Topics:   Strategy

Topics:   Strategy

November 30, 2021

Navigating Capital Allocation: Best Practices for Boards

November 30, 2021

One of a firm’s most crucial responsibilities is capital allocation, a process by which management teams and boards deploy financial resources both internally and externally. Though extremely important, history shows that many companies struggle with carrying out the process correctly.

Take share buybacks, for example, a procedure that’s widely debated. The data show that S&P 1500 companies spent significant capital buying back stock between 2006 and 2008, only to pull back on buying between 2009 and 2011 when their valuations and share prices were much more attractive. The timing was terrible.

The same trend occurs with capital deployed toward mergers and acquisitions (M&A). Companies generally buy high and deploy a disproportionate amount of M&A capital late in the business cycle when valuations and fundamentals are often at their zenith. Companies also tend to increase capital spending in the middle or later parts of other economic expansions—right before demand for their goods declines.

However, the fact that the average company deploys capital suboptimally does not predestine every firm to do so. Not only is it possible to beat the odds, but it is also becoming an imperative. With structurally slower economic growth across most of the developed world, there is more excess capital that needs to be redeployed each year. The returns on this excess capital are becoming a larger driver of long-term shareholder returns, as well as an increasingly important source of sustainable, competitive advantage for firms that deploy capital well.

As a result, it is imperative for boards to create sustainable, comprehensive processes around capital allocation to maximize long-term shareholder value while also benefitting all stakeholders.

I’ve been analyzing companies’ capital allocation decisions and strategies for more than 23 years, first as an analyst, then a portfolio manager, and now a chief investment officer and head of investment strategy. I’ve come to learn that there are several key actions boards must embrace to build strong, repeatable processes around capital allocation. Below are three of the most important.

Compare Returns of All Alternatives When Deploying Capital

Every capital deployment decision should be subject to a comprehensive analysis of the expected cash-on-cash returns over the intermediate term, followed by a comparison to the returns from alternative forms of capital deployment.

In addition, it is essential to consider how the decision will impact the firm’s return on invested capital, free cash flow per share growth rate, cyclicality, and organic growth rate relative to all the various alternatives, including taking no action. Some of the best capital allocation decisions are those to say, “No.”

Monitor the Returns from Capital Deployment

The importance of monitoring returns on capital deployment goes much deeper than simply holding management accountable. It is an opportunity to learn from success and failure.

As part of their normal capital allocation review, boards should ask the following questions:

  • What are the characteristics of prior capital deployments that delivered strong, mediocre, and poor returns?
  • Which capital deployments generated returns that surpassed our original projections? Which capital deployments generated returns that came in below our original projections? Why?
  • What can we do better and how are we going to do it?

A board that is willing to examine past decisions critically and learn from them is far more likely to improve over time and avoid repeating mistakes.

Never Deploy Capital from a Position of Weakness

A firm should not alter its capital allocation framework, objectives, or return threshold because of changes in the core, underlying business. The firm should not undertake acquisitions, repurchase shares, or approve a large capital spending program to cover up a potential earnings-per-share miss or top-line air pocket. Letting returns become subservient to some broader strategic objective and deploying capital from a position of weakness are likely to destroy shareholder value. Historical evidence also suggests that this defensive capital allocation strategy not only tends to harm long-term shareholders, but frequently fails to achieve the strategic objective underlying the poor capital allocation decision.

For more best practices around capital allocation and to learn from companies who have it figured out, see David R. Giroux’s Capital Allocation, to be published in December.

David R. Giroux is a portfolio manager in the US Equity Division at T. Rowe Price. He manages the US capital appreciation strategy, including the capital appreciation fund. He also is head of investment strategy and chief investment officer for equity and multi‑asset. He is a vice president of T. Rowe Price Group.


NACD: Tools and resources to help guide you in unpredictable times.

Become a member today.

Comments

Read Related Content