Study of Quality. Capital Allocation. Working Capital.

**L’Oréal Case Study (Opening Example)**

- 20 years of ~6% average organic sales growth, only one contraction (2009).

- Post-tax return on capital increased from mid-teens to high teens.

- Strong cash conversion → 11% annual earnings growth, stock up >1,000% (5x market).

- Key drivers: reinvestment in R&D, marketing, acquisitions, plus dividends and buybacks (reduced shares by >10%).

**Capital Allocation Framework**

Companies have four main uses of capital:

1. **Growth Capex** – e.g., H&M opening new stores. Preferred use if high returns on incremental investment can be sustained.

2. **R&D & Advertising/Promotion** – Brand spending builds mental barriers to entry. Should be seen as investment, not just expense. Flexible but cutting too much erodes long-term value.

3. **Mergers & Acquisitions** – Often destroys value, but can work in specific contexts:

   - Consolidating fragmented industries (e.g., Essilor’s bolt-on acquisitions of local labs).

   - Buying strong brands and enhancing distribution (e.g., Luxottica + Oakley).

   - Leveraging network benefits (e.g., Diageo improving global distribution).

   - **ASSA ABLOY** (detailed case): 120+ acquisitions since 2006, raised margins from 15% to >16%, closed 71 factories, share price up 6x in a decade. Keys: decentralized structure, buying private companies, institutional experience.

4. **Dividends & Buybacks** – Excess cash should be returned. But companies often buy back shares when prices are high (bad) and cut buybacks when prices are low (missed opportunity).

**Working Capital**

- Net working capital = inventory + receivables − payables. Typically ~16% of sales for European companies.

- Growing companies tie up more cash in working capital, reducing cash flow.

- Ideal: low or **negative** working capital (e.g., software prepayments, insurance). This turns working capital from a cost into a benefit.

**Overall Theme** – Long-term value creation comes from a mix of: supportive industry structure, skilled management, differentiated products, competitive advantages, and disciplined capital allocation.