Building a Valuable Business? It's How You Spend It That Matters

This is Part 6 in a series on the expertise of capital in business. You may read the previous part here.

In the previous entry of the Capital Expertise Series we talked about the Capital Cycle — and got an initial sense of the importance of capital allocation. Marathon Asset Management likes to quote Buffett on this topic: “after ten years on the job, a CEO whose company annually retains earnings equal to 10 percent of net worth will have been responsible for the deployment of more than 60 percent of all the capital at work in the business.” The implication: how well an investment does is highly, highly dependent on the capital allocation decisions that management makes, especially if a company is held for the long term.

In truth, we’ve already examined the capital allocation playbook in an earlier entry in the series. In The Skill of Capital I walked you through the set of five moves you can make if you treat businesses as a cash generating black box, and then told you the story of Mark Leonard — who quit a career in venture capital and used that playbook to build an empire in Constellation Software.

In my experience, capital allocation skill is something that long term investors obsess over, whereas it is something that operators nearly never talk about. I think it’s high time we talked directly about it.

What is the Skill of Capital Allocation?

The concept of ‘capital allocation’ is actually really easy to describe. One way of looking at business is that it is a ‘box’ that provides a service to some set of customers on one end, and spits out a stream of cash out the other end. What you do with that stream of cash is called ‘capital allocation’. Why is this important? It is important because how you use the cash will determine the long term value of your business: either you spend it in ways that increase the future value of your company, or you return it to shareholders, netting no impact on future value, or you spend it in ways that just basically set it all on fire.

Here’s investor Will Thorndike, in his classic book The Outsiders (all emphasis mine):

CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important. (Teledyne CEO Henry) Singleton, in contrast, gave most of his attention to the latter task.

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

It is a paradox of business that spending even a little bit of time on the ‘capital allocation’ end of the equation can result in some outsized business outcomes. We’ve mentioned Henry Singleton in passing in the ‘Common Mistakes’ section of the Capital Cycle piece. I used Singleton’s story to make a point about being contrarian in the face of the capital cycle; Thorndike uses Singleton’s story to make a related but entirely different point.

“What,” Thorndike asks at the start of his book, “makes for a great CEO?”

A layperson’s answer might be “a great CEO is a leader who builds a sustainable business that generates good returns for shareholders, serves customers, provides jobs to employees, and creates value in the world.”

Thorndike is an investor, and so he focuses on the first part of that sentence: “a great CEO is a leader that builds a sustainable business that generates good returns for shareholders.” Whether this is a fair characterisation is part of a broader debate about business: proponents of the ‘shareholder maximisation’ approach, for instance, would argue that ‘serves customers, creates jobs, and produces value in the world’ may be captured by the market valuation of the company. As an operator, I don’t completely agree with this, but that is a debate for another day. What I want to focus on is that yes, creating value for company owners is big part of the responsibility of the CEO, and since it is a big part, we should talk about that.

The truth is that if you focus on Thorndike’s definition — which is to look at the amount of enterprise value created by a CEO over the course of their tenure — then the set of CEOs you might pick as ‘good’ changes rather dramatically.

Ask a random sampling of people “who is the greatest CEO for the previous 50 years” and it’s likely that they would pick someone like ‘Jeff Bezos’, ‘Mark Zuckerberg’ or ‘Jack Welch’. These are bold business leaders, prone to pronouncements in the press, actively involved in creating and building highly valuable businesses. In his book, Thorndike focuses on Welch as an example, which is reasonable: Welch was one of the most celebrated CEOs of the 90s, and his retirement at 2001 meant his impact could be assessed in the fullness of time. Welch served as CEO of General Electric from 1981 to 2001, creating a superb 20.9% compound annual return for shareholders. During that 20 year period, the S&P 500 index averaged a 14% annual return. This, in turn, meant that GE outperformed the S&P 500 by 3.3 times over the course of his run; we cannot dispute that Welch did well for his shareholders.

But Thorndike then points out that if you take shareholder return seriously, Welch is not even on the same planet as Henry Singleton.

Singleton founded Teledyne in the early 1960s, and ran it for 28 years until stepping down as chairman in 1990. During this period, Singleton steered the conglomerate through several protracted bear markets — whilst Welch enjoyed the headwinds of an epic bull run that began in late 1982 and continued largely uninterrupted until early 2000. In the 70s, Singleton pioneered the then-heretical strategy of doing share buybacks when faced with a palette of subpar capital allocation alternatives (I’ll explain what that means in a bit). He eventually bought back 90% of Teledyne’s outstanding stock. The result? Teledyne’s compound annual return for shareholders was 20.4% over the course of his 28 year tenure. This sounds roughly equivalent to Welch’s return ... until you consider the performance of alternatives during the time period. Singleton’s relative performance was ridiculous: Teledyne outperformed the S&P 500 of the same period by over 12 times. Thorndike writes:

Using our definition of success, Singleton was a greater CEO than Jack Welch. His numbers are simply better: not only were his per share returns higher relative to the market and his peers, but he sustained them over a longer period of time (twenty-eight years versus Welch’s twenty) and in a market environment that featured several protracted bear markets.

His success did not stem from Teledyne’s owning any unique, rapidly growing businesses. Rather, much of what distinguished Singleton from his peers lay in his mastery of the critical but somewhat mysterious field of capital allocation—the process of deciding how to deploy the firm’s resources to earn the best possible return for shareholders.

And he did all of this with little involvement in the active management of his businesses, issuing few pronouncements in the press, operating with little fanfare from headquarters, enjoying long-term working relationships with legendary venture capitalist Arthur Rock and literal genius Claude Shannon, both of whom served on his board. After he had proven his model with Teledyne, a somewhat younger pair of men, one named Warren Buffett and another named Charlie Munger, studied some of his approaches, and applied them to an ailing textile company called Berkshire Hathaway.

Such is the power of good capital allocation.

What’s The Intuition Here?

Why is capital allocation so powerful? We actually already have the answer in the opening paragraph of this essay: as you recall, Warren Buffett points out that if a company retains just 10% of its net worth every year as retained earnings, at the end of 10 years the CEO who decides how to spend that 10% would have spent 60% of all the capital at work in the business.

But perhaps this isn’t intuitive enough for you. Thankfully there is an easier way to make this point. Buffett has proposed a simple test of capital allocation ability: “has a CEO created at least a dollar of value for every dollar of retained earnings over the course of her tenure?”

This sounds reasonable, until you think about it for a moment. Then you realise it’s basically insane.

Let’s walk through a concrete example. Google is a good business, yes? It has a powerful moat, and has as close to a monopoly as possible in one of the most lucrative markets in the digital economy. It generates billions of dollars in profit a year, at eye-watering margins. It has more cash than it knows what to do with. And therein lies the problem.

Alphabet — Google’s holding company — has spent more than $30 billion dollars on ‘Other Bets’ — at least, that we know about; it only broke out the expenditure as a separate category in 2015. In practice it’s probably spent more than that. Has this investment resulted in $30 billion in value? No. Let me restate that question, so that it’s clearer: will the expenditure produce a new set of businesses that are together worth more than $30 billion in enterprise value? The honest answer to that is ... maybe — we shall see. But remember Buffett’s test: has the CEO produced at least a dollar of value for every dollar of retained earnings? Right now Alphabet spends $1.5 billion every quarter on Other Bets — which is $1.5 billion of retained earnings that could’ve gone to other things, had it not been spent in service of a moonshot project. Every dollar incinerated each quarter is a hole that a winning bet must fill in later, if Alphabet CEO Sundar Pichai wants to even have a shot of passing Buffett’s test.

It’s not impossible, but the hole keeps getting bigger every year.

I know what you’re thinking. Yes, $1.5 billion in operating losses is a pittance compared to the $76 billion Alphabet generates every quarter. Yes, it’s probably good for society that companies are willing to spend big on fundamental technology advances, and to keep up that spending over a prolonged period. But that’s irrelevant to both the form and the function of Buffett’s test, and that is the point. You now have a sense for the tradeoffs a CEO must make to pass the test, and what a ridiculously high bar that test actually is.

For reference, Singleton produced 2.0x the value for every dollar retained in Teledyne. Buffett himself produced 2.3x in Berkshire, at least as of 2007 (the year of The Outsiders’s publication). This is what world class looks like.

As a thought experiment, let’s flip this scenario on its head. Imagine if you put someone like Singleton in charge of an entity like Alphabet. (This is not ridiculous: Singleton was an exceptional electrical engineer with multiple inventions to his name, and high technology conglomerates like Teledyne were the tech stocks of his day). Imagine that suddenly the excess cash generated by Alphabet’s core businesses became the sole responsibility of a tech savvy, talented capital allocator. And now imagine that this allocator had free rein to invest these dollars in either part ownership or full ownership of various quality businesses, along with a smaller budget to spend on conservatively originating new technology companies. Imagine that such an entity would be allowed to compound over the next five decades. How much more valuable might a company like Alphabet be?

This is quasi-rhetorical: it would be a heck of a lot more valuable than it is today.

(Ironically, Alphabet’s structure was modelled after Berkshire Hathaway. Whether this structure is modelled in form or in spirit is left as an exercise for the alert reader.)

In truth, large moats and high margins forgive a lot of sins. Alphabet is a fine company even without a good capital allocator at the helm. But perhaps now you have a better sense of what good capital allocation might mean for a corporation — and what might be possible if some of that cash is deployed differently every quarter.

The Five Moves

We’ve already discussed how there are basically just five moves in the capital allocator’s playbook. Let’s talk about each of them in turn.

Reinvest Earnings

You may choose to reinvest earnings in your existing businesses. To many operators, this is the default option: when a business is young, pouring money back into the business typically produces good growth. Problems only emerge when your business approaches maturity, and marginal investment in the business starts to produce decreasing returns.

In truth, reinvesting in your business is like picking an investment. If you choose to continually reinvest in an investment with a deteriorating rate of return, you would be doing something dumb. Your cash might be better deployed if socked into one of the other four options in this playbook. But most operators don’t think of their reinvestment decision in this manner — instead, they think like the company managers that they are. Why shouldn’t I spend more on my business? Why shouldn’t I sell into new markets, hire more staff, open up new offices? And so they continue pouring money into their businesses, bloating the company with headcount and process bureaucracy even as growth plateaus.

Pay Down Debt

If a company has debt on its books, it might make sense to take excess cash to pay down that debt. As we’ll see in several future case studies, one of the hallmarks of a good capital allocator is to keep debt burden at a reasonable level, so that the company can lever up to do opportunistic buying whenever times are bad.

This is especially useful when all of your competitors have gorged themselves and loaded themselves up with too much debt. In those scenarios, bad operators can’t move on a great deal, since they can’t take on any more debt to do additional acquisitions.

Mergers and Acquisitions

You could also buy a company! There are multiple ways to do this:

• You can issue new equity to fund the purchase of the company (in cash).
• You can purchase the company with your stock (either new or existing — say you have for whatever reason a reserve for acquisitions).
• You can pay cash from retained earnings.
• You can lever up.
• You can lever up and put the debt on the books of the company you’re acquiring.
• Or you could do some combination of all of the above.

The principle is the same: is the acquisition good for your shareholders? If you issue more equity, would the long-term value of the company you’re acquiring justify the dilution that existing shareholders would experience? If it costs money — retained earnings, say — or debt, would the value you get out of the company be higher than the cost of the capital you’re spending for it? And recall that it’s actually opportunity cost that matters here: the money that you’re spending on an acquisition might be better spent in one of the other four options.

This is tricky to do, of course. Often a company will look at a potential acquisition and say to itself “oh look at how much synergy there’s going to be!” This comes in two forms: either the company makes your combined products or services more valuable together, or you get cost synergies — which means it’s cheaper to run your business as a combined entity than before you do the acquisition.

In practice, most revenue or cost synergies turn out to be illusory. One way of thinking about it is that buying a company with cost synergy tends to be capped upside (there’s only so much costs you can save); whereas buying a company that’s a good business on its own merits tends to be unknown but unlimited upside (the business might be better than you think).

In The Outsiders, Thorndike points out the majority of good capital allocators seem to do the latter: that is, acquire companies that are simply good, defensible companies on their own merits. Berkshire certainly does this (Buffett and Munger are openly suspicious of proposed synergies). Constellation Software — which we last discussed in The Skill of Capital — buys good, defensible businesses, and then shares best practices amongst the various operating companies to improve them. There are many ways to skin a cat it seems ... assuming, uh, the cat is a good one.

Why do these CEOs limit themselves to buying good companies? At this point, we have an answer — it all comes back to Buffett’s test. Has a CEO created at least a dollar of value for every dollar of retained earnings over the course of her tenure? It doesn’t take that many mistakes to fail the test altogether.

So, ok: we’ve taken a look at the three ways to spend money. Let’s take a look at the final two moves in the capital allocation playbook: both of them methods for returning capital to shareholders.

Issue a Dividend

Why would a company want to return capital to shareholders? The glib answer is that it’s their capital — shareholders are ostensibly the owners in a company. The managers are usually owners too — at least in theory — most company executives are rewarded with large slugs of company equity. But in practice there may be principal-agent problems with this setup: sometimes managers do not think like owners, and treat shares like compensation; they hold the equity for the short term before selling into the market. Horror stories also abound: it’s not uncommon for management to take the capital deployed in the company and put it to use for their own comfort: think chauffeured Rolls Royces, expensive art displayed in the C-Suite’s offices, or private jets reserved for the sole use of the CEO.

The textbook answer as to why a company would want to return capital to shareholders is that a CEO cannot find a reasonable use for it within the company. You can see how this might happen: say you’re in a mature business, you have little-to-no debt you need to pay down, the capital cycle is red hot — making acquisitions unattractive, and you know the marginal rate of return for reinvesting in company operations is terrible — far below your hurdle rate. So instead of holding the cash on your books, you decide to return some of it to your investors.

The problem with issuing a dividend is that it’s not tax advantaged. Thorndike notes that all the capital allocators he studied in his book eschewed dividends for precisely this reason. In an interview, Thorndike says:

Specifically, they generally disdained dividends. They generally either avoided them, either avoided them altogether, or they paid a substantially lower — their dividend yield was substantially lower than the peer group. And the reason for that in every case was tax inefficiency. So one of the common threads across the eight [CEOs] was a real focus on tax minimization, optimizing kind of after-tax outcomes. And dividends just are inherently deeply tax inefficient. It is a two layers of taxation.

The exception to that across the group was the occasional use of special dividends. So as opposed to getting on the regular systematic quarterly dividend treadmill, occasionally some of these CEOs would pay a large one-time dividend, when they didn't have other alternatives, and you often time to coincide with favorable tax, the timing, timing relative to tax bills being passed or about to be passed.

So, if not dividends, what do they do instead?

Share Buybacks

It appears that what most good capital allocators do to return capital to shareholders is to do share buybacks. And they do this in a very specific way: they do lumpy purchases when their stock price is at an all-time low. Contrast that with the regular share buy-back programs that most mainstream corporations seem to do.

Why do they do things this way? Again, recall Buffett’s test, above. If your share price is undervalued compared to the intrinsic value of your company (and you have some internal valuation model of your company that isn’t nuts) — buying back shares increases the value of the shares remaining, pushing the price up ... and rewarding the shareholders that hold on.

Conversely, buying back stock when your share price is overvalued destroys shareholder value — this is no different from acquiring a company that turns out to be a dud, or setting your cash on fire by reinvesting back into subpar returns.

Is This Only Relevant for Large Companies?

No, not really. The idea that a business generates cash, and that the cash may be reinvested into opportunities that maximises the return of that capital — this is universal. It is just a slightly ... odd view of business. It’s certainly not the view of business most operators learn on their own.

Perhaps now you might see why Warren Buffett says things like “I am a better investor because I am a businessman, and a better businessman because I am an investor.”

Or why he writes things like:

... the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it's as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve (emphasis added).

In truth, capital allocation is ‘easy’ for the first few years of a company’s life: it’s generally a good idea for every spare dollar generated to be ploughed right back into the business — the returns are usually well-justified! This is even more the case for corporations that must raise equity or take on debt to build a viable company.

But even in this takeoff phase there are smart ways of thinking about capital, and there are dumb ways of thinking about capital. Thorndike proposes the following list of beliefs that characterise the best capital allocators:

• Capital allocation is a CEO’s most important job.
• What counts in the long run is the increase in per share value, not overall growth or size.
• Cash flow, not reported earnings, is what determines long term value.
• Decentralised organisations work better (for capital allocation).
• Independent thinking is essential to long-term success, and interactions with outsider advisors (Wall Street, the press, etc) can be distracting and time-consuming.
• Sometimes the best investment opportunity is your own stock.
• With acquisitions, patience is a virtue ... as is occasional boldness.

Some of these beliefs may be held at the early years of a company, long before any meaningful capital allocation decision must be made. To which I would add: taking shareholder returns seriously seems to be a through line across the best CEOs. Not because the other stakeholders in a business aren’t also important: you do want to do right by your customers, your employees, your suppliers, and your society ... but shareholders are a part of business, and taking care of them is important. This, I think, is another universal attribute that applies regardless of whether you’re running a big company or a small one: you can pretty quickly see if an executive team is able to think: “I am a shareholder, and I’m not going to spend company capital on an employee-only petting zoo. That’s just bad capital allocation.”

You might think this is obvious, but sometimes it isn’t. A Singaporean startup I was once tangentially involved with (we build the first version of their iOS app) bought a ski lodge in Japan with company money. This was, incidentally, a money-losing grocery delivery startup. They died a horrible death a few years later. I thought the whole episode was a good example of how bad at capital the CEO actually was — and how much he thought of his shareholders.

Wrapping Up

I’ll let Thorndike have the last word:

The business world has traditionally divided itself into two basic camps: those who run companies and those who invest in them. The lessons of these iconoclastic CEOs suggest a new, more nuanced conception of the chief executive’s job, with less emphasis placed on charismatic leadership and more on careful deployment of firm resources.

At bottom, these CEOs thought more like investors than managers. Fundamentally, they had confidence in their own analytical skills, and on the rare occasions when they saw compelling discrepancies between value and price, they were prepared to act boldly. When their stock was cheap, they bought it (often in large quantities), and when it was expensive, they used it to buy other companies or to raise inexpensive capital to fund future growth. If they couldn’t identify compelling projects, they were comfortable waiting, sometimes for very long periods of time (an entire decade in the case of General Cinema’s Dick Smith). Over the long term, this systematic, methodical blend of low buying and high selling produced exceptional returns for shareholders.

Shareholder return isn’t everything in business, but if you’re an owner, it’s a lot.

Appendix: Thorndike’s Checklist, and Book Recommendations

If it isn’t already clear, I highly, highly recommend Will Thorndike’s The Outsiders. Over the past five years or so, I’ve lost count of the number of times I’ve recommended the book to fellow operators. The book is illuminating precisely because it presents an entirely variant view of business. And on that note, I’ll be spending one or two more entries in the Capital Expertise Series adapting cases from the book, so you get a taste of capital allocation skill in action.

But I also want to call out Jacob Taylor’s The Rebel Allocator. As I’ve said many times over the course of this series — I am an operator, not an investor. Taylor’s book is written as a novel, and was my first introduction to the topic of capital allocation. Over the years — and thanks to the magic of the Internet — I’ve gotten to know Taylor a little, and I’ve learnt that he has a deep passion for influencing company managers on this topic. Well, he’s influenced me. Consider this my small contribution to paying it forward.

I’ll end this piece with Thorndike’s checklist, presented at the end of The Outsiders:

1. The allocation process should be CEO led, not delegated to finance or business development personnel.
2. Start by determining the hurdle rate — the minimum acceptable return for investment projects. This is one of the most important decisions any CEO makes. [Thorndike’s comment: Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the mid-teens or higher.)]
3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions. [Thorndike’s comment: Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic — it is often corporate code for low returns.]
4. Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark. [Thorndike’s comment: While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value if they are made at exorbitant prices.]
5. Focus on after-tax returns, and run all transactions by tax counsel.
6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.
7. Consider a decentralised organisational model. (What is the ratio of people at corporate headquarters to total employees — how does this compare to your peer group?)
8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.
9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.
10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns.

If all of this seems deceptively simple, that’s because I think that it is. I still don’t fully understand how it’s so difficult to do in practice. Empirical evidence tells us that few CEOs can pass Buffett’s test, and Thorndike himself states that the universe of good capital allocator CEOs is tiny. Perhaps it’s all a matter of exposure? Check back, perhaps, at the end of my career; I hope to have the opportunity to find out.

This is Part 6 in a series on the expertise of capital in business. You may read Part 7 here: Capital Allocation as an Antidote to Business Luck.

Originally published 18 October 2023, last updated 01 June 2024.