Capital allocation is simply the act of deploying and reinvesting cash resources to grow the value of a corporation. For a public company, there are only five basic levers in the toolbox: investment in organic growth, acquisitions, debt reduction, issuing dividends, and share buybacks. A gross oversimplification would be to liken it to a piano with only five keys. The CEO must hit the correct notes, with the right amount of force, at the right time.
William Thorndike’s seminal book, The Outsiders, garnered intense interest from the investment community around the importance of capital allocation. Eight CEOs from different industries were selected and chronicled for their unconventional methods in steering the progress of their respective companies. The key similarity between these leaders was their discipline in pursuing growth in per-share terms, and shaping their capital allocation practices around that discipline. Accordingly, investors enjoyed outsized returns over long periods under each of the CEOs.
One critical takeaway from the book is that the ability to assess a management team’s capital allocation skills is of paramount importance in evaluating any investment opportunity (assuming the investor is a long-term, passive holder). It may not be enough to correctly identify a business’s competitive advantages (i.e. moats) and pay the right price for the stock. If the captain steering the ship sub-optimally reinvests earnings into unsuccessful projects, overpays for acquisitions, or fails to consider that repurchasing the company’s own stock is a compelling option when the shares are significantly undervalued, the path of one’s fortune in the investment will invariably suffer.
Capital Allocation History – A Predictive Attribute?
Having stated all of the above, there is one observation I would like to expand on: a CEO’s record of capital allocation can be a predictive attribute. This presupposes that a study of history can provide insights that help forecast the future, or alternatively that past achievers are likely to continue achieving. One example of a tried and true capital allocator is John Malone of Liberty Media. An investment in Liberty Media in 2006 would have grown eight-fold or at a compound annual return of approximately 30 percent. Without further knowledge, one may be under the impression that such results can only be attributable to luck. In actual fact, Malone’s track record and decision-making as a public company CEO could have been observed over his 26 year reign at Tele-Communications Inc. (TCI). From his inception at TCI in 1973, one dollar invested grew more than 900-fold by 1999 (which happens to also work out to a 30 percent compound annual return).
Do I expect such returns going forward through investment in Malone-controlled companies, of which there are several? Definitely not. This is just a prime example of how consistent success in creating shareholder value is linkable to a verifiable history of following a distinct process of capital allocation. It involves a playbook of tax-efficient maneuvers to build per-share value and return capital to shareholders, including share repurchases, spin-offs, and making horizontal acquisitions with strict valuation criteria. Still sprightly at the age of 74, Malone is aggressively following the same playbook. I hope to benefit from his work for at least several more years.
Despite Malone’s success and appearances on the front page of newspapers, he is still a relative unknown as far as mainstream business celebrities are concerned. When I bring up the name, I’m amazed how many investment professionals have no idea who he is. The truth is I did not even know who Malone was until five years ago.
The identification of “Outsider” type CEOs is a core part of my job. I believe that eight out of sixteen companies in the Starvine strategy are operated by such individuals, while another four qualify as having good capital allocation policies but are “not quite there”. The management teams I select may not be as good as John Malone on average (except for the Malone companies in the portfolio), but their track records in generating shareholder returns are indisputable. With the knowledge that the intrinsic value per-share of my investments is growing, I sleep well, even when the market doesn’t immediately agree with my decisions. There remain several companies I dream of owning on my watch-list that are run by stellar capital allocators, but the issue is buying in at favorable prices.
In investing parlance, the practice of “jockeying” can be defined as identifying a manager (CEO, chairman and/or other key decision maker) and then becoming a beneficiary of her talents by way of investing in the common shares of the company that she operates. The obvious problem with having your investment thesis reside in one individual’s ability is key man risk. Similar to a heart surgeon with a great twenty year performance record, is the valuable track record invalidated once a new physician takes the helm? And so it is important, in my opinion, to have other pillars supporting the thesis – most notably valuation and business quality.
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