QV INVESTORS SEVEN TESTS
At QV, our investment professionals use seven core tests in their security selection process. One of these tests is capital allocation, which is essential to understanding how a company stacks up versus its peers. Essentially, it provides an investor with a way to gauge different investment alternatives. In our experience, good capital allocation within a company has led to solid long-term investment returns.
WHAT IS CAPITAL ALLOCATION?
Capital allocation refers to how a company allocates the funds it receives into the business from its operating cash flow, asset sales, stock issuance or bond issuance. There are many choices a management team can make in how they spend this money. It can be reinvested in the business by buying new equipment, or it can be used to acquire a company. Another alternative is to return this capital to those that have helped fund the business by paying back debt holders, buying back shares, or paying cash dividends.
WHY IS CAPITAL ALLOCATION IMPORTANT?
The capital within an organization is scarce and needs to be treated that way. If capital is not allocated correctly, it can destroy value in the company. As an example, if a company issues stock and borrows money to acquire a business, there is a cost to doing this. This is referred to as the cost of capital. As shareholders, we and others want to see an expected return on an acquisition that is higher than the cost of capital. This creates increased value within a business over time. If a management team can’t find investments within its business that are higher than the cost of capital, then we would expect them to return funds to shareholders and debtholders. One way to measure how well a company allocates capital is to look at its return on invested capital (ROIC).
HOW TO CALCULATE RETURN ON INVESTED CAPITAL (ROIC)
There are various ways to calculate ROIC. You can take the operating earnings before interest and taxes and then take off the taxes divided by the capital employed in the business. This gives net operating profit after tax (NOPAT). Earnings exclude the interest cost because you don’t want this calculation to be skewed by the amount of debt or the interest rate one company pays versus another. Capital is calculated by adding the shareholders’ equity to the total debt.
AN EXAMPLE: TANGO CORP. VERSUS BRAVO INC.
Let’s look at two imaginary companies in the same industry to compare their ROICs. Tango Corp.’s NOPAT was $8 million in 2022, while Bravo Inc.’s NOPAT was $7 million. Let’s assume that Tango has employed $80 million in capital and Bravo has employed $100 million of capital. According to the calculation above, Tango would have a ROIC of 10% versus 7% for Bravo. For every $1 of capital employed in the business by Tango, it earns $0.10 vs. Bravo’s $0.07. As an investor, we would want to own Tango versus Bravo as we are earning a higher return on the money invested in the business. Essentially, we are seeing better capital allocation. In investing, it is rarely all else being equal, so a lower valuation with a higher ROIC would be even better! However, this is only over one year. But what is the ROIC trend over time?
TRENDS IN ROIC
Investments in year one may not fully show up in the financial results until a few years in the future. Therefore, we want to see what the trend of ROIC is over time. For example, if we take the ROIC for our Canadian large cap strategy holding Canadian National Railway (CNR), it has an average over the last 10 years of 10.7%. However, the range has been relatively stable between 8.0% and 12.1%.
WHAT IS A GOOD LEVEL OF ROIC?
To add value to a company, the ROIC needs to be above the cost of capital over time. According to data from valuation specialist Aswath Damodaran, the cost of capital for North American railways is 9.0%. CNR’s ROIC averages 1.7% per year above its cost of capital. It has been adding value on average over the last 10 years.
It is useful to look at the rest of the market for comparable returns. According to investment bank Morgan Stanley, the average ROIC for the Russell 3000 is 9.1% from 1990-2021. Therefore, even though CNR is a capital-intensive business maintaining track across North America, it still has a higher-than-average ROIC.
DIVIDENDS AND SHARE BUYBACKS
Capital allocation decisions that get special attention are dividends and share buybacks. The reason is these are more visible to investors.
Typically, companies pay dividends to attract investors interested in an income stream from their investments. We like the discipline required by a company with a dividend payment. Once a dividend is initiated, investors expect that payment each payment period. Therefore, management must remain focused on ensuring they have the capital to pay the dividend.
We do not require a company to pay a dividend for us to be invested. This is as long as the management team has demonstrated they can earn higher returns by keeping the money in the business.
If there are not enough investments in the business above the firm’s cost of capital, we want the capital paid out. The caveat is that the debt level is at an appropriate level for the business. If it’s not, we would want the debt to be paid down first before any capital is distributed.
To return capital, a company could complete a share buyback or a one-time special dividend. Both options benefit from having no ongoing obligations.
Capital allocation is one of the most important decisions made by a management team. It is important to look at your equity holdings and evaluate if you have companies with strong track records of capital allocation. You want to include companies that consistently add value to their businesses over time.