The Viewpoint: Capital allocation priorities

With UK interest rates at 5.25% and corporate borrowing costs 2-3% higher than this, many firms are experiencing the highest debt costs for 15 years.

Equally, UK public equity market valuations are low versus history, other equity markets, and indeed the private market. In this higher cost of capital environment, the appropriate allocation of capital appears to be more critical than ever.

The traditional role of the CEO is one of the charismatic operator, but actually some of the most successful CEOs in terms of stock market returns have been good capital allocators, rather than operators or managers. The point is well articulated by Will Thorndike in his book, ‘The Outsiders’, where he explores how a group of eight CEOs running decentralised operations and centralised capital allocation, with an emphasis on controlling cashflows, produced exceptional long-term returns for shareholders. ‘The Outsiders’ CEOs profiled (including individuals such as Henry Singleton at Teledyne and Bill Anders at General Dynamics), outperformed the S&P 500 by more than 20 times! They remained disciplined, patient and independent, investing in their own stock when it was cheap, ready to shrink their company when asset values were high and aggressively acquiring when valuations were attractive.

Capital allocation priorities should be a core element of every executive management team’s agenda, but management must adapt their priority according to the current environment in order to generate the highest long-term returns. Management has five principal options to decide upon when deploying cashflow: organic investment; inorganic growth through acquisitions; repayment of debt; dividends; and share buybacks. The way in which companies deploy capital can lead to vastly different long-term results but good capital allocation can maximise future profits and shareholder value over the long term.

Following the significant de-valuation of UK public companies in recent years, acquisitions in the private market (where in many cases, valuations are still yet to adjust to the higher cost of funding environment) remain relatively expensive. In addition, acquisitions are generally regarded as a riskier form of growth than organic investment, so should demand a greater hurdle rate of return. 

Repayment of debt has risen in the priority list amid a soft macroeconomic environment as interest rate costs have soared. In many cases, higher costs of debt have been a significant factor in lowering forecast profits. After all, retiring debt that costs in excess of 7% with excess cashflow is a reasonable return and use of capital. The result is that UK plc balance sheets are in a demonstrably stronger position than they were two-to-three years ago.

Share buybacks have long been a major feature of the US market but have been creeping up the capital allocation agenda in the UK. The current UK equity earnings yield of around 9% means that the most attractive (and lowest risk) return for executive management teams may actually be to invest in their own stock (something that stronger balance sheets facilitate). Last year 13% of UK companies bought back at least 5% of their shares as, in many cases, valuations detached from fundamentals, driven in part by UK equity outflows; reducing the share count by buying back cheap shares can be very accretive to earnings per share over the long term and is tax efficient as capital gains are generally taxed at a lower rate than income from dividends.

Ultimately, what matters to investors is total return. From 1963 to 1990, Teledyne returned over 20% compound annual return to shareholders. The first period of Henry Singleton’s tenure was characterised by large acquisitions, funded by new equity issues when valuations were high. Over the subsequent 12-year period (1972 to 1984), he bought back 90% of Teledyne’s outstanding shares when valuations were low, returning excess cash to shareholders. Astute capital allocation by management remains fundamental to long-term shareholder returns.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.