This article initially appeared on Morningstar.ca, our sister website in Canada. Equity analyst Piyush Jain has adapted it for the Indian audience.
Smart use of capital is an important company attribute that value manager and author Kim Shannon looks for in building her stock portfolios. "We actually think that the topic of capital allocation is right on the money," says Shannon, president and chief investment officer of Toronto-based Sionna Investment Managers Inc. "The best firms that have created a lot of wealth for investors historically have been companies with very astute management doing very astute capital allocation."
Shannon, also the author of The Value Proposition, says there are many ways by which capital allocation can create or reduce the value of a company.
1) Acquisitions
According to Shannon, the most successful acquisitions tend to be smaller ones that complement the core business. It's important to pay attention to management's explanation of why they are making the acquisition and what benefits they expect to reap.
To that end, one takeover worth watching is the 2014 acquisition of Network18, a media and entertainment company by Reliance Industries Limited, or RIL.
Network18 owns TV channels (CNBC TV18, CNN-IBN, CNN Awaz), websites (firstpost.com, moneycontrol.com) and entertainment channels (Colors, MTV, Homeshop Entertainment) among other businesses.
The management at RIL talked about the synergy of the digital content generated by Network18 with the telecom operations of the company. In its press release, RIL explained that “the acquisition will differentiate Reliance’s 4G business by providing a unique amalgamation at the intersection of telecom, web and digital commerce via a suite of premier digital properties." The size of the deal (Rs 4,000 crore) was less than 5% of the total market capitalisation of RIL.
Similarly, last year witnessed the acquisition of two cement units of Jaiprakash Associates in Central India by Ultratech Cements. The acquisition was made at a reasonable price and management talked about gain in market share in a region where the company did not have a prominent presence.
In both the above instances, the acquisitions complement the company’s business. We shall be in a position to watch the above acquisitions in real time for the growth in value.
2) Dividends
As a form of capital allocation, dividends come in and out of favour among investors, depending on the market environment. Since dividend-paying companies have become very popular over the past decade, Shannon and her team are a little concerned that companies paying generous dividends may be over-priced as a group.
Even so, she recognises the importance of dividends and cites research that estimates two-thirds of the long-term returns from investing in equities are derived from the dividend yield.
Wary of special dividends paid with surplus cash, Shannon favours "old-fashioned dividend yields" that are paid out of the earnings generated by the business. "They're less subject to being gamed and incentivised."
A company that does come to mind is Coal India Limited, or CIL. In February 2014, the company paid a hefty special dividend of about $3 billion from its cash reserves. This implied dividend of Rs 29 per share in 2014 versus Rs 9.5 per share a year ago. Over the longer term, growth in its revenue from coal production will be a much stable indicator towards growth in its dividends.
3) Share Buybacks
A company may allocate capital to invest in itself through share buybacks. This strategy is used when a company thinks its stock is so undervalued that a buyback is a better use of capital than making an acquisition, investing in the business or paying down debt.
In 2013, Unilever, the parent company of Hindustan Unilever Limited, or HUL, launched a buyback for shares in its India subsidiary exceeding $3 billion. The price at which company was going to buy back the shares was more than 20% premium to the stock price at the time of the announcement. Looking at the minimal need for capital expenditure, the decision proved to be a favourable one. The stock price has increased by more than 50% from the buyback price.
"But human beings are not always rational in what they do," says Shannon, suggesting that buybacks may be a poor form of capital allocation when markets are expensive. For example, she says that last year, when the U.S. market was riding high, coincided with one of the highest amounts of share buybacks in U.S. financial-market history.
By contrast, in years like 2009 when stocks were very inexpensive, there was much less share repurchasing. "So clearly, (a buyback) is not always the true cheap alternative," she believes. The above behaviour was reflected in CIL's decision to not pursue a share buyback in FY14. The stock price had fallen to Rs 240 per share, about 30% below its fair value. Despite the stock being undervalued and the company possessing $10 billion cash equivalents on its book along with strong positive operating cash flow, the management refrained from an aggressive share buyback.
4) Reinvestment
Effective capital allocation may involve acquiring or upgrading physical assets such as property, buildings or equipment. For example, an automobile company needs to invest consistently in its research and development and introduce new models to fend off competition.
Two years ago, Tata Motors unveiled the ‘Horizonext’, a four-pronged customer-focused strategy for its passenger vehicles business. The aim is to create new models on fewer platforms, launch new models in new income segments, and refresh the older models. The company is also attempting to establish manufacturing facilities in key large geographic regions. As competition continues to get intensive in the automobile industry, the above investment will help the company maintain its competitive advantage and improve as well as protect its market share.
5) Debt Paydowns
In environments of low interest rates, debt paydowns may not be considered an effective use of capital as debt is less of a burden. A modest amount of debt, says Shannon, can boost the profitability of firms and have a positive impact on the return on equity. Until interest rates rise again, these debt loads won't get a lot of attention.
Let’s refer to RIL once again. Over the last couple of quarters, the company has raised more than $10 billion from overseas markets. The cost of debt is between 4-5.5%, at least 5 percentage points lower than what RIL had to pay in the Indian market. It was also lower than what it can earn on its medium maturity fixed deposits in India. The company shrewdly used low cost debt to fund its capacity expansion. As a result, the increased leverage has been beneficial for the company and shareholders.
