Farm of ideas: use it and lose it

  • Management struggles to exceed its growth ambitions and restore liquidity
  • Low-risk, high-yield stocks often offer
  • But shareholder value is created by good capital allocation choices, and not by prescriptive rules
  • Tons of new insight-generating data

There are many factors that determine whether a business is well run. But zooming out for a top-level view it all basically boils down to the quality of the capital allocation. Shareholder value is created when a business gets money where it can do the most good. The ability of companies to do this is the alchemy not only of “make-up” but also of capitalism itself.

But even for the most ardent free market, neither the corporate world nor the capitalist system can really be considered entirely perfect. For investors, this means that a key task is trying to understand the capital allocation skills of companies. Is the capital well distributed and will it continue to be so? Or is there room for improvement and management moving in that direction? Or, as is unfortunately quite often the case, has the logic of past capital allocation decisions disappeared along with the right options for the future?

For many businesses, including the great ones, there simply aren’t enough exciting opportunities that management can channel all the money a business makes. There are always options. But they can offer too low returns and too high risks.

Management teams in such a situation face the test of their ability to overcome growth ambitions and return money to shareholders. Allowing shareholders to try and find superior returns from a company’s excess capital is often the first allocation option.

Nonetheless, listed companies regularly pursue the glories of growth above all else. Perhaps no action is so infamous for destroying value as “transformative acquisition”. Even companies with an exemplary track record in capital allocation can become a reframing when it comes to big business. Protective equipment manufacturer Avon Protection (AVON) has been a high profile example for UK investors this year.

A recent study by academics Michela Altieri and Jan Schnitzler shed light on how shareholder returns are affected in companies that seem to feel pressured to spend rather than pay in cash. The researchers looked at U.S. businesses between 1985 and 2020. They compared the 30% that significantly increased their spending in the last quarter of the year with those that did not. The idea was to find businesses that seemed to have ended up with extra cash on their hands and quickly found a way to spend it – for example, those with a departmental budget to use or lose or plans to spend. doubtful glory waiting to be lit green.

Across a range of measurement methodologies, stocks of companies with big fourth quarter spending booms underperform weaker year-end spending. And very interestingly, the phenomenon has been most pronounced among companies with high cash generation, strong balance sheets but low dividend yields.

This may be a sign against the yang of research which has found that high-yielding, low-risk stocks tend to outperform. For example, Pim van Vliet, quantitative pioneer of this approach and author of the book High returns for low risk, described in an article from 2018 with fellow Robeco David Blitz that a principle-based strategy would have produced an annual return of 15.1 percent since 1929. This suggests that companies that demonstrate they are cautious in their internal capital allocation habits often make a good choice. Higher returns may also suggest that such boring capital allocation decisions (i.e. foregoing growth) are underestimated by the market.

Yet dividends are by no means always the best answer. This is why some people have recently become irritated by the normative dividend yield rules of equity income funds. The pros and cons are explored in more detail on page X of this week’s magazine.

But whichever side we find ourselves on in this particular debate, it’s generally a good thing if management can conquer piecemeal growth ambitions and just return the cash. At the very least, it certainly shouldn’t always be seen as defeatist. This is probably normally reasonable.

Links to the research mentioned in this article:

Michela Altieri, Luiss Guido Carli and Jan Schnitzler, Grenoble Ecole de Management, “Quarterly investment peaks, stock returns and investment factor“, Oct 2021

Pim van Vliet and David Blitz, Robeco Quantitative Investments, “The conservative formula: quantitative investing made easy“, March 2018

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