There’s a famous Warren Buffett observation 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.”
This seems like a relatively banal observation. If you think about it for a little bit, though, what Buffett is saying is pretty profound: the vast majority of all the long term value creation in a business is determined by how a CEO spends generated cash. If the CEO spends it well — say if she puts it into good bets — that capital could have compounded far and above a comparable index, the same way that investing well could have compounded your capital above the S&P500. But if the CEO spends it badly, that’s basically the same thing as setting all that cash on fire — cash that could’ve been returned to shareholders, to be put to better use elsewhere in the world. Watching all that cash burn is like basking in the glow of a paper bonfire.
In other words, the long term performance of a company is determined by how the CEO spends the cash generated by that company. This is not an intuitive argument — most people would think about innovation or business expansion — but it is a true one, and it’s one that Buffett has been beating the drum on since the late 70s.
(In fact, to make this hit harder: what Buffett is saying is that an outsized chunk of long term business performance depends on how you spend generated cash, and ignoring this ‘rule’ of business means that you are acting like a scrub — you are playing the game of business not by how it works, but by some set of made-up rules in your head).
There are really only five ways that CEOs can spend a company’s capital:
She can reinvest the earnings into the business.
She can use it to pay down debt (if the business has debt).
She can buy another company — that is, do mergers and acquisitions.
She can issue a dividend, or
She can do a share buyback.
This palette of five options make up a ‘capital allocation’ playbook. Do the five options well, and you’ll likely build a remarkable, market-beating business. Do it badly, and you fritter away the cash that your business generates, destroying wealth in the process.
The Commoncog essay that covers this topic is Building a Valuable Business? It’s How You Spend It That Matters. You may also want to read Commoncog’s summary of The Capital Cycle, or the series of cases about operating through the capital cycle.
The following series of cases cover a number of companies that do it well.