The number one job of a CEO managing a company is capital allocation, yet as Warren Buffett points out in his 1987 letter to Berkshire shareholders, this is a skill often lacking:
“The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered”
A huge reason for Buffett’s incredible 50 year record is that the dual role of investor and businessman fed off each other in a virtuous positive feedback loop, where as he improved as one he also became better at the other. Berkshire was a tremendous vehicle in which to channel his capital allocation prowess because it gave him a myriad of options
(a) Spread capital across Berkshire’s various subsidiaries wherever the best opportunities were
(b) Buy entire businesses that were offered to him at an attractive price (e.g Nebraska Furniture Mart, See’s Candy, Scott Fetzer)
(c) Purchase large blocks of stock in businesses through the stock market when the market was giving him an opportunity to do so at a cheap price (Coca Cola, Washington Post, Wells Fargo)
(d) Miscellaneous opportunities: High yield bonds, Arbitrage, commodities (He traded silver at one point), Currency trading etc
In fact, Berkshire has never payed a dividend till date because Buffett has always managed to find a way to utilize his resources to benefit his shareholders, and has had the discipline to simply sit on cash when he hasn’t.
Let’s break the approach down to the core ideas:
(1) “We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.”
In capitalism, value is created when return on capital exceeds cost of capital. On the return side of the equation, Buffett looks to create more than $1 of value for every $1 retained in the business, something he calls his “Retained Earnings” test.
(2) “Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it”
The cost aspect is even more interesting. Neither Buffett nor Munger think in terms of the traditional finance concept of Weighted Cost of Capital. They think in terms of opportunity costs. They are asking themselves if an idea is good enough to replace an existing one, adjusting for taxes & transaction costs.
(3) “You can’t compensate for risk by using a high discount rate.”
Buffett and Munger use a common yardstick to evaluate all opportunities rather than varying their discount rate based on the idea of taking “risk premiums”. This is usually linked to the US Treasury or “risk free rate”. The idea is to value more predictable outcomes and then reduce risk further by buying at a large “Margin of Safety” so that even a conservative outcome will yield a good result.
Okay, so the average CEO doesn’t have the full spectrum of options that Buffett has (or a brilliant co-pilot like Charlie Munger to bounce ideas off of). However, there is merit in learning from the model and thought process and applying it to the options that he or she does have
You may think this sounds very straightforward, and it would be if the world was run by the utility maximizing”Rational Econs” that traditional economic theory describes. However, we all know that human beings are far from rational, and some ways that translates into bad behaviour include:
(1) Companies tend to overpay for acquisitions, particularly when engaged in bidding wars. Charlie Munger summarized the cognitive biases at work at such auctions rather well, stating that –
“Well the open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior.”
See this case on Cisco for an example of this
(2) Companies don’t always invest in the business subsidiary with the best economic potential (ITC investing in Hotels for example). This may be due to the mistaken view that the objective is to grow at all costs, or simply an inability to overcome sunk cost bias. Growth without a sufficient return on invested capital is value destructive.
(3) Companies buyback overpriced stock, with the herd mentality justification that “everyone else is doing it”. This particular malaise is still uncommon in India because there aren’t that many mature companies of the same size as in some of the developed economies.
(4) Companies pay dividends when they should be paying off debt first, and then merrily go ahead and raise fresh equity capital from the equity markets. Yes, that was a potshot at Indigo.
In most cases, the reasons for folly boil down to the promoter being: a crook, ignorant or simply having bad incentives. The first two are fairly straightforward, and the third you could develop an academic field around (People did – It’s called behavioural economics)
From an investor’s standpoint, this discussion is relevant in two ways: Identifying cases where management is not behaving in a manner that is maximizing shareholder value, as described earlier as well as applying principles of capital allocation to their own portfolio.
(1) Avoiding”sunk cost fallacies”, continually throw good money after bad when an investment thesis has changed. Accept that a mistake has been made, learn from it and move on.
(2) Avoiding mental accounting, the worst case of which is when people allow high cost debt to pile up on one side while simultaneously investing money in a fixed deposit at a lower rate on the other.
(3) Consider opportunity costs: Whenever making a new investment, it must be significantly better than the existing ones. However when you do find something better, be ruthless and don’t let the endowment effect cloud your judgement. Your portfolio needs to be a competitive environment, not a government office where investments get a lifetime sinecure.
A lengthy post, but one that I hope covers some of the basics. I’d really recommend digging through the Berkshire Shareholder letters for a lot of comprehensive wisdom on the topic, as well as studying the careers of successful investors & CEOs.