Leadership is ultimately an exercise in decision making and running a company is no different. CEOs make thousands of decisions over the course of their careers. Some are trivial and some can make or break the future of the company.

Among the myriad of decisions that are made by CEOs none are more critical than deciding how to invest the resources of the company. William Thorndike said, “Capital allocation is the CEO’s most important job.” Thorndike is the author of The Insiders, the definitive book on capital allocation, so it is likely that he would say this. As investors we entrust CEOs to run the businesses that we own which makes an evaluation of capital allocation decisions critical to the future of our investments.

Capital allocation refers to the way that management in a business spend their capital. We can simplify this down to the three avenues for deploying capital:

  • The balance sheet
  • Investing in the business (internal and external)
  • Shareholder distributions

The capital allocation decisions that are made are based on the best utilization of the capital to create value for shareholders – the owners of the company. This is not a static decision, and will vary based on the company, the industry and market conditions.

Generally, if you’re evaluating a more mature business, you would look at whether they’re returning the right amount of money to shareholders through distributions. For a growth business, you might look at their investments. If you’re investing, or you’re returning money, you want to ensure that you have a strong balance sheet.

The role of the balance sheet in capital allocation

The flexibility to make capital allocation decisions often comes down to the balance sheet. If there’s a significant amount of debt, it can decrease the flexibility of the company’s options. It could mean that they aren’t able to borrow more money or hampers their flexibility to invest in the business or pay out dividends.

A bad balance sheet also means that a company is more at risk to external events – we saw this during the pandemic, with a prime example being the bankruptcy of Virgin Australia. Although all airlines struggled with border closures, quarantining and lockdowns, Virgin went into the pandemic with a significant amount of debt which resulted in bankruptcy and poor shareholder outcomes.

Large debt balances can indicate that paying down debt is the right decision. For example – Anheuser-Busch Inbev (NYSE: BUD) took on a significant amount of debt to purchase SABMiller. Our analysts believe this was a good acquisition, but for the near term, the company must focus on paying down this debt as it has significantly hurt their share price.

The other non-company consideration around the balance sheet is the level of interest rates. When interest rates are low, companies may carry more debt because the cost to pay that debt is low. When interest rates are high, they may not want as much debt because they are paying a lot of interest.

Investing in growth

The second capital allocation lever that can be pulled is to invest in the business to drive growth. Evaluating the track record of investing internally for growth means looking at the return that a company is getting from those internal investments. This is where return on invested capital comes in. Put simply, ‘buying’ growth and earning the same return as your cost of capital isn’t maximizing value for investors. As investors, we want management of companies that we own to find the right internal projects or acquisitions where they can earn a return that exceeds their cost of capital.

This is where the industry the company operates in and the maturity of the business comes into play. Some industries offer an abundance of opportunities. Some have few. New companies in expanding industries may be overwhelmed with the opportunities to pursue growth. These seemingly endless opportunities can lead to poor decisions. They may have access to large amounts of capital because they are in an exciting new industry – which can lead to over hiring, lavish benefits for employees and making poor acquisitions of similarly overpriced companies.

More mature companies that operate in industries that aren’t growing fast have different investment opportunities. In many cases those companies concentrate on returning money to shareholders through dividends or share buybacks.

Return cash to shareholders can be the best option for more mature companies. Running a lazy balance sheet or investing in new projects with poor returns is a surefire way to destroy value for investors. If unable to earn their cost of capital, a company is better off returning money to shareholders, either through dividends or buybacks.

Strong capital allocation decisions

Our analysts offer a capital allocation rating, ranging from Poor to Exemplary for shares within our coverage universe. An example of a company with an exemplary rating is Woolworths (ASX:WOW). Their balance sheet is sound, the investments they make in their business are exceptional and our analysts believe that the dividends to shareholders are appropriate.

When we look at Woolworths, they are a defensive retailer which faces minimal cyclicality – and this is because virtually all of group operating income comes from grocery retailing. Regardless of what is happening – pandemics, lockdowns, floods, droughts, apocalypses – people will still darken Woolworths’s doorway.

Woolworths’ balance sheet is in excellent shape. Financial leverage, as measured by debt/EBITDA, is minimal, and we estimate a highly maintainable three-year forward average of 1.2.

The maturity of the supermarket business, emerging threats from online retailers and the strength of Woolworths franchise all influence capital investment decisions. Woolworths leverages the scale and cost advantages inherent in their dominant position when investing into new stores and store renewals. Investments in online channels and fulfilment methods build resiliency in the face of threats from online retailers.

The maturity of the supermarket industry allows a high level of distributions to shareholders given the lack of avenues for them to invest at a rate above the cost of capital. Woolworths’ payout ratio is historically at 73%, which our analysts think is appropriate for the business and industry that Woolies operates in and is the best way to maximize value for shareholders given the high levels of franking credits that the business generates. 

Woolworths also excels at understanding when to divest from business. An example is their retail fuel network. In this case, their divestment allowed them to return capital to shareholders via a 1.7 billion off market share buyback that utilized excess franking credits in 2019.

There are a few lessons that we can take from Woolworths. The first is that investors must consider the industry and wider operating environment of a business, and how that may impact capital allocation. Not all businesses are operating in the same conditions so you can’t apply the same capital allocation strategies across the board. Through Woolworths we can also see that businesses do not need to pick just one lever to pull when considering capital allocation. They’ve made active decisions to return capital to shareholders through dividends because it is the best way to create value, but they also leverage scale to make appropriate investments in expansion, and thoughtful decisions to divest businesses where it makes sense.

Poor capital allocation choices

We don’t often assign a ‘poor’ capital allocation rating to companies we cover. AMP (ASX: AMP) is one example where our analysts do not believe that management has made decisions in the best interest of shareholders. Their business strategy was poorly executed, and it cost shareholders. Specifically, our analysts call out AMP’s apathy to improving their corporate governance and culture.

AMP’s mishandling of sexual assault allegations is well known, as well as the poor corporate governance that helped breed misconduct amongst financial advisers. This destroyed AMP’s reputation when it was uncovered in the 2018 Royal Commission, and they haven’t been able to wash away this stain. Additionally, there were a series of poor executive appointments to people that inhibited the business’ turnaround. These decisions contrasted with the state strategy of the business – to restructure and simplify.

AMP has a long history of poor capital allocation decisions. A prime example is the 2011 AXA acquisition. AMP completely misunderstood this business and were subsequently plagued by higher-than-expected claims and lapsed policies that culminated in large losses. This led to poor shareholder outcomes through a fall in the underlying earnings per share over time. The key driver was the dilution from the nearly 700 million new AMP shares issued for the acquisition.

What can investors learn from AMP? We can learn that poor execution of strategy, and poor capital allocation decisions can come at a significant cost to shareholders. In 2001, AMP was trading at over $13. It is now trading at $1.10. There are several factors that have contributed to the market losing faith in this once, financial giant. However, there is no doubt that poor governance, and poor capital allocation have been contributors to their fall from grace.

As investors, we care about future earnings and profits. Capital allocation is an important piece of this puzzle and a significant determinant of the value that you receive as a shareholder. Although there’s no template for ideal value creation, we encourage investors to focus on the approach that businesses use to allocate capital.