“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.