Invest in What’s in Front of you: Capital Allocation
Management’s ability to allocate capital productively is
probably the most underrated subject in all of investing. It is management's most important function. Capital allocation is what the management team does with the free cash flow the business generates. If it is invested efficiently the return on invested capital will over time, stay up in the mid teens or even higher. If management is fulfilling this responsibility a dollar invested in the business will be worth more than a dollar invested in the market. This means that the present value of the long term cash flow from an investment exceeds its initial cost. The proper goal of capital allocation is to build long-term value per share.
A company can choose to allocate capital in the following ways...capital expenditures for growth, (research and development, mergers and acquisitions and advertising and promotion) or they can distribute cash to the shareholders through dividends and share buybacks.
The best way to determine if managers are good at allocating capital is to review the results of their past decisions. The best capital allocators are good and patient stewards of the shareholder's assets and often own shares in the company aligning themselves with their shareholders. They think and act like long term owners of the business. They gear both their strategic and tactical decisions toward maximizing the long-term intrinsic value of the business, even if it means forgoing lucrative short-term financial rewards or incurring the displeasure of the short-term-orientated analysts on wall street. It takes strong leadership to sacrifice near-term earning to make prudent investments that will enhance the company's long-term competitive position. In contrast, a management team that obsesses over quarterly earnings probably has something other than enhancing long-term shareholder value in mind, they are more likely to be interested on hitting their short-term numbers that have been written into the options they hold. Always check the proxy statement to see if the options held by management reward short-term incentives rather than the long-term.
I'll be writing about free cash flow, return on invested capital and capital allocation in future posts as I think they are the three most important things in investing. And remember invest with what is in front of you and don't try to predict anything. Concentrate on your process and the outcome will look after itself.
A company can choose to allocate capital in the following ways...capital expenditures for growth, (research and development, mergers and acquisitions and advertising and promotion) or they can distribute cash to the shareholders through dividends and share buybacks.
The best way to determine if managers are good at allocating capital is to review the results of their past decisions. The best capital allocators are good and patient stewards of the shareholder's assets and often own shares in the company aligning themselves with their shareholders. They think and act like long term owners of the business. They gear both their strategic and tactical decisions toward maximizing the long-term intrinsic value of the business, even if it means forgoing lucrative short-term financial rewards or incurring the displeasure of the short-term-orientated analysts on wall street. It takes strong leadership to sacrifice near-term earning to make prudent investments that will enhance the company's long-term competitive position. In contrast, a management team that obsesses over quarterly earnings probably has something other than enhancing long-term shareholder value in mind, they are more likely to be interested on hitting their short-term numbers that have been written into the options they hold. Always check the proxy statement to see if the options held by management reward short-term incentives rather than the long-term.
I'll be writing about free cash flow, return on invested capital and capital allocation in future posts as I think they are the three most important things in investing. And remember invest with what is in front of you and don't try to predict anything. Concentrate on your process and the outcome will look after itself.
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