Companies that make good capital allocation decisions compound value over time. A great example is Warren Buffett’s Berkshire Hathaway (NYSE: BRK.B).
Berkshire has only paid a dividend once, in 1967. Since then, it has not paid any dividend to its shareholders, and has reinvested its earnings instead.
From 1965 to 2018, Buffett has expertly grown Berkshire’s book value per share by 18.7% annually. Its share price has mirrored that performance, climbing by 20.5% over the same period – compounded, that’s a gain of 2,472,627%.
It is, therefore, evident that a management team’s ability to make good capital allocation decisions is a key factor in compounding shareholder wealth.
But how can we tell whether a management team can make the right decisions to grow shareholder wealth?
A track record of great capital allocation decisions
The most obvious thing to look at is how effective have management’s capital allocation decisions been in the past?
In Warren Buffett case, it’s easy to tell that his decisions have worked out tremendously well. We can judge the overall quality of his decision-making by the growth of Berkshire’s book value per share. But we can also judge his individual investment decisions. One of the key investments that Buffett makes for Berkshire is the purchase of stocks. For this, we can observe the changes in the price of the stocks from when he bought them to today.
But not all capital allocation decisions are so easily measured. Many decisions that a company’s management team makes are based around future earnings and include investments in intangibles which may not be easily calculated.
Measuring success
To me, a good way to measure whether a company has been allocating capital wisely is through its return on equity. If a company has consistently managed to earn high returns on equity, it shows that the capital allocation decisions have been sound.
The return on equity is calculated by dividing a company’s net profit over its shareholders’ equity. Generally speaking, there are two things that we want to see here. First, the return on equity figure should be consistently high. Second, shareholders’ equity should increase over time.
How to measure the success of private acquisitions?
The success of private acquisitions is difficult to quantify. Companies can make acquisitions for a variety of reasons which will not pay off financially for years, sometimes even decades. Just look at Facebook’s purchase of Whatsapp for example. Facebook paid US$21.8 billion for Whatsapp in 2014 and has yet to really monetise the app.
So instead of looking at the direct financial gain, we could judge acquisitions based on a variety of other factors. Here are some questions you can ask when deciding if an acquisition was prudent:
- Does the acquisition improve the company’s competitive position?
- What reasons were given by management on why the acquisition was made?
- Was the acquisition price in line with other deals made recently?
- What other financial benefits can the acquirer make from the acquisition?
- How was the acquisition funded? If debt was used, how much and would that put the company in a weak financial position?
Investors also need to give an acquisition time to play out. It may be best to only judge whether an acquisition was successful at least two to three years after the acquisition was made.
When should a company pay dividends?
Another critical thing in the evaluation of management’s capital allocation chops is to gauge whether the company is prudently rewarding shareholders through dividends or buybacks.
Not all companies need to reinvest their entire earnings into the business. This may be true if a company has a very mature business and only needs to reinvest a small per cent of its earnings. In such an instance, I prefer to see the company return capital to shareholders either through dividends or share buybacks.
The last thing I want to see is a company hoarding large amounts of cash for no apparent reason. Having a strong balance sheet is very important. But holding too much cash will also be a big drag on the company’s return on equity.
Investors who receive dividends could put the cash to much better use.
Final words
Identifying good capital allocation decisions is important when it comes to our search for companies that can grow shareholder wealth. A company with a great business may still end up squandering its money if its managers are incompetent with capital allocation.
As minority shareholders in public-listed companies, stock market investors need to find companies with managers that they trust can put their capital to good use.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.
