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.

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.


The Individual Investor’s Edge

“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” — Warren Buffett, 2013 Letter to Berkshire Hathaway shareholders

As Albert Einstein wisely stated, compound interest is the eighth wonder of the world:  He who understands it earns it while he who doesn’t pays it.  The vast majority of individuals who take the initiative to accumulate savings should follow Warren Buffett’s advice on using index funds and dollar cost averaging to achieve satisfactory returns over time.  For those earning at or above the median wage in the United States, it would be very difficult to end up poor if one simply saves ten to fifteen percent of gross income and dollar cost averages into the S&P 500 over several decades.

But what about non-professional individual investors who want to achieve better than average results?  In the short run, the stock market resembles a manic-depressive character who bids up prices one day and sends them down the following day without much of a reason for the change in sentiment.  Benjamin Graham’s “Mr. Market” character perfectly personifies the psychology of financial markets in the short run.

Any individual who pays attention to the markets can observe this insanity and it is seductively easy to draw the logical conclusion:  If the markets are so crazy, why not try to profit from the insanity?

Circle of Competence

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

One of the ironies of financial markets is that while short term action may appear utterly stupid, it is a grave mistake to assume that market participants are individually stupid or that it is somehow easy to outperform market averages by actively trading.  Investors would do well to constantly think about the fact that there is another equally motivated investor on the other side of every trade they are considering.  That investor may resemble Mr. Market’s irrationality at any given time, or he may have superior insights into the security in question.

The existence of superior insight is often referred to having a “circle of competence” encompassing the activities of the business or industry in question.  To claim that an industry falls within one’s circle of competence is not to be taken lightly.  It involves far more than being familiar with a company’s product line or reading about the industry in question in the newspaper.  One must possess expert knowledge of the subject matter to possess superior business insights that other market participants do not also possess.  For most non-professional individual investors, this type of insight is only likely to exist in subject matter related to the investor’s profession.

The problem is that most investors would be ill advised to concentrate their personal investments in their employer or its competitors since there would then be a correlation between the individual’s source of employment income and the performance of his investments.  A general industry downturn could cost the investor his job and, at the worst possible time, result in a severe depreciation in his investment portfolio.  Few individuals, even those with a reasonable emergency fund, would find this correlation of misfortune to be a pleasant experience.

But is it not possible to obtain competence in fields outside one’s area of employment?  It certainly should be with enough intelligence, dedication and effort.  Few individual investors are going to be motivated to spend the time and energy required to truly understand multiple industries, let alone develop special insights that professionals do not have.  It is certainly not impossible for a small percentage of individuals to possess this ability.  However, it would certainly be very difficult for most investors to do so.  On the other hand, it may not be that difficult to obtain a working knowledge of various industries and businesses.  In this case, an individual would possess knowledge that is at least as good as other market participants but perhaps have few, if any, special insights into the industry or business in question. Can such an individual expect to show any meaningful results in exchange for the effort?

Timeframe Arbitrage

The enterprising individual investor has one major advantage that nearly all professional investors lack:  there is absolutely no logical reason to care about short term performance when evaluating investment candidates.  To the extent that commitments to common stocks have a timeframe measured in several years (ideally five to ten years or longer), there is really no reason whatsoever to care about the price movements of the investment over the next week, month, quarter, or year.

The ability to take such a sanguine view of the world is limited to non-existent for the vast majority of professional investors.  Professional investors who are engaged in active management of a portfolio are evaluated based on their performance relative to other active managers as well as benchmark indices.  Professional prestige, career advancement, and compensation hinges on short term performance.  For this reason, many professional investors “closet index” in an attempt to closely replicate the results of a benchmark and deviate from this practice only when they believe that doing so provides an edge in the short run.  The pain of falling far short of a benchmark can be far greater than the pleasure of exceeding it.

It is true that there are many value oriented professional investors who take a longer term perspective.  However, such investors are still not immune to shorter term comparisons.  It is striking how many value oriented hedge fund managers publish quarterly letters to shareholders in which holdings are analyzed based on performance over a meaningless timeframe.  Why is this done?  Clearly investors demand that kind of feedback from managers and it is necessary to comply with this demand in order to retain assets under management.  Even with a long term mindset and the best of intentions, it is hard to see how a value oriented professional investor can make decisions to maximize value in 2020 when he knows that it will be necessary to explain short term price movements a couple of months from now when year-end 2015 results are reported.


Most individual investors are well advised to simply save as much of their income as possible and dollar cost average into one or more low cost index funds over many decades.  Using this approach, one need not make exceptional amounts of money to retire with a greater net worth than the vast majority of Americans.

With success virtually assured using such an investment approach, one must have very good reasons to deviate and embrace active portfolio management.  Still, many enterprising investors will seek to do better either because they wish to accumulate capital at a faster rate or simply because they enjoy the process (the most successful with have both characteristics).  Such investors will need to develop a working understanding of a number of industries and businesses to have a decent prospect of outperforming a benchmark index over time.

But do they require the truly superior insights implied by the circle of competence concept?

Surely having superior insights is something an investor should aspire to achieve since the truly big winners most likely require such insight.  However, achieving insights that put the individual on par with professionals operating in the same industry could be sufficient if the individual investor harnesses his or her major advantage:  timeframe arbitrage.  By doing so, the individual can invest in situations that may appear compelling to a professional in the long run but not in the short run.  The individual will view himself as trading with people who are not stupid but simply have different priorities and goals.