The most important decision a CEO can make

Senior Investment Specialist Shani Jayamanne on the importance of capital allocation.
By Morningstar |  09-11-22 | 
 

Among the myriad of decisions made by CEOs, none are more critical than deciding how to invest the resources of the company.

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:

  • 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.

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.

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 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.

Shani Jayamanne is a senior investment specialist based in Sydney. The above is an extract from The most important decision a CEO can make

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