Many investors praise (and seek) CEOs who they judge to be excellent allocators of capital. But just how valuable is this concept? I would argue that, as an investment selection tool, it is deceptively simple and provides less information than it appears to, sort of a “when your only tool’s a hammer” thing, where investors are applying concepts of finance to areas that are not purely financial in nature.
The first big problem I see is, how do you decide what great capital allocation looks like? In the broadest sense, it is a series of decisions made by management that look smart in hindsight. Okay, so how do you judge what a good decision is? In most cases of buybacks, dividends, acquisitions, use of debt, and investments in operations (the five main categories according to Will Thorndike, who popularized this concept in The Outsiders) you mostly judge decisions by how the company’s stock performed in the following years. Were buybacks made at a cheap price relative to where the stock is now? Did acquiring XYZ company appear to create value? Will the use of debt come back to haunt us? Did management’s new initiative work? You can ask many variations of these questions, and the answer over a 5 year period almost always leads to share price performance. So you can call it whatever you want, but be careful not to put much more weight on it than you would on price performance.
Secondly, smart capital allocation is easier said than done. We can fantasize all we like about buying back our shares when they are cheap, or making all-stock acquisitions of cheaper companies, but that doesn’t make us better capital allocators. There are many ever-changing factors that drive capital allocation decisions. Navigating them intelligently requires tremendous insight, usually backed with a good deal of experience. What’s more, I’m pretty sure a CEO has many responsibilities besides maintaining an accurate “fair-value” estimate for their business. I think the investment community consistently overestimates the importance of this particular activity for the same reason that we humans tend to think that the thing we spend the most time and energy on is necessarily the most important thing.
Thirdly, I think a lot of investors grossly underestimate what goes into running a business. I’ve benefited tremendously as an investor from my interviews with entrepreneurs (complete list at https://www.nicholaspihl.com ) because it’s deepened my understanding of how businesses actually work. There are a whole lot of things besides capital allocation that matter when growing a business. In fact if you’re lucky (and good), capital allocation will be the least of your worries because you’ll be faced with an ever-increasing, ever-improving set of opportunities and you’ll be preoccupied with growing to meet that. If you’re less fortunate, you’ll find yourself mired in a situation that no amount of efficient capital allocation will get you out of, no matter how good you are. (As an aside, I suspect this is usually a value-creation deficiency. Another term equally useless as “efficient capital allocation.”) Brent Beshore has a good line to this effect, “small businesses don’t stay small on purpose.” Maybe it’s a price thing, or an operational efficiency thing, or a customer experience thing, or a market size thing. What’s worse, whether or not it’s smart to try to get out of that situation (from a capital allocators standpoint) depends on a lot of things, most of which are uncertain. Which brings me to my next point….
…There is no capital allocation there is only business. The fact that four of the five categories have almost nothing to do with “operational improvements” might give the impression that actually running and growing the business is relatively unimportant. But this obviously isn’t the case. For the preponderance of successful businesses on this planet, including publicly traded companies, this area deserves much more attention than dividend policy, buyback programs, acquisitions, or use of debt. Changes to any one of these four areas are pretty infrequent in most cases. In fact, a significant shift is usually a newsworthy event when it occurs at a large, publicly traded company. I don’t think there’s an investor on the planet who hasn’t read an article about Apple’s buyback policy. And Apple is a useful example. If you were Tim Cook, deciding how much stock to buy back, what are the main things you’d consider? Probably, there was some thought about leverage, cash flows, safety, and valuation, but I defy anyone to point out a single consideration that isn’t couched in the fundamentals of the business. New product rollouts, iPhone pricing and market share, brand value, services revenue… By contrast, if Apple’s leadership focused exclusively on financial ratios, the company would be ruined in 10 years.
Admittedly, there appear to be some managers who have a real knack for capital allocation. Warren Buffett (obviously) at Berkshire; Bob Iger with his acquisitions of Pixar, Lucasfilm, and Marvel; Mark Donegan at Precision Castparts; and Zuckerberg looks pretty good too with his purchase of Instagram for $1B. And truth be told, I would rather have people like Buffett, Iger, Donegan, and Zuckerberg managing my money, but this is only one lens through which to assess a company’s leadership. Further, sizing up the management is nothing new in the world of investment analysis, and I would argue that analysis of capital allocation decisions is something that would happen in a diligent analysis of leadership anyway, even before the idea was popularized.
With that in mind, let’s look at Jeff Bezos, arguably the greatest business mind in 30 or more years. Proponents of capital allocation will often trot him out as a particularly skilled capital allocator (he did after all, get paid to buy Whole Foods), plus just check out how their share price has risen, he must be getting 30%+ ROIC all the time! /s
But there’s much, much more to what makes him successful. He’s created an unusual culture of accountability, entrepreneurship, customer-focus, and ambition at the company. People don’t go work there necessarily to get paid more, they go to be part of something incredible. On top of that he’s a visionary who seemingly thinks 20 years ahead, who seems to understand what his customers will want even before they want it, and who’s not afraid to throw his weight around (look at the offers he’s getting for Amazon’s HQ2). Yes he’s been an amazing steward of Amazon’s capital. But it’s not an optimization thing so much as his ability and drive to deliver tremendous value to consumers.