How We Spend Our Money, Part II

Phil Ordway
Apr 23 · 8 min read

If science advances one funeral at a time, how does business advance?[1]

The “funeral by funeral” pace of progress applies business too, but with a wrinkle. Capitalistic systems are famous for their brutal competition, crucibles that ensure only the strongest survive.[2] But the practice of business, distinct from physical sciences governed by absolute laws, is defined by its practitioners. And when those practitioners are a particularly homogeneous group, it shouldn’t be a surprise that progress is slow.

Refer back to Part I of “How We Spend Our Money” and the assertion that we may be living through the end of the Dark Ages of Financial Capital Allocation. The reason may be linked to a type of diversity that is often ignored.

Almost all CEOs and directors would agree that diversity in the business ranks is a good thing, and that point shouldn’t be up for debate from a social or a business perspective. Diversity of opinion is crucial for any effective decision-making body, but that’s not possible when the members of the body have functionally identical backgrounds. Women and minorities have made some progress, but not enough. And when it comes to the age of executives and directors, companies have made almost no changes over the decades. If all decision makers come from the same age cohort, they will miss many things a more age-diverse group would spot easily.

Financial capital decisions offer a good laboratory because the current generation of leaders came of age right as the rules and norms started to change. Most CEOs and board members are 55–70 years old (see below) so they were getting their formative experience and education 30–45 years ago. And back then the world was a different place.

30–45 years ago share repurchases were done mostly by mavericks — they were rare and difficult to execute before a regulatory change in 1982[3] — and many people still associated buybacks with “manipulation.” Dividends, on the other hand, sent a strong signal of stability and “blue chip” quality. Taxes and interest rates were much higher than they are today. The asset-light tech economy was still a pipe dream; executives needed to find enough capital to sustain their growing industrial-age businesses, so decisions to deploy excess capital were rare and given little thought.

But is the original premise correct? Are CEOs and directors homogeneous by age? In a word, yes. Unless there is a 20- or 30-something founder, the CEO is almost always at or beyond middle age. A 2017 Korn Ferry study found that among the top 1,000 U.S. companies by revenue the average age of a C-suite executive was 54, and the average CEO was 58.[4] Spencer Stuart found that, despite the attention-getting spate of tech wunderkind CEOs in their 20s and 30s, most companies have older — and longer-tenured — CEOs than they did a decade or two ago.[5]

Boards are even less age diverse. I took a random sample of 50 companies in the S&P 500 encompassing 564 individual directors — yes, the average and median board size is over 11, which may be a separate problem — and the descriptors of this sample are telling.[6]

In broad terms, large-company boards are big, 75% male, and 80% mid-/late-career (ages 52–72).

· The average (and median) director is 63 years old.

· The youngest director is 32 and the oldest is 94.[7]

· There are four directors under the age of 40 — that’s 0.7% — and there are also four directors over the age of 90.[8]

· There are exactly as many directors over 85 — nine — as there are directors under 45.

· The age distribution is tightly clustered. Half of all directors fall between 58 and 68 years of age, and more than 80% belong to the same generation (ages 52 to 72).

· 135 directors — 24% — were women.

· The average (and median) board had more than 11 directors.

· The average (and median) board had 4.5 committees.

· 15 boards — 30% — had a finance committee.

· 13 boards — 26% — had an executive committee.

Most companies also follow the Delaware-minimum proscription when it comes to committees, and despite having formal responsibility, most companies handle financial capital allocation as a mere subset of their other obligations. “How we spend our money” may be getting ample operational attention, but it’s almost a formality for many boards. Fewer than a third of the companies in the study have a dedicated finance committee, and those responsibilities and qualifications vary widely.

In a broad search using Edgar, Google, Bloomberg, and FactSet, I could only find a handful of public companies that have a capital allocation function at the board level.[9] It should be little wonder that many companies just hide behind the dreaded boilerplate: “A balanced, disciplined approach to capital allocation.”

Consider the counterexamples found in following list of companies.[10] It would be overkill to list each company’s virtues, but suffice it to say that all of them have at least one exemplary practice. They have a clear, effective framework for spending their money wisely; candid stakeholder communications; an investor’s mindset and a focus on opportunity cost; a practice of pre- and post-mortems; robust, often non-traditional management teams and boards; active outreach to attract the “right” stakeholders; an avoidance of quarterly guidance; a decentralized structure; and a willingness to suffer short-term pain for long-term gain.

· Amazon (AMZN)

· AutoNation (AN)

· BNSF[11]

· Brookfield (BAM)

· Cable One (CABO)

· Cimpress (CMPR)

· Constellation Software (CSU-CA)

· Credit Acceptance (CACC)

· Culp (CULP)

· Daily Journal (DJCO)

· Fairfax (FFH-CA)

· Fiat (FCAU)

· Four Corners (FCPT)

· Graham Holdings (GHC)

· Henry Schein (HSIC)

· Judges Scientific (JDG-GB)

· Markel (MKL)

· Morningstar (MORN)

· Murphy USA (MUSA)

· Netflix (NFLX)

· NVR (NVR)

· Phillips 66 (PSX)

· Post Holdings (POST)

· Sherwin Williams (SHW)

· Texas Instruments (TXN)

· WABCO Holdings (WBC)

This list is by no means exhaustive, and all suggestions are welcome.

It would also be interesting to test this list (or a similar list) for evidence of a “high-quality financial-capital-allocation” factor. A simple back-test might be somewhat informative — generic stock repurchase factors are known to have some validity — but a more robust study is beyond the scope of this essay. Stay tuned.

In the meantime, the virtues of the companies on this list should be self-evident and provide worthwhile material for all investors and executives to study. Business leaders can review these companies’ individual practices to pick and choose things that will fit with their organizations. A few brave souls may even rip the Band-Aid off, making the hard decisions that will lead to short-term discomfort and long-term prosperity.

Here are a few broad recommendations that should be palatable to both crowds.

· Create a specific framework for spending money, and remember that money is fungible. One size does not fit all, but a specific process that follows some basic principles can be tailored to each organization.

· Have a mix of generations. Older, younger, and middle-aged decision-makers have different strengths and weaknesses that will yield better results than decisions made by a single generation.

· Set the right benchmark and hurdle rate. Use the company’s incremental ROIC as the opportunity cost by which all projects are measured.

· Give spending decisions the company’s full attention. Attract, retain, and empower the right people to analyze and implement spending decisions.

These examples and recommendations are not perfect by any stretch of the imagination, but the bar is so low that doing just one or two things right is enough to create a meaningful advantage over the competition.

[1] The quip about science is attributed to legendary physicist Max Planck. “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.” Human psychology has proven time and again that people cling to their old ideas, even in the face of contrary evidence.

[2] As an aside, Seth Klarman’s recent speech on the future of capitalism was exceptional. https://www.alumni.hbs.edu/stories/Pages/story-bulletin.aspx?num=6818

[3] https://www.sec.gov/divisions/marketreg/r10b18faq0504.htm

[4] https://www.kornferry.com/press/age-and-tenure-in-the-c-suite-korn-ferry-institute-study-reveals-trends-by-title-and-industry

[5] http://fortune.com/2015/12/13/oldest-ceos-fortune-500/

[6] Granted, 50 companies and 564 directors is not a robust sample, but the numbers did not move much beyond a sample size of 10 companies. All data taken from proxy filings made with the SEC during 2018.

[7] Congratulations to Susan Li of Alaska Airlines and Charlie Munger of Costco.

[8] This is not to say that older directors are a bad idea. Quite the contrary — it is hard to imagine a worse decision than kicking Charlie Munger off a board 20 years ago just because he hit the conventional age limit of 75. As with most things, strict rules such as age limits may come with good intentions but they often have even worse unintended consequences.

[9] I could find only six companies with a capital allocation committee (although I hope I’m missing many more): Jakks Pacific (JAKK); Playa Hotels & Resorts (PLYA); Charles River (CRL); Regency Centers (REG); Carolina Financial (CARO); and, ironically, General Electric (GE) — then-CEO John Flannery announced in November 2017 plans to shrink the board and make an explicit push to improve the allocation of the company’s financial capital. In 2018 Tupperware (TUP) disclosed the “Capital Allocation Sub-Committee, which held one meeting in 2018, [and] was created by the Board in 2018 to review the Company’s capital allocation approach and current and future needs.”

[10] This list is meant to be illustrative only and it is really, really not investment advice. Valuation — among many other crucial factors — is ignored here.

[11] Berkshire Hathaway is intentionally excluded from this list. Warren Buffett is sui generis, and even the mention of his name can cause some mere mortals to lose hope. Focusing on the paragon seems to detract from the overall message and make even incremental progress seem unattainable. But consider instead its subsidiary BNSF and this excellent interview with its outgoing CEO: “The railroads are still investing significant sums, but we’re starting to be goaded into lower capital targets by Wall Street, the sell-side guys. They’re giving railroads kudos for saying, ‘Oh, I can spend capital as a percent of revenue.’ That’s not the best measure. We don’t spend capital as a percent of revenue. We spend capital based on gross ton-miles we haul. Bridges don’t wear out with revenue; they wear out with units and gross ton-miles. So now…some of the railroads are saying: ‘We can get our capital as a percent of revenue down to 15% [or] 13%.’ And yet, railroads are making record profits. And now we’ve also got political shifting of the sands…I think we’re at a tricky time now. The Street…has been extremely aggressive with the publicly traded railroads. They’re saying that less is better. Less capital is better. Fewer market opportunities are better. Fewer unit trains are better. It’s all about lowering the operating ratio. I disagree with almost all of that. I truly believe that every industry, every business, needs growth.”

https://www.railwayage.com/freight/class-i/matt-rose-less-is-not-better

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