The Hidden Power of Capital Allocation (And Why Order Matters)

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2:07All right, folks, welcome to Investing for Beginners podcast. Today, we have our good friend Brian Feraldi from Long Term Mindset back to join us today. Today, we're going to talk about the hidden power of capital allocation and why order matters. So, Brian, welcome back to the podcast. Thanks for joining us this morning. And let's talk about some capital allocation. Thanks, Dave, for having me. It is great to be back. And this is a topic that I think is incredibly important for investors, especially investors in individual businesses, to really understand because it's something that is confusing at the outset.

2:44But once you understand the framework, once you understand the choices that management team has, a whole bunch of things about analyzing businesses just starts to make sense. Yeah, yeah, totally. So, I guess let's start with like what separates great businesses from averages one. It's not just what they do. It's about what they choose not to do with their cash. So, you know, capital allocation is very important today. There's a lot of conversation about it around AI. So let's talk about the, like how this impacts the CEO capital allocation, and we'll kind of walk through the order, how it works, and yeah, that.

3:22So let's talk about why capital allocation matters. So could you give us maybe a definition of it? Sure. Capital allocation is simply the process of management allocating the capital that the business has. The capital the business has could be generated generally from two different sources. Source A is internally generated funds. So the profits or the cash flow that the business generates. The management team has to choose what do we do with the profits that the business is generating. The second source, which is more common for startups and early stage businesses, is capital raised from outside sources.

4:00In the beginning, that's typically done from investors in the form of equity. Later stages, it's done from banks in the form of debt. But management teams have full control over the company's capital allocation decisions. And what the companies choose to do with that capital can have an enormous, enormous impact on the future value creation of the company. I mean, none other than Warren Buffett believes that the CEO's number one most important job is capital allocation. So it's something that Buffett pays attention to. Therefore, we should pay attention to it. Yeah, exactly. So who do you think are some of the really good capital allocators, maybe today and maybe recent past?

4:46There are lots of great capital allocators to choose from. And a very quick short code is to look at market capitalizations. You don't become a multi-trillion dollar corporation like NVIDIA, like Microsoft, like Apple, without being extremely good, extremely skilled at capital allocation. But beyond that, when I think about really good capital allocation, not at the mega scale, I think of companies like AutoZone or O 'Reilly Automotive. These are companies in pretty boring, pretty stable businesses, auto parts suppliers. But those companies have generated enormous returns for investors, almost like 20 % company annual growth returns, almost sheerly due to capital allocation decisions by the management team.

5:32So when used appropriately, capital allocation can be a huge turbocharger to returns and investor returns. And unfortunately, the inverse is also true. When done poorly, you can take a very good business and essentially drive it into the ground. Yeah. So let's maybe double down on that a little bit. So we all focus on the great capital allocators, but what happens to the poor capital allocators? How does that impact us as investors? Yeah. So as a business is generating profit, the management team has to choose, again, what do we do with that profit? And as a broad statement, there are five general things that they can do with the profit.

6:15So let's walk through those. First is reinvest in the core business. So take those profits and replow it back into the business. This could come in tons of different forms. The management team could use that capital to buy new buildings, open up new stores, hire research and development folks. They could re-spend that on marketing. They could hire new management teams. They could expand into new international markets, open up new geographies, build new products or services, right? The list of choices within reinvesting in the core business is almost endless. So that's one option that they have.

6:57A second option is strengthen the balance sheet. So as the cash is coming in, they could simply increase their cash balance, right? Do nothing with it and build up their cash balance, or they could pay off debt that they have in the business, making the business more resilient. Another option is mergers and acquisitions. They could use the capital to buy out competitors, buy other companies, enter new businesses. A fourth option is give that money directly back to shareholders in the form of a dividend. So just take the cash and pass it right along to shareholders. Some investors love this. And then the fifth and final option would be stock buybacks.

7:38So go to the public markets, repurchase your stock and bring it in and retiring it, thereby reducing the number of shares outstanding. So those are the five core options that investors have, and all of them have pros and cons associated with them. So getting them in the right order at the right time, if you do that well, you can really boost your investors' returns, screw it up, and you could you could end up going bankrupt if your capital allocation was really that poor. Right. And I think the thing that we need to remember too, is that every dollar that they choose to spend has an opportunity cost and you only get to spend it once.

8:17And so these decisions are very, very, very important. And if a company chooses poorly, you know, if they're like trying to build empires or buying acquisitions that aren't really necessary for the business or overpaying for buybacks, which is a really popular thing right now, that can really destroy shareholder value. And I think a lot of people don't really understand how important this really is. Yeah. A recent example of this that keeps coming to mind is Teladoc and Livongo. During the COVID periods, Teladoc was a go-go growth stock, training at all-time highs. And at their peak valuation, they bought another publicly traded company called Livongo Health.

8:57That was a capital allocation decision on the part of Teladoc's management team. So they almost doubled the size of the business overnight. And when you're trading at a very high valuation, everybody was applauding the idea at the time. Looking back, that has proven to be a disastrous, disastrous use of capital. The synergies weren't there. The growth slowed down. Teladoc's already bruised balance sheet, got even worse. Combining the two companies together just didn't work. And Peladoc Health stock, the last time I looked, was down over 70 % from its peak, perhaps even more. I haven't checked it recently.

9:36But to me, that's a prime example of horrible capital allocation decisions by a management team and what can happen to shareholders if management teams screw this up. Yeah, yeah, exactly. Let's kind of segue into the order. You mentioned that at the end. Why does the order matter? Yeah. So at different times in a company's history, they should really focus on different aspects of capital allocation. And the order that they allocate capital really matters. Some management teams have a disciplined process that they use for allocating capital and a step by step process that they go through. Others don't, and they just do it by winging it.

10:17An analogy here that I think is appropriate is think about the process of raising a kid. What you focus on with that kid should be highly dependent on that kid's age. If they're three years old, you don't want to be focused on SAT test prep. That's way too early in their life. What you really want to focus on is nutrition, the basics of language, and making sure their health is growing appropriately. This to me would be like analogy to reinvesting in the business. When a company is young, it should focus all of its capital allocations chops on just reinvesting in the core business to make sure that it grows and is healthy.

10:56Later, when the kid is 18 years old, that's when you need to focus on more superfluous things like perhaps how they look so they can attract a mate or traveling or luxuries in life because they're already bigger and they're more established in their life. That, to me, is a good analogy for focusing on dividends and buybacks and perhaps acquisitions. So when you do things, so the capital allocation timing really matters. But again, this is something that is easy for companies to screw up, and it's easy for investors to screw up when they're analyzing a business. Because if you use the wrong metric or look at the wrong metric for a company at the wrong time, you're going to get the wrong conclusion.

11:40Yeah, that's a great point. Can you give me maybe an example or two of using the wrong metric at the wrong time of the business that may be appropriate? Yeah, the classic one to me is the price to earnings ratio. A lot of new investors learn about the price to earnings ratio, and it is something that they apply to companies at all stages at all times. I mean, for how many years would an investor look at Amazon and say the company's price to earnings ratio is 500 or 1 ,000 and just immediately write off the company as uninvestable? That one hits home for me because for years, I thought Amazon was uninvestable because its PE ratio was in the triple digit.

12:25That to me is akin to looking at a seven-year-old and saying their SAT score sucks. Like this kid is going nowhere in life. So this, but if you waited for Amazon to mature and then looked at its PE ratio or then looked at its SAT score, then that number would be helpful. So if a company is early stage, the worst thing that you can do is look at valuation multiples because they'll tell you the wrong thing. So as an outside investor, you need to know which part of capital allocation is management focused on before you can figure out, can we use this metric to judge how they're doing as a business?

13:04Yeah, that's a great point. So I think when I think about capital allocation and like the order of operations, if you will, I think you touched on the stage of the company because not all uses of capital are equal. Like paying a dividend for a early stage business probably is not the greatest choice of allocation versus something like reinvesting in the core business because they don't get the same kinds of returns, right? Yeah. With reinvesting in the business, the range of returns that you can get are absolutely enormous. Sometimes you can invest in internally generated products that go nowhere and destroy value.

13:49In other cases, you can invest in internal projects and you develop the iPhone. And what's the return on investment for the development of the iPhone? I mean, is it a million percent? Is it a couple of million percent? So by reinvesting in the company, you can get a very high rate of return. And this should really be the number one focus for essentially all companies out there. To me, this is actually the first capital allocation choice that every CEO should ask themselves. Are there ways that I can reinvest capital back into the business and have a high likelihood of generating a return on that investment that exceeds my cost of capital?

14:31If the answer is yes to that question, the CEO should stop all capital allocation beyond that and focus solely on funding products, projects that create value. Yeah. Yeah. That's exactly right. So kind of to your point, a company like Snapchat, that choosing to buy back shares at their stage may not be the best choice, whereas O 'Reilly choosing to reinvest in the core business may not be the best for them kind of because there are different stages. Yeah, exactly. So let's go with a non-controversial company that everyone knows, SpaceX. SpaceX is a privately held company. They are investing heavily in rocket technology, right?

15:12They're trying to build up these programs to get us to Mars. We don't have a good look at SpaceX's financials. But if I was to guess, I would guess that they are not profitable right now, or perhaps just on the break-even perspective, but they are heavily in growth mode. So from a SpaceX capital allocation decision, Elon Musk should take all of the profits, all of the cash flow, all of the capital that the company has access to, and reinvest in building new rockets, upgrading their rocket technology, upgrading their ship technology, building new launch pads, hiring new salespeople to bring in new customers from around the world.

15:50That should be all of Elon Musk's focus. It would be a disastrous decision for Elon Musk at the company stage to say, let's start paying a dividend, or let's start buying back stock, or let's do things to reward shareholders. That's the wrong thing to do because the company isn't consistently profitable yet. On the converse side, let's take a company like Coca-Cola. Coca-Cola does not have, It's big. It's everywhere. It does not have unlimited ideas or good uses of capital to reinvest in the business. And they're generating so much cash. They're generating so much cash around the world that using all that capital to reinvest in the business would actually be a poor capital allocation decision.

16:30That's why the company is focused on paying dividends. It's focused on buying back stock. That is the correct thing for Coca-Cola, a mature company, to do. Yeah, that's a great point. Right. So can we talk about maybe a framework for capital allocation, like how we can think about it as investors and when we're trying to analyze a business? You mentioned the return on investment needs to be greater than the cost of capital. Maybe can we kind of walk through some ideas of how that might work? Yeah, sure. So to me, this is the very first question. When thinking about capital allocation, this is the very first question that every CEO should ask themselves.

17:06Are there opportunities available where I can reinvest in the business and I can estimate that my return on that investment will exceed my cost of capital? Now, cost of capital is a squishy term. It's most useful when looking at discounted cash flow models. And the cost of debt is a very known number. It's just the interest rate that you pay. The cost of equity is kind of a squishy number. Some investors use 10 % or 12%, but let's just use a blanket statement that a company's cost of capital is 10%. Let's just use that as a blank number. So when a management team is allocating capital to internal projects, the only question they should ask themselves is, is the return on this investment above 10 % per year?

17:51If the answer is yes to that question, they should fund that project. Now, they might rank their projects in order of expected return and fund the highest return ones first, but this is the number one question that they should ask themselves. As an example, let's say you are AutoZone, right? And you are asking yourself, should we open up a store in Western Montana? Let's say they don't have a store there and they're asking themselves, should they open up a store there? Well, they should do some analysis, say what's the cost of building the store? What are the expected sales from the store? How far can we draw from?

18:28What are the expected profits? What are the expected returns on? And if they determine that opening up this new store would generate a 30 % return for them, they should absolutely open that store, absolutely do that project. Conversely, if their analysis shows that opening up that store would result in a 1 % return on investment form, they should not open that store at all. They would be destroying capital because the return that they get does not exceed their 10 % hurdle rate. So that very basic analysis should be the starting point for all capital allocation decisions. Have you ever gotten a sinking feeling in your stomach when you see an ad for AI?

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21:35If they had the choice, how would they decide? Yep. So to me, the framework that I would prefer is all CEOs start with return on investment calculations of reinvesting in the business. That should be choice number one. Even if a company has debt, I still think if you can invest your capital and earn 20 % or 50 % or 100%, that's a better use of capital than paying off debt because the interest rate on debt is probably 4 % or 6 % or 10%. So it's better to get a 30 % return on your capital than to reduce an 8 % interest rate. But once you exhaust your list of good, high probability, high return on investment decisions, you still might have excess capital.

22:22After that, the next question that management team should ask ourselves is, is there a need for us to reduce our leverage? So the leverage I'm talking about is financial leverage. And the question there is, do we have debt? Now, there are lots of companies out there that have no debt at all, especially early stage growth companies. So for them, the answer to this question is, no, we don't have any debt. But if you're a bigger company, and you're paying a high interest rate, again, 6%, 8%, 10%, something like that, you should, the answer to that question might be yes. And if the answer is yes, well, that's what you should do with excess capital.

22:58De-lever the business, strengthen the company's balance sheet, and make the business more resilient. Dave, this is the same question that every person should ask themselves. If you have credit card debt, or if you have high interest student loan debt, and you have excess money that you don't know what to do with, you should use that money to pay off your debt. It makes you, the, as an individual, more financially resilient, same thing for companies. Okay. That makes a lot of sense. So let's say that the company exhausts their list of possible reinvestments in the business and they are paying down the debt.

23:35Let's say they have extra cash left over, you know, like we have, you know, an extra a hundred hours at the end of the month in our checking account. What are they, what could they do with that? Yeah. So the third question I think CEOs should ask themselves is, is profit generation sustainable? I.e., is the core business that I've created, does it produce predictable profits? Or are my profits highly unpredictable or highly sensitive to an outside force like interest rates or the market conditions in general? If a company's profits are not predictable, they sell a fad product or they sell into cars, which are very sensitive to interest rates, or they sell construction equipment, which is very sensitive to new housing construction.

24:25If profits are not sustainable and profit generations are not predictable, my favorite thing for them to do is build their cash cushion. I don't think they should buy back stock. I don't think they should pay a dividend. I think they should focus on strengthening the balance sheet, because if you know that your profits could disappear in the future, you need an emergency fund of sorts to get you through those hard times. So ask yourself, is profit generation sustainable? If the answer is no, just build your cash position. Now, if the answer to that question is yes, we have a predictable product, we have recurring revenue, we can easily forecast what our profits are going to be, then I think you should go on to the next question.

25:09And the next question is, is our stock currently trading below its intrinsic value? And you can probably guess what they should do depending on the answer to that question. So what should they do? Well, so now the company can start to ask themselves, can we return capital to shareholders? And the way that you can do that is primarily for two methods. One is a dividend and two is buying back stock. Now, as Buffett has famously pointed out, buying back stock can be a great decision at one price and a horrible decision at another price. So the way that management teams should answer this question is checking their stock price, their current valuation, in compared to a conservative estimate of their intrinsic value.

25:56If their stock is trading at a very high valuation rate, like many companies today currently are, it is not a good use of capital to buy back your stock. You should be buying back your stock when your stock is temporarily depressed or trading well below its intrinsic value, kind of like Facebook was back in 2022 when everyone was scared of TikTok was coming to record. A meta buying back its stock at$100 per share, great use of capital. It's currently trading at about$750 per share. Is that the same good use of capital? The answer is probably not. Yeah. Yeah. That's a great example. And that, I guess when you're thinking about when a company tells you in the 10K or an earnings report that they've been authorized to spend such and such to buy back their shares and you see them doing it regularly, do you think that that valuation idea is actually going on or is it more related to they're doing it for air quote PR it makes them look good like they're returning capital to us regardless of the valuation yeah all the studies that I've seen on this basically say the same things CEOs are just as bad at timing the market as individual investors are which is a shame because they should know their business and their intrinsic value of their business far better than any investors but buybacks tend to surge when prices are at all times high and they tend to plunge when prices are when you're in a bear market or it's at an all-time low so ceos as a whole buy high and and and sell and sell low they just do the wrong thing this is why two two questions ago we asked is profit generation sustainable and if the answer there is no that's why my choice should always be to build cash.