Many CEOs have remarkable success in finding ways to generate copious amounts of money, but few of these leaders are skilled at taking that money and using it to its fullest potential. In the business and finance world, we call this Capital Allocation.
Warren Buffett describes this as something essential to the long-term success of a business, but also states that most CEOs are terrible at doing so. Let’s take a look at the role and responsibility of CEOs and the various ways of allocating capital.
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Fiduciary Duty to Shareholders
The CEO of a company has a direct responsibility to make decisions and act on behalf of its shareholders. In terms of making financial decisions for shareholders, this means understanding the money that the company is generating and using that money to benefit the shareholders. The CEO and the CFO have a legal responsibility to perform this task in the best interests of the owners (shareholders) – this is called a fiduciary duty.
In smaller private businesses, the CEO may also be the 100% shareholder of the business. In this case, they may choose to allocate money however they wish. But decisions should always be made by acting in the best interests of the shareholder – even if that owner is you. And in a situation where you are not a 100% owner, the money belongs to the shareholders. Your responsibility is generating a return that meets or exceeds a return that the shareholder could receive elsewhere. Otherwise, the money should be returned to the shareholder – as a dividend, discussed in further detail below. This should be viewed as the default decision.
In most cases, the management team may decide there are better options than returning money back to the shareholders. There are 3 primary options:
- Improve the Balance Sheet
- Expand the business
- Return money to the shareholders
Balance Sheet
The balance sheet is a reference to a company’s assets (cash, property, inventory, equipment), and the liabilities or debt. There are 2 ways to improve the balance sheet.
- Reduce Debts – Many companies have varying debt on the balance sheet – this is typically used as leverage, to grow a company and usually comes in the form of a loan. By holding a loan, there is always some risk involved in the inevitable scenario that the company is not able to make loan payments. This can be especially risky in periods of higher interest rates, such as in current times. So, one way of allocating cash is by paying down loans in larger amounts. In an ideal environment, lenders may even offer a loan buyout term below your interest, and in turn, they use that money to loan out to others at a higher rate.
- Holding more cash – When times are less predictable, a good allocator may decide to hold onto cash and build a defensive war chest. Having access to cash gives more flexibility during uncertain times. After several months, you can always decide to pay down debts, invest back into the company, pay dividends, or continue to hold onto the cash.
Expand the Business
Deciding to expand the business can happen in a multitude of ways. The 3 primary ways are through promoting growth: (i) investing in assets (Capital Expenditures; Growth CapEx), (ii) investing in day-to-day activities (Operational Expenditures; OpEx), and (iii) buying other companies (mergers and acquisitions; M&A).
- Growth CapEx
There are two types of capital expenditures: maintenance, and growth. Maintenance refers to money that is spent on existing assets to keep them functional to preserve existing income. Whereas, growth refers to upgrading, and expanding existing assets to produce additional income – hence the growth.
Examples: new buildings to expand operations, new equipment to produce additional goods, new vehicles to transport or generate an increase in sales.
Growth CapEx is a decision to grow the company. Growing the company, building a larger moat, or simply producing more future profits is the goal. BUT there should be a clear and direct path based on a specific growth trajectory. Remember, the goal is to have a result – that exceeds other investable options.
- Discretionary OpEx
OpEx is similar to CapEx, but the money is spent on different things. OpEx includes things such as marketing, advertising, and R&D. Spending more on any of these items would be with the intent to generate additional money in the future. The return that is expected should be higher, than simply returning money back to shareholders with dividends. For the last 10 years, tech companies have spent a vast amount of money on OpEx namely in R&D. This can become exceedingly expensive when trying to beat competitors to market or developing something completely innovative. These expenses are catching up and beginning to hurt the bottom line of many notable companies, so they are now forced to reduce this expense significantly.
- Mergers & Acquisitions
One of the best ways to bring in a defined growth opportunity (predictable returns) is to purchase or merge with another company. The reason being, is that other companies also have a history of revenue and can be more accurately measured, rather than building it in-house and spending an incredible amount of time and then competing. Most growth-oriented management would rather use M&A simply to reduce risk and have a more predictable outcome.
Return Money to Shareholders
There are two ways to return money to shareholders: dividends & share buybacks.
- Dividends
This is the simplest way to return profits back to shareholders. Management will evaluate the growth strategy and determine a percentage to return to shareholders and a percentage to retain.
For example, if a company generates $100M in profits and pays out $60M in dividends, it has a 40% reinvestment ratio. This amount is usually determined by management and the board of directors. The only time money should NOT be distributed is, if the company believes that holding onto it will provide future returns that are higher than market expectations.
- Share Buybacks
Share buybacks are far more common than dividends. The ideal reason to buy back shares from the market, is that the board determines the price is low and is an effective way to bring value back to shareholders. This simply reduces the overall supply of shares, and in turn, increases the value (supply & demand). As a result, it will also mean that the dividends are distributed to a smaller portion of shares providing a larger dividend per share. This provides a larger upside to a smaller number of shares, which will possibly move the stock price up as well.
Many of the most successful CEOs have used buybacks. In a well-managed company, this can provide tremendous value to the long-term shareholders.
Brilliant Allocator Required for Solid Execution
In most large businesses, you will find a combination of all these factors, and in many cases, it is far more complex. Allocating capital is both an art and a science and requires a brilliant allocator to execute. Aside from allocating money, decisions also must be made to raise money, such as borrowing money, selling additional shares, or a hybrid of both to fund growth. So, it’s not as simple as always earning a profit and then reinvesting.
Sound financial policies should be in place based on the needs, and expectations of the company. These may include optimal debt levels, minimum levels of cash on hand, and expected returns on money reinvested for growth. These numbers help investors and shareholders determine if a company’s expectations are aligned with their own in terms of risk and reward.
Riding Uncertain Times
Financial policies will be constantly changed depending on economic conditions. Interest rates are usually the number one deciding factor. As debt becomes more expensive most companies will reduce risk to a minimal level until the economic environment is more predictable. During these times, investors and shareholders will look for debt reduction, and cash buffers as a security blanket for their investments, rather than projected growth and expansion.
Holding Onto Money
There is also inflation to think about. Money held today is more valuable than money next year. It will certainly be true in longer time frames. So, holding onto money for too long, may also produce less than desirable outcomes for shareholders. Tech giants, such as Google produce huge amounts of cash, which are either being held in cash or reinvested for growth. But holding too much cash for too long may not bode well with investors, as it’s not generating money, but rather losing money.
Controversial CapEx Investments
Then there are controversial CapEx investments made by companies like Meta. Investors trusted that Mark Zuckerberg would continue to be a visionary in the technology space given the fact that Meta generates vast amounts of cash. Most have been willing to take on this risk vs. return profile as of late. Now Zuckerberg has decided to commit to the largest CapEx investments ever to deliver a Metaverse.
How did investors react? Very negatively. In one day alone, investors sold and crashed the stock by 24% because of the decisions to continue this large investment. Zuckerberg disagrees. He has decided to continue building a metaverse. Meta continues to bring in substantial amounts of cash and he believes that this Capital Expenditure will offer investors a great return on their investment. Only time will tell.
Conclusion
Being a proficient savvy capital allocator takes an impeccable amount of skill, talent, and knowledge of markets. As a capital allocator or an investor, it is imperative to understand what it takes to be outstanding. The best allocators will continually focus on driving clear value to shareholders using 3 primary methods: (i) improving the balance sheet, (ii) expanding the business, and (iii) returning money to shareholders. The ways in which doing so are endless, and this is where the true talent comes in. It requires a great amount of skill, creativity, and tenacity to be one of the few masters of capital allocation. By following the strategies of the 3 primary methods, you too can become one of the great master capital allocators over time through careful observation, research, selection, testing and practice over time.