The 3 Forgotten Practices of Mastering Capital Allocation

Do you ever wonder what Warren Buffet does with his days? How did he become the most successful CEO in the history of the corporate world? Yet at the same time, he has little involvement in the day-to-day operations of any one of his dozens of companies under the Berkshire Hathaway umbrella of companies.

The answer is he focusses all his time and efforts on one activity – capital allocation. Capital allocation is deciding how to best utilize available free cash when available and how to best raise cash when its not.

There are ten levers of capital allocation – five that provide sources of cash and five that give an executive and board member the opportunity to deploy it.

The tricky part of capital allocation is not understanding what each of the levers is, but instead knowing when to pull them. Pulling the right lever at the right time on a consistent basis is a recipe for generating outstanding shareholder returns. However, pulling the wrong lever and the wrong time can be disastrous.

Here are three ideas to keep in mind if you are an executive or business owner that wants to master the art of capital allocation.

1. Centralize capital allocation decisions
Warren Buffet once said of his business philosophy, “Hire well, manage little.” His long-time business partner Charlie Munger said “Berkshire Hathaway is an odd blend of highly decentralized operations with highly centralized capital allocation.” What each of them is saying is that they stay out of day-to-day managing activities of the businesses in which they invest and focus all their energies instead on identifying what is the best use of the cash used or required for these businesses.

When you centralize capital allocation decision making, it might turn out that reinvesting the free cash flow of one line of business into another makes more sense than leaving that discretion to individual managers. In fact, as is often the case at Berkshire Hathaway, the best use of internally generated cash flow is to invest in new businesses outside of the existing portfolio. Only Mr. Buffet and Mr. Munger have this higher level perspective to look out and across all the investment opportunities available to Berkshire Hathaway.

2. It’s all about the cash
Capital allocation focuses on cash generated or spent. While capital markets tend to fixate on top line revenue growth and bottom line earnings, the net change in cash is often something entirely different.

Capital allocation decisions are self-evident after the fact and most visible when you look at the statement of cash flows. Look at how much is being spent on capital expenditures, dividends, share buybacks, and debt repayment. Look at how much is being raised by liquidating working capital and capital assets or raising new sources of debt and equity financing. These are evidence of the level of capital allocation being pulled during a given period.

3. Capital markets are imperfect
Rather than complain about the volatility of capital markets, use it to your advantage. Does the value of public companies really swing up and down by 2%, 5% or sometimes 10% or more in any given day? Of course not! Certainly there is news that capital markets digest every day that moves the value of companies up and down but no one knows for sure the future.

However, good executives and good directors know the value of one company better than all others – that is, the value of their own company. When capital markets punish a stock price, provided you have managed your balance sheet prudently, it provides the master capital allocator with the opportunity to buy back their own shares. When capital markets are favoring your company and pushing the valuations of your stock ever higher, your stock becomes a currency you can use to raise more capital or acquire weaker competitors.

Henry Singleton, former CEO of Teledyne, used his own stock as currency to make over a 100 acquisitions in the span of 10 years to capitalize on the higher valuations attributed to conglomerates during this period. When capital markets changed their tune and conglomerates fell out of favor, Mr. Singleton stopped pulling the acquisition lever and started buying back shares in Teledyne. In fact, he bought back 90% of the outstanding shares and generated a 42% compounded rate of return on these repurchases in doing so.

Fascinated yet? To learn the whole story and perfect your understanding of capital allocation, check out our course on Mastering Capital Allocation.

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