Yesterday I attended the Columbia Investment Management Association (CIMA) annual conference, a very well-attended series of panel discussions and Q&A featuring famous value investors. It was off the record, so I can't really blog about it (FYI that was me very timidly asking David Einhorn whether his recently disclosed investment in gold contained a margin of safety).
One question struck me in particular. A young man (I think his first name was Omar) asked one of the panels how, being capital allocators themselves and knowing how hard it is to do well, they evaluate the capital allocation ability of the managements of the companies in which they invest. The panelists, almost all of whom names you would know and who profess to follow in the steps of Graham and Buffett, either misunderstood the question or chose not to answer. Which is a shame, because because the question is all-important. Here is how I would have answered:
That's a great question, Omar. It may be the most important question a modern value investor asks himself. A little arithmetic will illustrate what I mean.
Let's say your goal in life as an investor is to earn 15% per year over the long term, which would be truly outstanding. Broadly speaking your ability to earn this 15% depends on three factors:
a) The size of the discount to intrinsic value at which you're able to purchase an investment.
b) The growth in intrinsic value of your investment during the time you own it (or more strictly speaking, the additional growth in intrinsic value over and above what's already reflected in the price of the investment).
c) The time it takes for either the discount to narrow, or the IV to grow.
Factor c) is hard to predict--that's why you try to invest with a margin of safety. Let's focus then on the first two factors.
Back in the day, when Ben Graham and Walter Schloss were doing their thing, there really was such a thing as a 50-cent dollar. That is, you could look for something worth 100 that was trading for 50, hold it for five years, and earn your annual 15% without any intrinsic value growth whatsover. That is, it's worth 100 today and it will be worth 100 in five years.
At the risk of speaking famous last words, today there are very few true 50-cent dollars available, especially for those managing larger pools of capital. The value investor who wishes to earn his 15% must therefore get some help from the growth in intrinsic value of the companies in which he invests. Suppose you can only find a 67-cent dollar, i.e. something trading at a 1/3 discount. If you hold it for the same five years as above, and you want to earn your 15%, then the discount to IV must go away and the IV must grow at an annual rate of 6%, which, as it happens, is about the rate Corporate America as a whole grows annually on average.
By now you see the relationship: The greater the growth rate of an investment's IV during the time you own it, the less of a discount you have to buy it at in order to earn your required return. If your company is a true cigar butt (e.g. a company with a hidden portfolio of bonds) generating no capital to allocate one way or the other, then you have to find a 50-cent dollar, which is hard work. If your company's ability to allocate capital is just about average, then you only have to find a 67-cent dollar.
But what if your company's ability to allocate capital is above average? What if your company has the ability to grow its IV at 10% annually? In that case, you need only find an 80-cent dollar in order to earn 15% per annum over five years, assuming the discount narrows to zero. An investor who only has to find 80-cent dollars rather than 50-cent dollars has a much easier time of it, especially today.
You may have noticed that I'm equating "the ability to grow intrinsic value" with "the ability to allocate capital." That is on purpose. With very few exceptions, a company's ability to grow its intrinsic value over time is basically equivalent to its ability to allocate capital. The growth in IV tracks closely the amount of capital added to the enterprise over time, which in turn depends on how much capital the enterprise generates, how much it retains, and the return on the capital generated and retained (and reinvested, etc. etc.), which in turn is what we mean by "the ability to allocate capital." I can think of only three exceptions to this rule. One is companies like Ebay that benefit from network effects--once they get their mousetrap going, it grows without their having to add more capital to it. Another is companies like Dell in its heyday, who have such good working capital dynamics that their customers essentially provide the capital needed to grow. The third is companies that can simply raise prices year in and year out, like newspapers once upon a time.
So a company's ability to allocate capital well is hugely important to the modern investor. It's what I meant by the title of this post. We the value investors of today, the owners of passive minority stakes in companies, are essentially hostages of the "real investors" upon whom we depend to earn our required return: those making the capital allocation decisons at the companies themselves.
I have yet to answer the question asked. All I've done is remind everyone how important it is (much more important than the guy who asked about gold's margin of safety). So how then do you evaluate the ability to allocate capital?
The first thing to realize is that the ability of a company to allocate capital well, unfortunately for those who believe in the Great Man theory of business, depends to a great extent on the industry a company is in. With very few exceptions, public companies must reinvest the capital they generate in something similar to what they already do. If you are in the horse and buggy industry, you can be the best CFO in history and it won't matter--your ability to allocate capital won't lead to much growth in intrinsic value. Conversely, if you're in a fast-growing industry with stable market shares, you've got the capital allocation wind at your back (think of Coke in the late 80s). Most companies are somewhere in the middle--figuring out exactly where is part of your job as an investor.
The second thing to realize is that over the course of a few years, a company will make many many capital allocation decisions, all of which are available for you to investigate and judge. You can start in the obvious place, the financing section of the cash flow statement, and evaluate the dividend policy. If the company is earning a lower return on capital than Corporate America as a whole, why isn't its dividend higher? Conversely, if the company has a high return on capital (and on the marginal capital it retains), why does it pay a dividend at all? In the same section, evaluate the share repurchase/issuance decisionmaking: Is the company buying back overvalued stock? Is it issuing undervalued stock?
Then you can move up to the investing section of the cash flow statement. Are capital expenditures leading to gains in IV, or are they simply needed for the company to stay in place? Have the company's acquisitions turned out well? In the operating section you can look at working capital management, an often overlooked consumer of cash for growing companies (and another reason why EBITDA - capex is an incomplete measure of cash flow). Think of a retail location with fast-growing same-store sales. If those sales come at the expense of even faster-growing receivables and inventory, the company may not be deploying capital well.
That's six capital allocation factors so far: dividends, share repurchases, share issuances, capex, acquistions, and working capital. All of them represent capital allocation decisions in management's discretion, and with a little work you can figure out how good these decisions have been.
But don't stop there. Many capital allocation decisions show up on the income statement. When a company like Coke spends heavily on advertising, accounting treats it as an expense but you should really think of it as a kind of capital expenditure, a discretionary decision to allocate capital in a particular way. Soon after Berkshire Hathaway acquired full control of GEICO in 1995, it stepped up spending on advertising. Not only that, but GEICO thinks about the productivity of its paid advertising by also keeping close track of unpaid advertising, i.e. word of mouth referrals and customer retention. A new customer you acquire when their friend tells them about the company is a customer you don't have to acquire yourself. A customer who renews his policy with you because he's happy is a customer you don't have to reacquire through advertising. All of this comes under the heading of "ability to allocate capital." When Goldman Sachs steps up headcount and compensation expense, it's also allocating capital by "investing" in talent. And like all capital allocation decisions, it is subject to evaluation--does it increase the intrinsic value of the company over time or not?
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