On Thursday we published Part 1 of this two-article series, presenting five principles for effectively deploying capital. Read Part 1 here. This article contains five more such principles.

First, here is a review of the first five principles from yesterday’s article:

  • The Top Priority Is Survival
  • Buy Low and Sell High — Really
  • Don’t Follow the Crowd
  • Investment Usually Outperforms Financial Engineering
  • Prioritize Organic Investment

Principle 6: Be Willing to Grow Carefully by Acquisition and Shrink Through Divestitures or Spinoffs

It has become a bit of a business cliché to say that “most acquisitions destroy value.” Fortunately, this is not true, generally.

The vast majority of our capital market research across industries and varying time periods shows that those investing more in acquisitions do, on average, deliver higher average TSR.

We all know of spectacular acquisition failures, such as the 1998 acquisition of Chrysler by Daimler and the 2010 acquisition of Palm by HP. Both deals turned out terribly for the acquirer in rapid fashion. These and other such disasters make for eye-catching news headlines but are truly a small minority of cases.

Although acquisitions should be a second priority behind organic investment, it is quite possible to build a successful acquisition track record. Like learning all other skills, acquisition expertise requires development and practice. That’s why serial acquirers tend to perform better than occasional acquirers.

It’s also critical to align acquisition strategy with business strategy. Companies should actively monitor a list of potential targets and constantly grade them on fit and desirability, as indicated by the value expected to be received in relation to the price.

Success is much less likely with such a deliberate process, versus when deals originate with a banker stopping by with a pitch book of ideas, or an offering memorandum on a company that wasn’t otherwise contemplated by the acquirer. It’s like having a real estate agent regularly show you and your family houses that are available; you may end up moving to a bigger and more expensive house than you’d previously considered.

Principle 7: Leverage Tends to Stifle Investment

Maintaining high debt leverage can be a bigger problem than buybacks in some companies. In good times, leverage seems good. If our business is growing strongly with nice profit margins and decent rates of return, having more leverage will amplify the EPS growth rate, and total shareholder will often follow it, to at least some degree.

But if, or frankly when, the economy falters, the industry loses momentum, or our company suffers a competitive setback, perhaps due to a new competitive product that leapfrogs our own, then the leverage will amplify the downside just as it did the upside.

From the S&P 500 peak on October 9, 2007, through the trough on March 9, 2009, the S&P 500 fell 57%. In most sectors, the companies that had higher total debt as a percentage of EBITDA at the start of the market downturn had worse TSR over the 17-month period than their less-levered peers. The most notable exception to this was health care, which is among the least cyclical of industries.

What’s worse is that the amount of debt leverage seems to also have a negative impact on the willingness to invest in growth. This is unbelievably important, yet generally goes unrecognized.

Many corporate finance experts claim that having more debt creates value by causing a reduction in the weighted average cost of capital and showing how the present value of free cash flow rises. But they fail to incorporate the effect the debt has on the amount of long-term free cash flow.

Companies faced with the financial risk associated with high debt levels tend to invest less in the business, and this behavioral effect can make company value drop even though the company has reduced its weighted average cost of capital.

Principle 8: Implement Buyback Execution Rules

The goal of buybacks should be to create value for the remaining shareholders by buying back shares that management believes are worth more than what must be paid to repurchase them. It’s no different from buying stock in another company.

To combat the tendency of companies to buy back more stock when it’s expensive than when it’s cheap, as discussed above, companies should implement rules-based processes for executing stock buybacks.

It’s important to recognize that companies pursuing buybacks tend to suffer declines in their price-to-earnings valuation multiple. So, perhaps companies should mandate that the words “buyback” and “EPS” never be mentioned in the same meeting, and whoever breaks this rule has to put $20 in the holiday lunch fund. At least for the first year of this policy, it should provide a tidy sum for some joyous celebrating at year-end.

Principle 9: Dividends Are Value-Neutral

Potentially the most misunderstood use of capital is the dividend, which is only a means of giving shareholders access to money they already own. Nothing more, nothing less. By definition, dividend policy cannot create long-term value.

There is a theory that dividends communicate confidence in the business, and sometimes this is true. But frankly, a faltering dividend trend is more likely to convey a lack of confidence. Dividends are more an outcome of capital deployment strategy than they are a strategy in and of themselves.

One potentially beneficial, but rarely tapped use of dividends is as a better alternative to stock buybacks when a company wants to distribute excess capital while its share price is above the midpoint of the market cycle. This still isn’t true value creation; it’s the avoidance of the value destruction that would come from buying back what will later seem to have been overpriced shares.

Principle 10: Value Creation Is Hard Work

Recognize that there are no tricks, easy paths, or quick fixes. For example, if the company’s earnings have been growing for a few years, but now the economy is peaking and earnings growth is slowing, a quick fix to boost next quarter’s EPS by repurchasing a boatload of stock may give the share price a pop on the announcement date.

But over the ensuing cycle, management and shareholders alike will probably regret the move and wish management had held the cash to be used when assets, including the company’s own share price, were more attractively priced.

Of course, the golden rule of capital deployment — whether we’re considering capital expenditures, acquisitions, or buying back our own shares — is that value is created only when we buy something that turns out to be worth more than what we paid.

If we’re interested in long-term, sustainable value creation, what matters is what something worth over the long haul, not the day after we buy it.

Gregory V. Milano is the founder and CEO of Fortuna Advisors, a strategy advisory firm. A leading expert in capital allocation, behavioral finance, and incentive compensation design, he is the author of “Curing Corporate Short-Termism: Future Growth vs. Current Earning.”

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