Capital Allocation

One of the most important responsibilities of a company’s management team is capital allocation. The hallmark of an exceptional CEO are the returns generated for the shareholders of that company over the long term.

The book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William N. Thorndike details the wisdom of what makes a successful company, closely evaluating the performance of 8 outstanding companies and their leaders.

The 8 CEOs operated in different industries and markets and the returns made for shareholders over the long term were extraordinary. A common theme emerged – a strong focus on Capital Allocation.

CEOs often come up through the ranks – they are great at knowing what the company needs to do to operate (marketing, engineering, operational knowledge), and they know the company and industry well. However, the capital management allocation piece is often missing as they have not needed to learn it. As Warren Buffet has said,

“Capital allocation is one of the most important tasks of a CEO, yet almost none of the people who rise to be CEOs are trained for it.”

A strong focus on Capital Allocation and build value per share will benefits shareholders over the long-term, however financial markets and media seem to be focused on more short-term measures, such as sales revenue growth or the $ profit growth of the company. Management KPI’s are also typically short-term focused. The above metrics are easy to see, measure and comment on, and therefore become the focus.

Whilst revenue and profit growth can be important achieving those as the expense of wasted or inefficient use of capital is a grave error.

A businesses capital needs to be treated with respect, protected and grown. How capital is allocated will depend on the ever-changing investing and business environment.

Capital can be used to:

  • Expand existing operations
  • Buy a new business
  • Reduce debt
  • Distribute to shareholders (dividends or capital return)
  • Buy back shares in itself

Any of the above will be the right use of capital at different times in the businesses life and where it is in the economic cycle. Being able to use capital in the right way at the right time will make a difference to the long-term returns to shareholders.

Other common themes that emerged from the eight successful CEOs were:

  • Small headquarters with minimal staff
  • Headquarters away from financial centres (avoiding the hubris)
  • Operational control is decentralised
  • General managers given autonomy but not over capital decisions

Analysing management to judge their capital allocation decisions is difficult. It’s often hard to understand the decision-making process of a business. However, closely following a company for a long period of time will allow you to decide if the business is worthy of investment.

If you are in need of investment advice or would like a complimentary consultation, please contact me.

Posted in Business.