New Mauboussin Report: Capital Allocation Outside the U.S. – Evidence, Analytical Models, and Assessment Guidance

Capital Allocation Outside the U.S. – Evidence, Analytical Models, and Assessment Guidance

Credit Suisse’s Global Financial Strategies team has published a new report, “Capital Allocation Outside the U.S.” It includes new charts and examples and reflects the latest academic research.

  • Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.
  • In this report we examine the sources and uses of capital for Japan, Europe, Asia/Pacific excluding Japan, and Global Emerging Markets. This extends our analysis beyond the United States, which we discussed in a prior report.
  • Countries or regions with a high return on invested capital (ROIC) can fund a substantial percentage of investment internally whereas those with low ROICs must rely more on external financing.
  • Capital allocation is also determined by the largest sectors in a country’s or a region’s economy, the stage of economic development, cultural norms, and regulations.
  • We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

See here for a collection of links to other Mauboussin papers.

mmcapall

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New Mauboussin Report: Capital Allocation – Evidence, Analytical Models, and Assessment Guidance

Capital Allocation: Evidence, Analytical Models, and Assessment Guidance

Credit Suisse’s Global Financial Strategies team has published a new report, “Capital Allocation.”

  • Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.
  • Capital allocation is always important but is especially pertinent today because return on invested capital is high, growth is modest, and corporate balance sheets in the U.S. have substantial cash.
  • Internal financing represented more than 90 percent of the source of total capital for U.S. companies from 1980-2015.
  • M&A, capital expenditures, and R&D are the largest uses of capital for operations, and companies now spend more on buybacks than dividends.
  • This report discusses each use of capital, shows how to analyze that use, reviews the academic findings, and offers a near-term outlook.
  • We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

mm_capall

See here for a collection of links to other Mauboussin papers.

New Mauboussin Paper: Capital Allocation – Updated Evidence, Analytical Methods, and Assessment Guidance

“The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively.” —Mauboussin & Callahan, Capital Allocation – Updated Evidence, Analytical Methods, and Assessment Guidance

Thanks a lot to a reader of the blog for sending me the link to this new paper!

Another great read (dated June 2, 2015) is out from Mauboussin and Callahan, both currently at Credit Suisse.

Below en excerpt from the frontpage of the paper describing the content.

• Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.

•Capital allocation is always important but is especially pertinent today because return on invested capital is high, growth is modest, and corporate balance sheets in the U.S. have substantial cash.

• Internal financing represented more than 90 percent of the source of total capital for U.S. companies from 1980-2014.

• M&A, capital expenditures, and R&D are the largest uses of capital for operations, and companies now spend more on buybacks than dividends.

• This report discusses each use of capital, shows how to analyze that use, reviews the academic findings, and offers a near-term outlook.

• We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

Click image to download PDF. Also, the Mauboussin link post will be updated to include this one to.

NM1When I woke up this morning I saw that Michael himself had written a few words on his Twitter account about my collection of links to his papers. For an amateur like myself this felt great!

Skärmavbild 2015-06-20 kl. 16.20.09Happy midsummer to all of you out there!

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Markel: Book Value Growth and Capital Allocation

Markel Corporation Annual Report 2014

MKL2Markel’s annual report for 2014 has been released and can be downloaded here.

Here is our annual report to you for the year 2014. If you are reading this, it’s probably because you already own Markel. This is your company. You own it and we work for you. In the course of this report we’ll attempt to answer two major questions that we think you would want to know as owners of the business, namely, “How are we doing, and, what’s next?” (Source: Annual Report, 2014)

Also, the letters to shareholders dating back to 1986 is also found at Merkel’s homepage (see link above).

BUSINESS OVERVIEW

We are a diverse financial holding company serving a variety of niche markets. Our principal business markets and underwrites specialty insurance products. We believe that our specialty product focus and niche market strategy enable us to develop expertise and specialized market knowledge. We seek to differentiate ourselves from competitors by our expertise, service, continuity and other value-based considerations. We also own interests in various industrial and service businesses that operate outside of the specialty insurance marketplace. Our financial goals are to earn consistent underwriting and operating profits and superior investment returns to build shareholder value. On May 1, 2013, we completed the acquisition of Alterra Capital Holdings Limited (Alterra), a Bermuda-headquartered global enterprise providing diversified specialty property and casualty insurance and reinsurance products to corporations, public entities and other property and casualty insurers. (Source: Annual Report, 2014)

Book Value per Share

Compounded annual growth rate in book value per share during the last twenty years has been 16% (see image below taken from the 2014 annual report).

I have also put together a simple diagram showing book value per share from 1996 to 2014. During this time period book value grew from $25.71 to $543.96.

MKL1

MHR1

 

Capital Allocation

In the shareholder letter Markel lays out a detailed description of its capital allocation policy (emphasis added).

First, we look to support organic growth in our existing insurance and Markel Ventures operations. We have a team of proven, successful operators within the walls of Markel. Our first choice is to give them more resources when they have the opportunity to put money to work effectively.

Second, we can pursue acquisitions in the realm of insurance or non-insurance businesses (that should cover it). We have experience and a proven track record of being able to successfully acquire and operate businesses all around the world. In the short-term, we can do math and count money. We can, with reasonable precision, know what things cost and what returns we can earn when we own them. We’ve done that.

More importantly, in the longer term, we see that our values and our culture work all around the globe. Talented people want to be part of this company. With talented and honest people we can accomplish anything. As such, in the long run we expect the businesses we buy to grow far beyond our initial estimates of size and profitability and to eventually exceed our wildest expectations. We do more of what works, and we give more resources to the talented associates who make good things happen. We do less of what doesn’t work, and we reallocate those resources to others.

This works. It is what matters over time.

We ask for an unusual degree of trust and flexibility from our owners and we try our best to be explicit in communicating how we are proceeding with our plan to build one of the world’s great businesses. The good news is that you have decades of evidence demonstrating that we deserve this trust and will carry on in building the value of your company. We intend to keep going.

Thirdly, we acquire publicly traded equity and fixed income securities for the dual purposes of supporting our insurance operations and earning good returns on our capital. The great news to report is that our investments did what they are supposed to do. They supported the insurance operations AND they produced excellent returns on our capital.

As to our equity selection process we continue to use our durable four step process in seeking excellent long-term investments. We look for, one, profitable businesses with good returns on capital and modest leverage; two, management teams with equal measures of talent and integrity; three, businesses with reinvestment opportunities and/or capital discipline, at; four, reasonable valuations. You’ll find this language in every Markel annual report since 1999. We believed in this approach since the beginning. We just started explicitly stating it in the annual report that year. Expect this language to continue in future annual reports.

As to our fixed income operations, we look for the highest quality fixed income securities that we can find to match up against our insurance liabilities. In large measure, we match the expected duration and currencies of our insurance liabilities to fixed income securities with similar durations and currencies. We do not attempt to forecast or profit from interest rate or currency movements. While we remain humble about our ability to earn returns from forecasting the future, we do remain responsible for protecting our balance sheet against big changes in those factors. As such, we continue to own a portfolio of fixed income securities which mature faster than what we expect from incoming insurance claims. We will continue to maintain this modest override from our normal design until such time as interest rates are higher than current levels. We just don’t think we are being paid appropriately to take the risks of owning long-term bonds so we won’t do it. It is the same decision any underwriter at Markel would make when they don’t think the rewards justify the risk.

We manage practically all of our investments in house at an extraordinarily low cost. At year end the total investment portfolio stood at $18.6 billion. Our total in house management costs remain a single digit number of basis points of that number and can’t even be measured until you get to hundredths of a percent. Additionally, we tend to be incredibly tax efficient in managing our investments given our long-term ability to buy and hold quality equity investments. This is a massive addition to the long-term returns you earn as shareholders. We continue to use our four lenses to find and select investments and we often ignore investment fashions and conventional wisdom while doing so. Currently, two features of today’s marketplace strike us as good examples of ways in which we behave differently than most institutions.

One example is the current move to passive and indexed investments. One goal of indexers is to reduce investment costs. Count us in for that part. As we cited earlier, we operate at very low investment management cost levels. The problem with indexing, and when it cycles in and out of favor, is that it is a relatively brainless activity. Certain behaviors and practices get reinforced by money gushing in or out of indexes, and prices of real companies get distorted in the process. We’ve been around long enough to have witnessed the dreadful returns experienced by indexers in the late 90’s and early 2000’s. We’ll try to use brains and common sense to avoid the excesses of index strategies while at the same time competing toe to toe with them on costs. Our record of now being in our third decade of outperforming the S&P 500 should give you some confidence in our approach.

A second example of how markets periodically become unhinged from long-term reality can be seen in the current action of the oil market. Arguably, oil is the most liquid, important and globally traded commodity on the face of the earth. Hundreds if not thousands of companies participate in the energy business. Hundreds of thousands if not millions of people work in, and study this field. The fact that oil could sell for over $100 per barrel, and for less than half that price within a few short months, should be about all of the evidence you need to dismiss those who believe in efficient markets, or forecasting just about anything.

Our investment record has not and will not be based on our ability to forecast the future of geopolitical changes, interest rates, currency moves, technological change or any other factor that occupies the minds and hours of countless investment professionals. We simply accept that all of those things will continue to fluctuate and change, and that our four part process does the best job we know of finding the people and financial circumstances who will make the best of whatever happens.

Our fourth and final choice for capital allocation happens when we believe that the repurchase of our own shares creates better returns than any of the first three choices. We’ve only purchased modest amounts of our stock over the years and we believe that you are better served when we can reinvest capital into businesses which create attractive recurring returns. (Source: Annual Report, 2014)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Checklist for Assessing Capital Allocation Skills

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance is another great paper written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse. See here for yesterday’s post.

CA1Capital Allocation: The Problem

Let’s us start with an excerpt from the paper and a quote from Warren Buffett about the problem of capital allocation, i.e., that the heads of many companies are not skilled in capital allocation.

“…our focus here is on how companies spend money.

The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to allocate the capital of the companies it controls. Buffett is worth quoting at length:

‘This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)'”

Checklist for Assessing Capital Allocation Skills

In the end of the paper the authors share a Checklist for Assessing Capital Allocation Skills. This checklist is reproduced below.

Past Spending Patterns

  • Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
  • How has the company funded its investments?
  • Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
  • Have there been shifts in the pattern of spending?
  • If there is new management, has spending changed?
  • Who makes which capital allocation decision?
  • How does the company conduct its budgeting process?

Calculate ROIC and ROIIC

  • Have you calculated ROIC over time and observed a trend?
  • Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
  • Have you compared the company’s results to those of its peers?
  • Have you calculated ROIIC for one year and rolling three- and five-year periods?

Incentives and Governance

  • How is the company’s incentive compensation structured?
  • How much stock does senior management own?
  • Is total shareholder return calculated on a relative basis?
  • Have you examined the company’s incentive score?
  • Are the measures in place to encourage management to think for the long term?

Five Principles of Capital Allocation

  • Does the company use zero-based capital allocation or is it dominated by spending inertia?
  • Is the company focused on funding strategies or projects?
  • Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
  • Does the company prune businesses with poor prospects for creating value?
  • Does the company know how to calculate the value of its assets and does it act accordingly?

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance

A Guide for How to Think About Capital Allocation

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance is another great paper written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.

CA1

  • Capital allocation is a senior management team’s most fundamental responsibility. The problem is that many CEOs don’t know how to allocate capital effectively. The objective of capital allocation is to build long-term value per share.
  • Capital allocation is always important but is especially pertinent today because return on invested capital is high, growth is modest, and corporate balance sheets in the U.S. have substantial cash.
  • Internal financing represented almost 90 percent of the source of total capital for U.S. companies from 1980-2013.
  • M&A, capital expenditures, and R&D are the largest uses of capital for operations, and companies now spend more on buybacks than dividends.
  • This report discusses each use of capital, shows how to analyze that use, reviews the academic findings, and offers a near-term outlook.
  • We provide a framework for assessing a company’s capital allocation skills, which includes examining past behaviors, understanding incentives, and considering the five principles of capital allocation.

Executive Summary

  • Capital allocation is the most fundamental responsibility of a senior management team of a public corporation. The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. The proper goal of capital allocation is to build long-term value per share. The emphasis is on building value and letting the stock market reflect that value. Companies that dwell on boosting their short-term stock price frequently make decisions that are at odds with building value.
  • Capital allocation is always important but is especially pertinent in the United States today given the high return on invested capital, modest growth, and substantial cash on corporate balance sheets. Companies that deploy capital judiciously have a significant opportunity to build value.
  • Internal financing represented almost 90 percent of the source of total capital for U.S. companies from 1980-2013. This is a higher percentage than that of other developed countries including the United Kingdom, Germany, France, and Japan.
  • Mergers and acquisitions (M&A), capital expenditures, and research and development (R&D) are the largest uses of capital for operations. In the past 30 years, capital expenditures are down, and R&D is up, as a percentage of sales. This reflects a shift in the underlying economy. M&A is the largest use of capital
    but follows the stock market closely. More deals happen when the stock market is up.
  • The amount companies have spent on buybacks has exceeded dividends for the past decade, except for 2009. Buybacks did not become relevant in the U.S. until 1982, so you should treat comparisons of yields before and after 1982 with caution. Research shows that the overall proclivity to return cash has not
    changed much over the decades, but the means by which the payout occurs has shifted.
  • Academic research shows that rapid asset growth is associated with poor total shareholder returns. Further, companies that contract their assets often create substantial value per share. Ultimately, the answer to all capital allocation questions is, “It depends.” Most actions are either foolish or smart based on
    the price and value.
  • Divestitures are substantial and generally create value. If the buyers tend to lose value, it stands to reason that the sellers gain value. Selling or spinning off poor performing businesses can lead to addition by subtraction.
  • Past spending patterns are often a good starting point for assessing future spending plans. Once you know how a company spends money, you can dig deeper into management’s decision-making process. Further, it is useful to calculate return on invested capital and return on incremental invested capital. These metrics can provide a sense of the absolute and relative effectiveness of management’s spending.
  • Understanding incentives for management is crucial. Assess the degree to which management is focused on building value and addressing agency costs.
  • The five principles of value creation include: zero-based capital allocation; fund strategies, not projects; no capital rationing; zero tolerance for bad growth; and know the value of assets and be prepared to take action.

Some Great Data

Below are some of the great exhibits that’s in the paper.

CA2 CA3 CA4 CA5 CA6 CA7 CA8 CA9 CA10 CA11 CA12  CA14 CA13CA15

 

 

Disbursing Cash to Shareholders

“When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” ― Warren Buffett, Shareholder Letter 1984

Capital allocation

Capital allocation is an important area when it comes to running a business, and it’s important to understand both sides of it, re-investing capital in the business versus distributing cash back to shareholders. The managers in charge of making these kinds of decisions have to have the knowledge to know the pros and cons, and thus be able to make the best capital allocation decisions possible to create the most value there is to create for shareholders of the business.

Also, as an investor you need to be able to understand the capital allocation decisions made by mangers and how it all affects the underlying value of the business, and if the capital allocation decisions made look reasonable and thus value creating or done mostly in the interests of the managers themselves, for example retaining earnings to build an empire that leads to bigger paychecks etc.

Disbursing Cash to Shareholders: Frequently Asked Questions about Buybacks and Dividends

A great way to learn more in this area is to read this recently published report discussing a few of the issues when it comes to disbursing cash to shareholders. This new report is written from Michael J. Maubosin and Dan Callahan, both currently at Credit Suisse. The report can be found here.

The following graph is found on the front page of the report, showing the historical growth in dividends, buybacks and the S&P 500 during 1982-2013.

BD1

The front page also contains the following summary points about the topic of buybacks and dividends addressed in the report. Have a look at them and then take some time to read the report itself.

  • Corporate cash balances are building because Corporate America’s return on investment is high and its reinvestment rate is modest. The issue of disbursing cash to shareholders is a crucial and timely issue in determining shareholder value.
  • Share buybacks and dividends are two methods to return cash to shareholders. Executives view the two very differently and are often unsure of the best way to proceed. Superficial media coverage and wide-ranging input from investors drives this confusion.
  • This report answers frequently asked questions. This format allows us to cover the pertinent issues as well as address a number of canards that persist with regard to these topics. 
  • A company should retain its earnings if it can earn a rate of return that is above the cost of capital. But if shareholders can earn a higher rate of return on capital than the company can, the company should disburse the cash.

The report is well worth reading, so check it out here.