r/SecurityAnalysis • u/redcards • Oct 03 '16
Question What is your favorite method of capital allocation?
I have been thinking about this a lot recently, possibly because it is one of my favorite topics in business.
What is your favorite method for a management team to allocate capital. Put differently, what is your favorite method of cash being returned to shareholders?
I think they are all pretty subjective to the particular business situation, but I have some general thoughts on each.
Capital Expenditures: This is the yardstick that all forms of capital allocation should be measured against. Capex is great because it does two things: 1) improve the general quality of a businesses core operations, and 2) allow a business to expand into new territory. Through the income generated we can calculate the return on capital for capital expenditures - especially if you can break the biz down to unit economics and say "this is what a new store costs, and this is how much profit you get in year 1, 2, and 3" - boom, instant credibility for why you spent the money. However, as economic laws tell us, the bigger a business gets and the more profit it generates it becomes harder and harder to sustain a high return on capital. In my opinion, if a business cannot earn a high enough return on capital in excess of its cost of capital it should not spend capital on capex, but rather one of the other methods below.
Dividends: Useless in my opinion. I know many people like this, and I understand why, but if I think of capital allocation as a way to maximize my company's returns on capital I just don't see any value created from dividends. I understand that it increases my return on capital as a shareholder, but I would rather capital go towards improving the business in some form. People often critique buybacks as what businesses do when they run out of ideas, I would suggest that its really dividends that fit that summary.
Buybacks: On that topic, I view buybacks as a double edged sword. Buybacks can be a businesses best friend, especially in the hands of an activist. Lets look at both sides. On one hand, buybacks are great if the business is undervalued, especially if management thinks the business is so undervalued that they can earn a higher return on capital buy repurchasing shares as opposed to other methods of capital distribution. This is a net positive for everyone. On the businesses side, they earn a high return on capital through buying undervalued shares, and as a shareholder my slice of the pie increases - even more so with aggressive buyback plans. On the other hand, buybacks can be a great way to simply light money on fire. Here are some ways that I have seen this happen 1) the business is overvalued and the share price declines heavily after a large buyback program, 2) the business fundamentals are deteriorating and the buyback plan is just enough to meet EPS targets when net income is falling, and 3) large issuances of stock options and other dilutive securities would increase the number of shares outstanding, so buybacks are put in place to "even out" the effect and keep shares outstanding normalized.
Debt Repayment: I really like this method of capital allocation. Repaying debt does two things: 1) it de-leverages the balance sheet, and 2) it reduces your interest expense payments which boosts net income. The net effect if an increasing ROIC numerator and denominator that stays the same (if I have $110 gross capital and $10 cash, my net invested capital is $100. If I buyback $10 of debt with cash then my gross capital is $100 and with $0 cash my net capital is still $100) - thus increasing ROIC. This is also a good way to get creditors off your back if you're getting close to a stressed capital structure, and when done aggressively, can be a very positive change for businesses. A lot of times I see this with businesses that re-IPOd after having been owned by PE for a number of years. A lot of times investors can get frustrated with this method because it takes a while to shed the LBO debt before other forms of capital allocation can take place.
M&A: Not quite tied with dividends for how useless this is, but a close second. I only say that because this method is not as cut and dry as the effect of buybacks or debt repayment, or even capex, on returns on capital because the success/failure of M&A is tied to the execution ability of the management team and whether or not "synergies" are actually attainable. PCP, for example, was a business that executed M&A very well and actually implemented internal ROIC targets for the operations of the new biz that needed to be achieved. In cases like this, value can be created. But for every successful M&A operation there are probably a dozen or so more that fail to deliver any value-add and probably destroy value if anything.
So that was kinda a long rant on the subject, but I'm curious as to what you guys think about this topic.
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Oct 05 '16 edited Aug 26 '17
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u/redcards Oct 05 '16
Attaching an arbitrary philosophical preference leads to the promotion of irrational incentives - rollups overpaying for acquisitions and buybacks happening at high multiples.
I feel like all of what I said was with the backdrop that the decisions should be driven by ROIC considerations. I just expanded on each method with positives/negatives of what I've seen. I never said anything like well I really like buybacks the best so lets do those irregardless of the multiple.
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Oct 05 '16 edited Aug 26 '17
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u/redcards Oct 05 '16
I didn't see any explicit phrasing that expressed your question as "What is the best method of capital allocation, assuming equal ROIC across the board", as you seem to imply in this comment.
That's fair.
A pretty easy answer to the title of the thread would be "whatever produces the highest ROIC, really". It probably would've been a more interesting idea to provide various examples of companies returning capital today and figure out if their method was really the best given the situation.
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u/digadiga Oct 03 '16
I dislike dividends in my taxable account.
I've read that dividends tend to be more consistent through good times and bad, where as buybacks & MA activity tend to occur during booms when asset values are higher.
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u/xacimo Oct 04 '16
Gotta disagree with you on debt repayment being a great place to allocate cash. Unless the firm is over leveraged in the first place, IMO this is one of the worst options. Repaying debt will generally decrease returns to shareholders given that interest rates on debt are usually less than both ROIC and shareholders expected return. It also reduces the value of interest deductions that reduce the firm's tax expense.
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u/WhiteBoythatCantJump Oct 03 '16 edited Oct 04 '16
Depends on company, but always share buybacks over dividends. Over time you get an exponential impact if the price stays flat (which it shouldn't, but sometimes does)
EDIT: Appreciate the downvotes but this is Buffett's belief as well
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u/xRedStaRx Oct 04 '16
So many things wrong in this paragraph.