This is the first of two articles addressing capital deployment.
Capital deployment decisions are among the most important strategic choices facing managements and boards. However, it can be difficult to choose between investing organically or acquisitively in the business versus paying down debt, building cash, or distributing capital via dividends or share repurchases.
Some companies are better off distributing more while others should emphasize investing. But many find the tradeoffs to be unclear, because companies often use different metrics for evaluating the different options. This complexity is best dealt with by establishing principles to guide management and designing processes to rigorously follow those principles.
We’ve identified 10 key principles for effective capital deployment that provide the foundation for establishing an enduring capital deployment process to drive long-term value creation. The first five principles appear below; the other five will be covered in the second article of this report.
To have an opportunity to achieve success, company leadership must first circumvent complete failure by ensuring business survival. Management must avoid excessive risk-taking, provide adequate financing capacity and liquidity, and protect important tangible and intangible assets, including key personnel, brands, technologies, and other essential differentiators.
Many business failures are avoidable with adequate forethought and planning, but most truly difficult challenges come from underestimating change.
For example, companies producing record albums when CDs were introduced in 1984 probably expected a more gradual transition, but what they got was an abrupt upheaval. By 1990, most music was purchased in the form of CDs. And then CDs were replaced by electronic content ownership, which has now been replaced by streaming. What’s next?
Survival is obviously the top priority, but most managements don’t pay enough attention to change. Management must devote resources to identifying potential threats to survival and then act to get ahead of change and turn these potential threats into opportunities.
The biggest obstacle, of course, is short-termism, which is reinforced by overconfidence, procrastination, and a distaste for cannibalizing existing products or services. It also doesn’t help that many managers feel they can readily influence their own short-term compensation but often view long-term incentives as a bit of a lottery.
Management processes and incentive compensation must be structured to explicitly address and reduce the impact of each of these obstacles.
To emphasize net present value in capital deployment requires a mindset of always buying low and selling high. In the movie “Caddyshack,” Rodney Dangerfield bellowed into his golf bag phone, “What’s that? Then sell! Oh, they’re selling? Then buy!” Audiences laughed because of the absurdity, but also because of the cliché.
Still, clichés are clichés for a reason, and the value of selling when others are buying, and vice versa, is obvious to the vast majority of investors. But corporate executives tend to do the opposite. It can sometimes be difficult to tell when prices are too high or low, so executives must pay careful attention to cycles and rely on thoughtful analysis to actually buy or sell assets when prices are favorable.
One important way to do this is to explicitly factor the expectation of operational, financial, and other cycles into planning and decision-making.
One oil and gas CFO explained how he uses the same midrange oil price when considering the acquisition of new oil and gas reserves, regardless of where the industry is in the commodity price cycle. That way, he tends to buy more reserves when they are cheap and fewer when they are expensive.
For companies in industries that don’t experience much cyclicality in financial performance, it’s still important to pay attention to market cycles.
From the 2007 peak to the trough of the market in the 2009 financial crisis, the median utility company suffered TSR of –41%. Utilities are not viewed as being cyclical. Indeed, the median utility, Exelon, saw its EPS increase slightly from $4.03 to $4.09 from 2007 to 2009, while its EBITDA increased 9.5%.
Sp why was its TSR–41%? Market fear. Exelon acquired no competitors that year, but perhaps it could have improved its long-run performance by buying a very stable competitor that would have essentially been on sale.
Make it a strong policy to never select capital deployment choices because some loud shareholders ask you to do it, or because bankers say everyone is doing it, or because you overheard on the golf course or at the yacht club that your rival is doing it.
Did Warren Buffett see everyone buying railroads in 2009 when he announced the investment of $34 billion to buy the Burlington and Northern Santa Fe railroad? Doubtful. In fact, it was the fact that everyone lost interest in railroads that created the opportunity. Did he care what the immediate investor reaction would be, or did he focus exclusively on whether he could buy an asset for less than his assessment of its long-term intrinsic value?
We seek to make capital deployment choices that create value regardless of whether they are perceived as “trending.” And indeed the best investments are often not trending; good — that is, value-creating — ideas that everyone is pursuing aren’t value-creating for long.
This contrarian mindset is not new. In 1841, Charles Mackay published “Extraordinary Popular Delusions and the Madness of Crowds, “which discusses Dutch tulip-mania, the South Sea Company bubble, and numerous other examples where the crowd, or the market for our purposes, got it wrong.
Market bubbles are an unbelievably interesting deviation from long-run market efficiency, and Mackay’s book offers one of the earliest commentaries on the subject. What’s most useful for corporate managers is to understand the innate desire to follow the crowd. This type of “herding” can be seen today by both companies and investors in the market.
For those who were old enough at the time, look back at the Internet bubble and think about the typical business news commentary in those days. The repetitive buzzing of “profits don’t matter anymore, it’s about clicks and eyeballs” fueled an emotional response, a “fear of missing out.” The FOMO, afflicted even the well-schooled in finance, valuation, and basic economics, among other less sophisticated investors.
Capital deployment processes must explicitly contemplate emotional bubbles and their effect on the likely trends and opportunities to be managed.
Principle 4: Investment Usually Outperforms Financial Engineering
Much more long-term value comes from investment and execution than from financial engineering. The graphic below shows the positive relationship between investment in the business and TSR.
Investment creates value, on average, because it’s not a zero-sum game; and companies, on average, deliver returns well above the required return demanded by investors.
Managers need to be disciplined, since it’s easy to make bad investments, but this should only lead them to be extra careful rather than lead them to avoid making investments altogether. As long as the incremental return is above the required return, managers should drive the reinvestment rate as high as possible.
Virtually all great business success stories began with some form of organic investment, especially investments that increased differentiation through innovation and branding. So, organic investments should always be given priority over acquisitive investments.
The range of organic investment opportunities is wide. It includes projects that are familiar, have reasonable risk exposures, and are expected to produce decent, but not extreme, upside potential.
Such projects include expanding production capacity, improving efficiency and productivity, and updating the look and feel of retail stores, restaurants, and hotels. These can be classified as either doing more of what we already do or doing what we do better.
Opportunities also exist to invest in less familiar areas, sometimes taking on greater risks and potentially realizing extremely substantial returns. This can include the development of new products and services, the marketing launch of totally new or significantly rejuvenated brands, or the expansion of delivering products and services to new geographies.
For example, consider a pharmaceutical company that contemplates investing for many years in expensive scientific research with the hope of developing a new drug that then requires tremendous research and marketing to ensure efficacy, navigate regulatory approval, and bring the treatment to market.
Every company should dedicate at least a reasonable portion of its investment budget to higher risk-reward areas; and for those with existing commercial products and services, there will usually be plenty of opportunity to make lower risk-reward investments to drive the existing business forward.
But both the low- and high-risk organic investments should be prioritized over acquisitive investment.
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.”