a company may choose to reward shareholders by returning the excess cash it has to shareholders as dividends. A company may also pay a dividend if there’s no other effective way to use its cash; in such an instance, returning cash may be more beneficial for a company’s shareholders than it hoarding cash.

What’s the best way to use its financial resources?

With so many different ways for a company to use cash, how do investors tell if management is making the best use of a company’s resources to maximise shareholder returns?

Unfortunately, there is no one-size-fits-all solution. Shareholders need to assess manager-decisions individually to see if each makes sense. 

That being said, there is one useful metric that investors can use to gauge roughly how well capital has been allocated. That is the return on equity (ROE).

A firm that has been making good capital allocation decisions will be able to maintain a high ROE over the long term. It is also important to see that the company’s shareholder equity is growing, rather than being stagnant (a stagnant shareholder equity implies that a company is simply returning capital to shareholders).

Facebook is an example of a company that has been using its capital effectively to grow its business. The social network’s ROE has grown from 9% in 2015 to 28% in 2018. Furthermore, even after accounting for a US$5 billion fine, Facebook still managed to post a 20% ROE in 2019, demonstrating how efficiently the company is at maximising its resources. Facebook’s high ROE is made even more impressive given that the company has no debt and has not paid a dividend yet.

The best capital allocator

While we are on the subject, I think it is an appropriate time to pay tribute to one of the best capital allocators of all time- Warren Buffett. He has compounded the book value per share of his company, Berkshire Hathaway, at 18.7% per year from 1965 to 2018.

That translates to a 1,099,899% increase in book value per share over a 53-year time frame. 

If you invest in Berkshire, you are not merely investing in a business. You are also banking on one of the best money managers of the past half-century.

Buffett’s success in picking great investments to grow Berkshire’s book value per share has, in turn, led to the company becoming one of the best-performing stocks of the last half-century in the US.

The Good Investors’ conclusion

Too often, investors overlook the importance of companies having good capital allocators at the helm. Unfortunately, Singapore is home to numerous listed companies that seem to consistently make poor capital allocation decisions. 

These decisions have led to poor returns on equity and in turn, stagnant stock prices. It is one of the reasons why some stocks in Singapore trade at seemingly low valuation multiples.

Knowing this, instead of merely focusing on the business, investors should put more emphasis on the manager’s ability and how capital is being allocated in a company.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.