Leadership is ultimately an exercise in decision making and running a company is no different. CEOs make thousands of decisions over the course of their careers. Some are trivial and some can make or break the future of the company.
Among the myriad of decisions that are made by CEOs, none are more critical than deciding how to invest the resources of the company. William Thorndike said, “Capital allocation is the CEO’s most important job.” Thorndike is the author of The Insiders, the definitive book on capital allocation, so it is likely that he would say this. As investors we entrust CEOs to run the businesses that we own which makes an evaluation of capital allocation decisions critical to the future of our investments.
What is Capital Allocation?
Capital allocation refers to the way that management in a business spend their capital. We can simplify this down to the three avenues for deploying capital:
- The balance sheet
- Investing in the business (internal and external)
- Shareholder distributions
The capital allocation decisions that are made are based on the best utilization of the capital to create value for shareholders – the owners of the company. This is not a static decision, and will vary based on the company, the industry and market conditions.
The Role of the Balance Sheet in Capital Allocation
The flexibility to make capital allocation decisions often comes down to the balance sheet. If there’s a significant amount of debt, it can decrease the flexibility of the company’s options. It could mean that they aren’t able to borrow more money or hampers their flexibility to invest in the business or pay out dividends.
A bad balance sheet also means that a company is more at risk to external events – we saw this during the pandemic, with a prime example being the bankruptcy of Virgin Australia.
Large debt balances can indicate that paying down debt is the right decision. For example, Anheuser-Busch Inbev (NYSE: BUD) took on a significant amount of debt to purchase SABMiller. Our analysts believe this was a good acquisition, but for the near term, the company must focus on paying down this debt as it has significantly hurt their share price.
Another factor to consider is interest rates. Low interest rates may justify more debt, while high interest rates can make debt burdensome.
Investing in Growth
The second capital allocation lever is to invest in the business to drive growth. Evaluating the track record of investing internally means looking at the return that a company is getting from those internal investments—this is where return on invested capital comes in.
Some industries offer more opportunities than others. New companies in expanding industries may misuse capital. Mature companies in stable industries may find more value in returning cash to shareholders.
Returning cash to shareholders can be the best option for mature companies. Poor internal investments or idle balance sheets can destroy value.
Strong Capital Allocation Decisions
Our analysts offer a capital allocation rating ranging from Poor to Exemplary. An example of an Exemplary company is Woolworths (ASX:WOW).
Woolworths’ balance sheet is strong. Financial leverage is minimal with a forward debt/EBITDA average of 1.2. As a defensive retailer, Woolworths performs well in all economic conditions.
Woolworths:
- Leverages scale for cost advantage
- Invests in online channels and new stores
- Maintains a 73% payout ratio
- Effectively divested their retail fuel network, enabling a $1.7 billion share buyback
Lessons from Woolworths include understanding the operating environment and applying multiple capital allocation strategies effectively.
Poor Capital Allocation Choices
AMP (ASX: AMP) is an example of Poor capital allocation. Poor execution and governance have significantly damaged shareholder value.
Issues include:
- Mishandled sexual assault allegations and governance failures
- Poor executive appointments
- The 2011 AXA acquisition – high claims and losses, 700 million shares issued, and shareholder dilution
AMP’s share price fell from over $13 in 2001 to around $1.10 today. This shows the devastating impact of poor capital allocation and leadership.
Conclusion
As investors, we care about future earnings and profits. Capital allocation is a significant determinant of shareholder value. While there's no one-size-fits-all approach, evaluating how companies allocate capital is a critical part of investment analysis.
