Of Capital Allocation

Capital Allocation is fundamentally about investing rationally. It is by far, the most important job and responsibility of any board or a CEO because its impact on an enterprise’s value is enormous. CEOs should first act as Chief Capital Allocation Officers or CCAOs. Management teams and boards with a clear and rational approach to capital allocation are rare and valuable.

Capital Allocation involves deploying (or raising) cash in at least 4 ways:

• reinvest towards the organic growth of the business

• make an acquisition or a divestment

• pay a dividend

• repurchase shares (or issue new shares)

In each case, intrinsic value gained must exceed the price paid. Warren Buffett has stated the first law of Capital Allocation as “what is smart at one price is dumb at another.”

A cardinal rule for capital allocators is to understand and focus on per-share intrinsic value. Managers must allocate capital in ways which result in the increase of the per- share intrinsic value and avoid all moves that decrease it. While this may seem obvious, it’s practice is constantly violated in the corporate world. When misallocations occur, shareholders are hurt. CEO’s who recognize their lack of capital- allocation skills (which many do not) will often try to compensate by turning to their staffs, management consultants, or investment bankers. On balance, they are more likely to accentuate the capital allocation problem than to solve it.

In the fields of investments and acquisitions, activity is often correlated with achievement. Indeed, frenetic behavior is counterproductive and ends up destroying value. A poor capital allocator is always reluctant to look at the results of the capital projects or the acquisitions that he or she had proposed with great detail only a year or two earlier to a board. They never show how the reality worked out relative to their projections. That’s human nature.

Husain Kothari

August 2017

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