In the next two notes we will describe what capital allocation is and the impact it has on investment outcomes. We have split the discussion on capital allocation into two notes because of its importance in our research process and the great effect it can have on the timing and magnitude of investment returns. In this note, we discuss each mechanism available to a board of directors and senior management to allocate capital, and in the second note we will describe our research team’s view on capital allocation priorities and how we evaluate a company’s historic use of capital and its go-forward strategy.
Capital allocation is a critical responsibility for every board of directors and senior management team. When a business generates free cashflow, the result over time is an accumulation of cash on the balance sheet. When the cash (or other liquid asset) of a company is deployed, a decision must be made with respect to its best use. The range of decisions is straightforward. Capital can be allocated in one or more of the following ways:
- Dividend distribution to stockholders,
- Stock buybacks through open-market purchases or tender offers
- Reinvestment in the company through capital expenditures (“Cap Ex”),
- Invest in other businesses through a merge or acquisition (”M&A”),
- Debt reduction through bond buybacks or debt retirement, or
- Continue to accumulate cash on the balance sheet.
There are many nuances within each of the six alternatives that create an almost endless combination of choices. As an investor, it is important to understand the effects each of the six options has on the business and why a board or management team may choose one option over another. Below we provide a brief description of each alternative.
Dividends return capital to stockholders. A company’s dividend policy is typically stated in its investor communications and can include:
- No dividend,
- Consistent per-share dollar amount,
- Consistent total dividend payout (amount per share varies based on changes in shares outstanding),
- Distribution of a percentage of a specified earnings metric (net income, free cash flow, EBIT, etc.), or
- Distribution of all available cash.
Some stockholders demand a dividend as a condition precedent of investing regardless of the available opportunities to reinvest the capital in other ways. Dividends can also be a prudent way for investors to extract equity value in the peaks of a cycle (effectively leaving the company to raise additional capital for any current or future capital project needs).
Dividends can result in ordinary income to the stockholder rather than capital gains treatment so can be less efficient from a tax planning perspective. Some investors may also view dividends as an admission by company management that it doesn’t have adequate capital expenditure or M&A opportunities to invest available capital at an “acceptable” rate of return. The acceptable rate of return will vary by company, industry, geography, and stockholders’ preferences, and we have found there is not a universal answer to the question “what is an acceptable rate of return?”
Share buybacks are another alternative a company can use to return capital to investors. Share buybacks may support a company’s stock price by giving open-market sellers a counterparty buying at a higher price than may otherwise be available, which is particularly valuable to stockholders in companies with low levels of or limited trading volume or float. Buybacks also reduce the number of outstanding shares, which increases the remaining stockholders’ ownership percentage and can also benefit operating and financial metrics on a per-share basis. While buybacks have benefits and we concede company management has the most complete relevant data whereas public-market investors have limited data, successful execution of a buyback program is difficult, and many investors and academics have questioned the long-term value of share buybacks.
Capital expenditures are necessary for almost all companies that seek to operate as a going concern. Typically, Cap Ex is bifurcated into two buckets: (1) growth Cap Ex, and (2) maintenance Cap Ex. Growth Cap Ex is capital invested in the business for the purchase or internal development of new, earnings-generating assets, whether those assets are tangible or intangible (such as intellectual property). Examples of growth Cap Ex are the purchase of a new manufacturing press, acquiring a new dry bulk vessel, or investment in internal research and development to create a new product. Maintenance Cap Ex is capital used to maintain the existing assets of the business. Examples of maintenance Cap Ex are performing periodic maintenance on a manufacturing press, painting the hull of a vessel, or investment in research to maintain the functionality of a current product. The distinction between growth and maintenance Cap Ex is often ambiguous when viewed in a company’s statement of cash flows, but a conceptual line can be drawn to differentiate costs needed to continue operating the business, and the costs of growing or expanding the business.
Mergers & Acquisitions
Mergers and acquisitions are another use of a company’s free capital. Acquisitions allow a company to acquire assets (human, tangible, or intangible) more rapidly than it might otherwise be able to develop internally (“organic growth”) or quicker than it can acquire them from retailers or industry suppliers. Additionally, a merger or acquisition can have strategic importance allowing the company to enter a new market, gain additional market share, add a new geographic territory or take advantage of supplier or customer relationships the acquired company owns. Further, merging two businesses can result in a sharing of costs or the ability to cross-sell to each other’s customers, which results in a cost savings or increase in revenue and profitability, respectively.
M&A transactions exist in all shapes and sizes ranging from small “bolt-on” acquisitions to transformative mergers of two market-leading companies in the same industry.
While there can be many benefits, mergers and acquisitions can be difficult to execute well. Among the risks faced during an M&A transaction are failure to perform competent due diligence, overpayment or miscalculation of the target company’s value, overly optimistic synergy expectations, failure to integrate the two companies in an accretive or functional manner, taking management’s focus away from the core business, and regulatory scrutiny, among other issues.
Debt Paydown or Retirement
Paying off a portion of the principal or retiring debt all together is another use of a company’s available cash. A company can make open-market purchases of its debt, or make a tender offer for a specified number of bonds. Similarly, a company can pay down any private borrowings such as a revolving line of credit. It is important for a company to manage its balance sheet and outstanding debt so that it can make its periodic interest payments and pay off the principal balance of bonds upon maturity. Companies may also be compelled to pay down debt balances in order to meet financial metric targets (or ranges) mandated by loan covenants in private lending or commercial agreements.
Finally, senior management can decide to do nothing with the available cash and allow it to accumulate on its balance sheet. As we will discuss in our next note, this is usually not preferred. Stockholders and investors often feel that rather than having cash sitting still without generating earnings that a dividend should be paid so that the stockholders have the ability invest the idle cash in other earnings-generating companies or opportunities. However, on occasion, it is appropriate for a company to hold cash for management to be in a position to react quickly when presented with an opportunity. Capital raises, whether through public debt, public equity, or private lending, can be expensive and time consuming. Any delay in raising capital for a transaction may put the company in a disadvantageous negotiating position. For this reason, management may decide to accumulate cash.
Each of the alternatives we described can be used in isolation or combination, and the appropriate use of each can vary greatly from company to company and period to period. In our forthcoming December 28 note, we will discuss how our research team evaluates a company’s capital allocation priorities, and why clearly stating its capital allocation priorities and following through on those statements holds a place of heightened importance in our analysis.
As always, feel free to reach out to MIAM if you would like to learn more or discuss a particular company or idea.
The MIAM Research Team
 This is not tax advice. Please consult an independent tax advisor for recommendations based upon your individual circumstances.
 Edmans, A. (2020, October 22). Do share buybacks really destroy long-term value? The Harvard Law School Forum on Corporate Governance. Retrieved December 21, 2022, from https://corpgov.law.harvard.edu/2020/10/22/do-share-buybacks-really-destroy-long-term-value/
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