Intangible Assets and Capital Allocation

Intangible Assets and Capital Allocation

Capital expenditures are the amount of  money a company invests into its operations to sustain and grow its business. It can be divided into two separate areas.

Maintenance expenditures are made to maintain the company’s current operations. They are the ordinary operating expenses a company inccurs to sustain its business. They tend to be fairly predictable in nature.

Growth expenditures are not necessary to the current operation of the company but are made to help grow the business in the future. (read intangible assets). Growth Capex then, is the deployment of capital for the purposes of generating organic growth. It is discretionary spending that will demonstrate senior management's ability to invest for the future growth of the business.

Since it can be difficult to breakdown a companies capital expenditures, Its often best to just focus on the way senior management are allocating their discretionary capital.

Management is usually thinking strategically when they make investing decisions involving their advertising and marketing budgets thus increasing the companies scope and influence in their industry. Research and development spending often mean sacrificing the street's quarterly earning targets in return for increased revenue growth in the future. Putting money aside for major merger and acquisitions targets can alter the strategic direction of a firm and enhance investor return in the long run. Share repurchase and dividend decisions again involve thinking in terms of years instead of months (quarterly earnings). Good luck finding any of these intangible assets on the balance sheet.

Capital spending in R&D as a percentage of sales, is increasing every year reflecting the shift in the underlying economy. M&A is the largest use of capital period. This isn't monopoly money we're talking about. The capital allocation skills of senior management is crucial to the long term success of the firm.

The capital allocation ability of management can be further observed by reading the bios of senior management. How have they handled managing investments in the past?  Effective capital allocation involves a different skill set than what is required from operating the company on day to day basis. If management is allocating capital effectively they will be incentivized to own significant portions of their own companies stock. Check the proxy statement. Incentives should be built into the option packages that reward long term performing metrics.

Invest in What’s in Front of you: Capital Allocation

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.  

Invest in What’s in Front of you: Important Metrics

Invest in What’s in Front of you: Important Metrics

As a follow up to my previous post I want to say that I try to invest in what’s in front of me. When I wrote about “the marginal utility of information” awhile ago I listed seven things I look at when I’m investigating a company. Four of the items were financial metrics (revenue, free cash flow, return on invested capital and operating margin) while the other three were about placing those numbers in the specific context of the companies business model, the industry structure the company operates in as well as the capital allocation ability of its management. All of this information is available in the companies annual report. The Morningstar website is a good source of this information as well, especially for the financial numbers of a company.

Let's break down the financial metrics one at a time. One thing I should mention. You should always look at the numbers over a period of years. This is referred to as trend analysis. You want the numbers to steadily increase over time and if they don't you want to read about the companies operating history to find out why? You may even have to refer to previous annual reports...sorry.

Revenue represents the cash and promises to pay from customers for either services provided or goods delivered over the past year or quarter. It indicates how much business the company is actually doing. You want to see revenues grow over time as this is the engine for the company to grow and prosper as an ongoing business.

Free cash flow is what is left over after the company has paid all it's bill and expenses. They can raise the dividend, pay down debt, make acquisitions, buy back shares, invest in research and development and/or hire new and skilled employees. It is the ability of a company to self-fund making them less reliant on debt and raising additional equity. It makes them more self reliant. If the corporation's ongoing operations are consuming more cash  than they produce it makes them more vulnerable to their creditors and places them at a competitive disadvantage to other companies in their industry.

Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's  return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.

Operating Margin reflects how well a company can control its costs. the higher the margins, the better the cost containment and the higher the profits will be. It indicates how well a company is running its entire business from an operational standpoint.

Taken together theses metrics will indicate which companies are operating more efficiently for the benefit of their shareholders. The CFOs of these corporations will have the financial flexibility to build the company over time by increasing dividends, investing in R&D (constant innovation helps keep them ahead of their rivals) and make strategic mergers and acquisitions (helping the company to grow its market share and pricing power).

As everybody has access to these numbers you will often find the stocks of these companies priced to perfection. Sometimes its worth investing in them anyway but it often makes more sense to wait for a decline in the entire market. The forced selling that occurs during that time can put these stocks temporarily on sale for the value investor to take advantage of. Another investing opportunity can occur  when a good company misses it quarterly numbers causing its stock price to be punished and driven down. A small cap company can sometimes have these good metrics and be overlooked just because of it's size offering the investor another chance to buy an under valued asset.

In my next post I will finish up with the three remaining items that place the financial metrics of a company within the context of a companies business model etc.....whew.