Importance of Capital Allocation

The Importance of Management’s Capital Allocation Decisions for Long-Term Investors

Most investors focus on a company’s future earnings, industry growth prospects, and financial health. While these are important for evaluating the merits of investing in a company long term, say several  years, how well the company allocates capital should considered too.

The best example of poor capital allocation is General Motors. Starting in 1997, GM began its campaign of slow and steady destruction of shareholder value. The automotive business is capital intensive, so GM sold profitable units to “feed” its core auto manufacturing divisions.

If GM had sold or spun off its lower margin, capital intensive auto businesses and related entities, such as GMAC and others, and instead kept its good business units, the value of GM today would likely be about $85B. That’s right. If it had decided to get out of the car business, imagine the difference.

Non-Automotive Businesses GM Sold or Spun-off Since 1997

Business Unit Current Value Estimate(in $M)

GM Defense                                                      $1,5342

Hughes Aircraft                                                 $23,0192

Hughes Space & Communications

Defense & Aerospace                    $7,0392

DirecTV Group                                  $33,7801

Hughes Network Systems            $6161

PanAmSat                                           $4,3005

ElectroMotive Diesel                                      $5004

Electronic Data Systems                                                $13,9003

Total      $84,688

1. Current market value. 2. Price on the date of sale adjusted to present day value using the Spade Defense & Aerospace Index returns. 3. Value as of 2008 sale to HP. 4. Best estimate of total value–GM never released information on the sale price. 5. Value based on 2004 News Corp sale to private equity consortium.

It’s amazing to see just how big a role capital allocation can play in determining the value of an investment. Today shareholders of GM (now Motors Liquidation Company) have an investment worth just about nothing. If the management of GM had made the tough decision to sell underperforming business units and keep the businesses with excellent economics, shareholders would own stakes in an $85B company. That would make our imaginary GM larger than all other automakers except Toyota. GM would rank comfortably around the 60s in the Financial Times’ list of the largest companies in the world.

While the GM example is obviously an extreme, poor decisions about capital allocation by company management can slowly erode shareholder value in any business.

So how can an investor “check up” on management’s decisions?

Check Earnings Growth and Dividend Payout Ratio

One method is to look at the amount of earnings a company pays out as dividends versus the amount it retains. Then check how that ratio has affected the earnings per share. Has the EPS grown at a rate greater than the stock market in general, or would management have been better off giving cash back to shareholders in the form of dividends?

Examine Sales of Subsidiaries

Another method is to examine sales of subsidiaries. Can the company easily find a buyer for its subsidiary? Here’s how to tell. If lots of potential buyers emerge or are rumored to exist, the price of the sale keeps going up and/or the sale closes fast. Those factors indicate a company is selling a profitable unit. If the company has a difficult time finding a buyer, think GM with SAAB and Hummer, and deals keep falling through or the price of the sale keeps going down, then it’s likely the company is getting rid of an underperforming unit and is better off without it. Also look for references about how much the company originally paid for the business if it was acquired. Did the company pay $1B five years ago just to turn around and sell for $500M? If so, that can be a sign of poor capital allocation by management. Of course, the ultimate success of the transaction depends on what the company does with the proceeds from the sale going forward, but the constant selling of good profitable business units might hint at deeper flaws in the company’s core business.