Thursday, 15 August 2013

Allocation of capital is crucial to business and investment management.

Managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

1.   All earnings are not created equal.

In many businesses, particularly those that have high asset/profit ratios, inflation causes some or all of the reported earnings to become ersatz (inferior substitutes).  The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends.  Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength.  No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

2.  Restricted earnings are seldom valueless to owners, but they often must be discounted heavily.  In effect, they are conscripted by the business, no matter how poor its economic potential.

(This retention-no-matter how unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago.  At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value.  But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners.  Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, "Dig We Must.")

3.  The much-more-valued unrestricted variety of earnings may, with equal feasibility, be retained or distributed.  Management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted.  For a number of reasons, managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc.  But there is only one valid reason for retention.  Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.  This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors

4.  In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business.

During an inflationary period, companies with a core business characterized by extraordinary economic can use small amounts of incremental capital in that business at very high rates of return.  But unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash.  If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business.  The situation is analogous to a Pro-Am golf event:  Even if all the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.

Ref:  Warren Buffett

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