What’s interesting about moat is that if a moat needs to be continuously built, it isn’t a moat at all. How do you know if you’re paying up or overpaying for the moat? This time we invert the conundrum of moat to explore the symptoms of false-moat trap.
Proper allocation of capital is an investor’s number one job.” ~ Charlie Munger
“Charlie and I have only two jobs…One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” ~ Warren Buffett
One of the great skills that any investor or businessperson can have is a talent for capital allocation. And when it comes to capital allocation skills, one of the people even supposedly the world’s best capital allocators, Warren Buffett, looks at is Tom Murphy.
“Who’s Tom Murphy?” you may wonder.
Well, I’ll discuss more on my key learnings from Mr. Murphy some other day. But here’s what Buffett once told Lawrence Cunningham, the author of Berkshire Beyond Buffett1 about this man – “Most of what I learned about management and capital allocation, I learned from Murph. I kick myself, because I should have applied it much earlier.”
In fact, Mr. Murphy has been such a great inspiration for Buffett that when you study what the latter has said and written about managing a business, in many cases you are learning indirectly from the former. That is a good thing since Mr. Murphy did not say or write very much in comparison to Buffett. Like many great capital operators (like Henry Singleton) and managers he mostly let his business results speak for themselves, and did not spend any significant time seeking to be noticed by the public.
Along with Buffett himself, Murphy is one of eight CEOs praised in The Outsiders, a cult business classic, which attempts to define what differentiates a small number of leaders who massively outperform the market through their capital allocation skills.
Buffett is quoted in that book as saying that “Tom Murphy and [his long-time business partner] Dan Burke were probably the greatest two-person combination in management that the world has ever seen or maybe ever will see.”
As you can read in the book, the capital allocation formula that Mr. Murphy practiced and what made him so successful, was – focus on industries with attractive economic characteristics, selectively use leverage to buy occasional large properties, improve operations, pay down debt, and repeat.
Anyways, contrast what Buffett says about Mr. Murphy’s capital allocation skills with what he wrote in his 1987 letter3…
“…the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.
In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”) Berkshire, however, has been fortunate. At the companies that are our major non-controlled holdings, capital has generally been well-deployed and, in some cases, brilliantly so.”
What’s about Capital Allocation?
Without doubt, capital allocation is the most fundamental responsibility of a senior management team. Successful capital allocation means converting inputs, including money, things, ideas, and people, into something more valuable than they would be otherwise.
Now, why should value determine whether a management team is living up to its responsibility? There are two reasons.
Companies must compete, and so a company that is allocating its resources wisely will ultimately prevail over a competitor that is allocating its resources foolishly; and
Inputs have an opportunity cost, or the value of the next best alternative…so unless an input is going to its best and highest use, it is underperforming relative to its opportunity cost.
From Henry Singleton, Tom Murphy and Warren Buffett to Ajay Piramal and Jeff Bezos, managers who have created the maximum shareholder value over long periods of time have done it through how they have allocated their company’s capital.
This is unlike most companies and their managers who destroy the earnings that they retain with themselves, over time. After achieving a particular size or social standing, promoters no longer care about maximising returns on capital or growing real wealth. Instead, they get carried away by the idea of growing bigger, faster and thus indulge in making expensive acquisitions, setting up offices and factories around the country and around the world.
They expand the business for the sake of growth, but end up taking on significant debt and risk the long-term well-being of the company and its shareholders. They participate in competitive bids to acquire companies and, often, destroy value in the process. Few companies actually understand how capital grows and how it is compounded.
But then, as great allocators like Murphy tell us – “The goal is not to have the longest train, but to arrive at the station first using the least fuel.”
Most of our time and effort as investors is spent trying to figure out what something is worth in a very short time period. Professionals are consumed by questions such as, “Can a stock be traded for more or less in a few nanoseconds through high frequency trading mechanisms?”, “Are interest rates going to move up or down and what will that mean to this security trading price?”, “Is China going to go down, or Europe or……… and what will that do to stock prices?”, “Will we reduce the fiscal deficit?” and so on and so on and so on.
While those are all important questions, they pale in comparison to the task of finding a manager who can successfully produce earnings from a business, and reinvest/allocate those earnings profitably over long periods of time.
Spending the vast majority of our “investment” time and efforts focused on finding and owning businesses that can reinvest their capital profitably over a long period is the most important investment process that you can practice.
“Long period” is an important term here. Consider what Jeff Bezos says –
If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years.
Note the big idea here – “Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”
Anyways, with these ideas in mind, let me take you deeper into the concept of capital allocation, and showcase a framework for how to think about, how companies generally allocate capital, and how to assess a company’s capital allocation track record, and…
In this first post of this series, let me bring to you the basic framework for capital allocation that’s applicable to all companies across all industries. Of course, what’s right allocation for one business can be wrong for another, and it depends entirely on where the business is in its life cycle.
Also, as Buffett says, “The first law of capital allocation…is that what is smart at one price is dumb at another.”
So, without considering what’s smart capital allocation and what’s not, here is a framework I have created taking lessons from my various notes and readings on this subject.
This contains just the core ideas behind capital allocation, which, by the way, is too vast and dynamic a topic to be covered in a single framework.
The above flowchart showcases the key sources and uses of capital in a business, but here are ten important observations that you can take out from it –
1. Operating cash flow or OCF (internal financing) is one of the key sources of capital for companies. It’s however a direct result of how much return on invested capital or ROIC a company earns. For BSE-200 companies, as a universe, OCF has averaged 21% of total capex plus M&A plus other investments over the past ten years, and just 13% over the past five. In India, debt remains a preferred source of capital for large number of companies, unlike say the US market, where OCF provides 90% of total capital for companies.
2. As far as usage of capital is concerned, the maximum goes towards M&A activities, which are cyclical but the largest usage of capital for companies in general. In case of BSE-200 companies, for instance, investments that include M&A and investment subsidiaries have formed around 45% of sales over the past ten years. You can gauge the cyclicality from the fact that the range of such expenditure has been between 23% and 63% of sales.
3. Capital expenditure or capex is the second highest usage of capital. For BSE-200 companies in India, for instance, capex has averaged around 7% of sales over the past ten years.
4. To ascertain whether capex would create value, you need to look at –
a) Companies that are investing in industries with high ROIC and good growth prospects;
b) Companies that possess some competitive advantages; and
c) Industries that are not cyclical in nature
5. Working capital is another key user of capital, with the averaging around 4.3% of sales for BSE-200 companies over the past decade. Cash conversion cycle (CCC, which measures how fast a company converts cash in hand into even more cash in hand) is a good way to assess a company’s working capital efficiency, simply because lower CCC usually results in better ROICs.
6. R&D in India is generally the smallest uses of capital, though it is a good indicator of long term value creation. Just like advertising expenses, R&D usually builds value over a period of time.
7. As far as dividends as a use of capital is concerned, it is largely stable and resilient to business downturns. It’s generally a matter of prestige for companies to maintain or grow dividends over time.
8. A company’s stage in its lifecycle is what you need to look at whether assessing whether dividends is a good way for it to allocate capital or not. Old, mature companies are more likely to pay dividends than younger companies that need to preserve capital to spend on growth.
9. Consistent dividend, which comes from a company’s OCF, provides a strong signal about the management’s commitment to distribute cash to shareholders, and also of its confidence in future earnings of the business. In case a company is borrowing money and also paying dividends, you may call it a Ponzi scheme.
10. Buybacks are the second main way, after dividends, a company returns cash to shareholders….but buybacks are not used much in India. When looking at buybacks, consider the golden rule – A company should buy back ONLY when its stock is trading below its expected value and when no better investment opportunities are available.
To repeat what I mentioned above, Buffett wrote this in his 1987 letter to investors…
..the heads of many companies are not skilled in capital allocation, and … it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.
Almost three decades later, not much seems to have changed. Most CEOs, even the best performing ones even mention “return on capital” in their communication with shareholders, or when they talk about their business and it future.
Anyways, in the next post of this series on capital allocation, I will write on some barriers to good capital allocation (why most managers don’t get it), and how you can assess a management’s allocation skills. Till then, re-read what you read above…because it’s such an important subject.
- Berkshire Beyond Buffett
- Capital Allocation – Updated (Michael Mauboussin)
- Warren Buffett’s 1987 letter to shareholders