What is the purpose of a company?

There are a couple of ways you could approach that question. Many companies focus on articulating their mission statement – what change does that company want to bring about in the world? That is not the way I am approaching it today.

Today I’m thinking about it at a more basic level. And at the most basic level possible, the purpose of most businesses is the same.

A company exists to 1) generate profits for its shareholders and 2) reinvest or distribute these profits in a way that creates the most long-term value for its shareholders.

Once you accept this as a company’s basic purpose, the importance of capital allocation – the art of deciding what to do with a company’s excess cash from operations, any debt taken on and any money raised from shareholders – becomes immediately clear.

No surprise, then, that you’ll see its importance touted continuously by long-term investors.

Terry Smith of Fundsmith has said that “capital allocation decisions are amongst the most important decisions which management of companies make on behalf of shareholders.”

Todd Combs, who manages investments for Warren Buffett’s Berkshire Hathaway, said that “Capital allocation is one of the most important parts of the track record that must be examined by prospective investors.”

Buffett himself has said that “over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”

The five channels of capital allocation

Managers generally have five options when it comes to allocating capital:

  • They can re-invest in the existing business.
  • They can acquire other companies.
  • They can pay some of the profits out to shareholders as a dividend.
  • They can buy back shares.
  • Or they can pay down debt.

We aren’t going to look at examples of stellar capital allocation today.

Instead, we’re going to use Charlie Munger’s inversion method and look for cases where capital allocation decisions have potentially hurt rather than benefited shareholders. By understanding how not to allocate capital, perhaps we can better understand how it should be done.

To do this, I used Morningstar’s screener to find ASX and global companies that have been assigned a Poor Capital Allocation rating by our analysts. This means that in our analyst’s opinion, the company’s management has fallen short on one or more of the three criteria we judge capital allocation by.

These areas are:

  • Investment Efficacy – where and how effectively a company has invested capital
  • Balance Sheet – how a company is deciding to finance its operations
  • Shareholder distributions – if a company’s dividend and buyback policies have been appropriate

Most importantly, I wanted to find out why companies had been marked down. And I spotted a few major themes.

1. Neglecting the moat

“What should you be doing in running your business? Just what you always do: Widen the moat, build enduring competitive advantage, delight your customers, and relentlessly fight costs.” - Extract from a letter written by Warren Buffett to managers of Berkshire Hathaway owned businesses.

A moat is a structural advantage that allows a company to generate excess returns on investments for years on end.

Without a moat, a company is just another firm vulnerable to the competitive forces and sub-par profits that capitalism eventually guarantees. So if a company does have a moat, it stands to reason that it should do everything in its control to keep that moat intact.

It is here where Morningstar’s Roy Van Keulen faults the capital allocation of ASX Ltd (ASX: ASX), Australia’s leading provider of equity listings, settlement, clearing and trading.

Nobody is questioning the fact that ASX still has a Wide Moat. But Van Keulen faults the company’s past failures to nurture an important source of that moat – the supportive regulatory environment it enjoys in Australia.

ASX’s bungled promise to deliver a world-leading blockchain based clearing system is the biggest blot on its copy book here, and Van Keulen says it could weaken the exchange’s standing with regulators. In turn, this could threaten the legal monopolies it enjoys in several markets. Despite this, Van Keulen expects Australia’s equity markets to continue gravitating around ASX due to its powerful network effects.

An example from abroad could be Bayer (ETR: BAYN), the German pharmaceutical group.

In my article on moats in the pharmaceutical sector, I said that the major drug companies often have a two-pronged advantage: 1) they sell patent protected treatments at very profitable prices and 2) the cash flows, expertise and relationships gained from previous drugs put them in a strong position to discover and market new drugs, thus sowing more patent-protected profits.

Investments in research and development, then, are a key use of capital when it comes to maintaining moats in the pharmaceutical industry. Bayer, however, has significantly cut its R&D investments as a percentage of sales over the past few years.

Our analyst Damien Conover notes that Bayer “only spends on drug R&D at the low-double-digit range, below the industry average of high teens. Further, the company has shown low productivity with poor execution in pipeline development. The lower productivity is limiting the returns on invested capital.”

One potential reason Conover gave for Bayer’s reduced R&D spend are the unexpected extra costs from its ill-fated acquisition of crop science business Monsanto, where Conover says Bayer underestimated the damages they would inherit in the shape of glyphosate liabilities.

He recently downgraded Bayer’s moat rating from Wide to Narrow on account of potential glyphosate payouts, patent pressure in the pharmaceutical portfolio and poor pipeline results. It’s hard to imagine that the last two factors don’t stem at least partly from the reduced investment and focus on R&D.

This brings us neatly to the next major source of capital destruction: poor acquisitions.

2. Making poor acquisitions

Running the rule over past acquisitions obviously comes with the benefit of hindsight. Gamble the business successfully and you are lauded as an “outsider”. Get it wrong and you go up in the capital destruction hall of fame.

A few companies like Berkshire (NYS: BRK.B), Constellation Software (TSE: CSU) and Danaher (NYS: DHR) have excellent records as serial acquirers. But there’s a reason those names come so instantly to mind: there aren’t that many of them. Even Berkshire has had its fair share of howlers on the acquisition front, like the time it issued stock to buy Dexter Shoe. Acquisitions are hard!

Let’s get some obviously bad acquisitions out of the way first: those made primarily to bring more prestige and justify a higher salary for the CEO, acquisitions made to trigger bonus packages based on revenue or earnings growth rather than returns on capital, et cetera.

But even well-meaning and seemingly logical acquisitions destroy capital if they are not executed well. Or, just as crucially, are done at a silly price. Altria’s efforts to diversify away from their secularly challenged cigarette business offer a good example here.

Altria (NYS: MO) is best known for owning the Marlboro cigarette brand in the US. On paper, investing in vaping and cannabis made sense. It had the potential to offset declining cigarette volumes and bring Altria exposure to exciting growth areas.

Unfortunately, Altria has assembled a record of making these investments 1) at hype-fueled prices – like the 40 times revenue it paid to buy 35% of vaping business Juul in 2018 – and 2) potentially without enough diligence. As Altria’s investments in cannabis and vaping have destroyed a lot of shareholder value to date, our analyst Kristoffer Inton had little choice to rate Altria’s investment efficacy as poor.

Closer to home, our analyst Adrian Atkins has rated APA Group’s investment efficacy as Poor – mostly due to concerns surrounding what he calls an “aggressive acquisition policy” given high costs of raising debt for these deals and high levels of competition for assets – which reduce the chance of striking a bargain.

Atkins would prefer APA (ASX: APA) to focus instead on the opportunities it has to invest in organic growth – especially in gas pipelines that compound APA’s existing moat in this area by adding more nodes to its network.

3. Taking on too much debt

Deciding how to finance the company is a key aspect of capital allocation. This involves deciding how much debt to employ, when to raise debt or equity capital and on what terms, and how to manage the company’s debt load.

A big no-no to look out for here are companies that have too much debt relative to the nature of their business. If a company is in a cyclical industry but carries a high amount of debt, it could struggle to pay its interest bills if and when earnings weaken.

A heavily indebted company could also find it harder – or more expensive – to refinance its debt during hard times . This could put equity holders at risk of being diluted (through the issue and sale of new shares to raise funds) or being wiped out completely in a bankruptcy.

Seven West (ASX: SWM) shareholders weren’t wiped out in the end. But they endured a miserable few years (down 97% from 2013 to 2020) amid fears that the combination of leverage and secular declining business segments could lead to bankruptcy. They also saw the dividend disappear in 2017, a decision that – along with divestments and cost-cutting – ultimately nursed the company’s balance sheet back to a respectable state.

Carrying a lot of debt can also mean that management have less flexibility to create value, something that Samuel Siampaus thinks may apply to communications infrastructure REIT Crown Castle (NYS: CCI). While Siampaus doesn’t think Crown’s current debt level is overly dangerous, he does think it reduces management’s scope make opportunistic acquisitions or share buybacks.

4. Expensive buybacks

While we’re on the topic of buybacks, a quick reminder that they aren’t always good for existing shareholders. In the same way that overpaying to buy another firm can destroy capital, so too can share repurchases made at prices above the firm’s intrinsic value.

Again, this can come down to incentives. If a company’s management are paid bonuses based on earnings per share but profits are falling or flat, how can the company report higher earnings per share? It can buy back shares and reduce the denominator.

As Warren Buffett’s late business partner Charlie Munger once said: “Show me the incentives, and I’ll show you the outcome”.

I hope this article has given you an appreciation for how big an impact management’s capital allocation decisions can have on your outcome as a shareholder. For more insight on what makes good capital allocation, take a look at this article by my colleague Shani Jayamanne.

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