How We Spend Our Money

Business is amazing.

No, this is not a sappy paean to capitalism. Capitalism is great too, and it’s probably in need of some defending these days, but this essay is about business and how we spend our money.

Business — a level down from capitalism — happens when people come together in commercial activity as a means of livelihood. (Emphasis on people, activity, and livelihood.)

Business matters to everyone. Good business is a thing of beauty, and it goes well beyond the cliché of “creating good jobs.” It gives purpose and meaning while raising the standard of living for all of us. Good business is an engine of human progress.

But nothing worthwhile is easy, and business is not a one-way street. When business goes sour it creates misery, and it can ruin individual lives and great nations.

What distinguishes a good, productive, effective business from a bad one? One litmus test is “how a company spends its money.”

A non-specific test of “how” money is spent is going to open a can of unmeasurable worms, and that’s OK. Quantification is important, but distinctions are often required in zones of imprecision and uncertainty. When a business is providing a valuable service or product, treating its employees and customers the right way, saving everyone time and money…well, you know it when you see it.

Call it the Chairman Stewart test.

“Good” companies are wise and judicious in their spending. They invest in their people, putting more than the minimum required amount of capital into their salaries, benefits, and training. Good companies pursue continuous improvement; they make mistakes, but they correct them and move forward. They understand scarcity and avoid waste. Good companies create virtuous circles and feedback loops that offer one appetizing decision after another.

“Bad” companies are stupid and sloppy with their money. They try to cut corners. Some lie, cheat or steal, but many are just lazy, arrogant or greedy. Every decision is torture, a choice between bad and worse.

The glass is half-full, though, because the good news is…really good. The cycle of fear and greed remains undefeated, but stupidity and sheer ignorance are on the retreat. We should be in awe of the achievements of the business community, and even business antagonists would have to admit that American companies are more successful now than ever before. [1]

Better does not mean perfect, but better does mean smarter and more productive. Wastefulness is a sin, and companies that endure are good at eliminating waste. Most companies today are just more efficient — more effective in spending their money — than they were a decade or two ago.

Take any business of reasonable means and go back 20 years. Has it gotten better or worse in terms of asset utilization, employee productivity, and supply chain management? For almost all businesses that have survived the last two decades there has been massive improvement in most, if not all, facets. They use less energy, generate less scrap, and turn their assets faster. They embrace technology, using data and software to make better decisions. Is it any wonder that profit margins and returns on capital are higher?

It’s not all good news. There is still one area that seems to be making no progress: capital allocation.

It’s a loaded term. What does “capital allocation” even mean? To some it is the narrow practice of paying dividends and repurchasing stock, maybe with some acquisitions sprinkled in. To others it is an abstract, academic study of financial choice and scare resources. The best definition is often the simplest: capital allocation is how we spend our money.

There does need to be a distinction between operating and financial capital allocation. As noted, the operating results speak for themselves. Most businesses have improved the way they spend their money…except when it comes to financial decisions. Dividends, share repurchases, acquisitions, and balance sheets in general get short shrift when it comes to the logic and rigor of managerial decision making.

This could also be the single greatest opportunity in business today. When an idea makes sense but very few people are doing it, there is an advantage to gain.

In an ongoing survey of S&P 500 companies, I’ve pulled up the 2018 SEC filings and investor-relations documents for 50 individual entities.[2] I searched every word of the usual source materials (annual reports, proxy statements, investor relations presentations) to try to identify the company’s framework for how it spends money. Of those 50 companies, I found three that offer what I consider to be a rational explanation for their financial capital allocation. Three.

Many companies have figured out that they need to say certain things to toe the line. Priority #1 on the capital allocation boilerplate is “reinvesting in our business.” This is an easy one because it sounds good. Executives also have an endless list of internal projects, and it doesn’t hurt that evaluating such spending is difficult.

Priorities two through five are paying a dividend, pursuing acquisitions, repurchasing shares, and paying down debt. The order varies, but the options are almost never weighed against each other. Numbers are hard to find. Opportunity cost as a forcing mechanism is a foreign concept.

We don’t need to look any further for evidence of trouble than the absurd campaigns being waged by politicians to legislate — even to abolish — the practice of share repurchases.

In the quagmire of this debate we’ve lost sight of the fact that cash is fungible. A dollar is a dollar…except in the financial realm where mental accounting takes hold and certain dollars become funny money.

Dividends have long been a sacred cow, the all-American method for “returning cash to shareholders” and “providing a yield” to “widows and orphans.” Ignore the foregone flexibility and the tax effects; this is about signaling value![3]

Share buybacks, meanwhile, are manipulations meant to “prop up the stock,” goose earnings per share, or — in circular logic that delights the stockbrokers — to offset dilution from issuing shares.

Acquisitions are heroic acts of expansion. Cash and stock are paid to the seller with little regard to the exchange of value. It’s fine to use stock as a currency for acquisitions or compensation; just don’t use cash to buy any of that stock, even if it would make a great investment.

It’s absurd, but all hope is not lost. It took until 1934 to enact basic antifraud provisions, until 2000 to require “fair disclosure,” and until 2019 (!!!) to require a balance sheet representation of operating leases. Progress may be slow, but it’s never stopped.

Over the next decade or two the companies who survive and thrive may look back at this period as the Dark Ages of capital allocation. Sooner or later, more companies will follow the “good” ones up the ladder and treat every dollar as precious. It will take effort and a willingness to change, but the opportunity is massive, and it isn’t going away.

Part II will include my running list of companies that embrace these ideas in practice and a look at whether such companies make for superior investment ideas. Part II will also include a study of board composition and the role directors can play, along with a suggested roadmap for improving the quality of the shareholder base.

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[1] Success here is referring only to outright operating achievements, not the broader societal questions about tax policy, redistribution, capital versus labor, etc.

[2] No, 50 is not a robust sample size. I’m hoping to get through all 500 companies eventually, but for now I would note that the numbers have not moved much as the sample increased from five to 10 to 50. I’ll report back as the sample gets to 100 and (hopefully) to 500.

[3] And never mind that they’re paid in cash but often set as a percentage of non-cash net income. The logical fallacy only gets worse when dividends are set to yield a certain percentage on the market price.

This has been prepared solely for informational purposes. Information herein is not intended to be complete, and such information is qualified in its entirety. This is not an offering or the solicitation of an offer to purchase an interest in any fund, and it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security. Nothing herein should be construed as investment advice, an opinion regarding the appropriateness or suitability of any investment, on an investment recommendation.

Reliable methods were used to obtain information for this presentation, but the information herein cannot be guaranteed for accuracy or reliability and may be out of date or inaccurate.