Earnings season is aptly named. When companies report quarterly results, the corresponding headlines are mostly about net income. You have to scroll down in any given news item to even find out what sales were. Yet just as important to shareholders—if not more so—is what a corporation does with its cash once it’s made it. While it may not get as much ink, this process known as capital allocation goes a long way to determining what future earnings headlines will say and where a company’s stock price will be. It’s especially important today because U.S. companies have unprecedented amounts of cash on their balance sheets.
Amazingly, though, CEOs tend not to be particularly skilled in capital allocation. Most earn their positions by excelling in other areas, such as marketing, engineering, production or administration. But once in charge, they quickly realize that allocation is their primary task. “[It’s] a critical job that they may have never tackled and that is not easily mastered,” said the master of capital allocation himself, Warren Buffett, chairman and CEO of Berkshire Hathaway, in his 1987 letter to shareholders. “To stretch the point,” Buffett continued, “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.”
Michael Mauboussin, Credit Suisse’s Head of Global Financial Strategies, recently completed an exhaustive study of the different options CEOs have for capital allocation as well as the best ways to evaluate their performance—the results of which he published in an August report entitled “Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance.”
One of the more telling findings? Corporate executives like to do deals more than they like to invest in the companies they already own. Mergers and acquisitions have been the primary use of capital since 1980, and remained so in 2013: U.S. companies spent $950 billion, or 8.6 percent of total sales, on M&A last year. The popularity of M&A, mind you, is cyclical in nature. Last year’s portion allocated to M&A was just over half that of 2006 (16.1 percent) and less than a third of 1998 (29.4 percent), both years of stronger economic growth.
Capital expenditures are the second-most popular use of capital, totaling $707 billion last year. They also tend to be steadier over time, ranging from 5% to 10% of sales. Next come stock buybacks, followed by issuing dividends, research and development, and investments in day-to-day operations.
When evaluating a company’s prospects, says Mauboussin, it’s important to understand both its stated plans for capital allocation as well as its performance at doing so in the past, as measured by return on invested capital. It’s also useful to determine whether a company’s approach to corporate governance and compensation will help motivate management to make the right decisions about creating value for shareholders. Senior executives, for example, should be compensated with stock options indexed to the overall market or a peer group of companies, whereas executives who run operating units should be paid for exceeding long-term goals.
Mauboussin concludes that the best managers adhere to five main principles of capital allocation, four of which come from “The Value Imperative,” a book by management consultants James McTaggart, Peter Kontes and Michael Mankins. And smart investors should favor their stocks as well. The first: Companies should employ a so-called “zero-based” mindset with the goal of avoiding the inertia of merely repeating past strategies. Firms that aim to create the most wealth regardless of past decisions have delivered higher total shareholder returns. Second, companies should fund overarching strategies that include multiple projects, rather than focusing on specific projects. Executives who employ the latter approach are prone to manipulating the numbers to make them look good, Mauboussin says.
The third principle has to do with company mentality. While many executives regard capital as “scarce but free,” Mauboussin says it’s better to look at capital as “plentiful but expensive.” This adjustment in mindset reminds execs that even though the majority of U.S. companies generate much of their capital internally, they can also obtain financing from capital markets and redeploy capital from underperforming businesses. Capital isn’t free and allocation decisions do have an opportunity cost. Fourth, firms should have zero tolerance for businesses and products that underperform, and be quick to exit those strategies that provide no advantage. Finally, executives should act like investors, because ultimately, that’s what they are. The most effective managers approach their companies’ assets as they would a portfolio of stocks. “With a ready sense of value and price,” Mauboussin says, “management should be prepared to take action to create value.”