What is Capital Allocation?
Capital allocation is a core theme of this Substack, with one of my main reoccurring pieces of content being Capital Allocation Snapshots. In this post I wanted to briefly explain what I mean by capital allocation since I think it is a critical concept to understand if you are holding a stock for the long term.
At a high level, capital allocation is the process where a company deploys its cash into areas such as reinvesting in its business for growth, paying down debt, or returning some of the cash to shareholders. To elaborate on this further, a business has many areas where it can deploy its cash, an incomplete list being:
investing in capital expenditures to build a new factory
acquiring another business
selling part of the current business
buying and selling marketable securities
issuing or paying down debt
issuing stock
buying back stock
paying out dividends
The capital that gets allocated to the above areas can come from the profits generated by the business, or raising funds by issuing debt or equity.
The key to good capital allocation is optimizing the use of cash to provide the best return on investment for shareholders. If the company can not provide a decent return on investment from the cash it deploys, then it is better off returning the cash to shareholders so they can do something useful with it. An example of good capital allocation is if a business invests in software to reduce costs, creating a high return on investment. Bad capital allocation might look like a company acquiring its rival, but purchases it at an expensive valuation, producing low returns and asset write-downs.
These concepts seem like common sense, but great capital allocators are a rare breed. Many CEOs are mediocre capital allocators, and often times they incinerate cash by investing in poor returning projects or acquisitions. In the quote below, Warren Buffett riffs on how most CEOs of Corporate American are not focusing on capital allocation:
“When we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. This point can be important because 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. To stretch the point, it's as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.”
The book The Outsiders details several (mostly historic) CEOs that were great capital allocators, such as Warren Buffett, Henry Singleton, John Malone, and others. The CEOs profiled in the book are masters at the capital allocation optimization problem. Since they knew how to press the right buttons and turn the correct knobs on redeploying their cash, the companies that these CEOs ran greatly outperformed the market over long periods of time. One of the goals of this Substack is to find today’s great capital allocators, and potentially buy their stock if it is trading a reasonable valuation.