The Importance of Intelligent Capital Allocation
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
No company is better than the people who manage it. You can have superior technologies, access to valuable natural resources or even a dominant position in your industry, but if the company´s management is not making the right decisions regarding capital allocation, chances are shareholders will end up regretting their investment in the firm.
What happened to Netflix (NASDAQ: NFLX) can be a good reminder about the importance of solid leadership. Reed Hastings has shown a tremendous entrepreneurial spirit and an innovative mind by building Netflix from scratch and becoming the pioneer in online streaming. But he has made some remarkable mistakes which had important consequences on the company and its investors.
The Quickster disaster was very expensive for shareholders and meant some serious damage to the company in terms of public relations, and the company made a tremendously unwise capital allocation decision when buying back shares at prices above $200. How didn´t management foresee the fact that Netflix would need money to invest in the streaming business? Why did they believe a buyback was convenient at those record price levels?
That sounds like a mistake that won´t happen at Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). In his last letter to shareholders Buffett was quite specific about the two conditions he considers necessary in order for a buyback program to be a positive for the company and its investors:
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
Buffett has even quantified those two variables when it comes to share buybacks at Berkshire, stating both a maximum valuation ratio for the shares and a minimum of cash and equivalents in the balance sheet in order to implement such transactions:
At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.
Not only stock buybacks need to be scrutinized, shares emissions can be even more damaging for shareholder´s capital, particularly when the funds from those emissions are invested in projects which dubious prospects. Canadian gold miner Kinross (NYSE: KGC) has more than tripled its share count since 2006, and the worst part is than many of the projects in which the company invested seem to have been too expensive.
Kinross has done many goodwill impairments related to its acquisitions, which shows that management has been paying too much for some of these new projects. Impairments have been a recurrence in the last years, during 2011 for example Kinross wrote down more than $2.9 billion in goodwill related to its Red Back acquisition. A company which issues a lot of shares and them invests the proceeds at excessive prices is clearly not taking good care of its investors.
When investors purchase shares of a company, they are basically becoming part owners of that business, so it’s crucially important to monitor the capital allocation process closely. After all, the way management uses shareholder´s money is one of the main determinants of the returns investors can expect from their funds.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway and Netflix. Motley Fool newsletter services recommend Berkshire Hathaway and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.