A Message for Capital Allocators
A framework for making rational and value added capital allocation decisions for business executives.
“Good capital allocation is basically value investing.”
-Warren Buffett
On the morning of 20th March 2018, Xavier Simonet sits confidently in his chair at Kathmandu’s Christchurch headquarters. And why wouldn’t he be confident. After trebling the profit of luxury handbag designer Radley & Co in his two and a half year stint with the firm, Xavier is now in his third year at the helm of New Zealand outdoor retailer Kathmandu, tasked with turning around the struggled company after a disastrous UK entry attempt and botched hostile takeover. But, this Tuesday morning isn’t like most for the firm. The date marks the release of Kathmandu’s positive half-year financial report for the second half of 2017. Not only this, Xavier is due to announce Kathmandu’s $60 million (USD) acquisition of outdoor footwear supplier Oboz. Importantly, this $60 million is to be funded through a $40 million (USD) share issuance, with the remaining funds coming from new bank debt.
Embedded in Xavier Simonet’s role as CEO, is the responsibility to make capital allocation decisions for the firm, much like he did when Kathmandu agreed to wholly acquire the North American company, Oboz. Yet, capital allocation strategies seems to be largely misguided in aggregate. Despite being an essential tenet of the CEO’s job, capital allocation falls by the wayside in a lot of cases, with many CEO’s abiding by unchanged traditions, and institutional copycat strategies at the expense of the shareholder. This may not be the fault of CEO’s. Investors for years, have lauded their dividend treadmills, even if the dividend payments are counterproductive to the shareholder’s long-term interests. The famous value investor Benjamin Graham even claimed “that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating.” Despite what Benjamin Graham said, optimising one’s capital allocation approach requires more consideration than the consistency of dividends.
A Message to Capital Allocators, is a framework. A framework best understood as a checklist for helping to enact thoughtful, rational capital allocation decisions at the corporate level, all the while following the belief that the purpose of capital allocation is to maximise long-term shareholder value. A Message to Capital Allocators is not a critique, nor a harsh analysis of Kathmandu. Instead, the firm merely sits as an example to help the reader picture the ideas provided within the framework.
The job of the allocator
The capital allocators’ role centres around two essential components: (1) optimising the present profits of the business, and (2) investing (deploying) those profits to optimise future profits. Together, these components guide the allocator in building long-term shareholder value.
To build long-term shareholder value, the capital allocator has a handful of tools at their side, which allow them to deliberately adjust and monitor company metrics, to optimise the firm’s structure and growth opportunities. The discussion of these tools is the basis for this article.
DECISION MAKING & THE ALLOCATOR’S TOOLBOX
“The first law of capital allocation — whether the money is slated for acquisitions or share repurchases — is that what is smart at one price is dumb at another.”
-Michael Mauboussin
In the months leading up to 20th March 2018, Xavier Simonet had a buffet of options to decide from to help him use the company’s capital, before he and the Kathmandu senior management ultimately decided on their acquisition of Oboz. For better, or for worse, the decision announced by Kathmandu on that fateful morning, meant shareholders carried the opportunity cost of all the company’s options that went under invested.
All options considered, Xavier Simonet had the ability to deploy capital by: (1) increasing Kathmandu’s half yearly dividend, (2) repurchasing shares outstanding, (3) paying down company debt, (4) investing in company operations, (5) acquiring another firm, or (6) letting cash accumulate on the balance sheet (though this is more a deferral of options 1–5).
The decision of Xavier Simonet to fund the Oboz acquisition through 2/3 equity and 1/3 debt similarly meant the company forwent the possibility of using internally generated cash to acquire the firm.
In pursuit of understanding the rationale behind the decisions of a the effective capital allocator, and in the hopes of optimising the reader’s capital allocation strategy, we will dissect the investment and funding toolbox of the capital allocator one step at a time.
Decision-making criteria
The effective allocator’s strategy is predicated upon optimising for returns, not (company) size. This imposes a minimum return threshold that the effective allocator must receive from each and every investment. The return threshold is at the discretion of management, but must exceed the firm’s cost of capital. If the allocator’s investment forecast does not exceed their minimum return threshold, then they move methodically along the list from the most promising option for long-term shareholder value (reinvesting in company operations), down to the least attractive option (paying a dividend).
Return benchmark
Where debt has an annual coupon rate, equity shareholders have return expectations that together, impose an annual cost of financing on the firm. This is known as the cost of capital. The cost of capital is also an opportunity cost of investing in the firm, and represents the minimum viable return that the company must achieve in order to create value for its shareholders. Changes in the firm’s capital structure and operations will adjust the risk and thus the cost of capital of the firm. When a firm cannot return the cost of capital, investors will invest in comparable assets with a greater risk adjusted return profile.
Cash flow metrics
Free cash flow to the firm (FCFF) is the cash the owner’s receive after paying all tax, interest, capital expenditures and working capital for the year. While accounting earnings can be manipulated, FCFF is a raw measure of the capital in the hands of the owner, making it the metric of choice for the effective allocator when determining how much cash they have available for investments or distribution.
Importance of tax
As the shareholder ultimately receives the after-tax return in their pocket, the effective allocator optimises their allocation strategy around tax considerations. In many cases, this means deferring tax payments, or minimising accounting earnings to reduce tax bills. Paying annual tax reduces the return from compounding, when compared to deferring tax as far into the future as possible. The tax ‘tool’ is effected in different ways, depending on the tax codes where one operates. However, we can draw some common practices the effective allocator may make, when optimising for tax.
The most relevant taxes include corporate tax, capital gains tax, and personal tax rates. In cases where personal tax exceeds capital gains tax, then it becomes more appropriate to abstain from paying dividends entirely, since its more tax efficient to create homemade dividends by selling shares. In New Zealand, where dividends are offset by imputation credits that allow dividends to be taxed once at the personal income rate (as opposed to twice: company and personal rate), dividends become increasingly attractive as a way of returning money to shareholders.
(1) Reinvest in company operations
Sellers frequently have the advantage in pricing transactions due to the information edge they have over buyers. This one tenet can be useful for explaining why reinvesting in existing operations is the first port of call for the effective allocator. The allocator has pricing, control and information advantages when they invest in their own assets, giving them an edge over external investments.
Reinvestment in operations is however constrained by capacity, where external investments are not. Internal operations eventually produce diminishing returns on invested capital (ROIC) once the investments exceed the capacity the operations, R&D, and other internal investments allow. Capacity will vary from business to business and project to project. A few businesses also possess optionality; the choice to reinvest or remove cash from the company without hurting future profitability. While capacity for reinvestment may be low in businesses with optionality, the cash surplus these businesses generate is readily available for external investments.
(2) Mergers & Acquisitions
While mergers and acquisitions (M&A) are not inherently bad for business, numerous studies that show M&A destroys value for the buyer on aggregate, as companies fail to achieve synergies and overpay for the target company.
By reinforcing strict due diligence protocols, the effective allocator can still use M&A to compliment their investments, especially in cases where the target firm can improve existing operations, or facilitate greater returns over time.
(3) Share Buybacks
There is a common misbelief that buybacks are always value accretive for shareholders, since the reduction in shares outstanding must increase earnings per share (EPS). This is mathematically false. Despite the lack of understanding on the topic, buybacks are still commonplace, with allocators falling into one of three buyback schools of thought: (A) regular buyers, (B) impure motives, and (C) intrinsic value.
Regular buyers will periodically repurchase small portions of their outstanding shares to offset share issuances or management options and are indifferent to the price they pay. Their logic follows the thought that buybacks are done to supplement dividend issuances, and allow the firm to maintain a steady number of outstanding shares.
Impure motive buybacks are done by self-serving managers, who reduce the shares outstanding to meet EPS targets, or buy their personal shares. These managers should be rigorously avoided.
Intrinsic value allocators recognise that value is only added when buybacks are done when the share price is below the company’s intrinsic value, and will buyback shares aggressively when it happens, to reward long-term shareholders.
The effective allocator strives to be in the intrinsic value camp, and maintains stringent controls around buybacks to avoid mismanagement and misallocation of capital. Control over one’s allocation strategy first and foremost requires constant monitoring and review of the company’s intrinsic value — commonly calculated using a discount cash flow (DCF) calculation. Buybacks ought only to be made when: (1) potential internal and external investments do not meet and exceed return expectations, (2) the price of the company’s shares are lower than the intrinsic worth of the business, and (3) buying back company shares exceeds the risk-adjusted return expectations the company has set.
While buybacks are commonly thought of as a public company tool, allocators within private companies are also able to use buybacks. Private allocators have the added benefit of providing liquidity to those who want/need it, allowing them to manage disharmony in their investor base.
(4) Paying down debt
Reducing leverage, or paying down debt can be an attractive alternative for allocators in a handful of cases. Though, this applies less to firm’s that aim to maintain a specific leverage ratio, and more to the opportunistic allocator, who manipulates the company’s financial structure to optimise the long-term shareholder value.
In situations where the cost of debt exceeds the expected return on investments, it becomes advisable for the allocator to reduce the firm’s outstanding debt. Reducing debt thus becomes a greater source of risk adjusted return than adding additional projects. If the firm relies on debt to maintain a lower cost of capital, then paying down debt will not be advisable. Allocator’s should tweak this to their situation.
(5) Dividends
For the effective allocator, the payment of dividends is the last resort if prospective investments and buybacks not yield the minimum required return. Even so, stockpiling cash for future use may be more attractive if the allocator can reasonably expect investment yields to rise in the short-term.
If stockpiling cash doesn’t appear attractive, then the allocator may consider paying a one-time special dividend as opposed to beginning regular dividend payments. In this case, the allocator should take care to ensure tax rates are favourable to do so. If income tax exceeds capital gains tax, then it may not be worth paying the dividend as shareholders dependent on cash flow could be better served by selling shares to create “artificial dividends.”
The generic rut of paying periodic dividends is not a strategy particularly attractive to the effective allocator. Consistent payments (1) signal the firm has no use for its free cash flow, and (2) are often hard stop once shareholder expectations for them mounts. While some shareholders may raise concerns about the need for cash flow from their investments, the effective allocator can assure them, they are able to generate cash flows by selling shares.
THE BUYBACK MYTH
“We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardise a company’s ability to generate sustainable long-term returns,”
-Michael Mauboussin
The buyback myth suggests that buying back shares is EPS accretive in all cases, and was referenced earlier with the concluding remark that it is mathematically false. To improve the allocator’s understanding of the situation, one section is dedicated specifically to the mechanics and math behind buybacks.
Mechanics
During a buyback the company uses cash from the balance sheet to purchase outstanding shares from departing investors, thereby reducing the total shares outstanding. The corresponding accounting transaction is a decrease in cash, and an increase in treasury stock (i.e. a reduction in equity).
The shareholder value effect
In cases where the firm pays in excess of the intrinsic value, departing shareholders are rewarded at the expense of the remaining shareholders, and vice versa. Thus, the effect buybacks have on the remaining shareholders is a function of the price paid to acquire company stock.
The following example helps to illustrate this phenomenon. Say there are three business partners, who each own one $100 share of a business worth $300. If one business partner wishes to leave, and the other two agree to buy his share at $110, then the seller gains $10 ($110 proceeds less $100 value per share), while the remaining shareholders lose $5 ($95 continuing value less $100 initial value per share).
Conversely, if the selling partner is bought out for $90, then they lose $10 ($90 proceeds less $100 value), and the remaining shareholders profit an additional $5 per share ($105 continuing value less $100 initial value).
The EPS effect
Earnings per share are affected in a similar fashion to shareholder value, as EPS too, are a function of the price paid for the stock plus the foregone after-tax interest income that the cash would have generated sitting in short-term deposits. When the earnings yield (the inverse price to earnings ratio, E/P) exceeds the after tax interest rate on cash, then buybacks improve the EPS of the firm.
For example, if the earnings yield= 5% (a P/E ratio of 20) and the after-tax return on deposits = 4%, then buying back shares improves EPS since you’re giving up a 4% return (per share) in favour of a 5% return (per share), assuming earnings remain consistent. Though similar, the EPS effect is distinct from the shareholder value effect. The effective allocator will first and foremost seek to maximise long-term shareholder value, before considering the EPS effect.
The fact that buybacks can be more attractive than alternative uses of capital goes against the common perception, that management's role is to grow the business. Buybacks do however, have their place in the capital allocators tool box. The effective allocator must be freed from previous notions about their role, and recognise when buybacks can be value accretive to their firms, and when to leave the tool in the toolbox.
CLOSING WORDS
Over the course of A Message to Capital Allocators we’ve looked at what it takes to be an effective capital allocator, and the tools allocators have at their disposal. Effective allocators are disciplined people. They methodise their work to enable more rational decision making, by adopting a framework that is consulted each time an allocation decision comes to hand. And, while the tools and rationale of the allocator are described within the framework provided by A Message to Capital Allocators, there is still ample work that needs to be done by the allocator.
Primary to the framework is an understanding of the allocators own business. The allocator ought to understand their cost of capital, an approximate fair value (intrinsic value) of their firm, and a minimum return threshold for their investments. It is only once they understand their own firm, that they can consult the capital allocation framework, and start their journey to becoming an effective capital allocator.
