“When we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. 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.”
- Warren Buffett
When my partners and I first came up with the idea of starting our second company, (which eventually went on to become Nintai Partners - a healthcare-focused consulting firm) we spent a great deal of time thinking about the areas of the business we performed poorly or in areas we simply didn’t perform at all. We eventually chose 3 areas to focus on:
Employee Ownership: We felt the strongest performance we saw in our field was driven by employee ownership. We didn’t mean stock options that represented 0.01% of the firm that vested after a ridiculous number of milestones had been met. We felt ownership should be achieved in a straight forward, substantial, and timely manner.
Compensation Driven by Customer Satisfaction: Most consulting firms have a pretty uniform approach. Partners create and maintain relationships that led to the largest engagements possible, middle-management/project leads look for as many project amendments that help beat revenue goals, and project staff work ridiculous hours in a controlled panic to achieve seemingly impossible project deadlines with little incentive to create long-term value. We designed a firm that compensated staff on long-term value created by their project.
Retain Earnings to Drive Book Value: Our goal was to retain earnings and use them to create an internal investment fund. This fund would be the main driver of value for company shareholders. Owners could log on and see exactly how much each share was worth and calculate the value of their share of ownership.
After several years of growing the business, attending Board meetings, and managing the internal investment fund, it suddenly became clear that I was engaged in an activity that no academic program had even remotely touched on - allocation of capital. It took several more years to define that role, create a process that could assist in making better decisions (there are no “best” decisions), and work with the Board to find a way to measure how successful we were in our efforts. Much like Warren Buffett’s comment, none of us in senior management had any real training or experience in allocating capital. One of the partners was great in sales and marketing, I was trained in operations management, and the other partner we used for their connections in the local business community. Each Board meeting turned out more excruciating than the last as one particular member hammered home that my job as managing partner was to “allocate capital - pure and simple”. When that job was complete he said, then I could hopefully return to my shareholders and convince them I had worked in their best interest. It was certainly a different way of looking at things.
Allocating Capital: Everyday Life of the CEO
In the course of daily living, we are constantly making decisions about allocating capital. Ranging from whether that membership at the gym is worth it to deciding when to replace the old car with a new one, how we allocate our hard-earned dollars is a vital part of our daily life. Yet somehow - through the course of getting all that corporate in-house training or attending classes for that professional license - many managers seem to have lost their ability to calculate whether that corporate porterhouse steak is more valuable than the filet they looked at last week. That’s truly unfortunate, because senior executives are faced with how, when, and where to allocate capital on a fairly regular basis. In the corporate world, allocation focuses on four major capital categories - mergers and acquisitions (M&A), capital expenditures (CapEx), dividends and share buybacks, or research and development (R&D).
It’s important to remember that not all capital allocation is equal in either complexity or impact. For instance, some CapEx is allocated specifically to grow the company. An example might be a new plant to increase manufacturing capacity. Staying with that example, replacing equipment in an existing plant might be solely for the maintenance of current manufacturing capacity. This distinction is vital when it comes time to calculating return on capital for the year. As a senior executive once said in a meeting to discuss capital spending “I don’t like to pay for the privilege of standing still. If I’m going to lay out some serious cash, let’s make sure we aim to grow and to win”.
Management are better at certain types of capital allocation than others. For instance, we know the record for mergers and acquisitions is quite poor. Management has a tendency to get the animal juices flowing and the next thing you know we’re looking at a shiny new toy obtained at nose bleed prices. Management also does a relatively poor job when it comes to stock buybacks. Over time, we’ve come to see that management buys back shares when they are at their most expensive but stop buying when share prices drop. The link between price and value seems to be obscured if not entirely forgotten during these times. As Warren Buffett pointed out “the first law of capital allocation - whether the money is slated for acquisitions or share repurchases - is that what is smart at one price is dumb at another.”
So what are we to do if so many managers are so bad when it comes to allocation of capital? It’s not an idle question. Adam Weiss of Scout Capital pointed out that if you buy something with a 10% free cash flow yield and hold it for 3 years, management will be responsible for allocating a third of the intrinsic value of the company over that time. After ten years that jumps to 60%. As a shareholder, what could be more important than that? The answer is not much. So its beholden to shareholders - and through them Board members - to speak up and make sure senior managers understand its importance. At Nintai, we think there are three areas where focus - through training and incentives - should be applied.
Establish a Link Between Price and Value
In many cases, senior management can lose sight of the requirement that value be commensurate with price when it comes to capital allocation (meaning you get a dollar – or more – back from the dollar you’ve allocated). An example of this is the history of value destruction through managements’ M&A activity. Until corporate boards make the link between what management pays and the value created (or not create in most cases) by acquisitions, it is likely we will continue to see deals driven solely by ego, empire building, and false hopes. In the words of Robert Fuller “tsk….tsk…what a way to run a railroad!”.
Reward Management When Long-Term Value is Created
To reinforce the relationship between price and value, corporate boards should be looking for ways to compensate management for such value creation. Ways to measure such success should be left to board compensation committees, but it would seem to me several issues should be addressed in these awards. First, value creation should be focused on the long term. Second, a distinction should be made between value created by cutting costs and value created by growth. Third, value should be of a permanent nature, meaning growth isn’t transitory but multi-year in scope.
This Isn’t Just for the C-Suite
Understanding the link between price and value isn’t a concept for just senior management. Mid-level managers and line employees should be trained to think in such a manner from day one. If the expectation is that employees with strong performance records will find their way up the greasy pole, then corporate leadership should be thinking about training for all aspects of the business. A great example of this is training by Boston Consulting Group in their “CFO Excellence Series” (an overview can be found here). When one becomes aware that capital allocation is one of the most critical means of translating corporate strategy into action, then training can’t begin soon enough.
Not All Allocation of Capital is Created Equal
As I mentioned at the beginning of this article, there are four major ways that management can allocate capital - M&A, CapEx, Dividends/Buybacks, and R&D. Each of these require their own form of expertise. For instance, M&A center on two completely different - yet connected - skill sets. In the first, management should have strong internal mental models on calculating valuation. Second, management should have extraordinary self-control that allows them to sit and take 20 pitches in one at bat without taking a swing. While these may seem mutually exclusive, the two skill sets actually are quite complimentary. In this case, the whole is greater than the sum of its parts.
A distinction is made between capital allocation that is necessary to keep the doors open (defined as working capital) versus capital allocated to facilitate growth. Working capital is a simple calculation: current assets less current liabilities. It is possible that a company might have positive current assets - or even by technically profitable - but be forced to cease operations as it has insufficient liquidity. Because Nintai doesn’t invest in companies with such type of balance sheets or cash flows, there isn’t any reason to spend much time on this type of situation.
But we are definitely interested in the distinction between allocating capital for growth and allocating capital for maintenance. At Nintai we generally avoid capital intensive industries. Examples are industries that require steady capital injunctions to simply keep up with competitors or keep the business running. This might include the railroads or the steel industries in the 1970s. Another example is industries that require significant R&D to simply find replacements for an ever evolving list of non-patented direct-to-consumer product. In both cases, capital is employed to maintain market share and less to drive growth.
Asset Light or Capital Light Models
At Nintai, we have a bias towards businesses that are asset light or capital light in their strategy or structure. These are businesses that require little capital to maintain the business. Any new capital can either be used to grow the business or be passed on to shareholders. Examples of this include Nintai holdings SEI Investments (SEIC), Veeva (VEEV), or Manhattan Associates (MANH). Each of these companies share similar capital structures – little-to-no-debt, low average weighted cost of capital, high return on capital, and very low capital needs.
Another aspect of these companies (it’s unclear which came first - the competitive moat or the asset light model. One thing is certain though - they intertwine) is the deep competitive moat surrounding each of them. Not only does it take little capital to maintain their outstanding business characteristics, but also their respective leads in their markets. For instance, Manhattan Associates currently fields a return of return on capital of 68% - rising steadily from 12.8% in 2010. As Manhattan has dug its moat deeper and wider it has achieved an increasing return on capital.
It should be stated that while some asset light companies achieve high returns on capital, not all do. Bausch Health Companies (BHC) - the former Valeant Pharmaceuticals - created an asset light business based on raising prices and in-licensing orphan drugs. While that worked for a while – the company grew revenue per share from $5.46/share in 2004 to $30.48/share in 2015 - the inevitable bill came due on $30 billion in debt - and the company saw return on capital collapse 34% to -2.4%. After teetering near bankruptcy for a short will and a fire sale of assets, the company is slowly righting itself.
What Bausch Health and Manhattan Associates can tell us is that allocation of capital can bring either long-term success or long-term failure. A company simply can’t be successful when managers are poor capital allocators. As the former Valeant - now Bausch - shareholders can tell you, if your managers aren’t successful at allocating capital, then its shareholders won’t be successful investors. Traders may succeed - but not long-term shareholders.
Conclusions
At Nintai, we’ve learned over time (and through painful experience sometimes!) that our most successful investments have been with managers who created a business whereby they could generate high returns on capital and – in the long term - generate significant shareholder value. The characteristics of those businesses are:
Given these characteristics, management can create a virtuous cycle that consistently - and profitably - grows the company creating long-term value for its shareholders. As Warren Buffett pointed out in the beginning, most managers aren’t trained to create and run such an investment gem. When you find management capable of creating and sustaining such a model, then hang on and let them do all the heavy lifting. The only real question is why do anything else?
As always I look forward to your thoughts and comments
DISCLOSURE: Nintai Investments has a long position in MANH, SEIC, VEEV
- Warren Buffett
When my partners and I first came up with the idea of starting our second company, (which eventually went on to become Nintai Partners - a healthcare-focused consulting firm) we spent a great deal of time thinking about the areas of the business we performed poorly or in areas we simply didn’t perform at all. We eventually chose 3 areas to focus on:
Employee Ownership: We felt the strongest performance we saw in our field was driven by employee ownership. We didn’t mean stock options that represented 0.01% of the firm that vested after a ridiculous number of milestones had been met. We felt ownership should be achieved in a straight forward, substantial, and timely manner.
Compensation Driven by Customer Satisfaction: Most consulting firms have a pretty uniform approach. Partners create and maintain relationships that led to the largest engagements possible, middle-management/project leads look for as many project amendments that help beat revenue goals, and project staff work ridiculous hours in a controlled panic to achieve seemingly impossible project deadlines with little incentive to create long-term value. We designed a firm that compensated staff on long-term value created by their project.
Retain Earnings to Drive Book Value: Our goal was to retain earnings and use them to create an internal investment fund. This fund would be the main driver of value for company shareholders. Owners could log on and see exactly how much each share was worth and calculate the value of their share of ownership.
After several years of growing the business, attending Board meetings, and managing the internal investment fund, it suddenly became clear that I was engaged in an activity that no academic program had even remotely touched on - allocation of capital. It took several more years to define that role, create a process that could assist in making better decisions (there are no “best” decisions), and work with the Board to find a way to measure how successful we were in our efforts. Much like Warren Buffett’s comment, none of us in senior management had any real training or experience in allocating capital. One of the partners was great in sales and marketing, I was trained in operations management, and the other partner we used for their connections in the local business community. Each Board meeting turned out more excruciating than the last as one particular member hammered home that my job as managing partner was to “allocate capital - pure and simple”. When that job was complete he said, then I could hopefully return to my shareholders and convince them I had worked in their best interest. It was certainly a different way of looking at things.
Allocating Capital: Everyday Life of the CEO
In the course of daily living, we are constantly making decisions about allocating capital. Ranging from whether that membership at the gym is worth it to deciding when to replace the old car with a new one, how we allocate our hard-earned dollars is a vital part of our daily life. Yet somehow - through the course of getting all that corporate in-house training or attending classes for that professional license - many managers seem to have lost their ability to calculate whether that corporate porterhouse steak is more valuable than the filet they looked at last week. That’s truly unfortunate, because senior executives are faced with how, when, and where to allocate capital on a fairly regular basis. In the corporate world, allocation focuses on four major capital categories - mergers and acquisitions (M&A), capital expenditures (CapEx), dividends and share buybacks, or research and development (R&D).
It’s important to remember that not all capital allocation is equal in either complexity or impact. For instance, some CapEx is allocated specifically to grow the company. An example might be a new plant to increase manufacturing capacity. Staying with that example, replacing equipment in an existing plant might be solely for the maintenance of current manufacturing capacity. This distinction is vital when it comes time to calculating return on capital for the year. As a senior executive once said in a meeting to discuss capital spending “I don’t like to pay for the privilege of standing still. If I’m going to lay out some serious cash, let’s make sure we aim to grow and to win”.
Management are better at certain types of capital allocation than others. For instance, we know the record for mergers and acquisitions is quite poor. Management has a tendency to get the animal juices flowing and the next thing you know we’re looking at a shiny new toy obtained at nose bleed prices. Management also does a relatively poor job when it comes to stock buybacks. Over time, we’ve come to see that management buys back shares when they are at their most expensive but stop buying when share prices drop. The link between price and value seems to be obscured if not entirely forgotten during these times. As Warren Buffett pointed out “the first law of capital allocation - whether the money is slated for acquisitions or share repurchases - is that what is smart at one price is dumb at another.”
So what are we to do if so many managers are so bad when it comes to allocation of capital? It’s not an idle question. Adam Weiss of Scout Capital pointed out that if you buy something with a 10% free cash flow yield and hold it for 3 years, management will be responsible for allocating a third of the intrinsic value of the company over that time. After ten years that jumps to 60%. As a shareholder, what could be more important than that? The answer is not much. So its beholden to shareholders - and through them Board members - to speak up and make sure senior managers understand its importance. At Nintai, we think there are three areas where focus - through training and incentives - should be applied.
Establish a Link Between Price and Value
In many cases, senior management can lose sight of the requirement that value be commensurate with price when it comes to capital allocation (meaning you get a dollar – or more – back from the dollar you’ve allocated). An example of this is the history of value destruction through managements’ M&A activity. Until corporate boards make the link between what management pays and the value created (or not create in most cases) by acquisitions, it is likely we will continue to see deals driven solely by ego, empire building, and false hopes. In the words of Robert Fuller “tsk….tsk…what a way to run a railroad!”.
Reward Management When Long-Term Value is Created
To reinforce the relationship between price and value, corporate boards should be looking for ways to compensate management for such value creation. Ways to measure such success should be left to board compensation committees, but it would seem to me several issues should be addressed in these awards. First, value creation should be focused on the long term. Second, a distinction should be made between value created by cutting costs and value created by growth. Third, value should be of a permanent nature, meaning growth isn’t transitory but multi-year in scope.
This Isn’t Just for the C-Suite
Understanding the link between price and value isn’t a concept for just senior management. Mid-level managers and line employees should be trained to think in such a manner from day one. If the expectation is that employees with strong performance records will find their way up the greasy pole, then corporate leadership should be thinking about training for all aspects of the business. A great example of this is training by Boston Consulting Group in their “CFO Excellence Series” (an overview can be found here). When one becomes aware that capital allocation is one of the most critical means of translating corporate strategy into action, then training can’t begin soon enough.
Not All Allocation of Capital is Created Equal
As I mentioned at the beginning of this article, there are four major ways that management can allocate capital - M&A, CapEx, Dividends/Buybacks, and R&D. Each of these require their own form of expertise. For instance, M&A center on two completely different - yet connected - skill sets. In the first, management should have strong internal mental models on calculating valuation. Second, management should have extraordinary self-control that allows them to sit and take 20 pitches in one at bat without taking a swing. While these may seem mutually exclusive, the two skill sets actually are quite complimentary. In this case, the whole is greater than the sum of its parts.
A distinction is made between capital allocation that is necessary to keep the doors open (defined as working capital) versus capital allocated to facilitate growth. Working capital is a simple calculation: current assets less current liabilities. It is possible that a company might have positive current assets - or even by technically profitable - but be forced to cease operations as it has insufficient liquidity. Because Nintai doesn’t invest in companies with such type of balance sheets or cash flows, there isn’t any reason to spend much time on this type of situation.
But we are definitely interested in the distinction between allocating capital for growth and allocating capital for maintenance. At Nintai we generally avoid capital intensive industries. Examples are industries that require steady capital injunctions to simply keep up with competitors or keep the business running. This might include the railroads or the steel industries in the 1970s. Another example is industries that require significant R&D to simply find replacements for an ever evolving list of non-patented direct-to-consumer product. In both cases, capital is employed to maintain market share and less to drive growth.
Asset Light or Capital Light Models
At Nintai, we have a bias towards businesses that are asset light or capital light in their strategy or structure. These are businesses that require little capital to maintain the business. Any new capital can either be used to grow the business or be passed on to shareholders. Examples of this include Nintai holdings SEI Investments (SEIC), Veeva (VEEV), or Manhattan Associates (MANH). Each of these companies share similar capital structures – little-to-no-debt, low average weighted cost of capital, high return on capital, and very low capital needs.
Another aspect of these companies (it’s unclear which came first - the competitive moat or the asset light model. One thing is certain though - they intertwine) is the deep competitive moat surrounding each of them. Not only does it take little capital to maintain their outstanding business characteristics, but also their respective leads in their markets. For instance, Manhattan Associates currently fields a return of return on capital of 68% - rising steadily from 12.8% in 2010. As Manhattan has dug its moat deeper and wider it has achieved an increasing return on capital.
It should be stated that while some asset light companies achieve high returns on capital, not all do. Bausch Health Companies (BHC) - the former Valeant Pharmaceuticals - created an asset light business based on raising prices and in-licensing orphan drugs. While that worked for a while – the company grew revenue per share from $5.46/share in 2004 to $30.48/share in 2015 - the inevitable bill came due on $30 billion in debt - and the company saw return on capital collapse 34% to -2.4%. After teetering near bankruptcy for a short will and a fire sale of assets, the company is slowly righting itself.
What Bausch Health and Manhattan Associates can tell us is that allocation of capital can bring either long-term success or long-term failure. A company simply can’t be successful when managers are poor capital allocators. As the former Valeant - now Bausch - shareholders can tell you, if your managers aren’t successful at allocating capital, then its shareholders won’t be successful investors. Traders may succeed - but not long-term shareholders.
Conclusions
At Nintai, we’ve learned over time (and through painful experience sometimes!) that our most successful investments have been with managers who created a business whereby they could generate high returns on capital and – in the long term - generate significant shareholder value. The characteristics of those businesses are:
- The company is run by managers who understand the link between price and value;
- The company’s average cost of capital far exceeds its return on capital;
- The managers create/sustain a business with a wide competitive moat;
- The company can employ capital internally to create additional growth, market share, and shareholder value
Given these characteristics, management can create a virtuous cycle that consistently - and profitably - grows the company creating long-term value for its shareholders. As Warren Buffett pointed out in the beginning, most managers aren’t trained to create and run such an investment gem. When you find management capable of creating and sustaining such a model, then hang on and let them do all the heavy lifting. The only real question is why do anything else?
As always I look forward to your thoughts and comments
DISCLOSURE: Nintai Investments has a long position in MANH, SEIC, VEEV
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