When you think of any famous CEO, you probably think of the great products or services that they’ve championed. CEOs that build great businesses become very famous, and justifiably so. But building a business that generates tons of cash flow is just step one. The less interesting—but equally crucial—job of any CEO is allocating their capital. Capital allocation is not glamorous, but capital allocation choices have had a huge impact on stock returns historically. The bottom line is that disciplined, shareholder-oriented capital allocation plans produce great results—for both companies and investors…but reckless spending, acquisitions, and cash-raising lead to weak results.
How to Use Capital
When it comes to allocating (or raising) capital, CEOs have a fairly limited toolkit. As William Thorndike, author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, summarizes in his book:
CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.
Let’s look at each option and how they affect stock returns, on average.
Investing In Operations
“CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations.”
The first group is companies that have lots of new capital expenditures. I consider the 10% of companies every year[i] that are growing their capital expenditures by the greatest percentage year over year. These are the big spenders. How has this group done historically? They’ve delivered an annual return of 5.4%[ii]. That is roughly half the return of the market’s 10% return over the same period. Rapid growth may sound good, but these results indicate otherwise. Overzealous expansion has led to weak stock returns. These stocks are also more volatile than the market (22% annual standard deviation vs. 15.5% for the market).
Acquiring Other Businesses
The easiest way to find acquisitive companies is to look for those companies whose “goodwill” has grown by the greatest percentage in the past year. Goodwill is a balance sheet account that grows when one company buys another, but pays more than the book value of the company they are acquiring (the difference is added as an asset called “goodwill,” which ostensibly measures the value of things like brand name, patents, etc.). There have been a number of studies which show that big acquisitions tend not to work out for shareholders. The evidence from companies with the largest growth in goodwill supports these findings. This group has delivered an annual return of 6.5% (18% volatility), again significantly lower than the market’s 9.1% (14.8% volatility) return over the same period[iii].
Issuing Debt and Raising Capital
A third group is companies raising lots of cash through debt or equity issuance. These companies have been a disaster historically. The best way to measure this option is using financing cash flows. Financing cash flows come in different flavors, and are basically the “capital allocation” options listed above. Positive financing cash flows (money coming into the company) result when a company raises cash through new debt or equity offerings. Negative cash flows (money leaving the company) result when a company pays back creditors, pays dividends, or repurchases shares. This group is the 10% of companies that have the largest positive financing cash flows relative to their market cap (meaning they are raising cash). The stocks of these companies have grown at just 5.71% (21% volatility)--which is a little more than half the market’s 10% return (15% volatility) over the same period[iv].
Dividends, Share Buybacks & Paying Down Debt
The last category—and the one that delivers great outperformance versus the market—is the 10% of companies that have the most negative financing cash flows. These companies are sending cash back to stakeholders by paying dividends, repurchasing shares, or paying down debt. Their historical returns have been 15.4% per year (17.6% volatility), which is 5.4% better than the market’s 10% return (15% volatility)[v]. Sometimes these companies are referred to as having high “shareholder yields.” Owning these companies has worked great in the past.
The data from these four groups shows that you can do very well as an investor by following a CEOs actions. If they are spending like crazy, or raising tons of cash—look out. If, instead, they are sending cash back to stakeholders, then you should take notice.
Discipline Is Key
Back to The Outsiders. The author distills the lessons he’s learned down to 10 rules, the 8th of which is very important:
8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate [hurdle rate being some minimal acceptable return on investment, say 20%].
The discipline implied by this eighth rule is rare. CEOs awash in cash often spend overzealously on projects with lower than acceptable rates of return or on projects/acquisitions that are simply too risky. The successful CEOs described in The Outsiders had a disciplined process for spending on new projects. If there are no projects available that can earn a high rate of return, the best CEOs instead pay dividends, repurchase shares, or pay down debt.
Just like with investing, disciple is key for CEOs to be successful—and true discipline is rare. As Thorndike points out,
This outsider approach, whether in a local business or a large corporate boardroom, doesn’t seem that complicated; so why don’t more people follow it? The answer is that it’s harder than it looks. It’s not easy to diverge from your peers, to ignore the institutional imperative, and in many ways the business world is like a high school cafeteria clouded by peer pressure. Particularly during times of crisis, the natural, instinctive reaction is to engage in what behaviorists call social proof and do what your peers are doing. In today’s world of social media, instant messaging, and cacophonous cable shows, it’s increasingly hard to cut through the noise, to step back and engage Kahneman’s system 2 [thinking with your head instead of with your gut], which is where a tool that’s been much in the news lately can come in handy.
One example is with share buybacks. In general, they’ve led to solid returns for investors. But you’ll often read stories that buybacks are mistimed and stupid uses of cash. This is partly true. Look at the below table, which takes the 20% of stocks in the market that are buying back the most shares. It then splits this group out into give groups by valuation. You can see that when CEOs and their companies buyback shares at cheap prices[vi], their stocks tend to do very well in the next year, beating the market by 5% on average. But when they buyback stock while valuations are expensive, they get killed by the market, losing by 5% on average. The key lesson is that the best CEOs buyback shares when it’s smart to do so, not just because all the other kids are doing it.
1963-2013
Ultimately, choosing what to do with a company’s cash (or how to raise it) is one of a CEO’s most important decisions. By avoiding the big spenders, and buying cheap companies that are disciplined with their cash and rewarding their shareholders, you can outperform the market over the long-term.
[i] Rolling annual rebalance
[ii] 1963-2013
[iii] 1989-2013
[iv] 1972-2013
[v] 1972-2013
[vi] Cheapness measured by p/e, p/sales, ebitda/ev, etc