The Problem of Rational Capital Allocation

“In theory there is no difference between theory and practice. In practice there is.” — Yogi Berra

Imagine that you are the founder of a highly successful small chain of restaurants.  After immigrating to the United States from Italy as a teenager, you built up a modest amount of capital working several jobs and living an extremely modest lifestyle.  Finally, you opened a neighborhood Italian restaurant in midtown Manhattan in 1980 at the age of twenty-five.  It was not so much a restaurant as a tiny storefront offering take-out specialties and serving a lunch crowd.  Within a couple of years, lines were forming by 11:00 am and persisted for three hours or more each day.  Loyal patrons said that there was nothing remotely like it in the city.  Over time, you were able to raise prices at a rate moderately exceeding inflation with no noticeable drop off in demand.  This was followed by an expansion into a larger location with seating and, eventually, into a chain of eight nearly identical restaurants in Manhattan.

At the age of sixty, you have amassed a comfortable fortune, held mostly in cash, having elected to retain the vast majority of your historical profits rather than expand more aggressively.  You are happy with the lifestyle and financial security provided by your small restaurant chain and not particularly concerned about optimizing your business strategy any further.

You have achieved the American Dream.

Our example is fictional but chances are most readers could identify at least a few familiar examples of such a business.  The United States is full of highly profitable niche businesses that have created massive economic moats and must enjoy abnormally high returns on equity as a result.  In most cases, the founders of these businesses are tremendously skilled at the operational details that made their business into a success but either do not have the skills or lack the inclination to act as capital allocators.  But this may not be a tragedy.  At a micro level, sometimes optimization isn’t necessary to serve the purposes of a small business owner.

From Horatio Alger to Business School

But what if our fictional protagonist had chosen an alternate path to the American Dream?

Rather than choosing up-from-the-bootstraps entrepreneurship, our young immigrant could have focused on academics, graduated from college, and secured admission to one of the elite business schools.  It is likely that a man capable of extreme success in entrepreneurship would have found a way to graduate from business school with an elite MBA.  In theory, such an education would provide not only the tools to succeed from an operational perspective but also the added capability of being skilled when it comes to capital allocation.  After a couple of decades in the trenches, would it not be reasonable to expect that the same level of skill required to achieve success operationally would also be present when it comes to capital allocation, broadly defined?

In fact, this is a key question that is not asked nearly often enough.  If we assume that the large enterprise in question is a publicly traded company with a broad shareholder constituency, it is no longer remotely acceptable to focus only on operations and neglect capital allocation.  Unlike a small entrepreneur who might be perfectly justified to not focus much attention on capital allocation matters, this issue is of prime importance for the chief executive of any public enterprise.  Despite this importance, many CEOs are shockingly unskilled at capital allocation.  Having risen through the ranks through operational disciplines, capital allocation sometimes seems like a mere afterthought or, even worse, as a tool for obfuscating the true economics of an enterprise.

Oil Majors’ Dividends Survive Crude’s Plunge!

On Monday, November 16, a front page article in the Wall Street Journal documented how the world’s biggest energy companies have “doubled down on their promise to protect dividends, despite a precipitous drop in profits this year, driven by a steep decline in oil prices.”  The shares of large energy companies have long been havens for shareholders interested in receiving a regular stream of dividends, as the reporter notes:

Oil majors have little choice but to pay fat dividends to keep investors.  Most of these companies don’t offer investors compelling growth prospects as they struggle to replace even the millions of barrels of oil pumps every year.  Fat dividends are a crowd-pleasing but potentially risky strategy given concerns about the length of the current price downturn and its impact on cash flow.

The article goes on to describe the long term dividend record of the oil majors.  Many have longstanding records of rising dividends spanning multiple decades.  For example, Exxon has increased its dividend at a 6.4 percent annualized rate over the past 33 years.  CEOs openly admit that the dividend is paramount in their decision making process.  “This is all about making sure we can continue paying dividends to our shareholders,” said Royal Dutch Shell CEO Ben van Beurden.

At first glance, perhaps this attitude makes sense.  After all, a company is owned by its shareholders.  Large energy company shareholders overwhelmingly care about the dividend and the managers they have hired align their own behavior with the wishes of the owners.  So where is the problem?

Ultimately, companies attract the shareholder base they deserve.  If regular, recurring, and rising dividends are the end-all of a company’s existence, that is all well and good as long as the owners understand that they might be acting in a sub-optimal manner in order to generate this result.  Are shareholders looking at the overall capital allocation situation and thinking about how to best allocate free cash flow to maximize the overall intrinsic value of the firm in the long run?  Is a recurring and rising cash payout, made regardless of underlying business conditions, a way to optimize intrinsic value over time?  One gets the sense that these considerations are not openly and explicitly considered.  There is no point in picking on energy companies in particular.  Irrational thinking about capital allocation is pervasive in many other industries as well.

A Clean Slate

At the risk of being excessively theoretical, let us step back and consider what rational capital allocation might look like if one ignores past precedent, the cash dividend preferences of current shareholders, and the bias of current managers.  Even if the theoretical conclusions we draw are not entirely realistic in practice, it should help to consider what is optimal and then consciously depart from the optimal, when needed, in the interests of pragmatism. 

If the future could be foreseen perfectly, the intrinsic value of any firm rests on the free cash flow the business can generate over its remaining life discounted back to present value at an appropriate rate.  Obviously, one cannot actually know the precise timing and magnitude of cash flows even for the next few years let alone the remaining life of a typical business.  However, this is the theoretical place to start.  Once we begin to focus on free cash flow, it also becomes apparent that it is critically important to determine what a firm does with such cash flows.

At a basic level, a firm can use free cash flow for the following purposes:

  • Invest in internal expansion opportunities.  Widen the moat of the existing business through the intelligent allocation of capital as opportunities arise.  Our small restaurant owner chose to modestly expand the size of his chain from a single storefront operation to eight restaurants over thirty-five years.  Larger businesses invest internally as well.  For example, Burlington Northern Santa Fe makes investments in enhanced locomotives, track infrastructure, and technology designed to deepen its competitive advantage.  These investments go beyond the bare minimum capital investments required to simply maintain the characteristics of the existing business.  They are meant to widen the company’s moat.
  • Invest in external expansion or diversification.  A firm can use its free cash flow to acquire another business either within its existing business lines or in entirely different areas.  This is usually done in order to consolidate market share, capture “synergies”, or otherwise make the resulting enterprise more valuable than the sum of each operation standing alone.  More rarely, a conglomerate structure can be pursued in which a business acquires a totally unrelated business.  Of course, Berkshire Hathaway is the prime example of a successful conglomerate that readily comes to mind.  Usually, there must be some special skill present in management that justifies bringing multiple unrelated businesses under one corporate roof.  Chief Executives of conglomerates must be exceptional capital allocators.  Note that an investment program in marketable securities is essentially an external expansion diversification.  A firm is becoming a small fractional owner of businesses unrelated to its core operations.  Again, Berkshire Hathaway is a good example.  Charlie Munger’s Daily Journal Corporation is another example.
  • Pay Down Debt.  A firm can choose to deploy free cash flow toward changing its capital structure by reducing debt.  There are numerous theoretical constructs regarding the “optimal” level of debt that a firm should employ and this goes beyond the scope of our immediate concern regarding capital allocation.  A debt-free balance sheet is certainly a sign of conservatism yet there are legitimate reasons to carry debt even if a firm has abundant free cash flow available to become debt free.  Common reasons include tax efficiency as well as distortions caused by a high tax burden on American firms associated with repatriating cash from overseas operations.
  • Return Capital to Shareholders.  If internal and external investment opportunities are scarce and the level of debt is optimal, a firm may return capital to shareholders in two ways:
    • Cash Dividends.  This is the most common way in which a firm can return capital to shareholders and it is a very simple process.  A dividend is declared and paid out to all shareholders on a per-share basis, and all shareholders are left to address the tax consequences of the dividend for themselves.  Tax consequences can vary widely depending on the shareholder base.  While it is normal for a firm to declare a quarterly dividend and either hold it constant over time or steadily increase it, this is not a pre-requisite for the use of cash dividends.  Although unconventional, some firms choose to declare irregular cash dividends and establish no expectation regarding dividend recurrence over time.
    • Stock Repurchases.  Repurchases used to be quite rare but are now a very common means of returning cash to shareholders.  However, the motivation for many repurchase plans isn’t primarily related to returning cash to shareholders.  Instead, management may wish to “neutralize” dilution due to option issuance or may be seeking to temporarily boost the company’s share price.  There are complicated incentive systems at work that could very well lead to completely non-economic reasons for stock repurchases. The only rational reason to repurchase stock is when shares are available in the market at a price that is demonstrably less than a conservative estimate of a firm’s intrinsic value.  If such a condition does not exist, stock repurchases will destroy value regardless of the motivation behind the repurchase.

The listing above is hardly ground-breaking and forms the key set of principles that executives are supposed to consider when making capital allocation decisions.  Obviously, anyone who has earned an elite MBA, or any MBA for that matter, would be familiar with these core principles.  So why is it that we often see clearly sub-optimal decision making such as recurring cash dividends raised in an annual stair-step manner regardless of underlying business conditions?

Back to the Real World

As Yogi Berra famously noted, there is a big difference between theory and practice when it comes to operating in the real world.  Having the best intentions and following a sound and principled capital allocation process may not always be possible in all settings due to long standing institutional biases and shareholder expectations.  It would be utterly naive to suggest that a new CEO of a long established business engaged in irrational capital allocation practices could change the approach immediately.  Instead, what investors should look for is an overall approach consistent with rationality even if certain aspects may not be strictly defensible.

The first consideration is whether a firm has free cash flow available to deploy.  This is not necessarily a measure that must be taken on an annual basis and can perhaps be viewed in a normalized sense.  For example, a good business with a solid underlying moat may in fact be cyclical and lack ample free cash flow in periods when major investment opportunities exist.  The normal cyclical variances in free cash flow should not rigidly determine whether investment opportunities are exploited.  For a strong firm, it may very well make sense to engineer major acquisitions in times of business weakness by using debt or common stock, if shares are not especially undervalued.  In so doing, the long term intrinsic value of the business could be enhanced.

It is much more questionable, however, to continue paying large and rising cash dividends during times of weak free cash flow.  While certain investor groups may like the idea of steadily rising dividends, very few businesses have underlying economics that make such a dividend policy intelligent.  In the real world, variances in free cash flow will exist and should be taken into account when paying out dividends.  A rigid policy of fixed or rising dividends could actually impede intelligent expansion or acquisition opportunities in difficult economic conditions because, in addition to weak free cash flow, the firm will have to find cash for dividends.

For firms paying dividends, it makes more sense to either establish a variable dividend policy in which the annual payout varies completely based on economic conditions during the year or a very small dividend likely to always be covered by free cash flow plus a variable dividend, or “special dividend” determined based on available free cash flow.  Progressive is a good example of a company with a variable dividend policy.  A policy of special dividends has been popular among offshore oil drilling firms such as Diamond Offshore in recent years.  Such a policy is especially well suited for the highly cyclical oil industry, despite the attitude of the oil majors cited in the Wall Street Journal article.

If a firm chooses to pay a dividend while also repurchasing shares, it is incumbent upon the management to clearly explain why this decision has been made and what drove the proportion of cash return via dividends versus repurchases.  Repurchases should only be made in conditions where the share price is clearly and demonstrably below intrinsic value.  A clear warning sign of irrational capital allocation is a fixed share repurchase authorization that calls for buying a certain amount of stock each year regardless of the share price.  Sometimes firms even openly admit that they are doing this to offset stock option dilution.  However, this is irrational.  The issuance of stock options is a compensation issue, not a capital allocation matter.  Issuing shares to employees and repurchasing shares are two totally distinct transactions, despite the apparent need for some firms to pretend otherwise.

Rational and Practical Capital Allocation

Chief executives should ideally be competent operational managers as well as skilled capital allocators.  These skills are two sides of the same coin when it comes to achieving satisfactory returns on shareholder capital.  If a CEO is not a skilled capital allocator but is excellent operationally, perhaps the capital allocation function can be overseen by an independent director but this is hardly an ideal situation.  The Chief Executive must be the ultimate person accountable for overall returns to shareholders.  Excelling operationally while squandering the resulting wealth on indefensible capital allocation is hardly a good overall record.

Investors should be cognizant of the many historical and cultural reasons behind dividend policies that may not withstand strict scrutiny when it comes to optimizing capital allocation.  In such cases, the focus should be on not compounding past mistakes.  If a firm has a dividend in place, perhaps it is more practical to leave it in place but stop automatically increasing it in a stair-step manner each year regardless of business conditions.  Over time, inflation and real growth of a good business will reduce the economic meaning of a nominally fixed dividend and allow for incrementally better capital allocation without forcing a confrontation with established interests resistant to any change.

It is far less forgivable to tolerate share repurchase programs that lack rational economic merits.  A CEO who tolerates a repurchase of shares at high prices merely to offset stock option dilution or to temporarily boost the price of the stock is unworthy of shareholder trust and does not deserve to retain his or her job.  If a CEO puts in place a repurchase program, it must be clearly defended as accretive to the wealth of existing shareholders.  Any company repurchasing a fixed dollar amount of stock each year is almost certainly failing this test.

Ultimately, capital allocation will drive the real returns of investors over long periods of time.  Investors who ignore this key function and tolerate sloppy thinking and reasoning from their managers are likely to suffer lower returns over time compared to investors who demand a higher standard, even if that standard eliminates the vast majority of investment candidates from consideration.

How to Become a Better Reader

“In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time — none, zero. You’d be amazed at how much Warren reads–and at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”  — Charlie Munger

It is almost certain that the typical reader of this article has come across Charlie Munger’s famous quote on reading countless times.  The need to read extensively, not only when it comes to investment topics but much more broadly, is almost an article of faith for anyone who has spent considerable time studying the habits of highly successful investors.  Investing is a discipline in which one benefits from the cumulative effect of knowledge compounded over a lifetime.  In conjunction with life experience, pursuing a habit of regular reading can accelerate the wisdom required to identify opportunities with confidence.

Anyone who recognizes the truth in Charlie Munger’s statement is already well ahead of the vast majority of investors and has most likely already made efforts to emulate his approach.  For many people, doing so amounts to a completely different lifestyle in which diversions such as television are reduced or even eliminated in favor of several hours of reading per day.  However, those who are most interested in investing often make three choices that are likely to result in a sub-optimal return on the time invested.  First, most investors focus mainly on current events and therefore spend a great deal of time with newspapers and business periodicals.  Second, most investors will gravitate toward books on business or investing topics rather than adopt a more multi-disciplinary approach.  Finally, the scorecard investors use to measure their reading is often related to the sheer volume of material that has been read which puts an emphasis on speed and quantity rather than quality.

How To Read a bookThere are certain books of great value that can suffer from an overly simplistic title.  How to Read a Book, by Mortimer J. Adler and Charles Van Doren seems to fit in this category since, at a surface level, most of us have been reading books since grade school.  At varying levels of seriousness, most of us had to read hundreds of books of all types in order to graduate from college and for the most part, our intuitive sense of how to go about the process must have led to at least some success.  However, the number of truly influential books – those that we go back to mentally again and again – is a much smaller number, and perhaps it need not be so.  Perhaps we have suffered from the manner in which we have gone about reading over the years and could have retained much more value over time.

Most readers never consciously think about the various levels of reading when tackling a new book.  For the most part, readers will look at the cover, superficially skim the table of contents, and then just dive into the book and go through it in a linear manner.  However, at best, this process only goes through the first two of the four levels of reading documented in How to Read a Book. 

The first level of reading is referred to as elementary reading and is something the vast majority of people learn in grade school.  We understand what the sentences and paragraphs say in a basic sense because we understand the language that we have chosen to read in and have a decent vocabulary built over the course of many years.  However, merely understanding the words and paragraphs is only the most basic form of reading and has little to do with comprehension and true understanding of what the author is attempting to convey.  Some enhanced level of understanding occurs when one proceeds to inspectional reading which is really the art of systematic skimming.  The authors provide useful steps that will increase the return on the time spent at this level of reading.  One of the common errors is that readers often achieve only superficial knowledge of a book because they simply read through it in a linear manner rather than inspect the book systematically first.  The techniques to do so are quite valuable and most likely steps that most readers have not made explicitly in the past.

The authors emphasize that a thorough inspectional reading of a book may be all that is warranted based on the nature of the book.  It is not always necessary to proceed to the third step:  analytical reading.  Reading at this level requires a reader to go through an organized process wherein several questions are asked regarding a book and answers are sought.  As the authors state, analytical reading is “chewing and digesting it”.  This level of reading is not typically warranted if the reader is seeking entertainment or merely seeking information.  Analytical reading requires a significant time investment and it may be enough to simply do an organized inspection of a book.  It is up to the reader to determine whether it makes sense to proceed to an analytical reading of a book once the inspectional phase is complete.

Syntopical Reading is the highest form of reading because it involves reading a number of books on the same topic analytically and then placing the books in context in relation to one another and the overall subject.  This level of reading has the potential to bring about insights that are not found in any one of the books when considered in isolation.

As an example relevant to investors, one might want to conduct an analytical reading of Benjamin Graham’s The Intelligent Investor and Philip Fisher’s Common Stocks and Uncommon Profits and then come to grips with the underlying themes expressed in both volumes while drawing conclusions on investing that might not appear in either book in isolation.  This approach can, of course, be applied to other forms of literature including biographies.  It is quite possible than a thorough analytical reading of Roger Lowenstein’s Buffett: The Making of an American Capitalist and Alice Schroeder’s The Snowball: Warren Buffett and the Business of Life could lead to insights about Warren Buffett that one could not achieve by reading one of these books in isolation.

It would be difficult to do justice to the techniques expressed in How to Read a Book in a brief review, and this article is not so much a book review as a strong recommendation to pick up a copy and give the ideas serious consideration.  The fifteen distinct steps associated with reading well should resonate with most serious readers and bring about a better sense of understanding and comprehension resulting in a greater payoff for the time invested.

Charlie Munger likes to use the phrase “You are like a one-legged man in an ass kicking contest” to refer to individuals who have attempted to engage in some activity without satisfying the basic prerequisites necessary to have a good chance of success.  How to Read a Book significantly reduces the probability of being that one-legged man when it comes to reading comprehension.  It probably should be required reading for all incoming college freshmen, but it is better late than never.

In the video below, William F. Buckley interviews Mortimer J. Adler on Firing Line in 1970.  How to Read a Book was first published in 1940 and extensively revised in 1972.  Mortimer Adler died in 2001.

An Introduction to Charlie Munger’s Investment Philosophy

Of the tens of thousands of attendees at every Berkshire Hathaway annual meeting, it is likely that a majority have a working understanding of Warren Buffett’s overall investment philosophy.  Mr. Buffett is not only the public face of Berkshire Hathaway but also has become a celebrity in recent years.  There are probably only a handful of business leaders in America who have similar name recognition.  The same, however, cannot be said about Charlie Munger, Mr. Buffett’s longtime business partner and Vice Chairman of Berkshire Hathaway.  Much less has been written about Mr. Munger over the years and he has a far more modest media profile.  Many shareholders probably assume that Charlie Munger and Warren Buffett have an interchangeable view of investing but the reality is much more nuanced.

Charlie Munger: The Complete InvestorA number of excellent books have covered Charlie Munger’s life and philosophy but, until now, there has not been a relatively brief summary likely to be approachable for a Berkshire shareholder who is simply looking for a quick introduction.  This is why Tren Griffin’s new book, Charlie Munger: The Complete Investor, is likely to be of interest to thousands of Berkshire shareholders as well as others who make it a habit to study the ideas of those who have achieved remarkable success.  Since the book is relatively brief and can be read in one or two sittings, many readers who are already familiar with Charlie Munger may be skeptical regarding whether this book can provide a legitimate overview without being excessively simplistic.  A number of reviews are very skeptical and call the book a mere rehash of previously published material.  In our view, the book has value primarily for individuals who have not been introduced to Charlie Munger’s thinking in the past.

The fact that the book has many direct quotes from Mr. Munger is a source of derision in some of the negative reviews, but it would be almost impossible to write a book purporting to explain the Munger way of thinking about life and investing without extensive use of quotations.   Furthermore, although most of the quotes will be familiar ground for those who have followed Charlie Munger for years, the material will be new and captivating for other readers.  The witty nature of many of the quotations will likely prompt a curious mind to seek additional information elsewhere.

However, the book is not merely a compendium of quotations.  Mr. Griffin does a very good job of presenting the basic concepts of Benjamin Graham’s approach to value investing and this will be useful for readers who are new to the topic.  If all investors simply absorbed the information presented in Chapter 2, Principles of the Graham Value Investing System, much folly would be avoided even if that simply means that a reader resolves to use index funds and avoid the expenses, fees, and underperformance associated with poor active management.

Although most readers already familiar with Charlie Munger will find the chapters on worldly wisdom and psychology to be familiar ground, the book presents this material in a concise and approachable manner that can be read in a very short period of time.  Readers who want to delve deeper will no doubt want to read Poor Charlie’s Almanack which is, by far, the most entertaining and comprehensive coverage of Charlie Munger’s philosophy.  But Mr. Griffin succeeds in presenting the basics to a reader who could very well be intimidated by the time commitment required to read the Almanack.

One of the curious aspects of the book is that Mr. Griffin often repeats the term Graham Value Investing System while discussing Charlie Munger’s specific investment approach.  While it is no doubt true that nearly all value investors have adopted the foundational elements of Mr. Graham’s writings, Charlie Munger has been influenced to a much greater degree by Philip Fisher’s approach to owning higher quality companies.  Mr. Griffin does discuss Mr. Fisher’s influence but seems to more heavily weigh Benjamin Graham when it comes to explaining Charlie Munger’s overarching approach to investing.

Charlie Munger is often described as Warren Buffett’s “sidekick” at Berkshire, a depiction that is both disrespectful and inaccurate.  Although Mr. Munger is modest about his contributions to the success of Berkshire Hathaway, his role in nudging the company toward purchasing higher quality businesses rather than “cigar butts” has added enormous value over time.  Berkshire Hathaway shareholders, as well as other interested investors, would do well to study Charlie Munger’s life and investment philosophy.  Mr. Griffin’s book makes this process approachable with a minimal time investment.  As Warren Buffett has said, value investing is like an “inoculation”:  once presented with the basics, one either “gets it” or does not.  This book makes is far more likely that someone new to value investing will “get it” and seek out additional information on Charlie Munger in particular and value investing in general.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.