Perspective

Capital Allocation Frameworks and Long-Term Shareholder Value Creation

We strongly believe every business should have a capital allocation framework, given that a company’s ability to deploy capital effectively is one of the biggest determinants of its future success. For public companies with large cash balances or those generating significant amounts of operating cash flow, we think their capital strategy should be visible to investors.
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We recently wrote about how share repurchases can be deployed to the benefit or to the detriment of the long-term shareholder. Ultimately, they are a capital allocation decision and, like all capital allocation decisions, are dependent on anticipated return on invested capital (ROIC).

At TDM, given our long investment horizon, we spend a disproportionate amount of our time thinking about this topic. Not only do we allocate capital for a living, but we also believe that a company’s ability to deploy capital effectively is one of the biggest determinants of its future success. It is a belief we often reiterate to our portfolio companies’ executives and boards. The slide below – taken from a recent presentation we gave to a US public company board – is an example of this in action:

This long-term shareholder value equation is both logical and mathematically demonstrable. In fact, this is exactly what Jeff Bezos did in his 2004 Letter To Shareholders:

“Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share… shares are worth only the present value of their future cash flows, not the present value of their future earnings. Future earnings are a component—but not the only important component—of future cash flow per share. Working capital and capital expenditures are also important, as is future share dilution… Efficiently managing share count means more cash flow per share and more long-term value for owners.”

While this shareholder value equation may seem rather straightforward, we find that it is often forgotten, downplayed, or outright missing in many businesses we encounter. Similarly, compare the dearth of commentary on ROIC, share dilution or free cash flow conversion to the feverish debate centred on the varying interpretations to Rule of 40 (growth versus margin) in determining valuations.

At the end of the day, we find it hard to believe that, fundamentally, most long-term shareholders would not care about whether a business can generate actual cash and what it will use that cash for, given that the answer to this question can cause wildly differing returns outcomes. For a reminder of this, look no further than the example we walked through in our previous blog: “The Good, the Bad and the Ugly.”

Our Belief

Consequently, we strongly believe every business should have a capital allocation framework.

This framework should depict the options available to the company for investing available cash, and the expected return profile of each option. Whilst the company won’t necessarily disclose the latter to investors, for businesses with large cash balances and/or those generating (or soon to be) significant amounts of operating cash flow, we think they must provide visibility of their overall capital allocation strategy.

Frameworks

These frameworks appear in all different shapes and sizes:

In our view, the framework is responsible for communicating three things. We have listed these below alongside some of the types of associated questions that can run through investors’ heads.

  1. Management’s recognition of capital allocation as a fundamentally important topic – has the CEO and board invested the time thinking through the pros/cons of the various levers available to them? Why does the company have an enormous cash balance (relative to market cap) with no stated intention of deploying it – is there something they know that I don’t?
  2. Management’s overall philosophical approach to deploying capital (or not) going forward – is the company going to pursue M&A aggressively? Is it going to de-lever? What do these choices tell me about management’s view of intrinsic company value and organic growth? As a shareholder, is this something compatible with my investment appetite?
  3. The relative priority and associated returns of each option – do the current industry dynamics and growth outlook signify an opportunity to double-down on investment in organic growth? Or has the business reached a point of maturity which makes further investment in organic growth uneconomic versus mergers and acquisitions?

A framework enables management teams to control the narrative and feed some science into long-term oriented investor minds. It helps to address what might otherwise be speculation.

It is no coincidence that many of the great long-term investors – from Joel Greenblatt, to David Einhorn, to Nick Sleep – all highlight the importance of trying to understand management’s capital allocation capabilities as central to their investment approaches. As an example, here is Nick Sleep:

“… we work hard reading annual reports and proxy statements and interviewing management trying to answer the questions: what are returns on incremental capital and the longevity of those returns, are management correctly incented to allocate capital appropriately…

…The prime determinants of outcome are [purchase] price…and capital allocation by management. The first is in our control, that is, it is in our control to be patient and wait for the right price. The second involves a subjective judgment about the quality of management, and an assessment about the sustainability of business returns in the long run. It is these factors that occupy almost all our time.”

You will have noticed how prominent the quality and incentivisation of management is within the approach, too – a topic which also forms the central pillar in our Four Pillars investment framework.

TDM’s View on Capital Allocation Priorities

While being aware that every company is different and so there is no single correct ‘rule’, over the past twenty years of investing we believe boards should observe the following general capital allocation structure:

  1. Maintaining a healthy business:

    First and foremost, the framework should prioritise maintaining a healthy business. In our view this pertains to having a strong balance sheet (including appropriate recognition of any regulatory requirements), maintaining current competitiveness, and well-considered investments in long-term organic growth (i.e. those that exceed clear ROIC hurdles)
  2. Presenting options for excess capital:

    Companies should then map out all the options it has for investing cash beyond that which is required to maintain a healthy business i.e. excess capital. Each option should have an estimated return on capital assigned to it (the details of this probably wouldn’t be communicated externally), as well as any strategic considerations. This will naturally create a capital allocation hierarchy. These options are well-known but can include principal repayments, mergers & acquisitions and dividends, as well as share repurchases.

To successfully navigate the array of available options the board and management must have a live and realistic view of their company’s intrinsic value – both now and in the future. Without this, it is impossible to trade-off the possibility of share buybacks versus alternate options that have clearer return estimates. This view on intrinsic value also underpins stock-based compensation decisions or using scrip for acquisitions. Far too often this is overlooked as the starting point for the decision-making process.

A side note on buybacks

As long term-owners, we are a proponent of buybacks over dividends – ignoring the various and dynamic jurisdictional tax treatments – since a dividend forces a shareholder to take cash out of the business whereas a buyback offers shareholders a choice. Moreover, share repurchase authorisations are far more flexible than dividend commitments.

Of course, as stated in our previous blog, companies should then only repurchase shares when they form a view that the stock is conservatively below its intrinsic value – they are buying back stock cheaply – and the estimated risk-adjusted return profile exceeds that of the alternatives. As Warren Buffett again reminded us this year:

“To this obvious but often overlooked truth [that repurchases increase shareholder participation in company assets], I add my usual caveat: All stock repurchases should be price-dependent. What is sensible at a discount to business-value becomes stupid if done at a premium.”

In coming months, we hope to publish the case studies of two similar companies that took very different capital allocation approaches over twenty years, and the respective consequences for long-term shareholders.

Examples of Capital Allocation Frameworks

Below are three good examples of frameworks, each for different reasons – Intuit, Mineral Resources and Procore.

The framework contains a level of detail that evidences diligence on the part of Intuit’s leaders. Similarly it also displays the breadth of options available to the company.

Intuit

Here, the company’s priorities are clear, as is the delineation between what they consider ‘required’ versus ‘excess’ cash. They also specify liquidity, leverage, dividends and ROIC targets. (Not to mention, it is visually digestible for those amongst us who like a well-designed slide!)

mineral resources

Albeit lacking in specificity, Procore is in rarefied air by both elevating free cash flow per share as a primary objective and attempting to methodically outline how they intend to improve it.

Procore

Free Cash Flow Per Share

Having focused on the capital allocation component of our equation, it would be remiss to not touch on free cash flow and dilution.

In many ways free cash flow per share links all three parameters since it is dependent on a business’s capital expenditures and management’s propensity to repurchase and issue stock. Depending on a company’s conviction in its estimated return on capital it may want to throttle or accelerate capital expenditure which in turn increases or decreases (respectively) free cash flow in that year. As Warren Buffett believes, true “owner’s earnings” are only fairly calculated after one accounts for the capital expenses a company requires “to fully maintain its long-term competitive position and its unit volume”. In our capital allocation framework priorities (above), this sits within ‘Maintaining a Healthy Business’.

Furthermore, as Nick Sleep suggested back in 2005 – in this case referring to Costco:

“the correct response to a six-year share price famine is for the company to use its balance sheet to buy back shares at prevailing prices and allow the long-term growth in free cash flow per share (an inescapable function of steady margins, falling asset intensity, growing revenues and a shrinking base of shares outstanding) to translate into a higher share price over time.”

Not only does free cash flow per share capture management’s ability to repurchase its stock wisely, equally, it reflects their desire to issue it.

Recently, to our great delight, we have witnessed companies managing to and guiding shareholders to net dilution targets – see Confluent (1), Samsara (2) and Zeta Global (3 & 4) below:

Managing Net Dilution

In the same vein as our three objectives for capital allocation frameworks, the presentation of a net dilution framework tells us:

  1. that management cares about it;
  2. that they want to be held to account on it; and
  3. what we can expect going forward as current or prospective business owners.

Far from eschewing the distribution of stock to employees, we believe it’s a vital component of incentivising employees to think and act like us – long-term oriented business owners. In other words, it aligns incentives. What we don’t support is excessive or indiscriminate stock issuance to the detriment of long-term shareholders.

Our recent work has confirmed our belief that companies should be targeting <2% net dilution.

Conclusion

We urge more CEOs and boards to elevate the importance of free cash flow, capital allocation and share count in board room conversations and, moreover, convey the upshot of these discussions to long-term shareholders.

As growth investors we would be lying if we said we weren’t guilty of too readily appropriating topline growth as a corollary for prospective long-term shareholder returns. Ultimately, we are continually reminded (and humbled) by the universal truths of free cash flow, capital allocation and dilution.

About the author

James is a member of the TDM Investment Team. Alongside his day-to-day investment duties, he supports Block and advises other portfolio companies on growth strategy.

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