Capital Allocation and CEO Failure

For the novice investor it’s sometime difficult to understand, or even fathom, what companies and their fearless CEO leaders can do with the cash flow that comes into the business. But it’s something that we all need to understand because it is a critical component to the investment process. Not only does it help us grasp information around costs-of-goods sold but it also provides insight into margins, growth planning, and even the prudence of the management.

Now, when a company spends money on paying for costs in the regular course of business, it is the responsibility of the investors to look at how it is allocated and whether it can be adjusted, if there is opportunity for cost reduction, the money’s allocation to strategy, and a variety of other factors. As investors we must investigate this in order to determine if we are investing in a CEO that is making correct decisions with their revenue dollars. However, as generalists, we know that every business has a different costs structure and, therefore, it’s a little difficult to make general statements in a post like this. But that being said, there are some comments that can be brought to light with regards to the spending of money, specifically with regards to cash flow that is left over after business costs are covered: retained earnings. There are generally 4 ways that cash can be spent – and if they aren’t spent the prudent way, an investor can gain a lot of insight into the CEO, his decision-making capabilities, and the future of the company.

When there is an excess of cash, one of the primary ways that a CEO spends it, is by putting it back into the business to grow it. This could include providing working capital increases, purchasing new machinery and expanding offerings, upgrading facilities, and even something subjective such as building culture and happiness in the workplace. A CEO’s intentions for the business can be seen quite clearly here. But at the end of the day, the company is profitable and cash is used for attempted growth in a marketplace that requires it – otherwise they wouldn’t be doing it (I hope!).

A second way that this cash can be spent is the buy-back of shares outstanding. This is quite simple to understand. The firm has extra cash and is buying up the shares that are owned publically or by parties that aren’t involved in the operations of the company. Sometimes even, management will even use that cash to buy up shares that are owned by internal employees. If CEO is doing this purchasing, then it is frequently seen as a very positive indicator because the management would like to “reverse-dilute” their own shares, making them hold a larger percentage. Why do they want to hold a larger percentage? Maybe there is an acquisition coming and they would like to receive a larger portion of the buyout? Maybe they know profits are great and would like to receive more cash in dividends personally? There is a variety of reasons that this may happen, but it isn’t a necessary expense.

So now let’s assume that there aren’t any internal growth prospects and the management isn’t interested in buying up shares. The third way of spending excess cash is through dividend payments. There are a series of different reasons for this. Some of them are strategic, some of them are simply to keep the shareholders happy and electing a board that will keep on the same CEO and management team, and sometimes it is commitment based (if they’ve paid dividends in the past, the must keep this up in, at least, the same quantities to prevent negative indicators in the market). But again, it isn’t quite necessary to the development of the business.

The first method that we described is usually where failures in management are caught because the second and third aren’t specifically operations or growth oriented. But the fourth place where excess cash is spent is usually where management failure is caught. This is in the market of business acquisitions. There is such a huge trend right now in CEOs looking for their next Mark Zukerberg, and as a result they are snatching up acquisitions as frequently as they can. Unfortunately this is happening during a period where markets are rising, others are buying, and prices are being bid up. They are bandwagon hoppers. So they are buying high instead of low? That’s right – not the value investor methodology. Sure, sometimes these are strategic acquisitions, but more frequently than not, they are plays on increasing cash flow. It’s become a fad.

It’s sad to say but a good chunk of CEOs have reached that title through simply putting in their time and making their way up the rankings from a humble sales or operations position. And so, they don’t have the same experience in business decision-making as the founders did and are making business and acquisition decisions without the knowledge and business mind that they should have. Ironically… this poor decision making as a result of succession planned CEOs that don’t know what they are doing happens in value investment firms as well, the very engines that are looking to avoid this in other potential investments.

So when analyzing the management structure and CEO competency of a company that you’re thinking of investing in, go beyond corporate governance and public façade. Take a look at what the CEO is doing, specifically with capital allocations and ensure that they aren’t the failure that is going to tank your portfolio with irresponsible profit spending.