(As I being to write this blog, my head is swirling with a tsunami of thoughts. But at the same time, I want to present my thoughts in a simple and understandable manner. Hence I plan to write a few more blogs on this topic. )
Sometime earlier this year, I came across some wonderful writings on Capital Allocation by Jana, John Huber and William Thorndike (the author of the book -The Outsiders). While Buffett had mentioned in almost all his letters on how important capital allocation is and how CEOs lack these skills, I had somehow just let this concept go unexamined. But when I read the above blog posts, I began to understand the gravity of this concept and its implications on the company’s future. Each of the authors has explained it with beautiful examples and case studies to illustrate its impact. After I read them, I could only slap my forehead and say –‘but of course’! It seems so obvious now in hindsight, something that I feel I should’ve grasped sooner.
And now, that I appreciate it better, when I re-read Prof. Bakshi’s old blogs or his interviews or the Buffet letters I notice that that they have been saying it forever. (Google returns 264 results, when I queried for “Prof. Bakshi” + “Capital Allocation”. It was that obvious!) So has Vishal Khandelwal and others; but I understood it only now.
I initially thought I would write the complete A to Z of Capital Allocation in this blog, but then I realized nothing I write will add an iota of value to what has already been written and elucidated by all those people I mentioned above. So instead, I thought I’d share how I am using this newly acquired lens as far as my investment process goes.
So here it is.
First thing first- the cash flow statement is a statement of where the money is coming from and where it is going. As we know, it has 3 parts to it:
- The Cash Flow from Operations which gives an idea of the cash that the core business is generating
- The Cash Flow from Investing which gives an idea of the cash that is getting invested
- The Cash Flow from Financing which tells us if the company is a net borrower or re-payer or neither, if its selling more equity and how much dividend it is paying etc.
So if we were to take a long time horizon of say 5 to 10 years, we could get some clues on, where the company is investing and if it is funding its expansion with debt and/or equity or repaying debt or buying back shares etc. Secondly a long time horizon would have enough peaks and troughs for us to judge the capability and intentions of the management.
Now, not all sources of capital and not all uses of capital are equal and have their relative merits and de-merits, which I will share. (Caution: As somebody aspiring to be a conservative value invest, you will see some of my own biases coming in, when I provide my opinion.)
What have the source(s) of capital been in the last 5 to 10 years?
Sale of equity. The company can sell stake in itself and raise capital. This would be preferable if the company’s share price are trading at above the intrinsic share price. In the book, ‘The Outsiders’, William Thorndike talks of Henry Singleton who issued shares, when the share prices were high for the first 10 years and then repurchased them in the next 10 years when they were lower. So you see, issuing shares when the prices are much higher than the intrinsic value is not a completely bad idea. It dilutes ownership, but then if the capital raised can be put to work at high rates of return for a long period of time, why not?
Debt. If a company can borrow at low rates and invest it at much higher rates of return, it seems ok theoretically. But availability of debt at low rates can cause recklessness (think of the sub-prime housing crisis of 2008) and hence I would like to see debt being used on a short term basis and the company having a clear plan on returning to no-debt balance sheet.
Cash Flow from Operations. Of the 3 sources of capital, this to me is the best, because it does not create additional liabilities for the company (equity dilution or debt).I like companies that earn handsome cash flows from operations and can plough back a majority of that into their businesses especially if the current operations are yielding good results.
What have the uses of capital been in the last 5 to 10 years?
Asset purchases / Investment in current business. If the company is investing in fixed assets more than its yearly depreciation, it implies that it is investing more than what is getting depleted. I view that favorably. Also, I would like to know what is the company investing in (plants, machinery, buildings, shops) and are those investments in line with what I think are good for the company’s future.
Acquisitions. Warren Buffett and Charlie Munger have repeatedly emphasized that acquisitions are usually not good for the shareholders of the buying company as the % of those acquisitions becoming successful are very low. Yet, at the same time- besides Berkshire Hathaway itself, there are Constellation Software, Apple, Oracle, Microsoft, Google, Amazon and others that periodically do acquisitions and some of those turn out to be successful (like Google’s acquisition of YouTube, Amazon’s of Zappos). I am yet to appreciate how acquisitions work etc., hence my pessimism. Maybe another aaha moment waiting to happen.
Pay Dividends. At one point of time, I used to calculate dividend yield and had a bias for companies that paid good dividends. That is how ignorant I was! Now I am biased towards companies that pay a low dividend but have opportunities to invest the remainder portion of the earnings.
Share Buybacks. I used to view this favorably. But now I would like to compare the buyback price with what I think is the intrinsic price. I would view buybacks favorably if it is at a price lower than the intrinsic value and vice-versa (like what Henry Singleton did).
Debt repayment. Just a personal preference to look for companies that repay debt aggressively and like to be debt free.
Let me illustrate that with 2 real Indian companies and what I see from their Cash flow statements, through the capital allocation lens.
|COMPANY 1 Cash Flow Items||2011||2012||2013||2014||2015||2016||TOTAL|
|Cash Flows from Operations||83||78||55||117||103||127||563|
|Cash Flows from Investing|
|Purchase of Fixed Assets||53||38||21||13||101||100||326|
|Purchase of Investments||25||52||48||109||15||23||272|
|Cash Flows from Financing|
Additional information on Company 1:
- 5yr ROIC: 16%
- 5yr Earnings retention test (Ratio of Increase in Mcap/ Retained earnings): 4
My observations based on Company 1:
- Sources of Capital
- The Company has relied solely on Cash Flow from Operations for funding its expansion
- Uses of Capital
- The Company invested in excess of Cash Flow from Operations in purchasing fixed assets and purchasing investments (marketable securities).
- The Company has paid an average dividend of 9% of its cash flows from operations and has invested the remainder in its operations
- In the last 2 years, the Company seems to be investing more in Fixed Assets off late as compared to marketable securities; the ratio was vice-versa in the earlier years. This is probably because the company was keeping cash handy earlier to invest in fixed assets at the right time. This probably calls for an analysis to see if the investments that the company is making is in areas that are likely to yield results in the future.
- The Company has not made acquisitions or share buyback.
- Given that the Company has a high ROIC, it makes sense for it to retain earnings. But if the ROIC dips below say 15%, I would like it to either find avenues to invest at high rates of return or give it back to shareholders in the form on dividends or share buyback.
|COMPANY 2 Cash Flow Items||2011||2012||2013||2014||2015||2016||TOTAL|
|Cash Flows from Operations||0.4||2.8||18||20||16||27||84|
|Cash Flows from Investing|
|Purchase of Fixed Assets||25||16||15||9||9||18||92|
|Sale of Fixed Assets||0.4||2.3||3|
|Cash Flows from Financing|
Additional information on Company 2:
- 5yr ROIC: 70%
- 5yr Earnings retention test (Ratio of Increase in Mcap/ Retained earnings): 12
My observations on Company 2:
- Sources of Capital
- Between FY 2011 and 2013, the company has used sale of assets, debt, equity sale and cash flow from operations for its expansion. Since FY 2014, the company has relied solely on cash flow from operations for its expansion
- Uses of Capital
- The Company has used the capital to purchase fixed assets, paying interest, paying dividends and from FY 2014 onwards the company has been repaying its debt.
- The company has paid an average dividends of 19% of cash flow from operations every year and reinvesting the rest of it.
- The Company probably issued Shares in the earlier years (2010-11) to fund its expansion and no-debt and vice-versa in 2012 and 2013. And after that it’s been repaying debt.
- The company has not made acquisitions or share buyback.
- Given that, Company 2 is generating such high rates of return, and as per the earnings retention test, it makes sense for it to retain even more of its earnings for expansion or repayment of debt. This is a small company that is seeing a lot of opportunities to invest capital at very attractive rates and hence it should retain even more.
The above analysis is not a comprehensive analysis, because I have not analyzed the balance sheet or the P&L statement, the nature of business etc. It only an analysis of the Capital Allocation patterns of the management based on the Cash Flow statement and based on which I have tried to elucidate how the management is going about it. When the rate of return (ROIC) is high or when attractive business opportunities exist, it makes sense to retain even more. On the contrary when the ROIC is low, it makes sense to return capital back to shareholders, rather than retain it or invest in suboptimal opportunities.
I hope this blog has been useful to you in your investing journey. In the subsequent blogs, I’d like to share thoughts on why Capital Allocation matters.
- Jana’s blog: https://janav.wordpress.com/2016/04/21/the-zen-of-corporate-finance/
- John Huber/ Base Hit Investing’s blogs
- The Outsiders by Willam Thorndike: https://www.amazon.com/Outsiders-Unconventional-Radically-Rational-Blueprint/dp/1422162672/ref=sr_1_5?ie=UTF8&qid=1477405696&sr=8-5&keywords=the+outsiders