Capital Allocation

In his annual letters Warren Buffett talks about the importance of capital allocation. Paraphrasing Buffett, when a company can invest its earnings in incremental assets at high rates of return it should do so, or it should use this money to acquire — in whole or in part — fairly priced “wonderful” companies generating attractive returns. When these options are unavailable, the company should return earnings to shareholders through share buybacks if the company is meaningfully undervalued, or though cash dividends if the company is fairly valued or overvalued.

Buffett says one of Berkshire Hathaway’s key advantages is its ability, as a conglomerate, to dispassionately invest capital in closely held and publicly traded companies across a range of industries. This kind of choice makes it easier for Berkshire to find fairly priced companies — to purchase in whole or in part — that are growing sales and earnings at high capital return rates. Additionally, Buffett doesn’t insist on operating control when looking for investing prospects — he’d rather own part of a great company than all of an average company. This gives Berkshire a flexibility advantage over companies that want control. Buffett also notes how easy it is for Berkshire to internally shift capital from a “cash cow” subsidiary that can’t invest retained earnings at attractive returns to a growing subsidiary that can.

Berkshire’s flexibility in deploying capital allows it to continue growing despite large sales and a large market capitalization. Most companies can’t invest capital in such a varied way: they operate in one business and one industry, resulting in fewer acquisition choices and fewer ways to shift money around internally. Limited choice often causes a company’s management to invest capital poorly, either by (1) expanding an existing, low capital return business or (2) making a controlling acquisition at a premium price.

Berkshire benefits not just from the varied ways it deploys capital, but from the large capital amounts it has to deploy. The company invests equity capital in the form of earnings generated by its subsidiaries, in addition to debt capital in the form of insurance float generated by subsidiaries like GEICO. Insurance float is the up-front premium money insurers hold/invest until these monies are paid out in claims. Berkshire invests float in attractively priced equities generating high capital returns. Float is a debt liability on the balance sheet, but Buffett believes this is a mischaracterization: he views Berkshire’s float as a costless, revolving fund — which Berkshire can invest in attractive equities — whereby claim payouts are continually replenished by insurance premiums. Through the years Berkshire’s insurance float has steadily grown, giving the company more and more money to invest. Buffett notes that returns from invested float are then augmented or reduced by underwriting profits or losses. When insurance premiums exceed expenses and eventual losses there’s an underwriting profit. When expenses and eventual losses exceed premiums there’s an underwriting loss. In most years Berkshire’s insurance subsidiaries have generated an underwriting profit. 

Companies shifting from growth to maturity often have trouble adjusting their capital allocation: they retain earnings for low return projects or acquisitions instead of distributing this money to shareholders through dividends or share repurchases. It takes managerial discipline for a company to forgo low return investments, even when these investments generate additional sales, earnings, and earnings per share. Low return investments waste retained earnings because shareholders could invest this money elsewhere at higher returns.

Poor capital allocation, industry competition, technological disruption, and business model disruption all cause declining returns and regression to industry mean returns. A company can delay and sometimes prevent declining capital returns through (1) shareholder-friendly capital allocation and (2) unique activities/strategy a la Michael Porter (e.g., Apple and Southwest Airlines). 

Buffett notes that shareholders of companies that allocate capital poorly actually pay twice: once via the earnings retained and invested by management at low returns, and once via the lower market value assigned to companies that behave this way. Smart capital allocation, whether it’s repurchasing shares at appropriate times or retaining earnings at appropriate times, may be the best quantitative indication of good management.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.