Capital Allocation: The Superpower of (Some) Public Companies

Motley Fool senior analysts Bill Mann, John Rotonti, and Auri Hughes discuss six companies handling capital allocation in a Foolish way. Their topics include:

• How a stock with a slow-growing top line can become a long-term compounder.
• One company that was built to make acquisitions.
• When it's a "crime" for a company to pay a dividend.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 14, 2022.

Bill Mann: [MUSIC] This is why capital allocators, the superior capital allocators, tend to generate excellent long-term returns. They're hiring at a point in time in which their competitors are static or letting people go or are retrenching. These are the times in which the winners are made in the market. It's not times in which capital is as cheap as can be, it's the times in which chat capital is dear.

Chris Hill: I'm Chris Hill and that was Motley Fool Senior Analyst, Bill Mann. How good a company is at handling its cash says a lot. Do they pay a dividend, buy back stock, make an acquisition, or maybe just hold onto the money? These are decisions that long-term investors pay close attention to. Today, Bill joins fellow analysts, Auri Hughes and John Rotonti to talk about six companies handling capital allocation in ways we like to see.

John Rotonti: Hi Fools. I'm John Rotonti. I'm joined by Auri Hughes and Bill Mann. We are talking capital allocation and we're going to share with you some of the companies that we think excel at capital allocation. Before I ask Auri for his first pick, I just want to quickly go through what we mean by capital allocation. A business generates sales and then it chooses how to allocate the gross profits really that it generates from those sales. Some of the allocation can be into long-term growth investments, into things like research and development, even some sales and marketing may be consider long-term investment. Then capital investment, property, plant and equipment, capital expenditures. Those are all long-term gross investments that can be considered capital allocation.

When a company runs out of high return on capital investments that it can make either through, like we just said, research and development, capital expenditures, etc, then it has to decide what to do with its excess free cash flow. In that case, it can either pay down some debt, make an acquisition, buy back stock, or pay a dividend. Really a rule that I try to live by when I'm analyzing corporate management teams Bill and Auri is, if a company has high return on invested capital investment opportunities, then it should invest every single penny that it can into those high return investments, into those high return opportunities. It's a crime if a company is paying a dividend when it has high return on invested capital opportunities that it could be investing in. But on the other hand, if a company doesn't have any high return on invested capital opportunities, then it's a crime not to return capital to shareholders either through dividends or intelligent share repurchases. With that framework in mind Auri, what is an example of a company and its management team that you think excel at capital allocation.

Auri Hughes: I'm going to go Constellation Software. This is just a company I love and I continue to get to know and learn. I think it's a wonderful company to study for your business education in general because I think they've mastered M&A, essentially mergers and acquisitions. Essentially was started by a gentleman named Mark Leonard in '95 and he was a venture capitalist 11 years and he acquired small software plays. Then he continuously did this for long periods of time and the business has just grown tremendously. Over years, it compounded something like, I think in the high 20 or 30 percent for over 10 years. He's done this with a M&A strategy. I think this is profound because a lot of companies essentially destroy value with M&A and they're not great capital allocators or they overpay or they promise synergies and things that don't materialize and we see that later. But he has this wonderful strategy. One of the things that I think is unique is in CapIQ the share count when they went public was 21 million shares and today it's still 21 million shares. They've earned a return on equity in the high 30s for a consistently long period of time. I think this is one of the best companies in the world a lot of people don't know about. They are very disciplined and they have this process as well. I think the other unique thing to mention is as you get larger, you have to do more acquisitions to generate the same amount of earnings and return on equity because your capital base is growing. They've consistently been able to do this for a long period of time so I think Mark Leonard is just a master capital allocation.

John Rotonti: Bill, this is what you know, pretty well.

Bill Mann: I know it pretty well and Auri is exactly right. If you ever get a chance to go to the Constellation Software front page of their website, they are first and foremost interested in getting introductions to vertical management software companies that are interested in selling. This company is built for capital allocation. Because if you think about it, there's no such thing as let's go upload the Constellation Software suite. It doesn't exist. They're a series of small companies and they use the returns from those companies as force multipliers for other companies that they are interested in buying. They do them by the dozens each year at this point.

John Rotonti: Yes, Constellation has excelled at making these acquisitions. They do a 100 of them a year. They did literally 100s of these small acquisitions a year, but we don't want people to think that any company making acquisitions is going to be the next Constellation. There is research showing that 2/3 of corporate M&A, 2/3 of corporate mergers and acquisitions either destroy value or create no value. It just so happens that Mark Leonard and team at Constellation are exceptional, they are one of the exceptions. Berkshire Hathaway is an exception to this rule. Accenture is an exception to this rule. Accenture makes 40 or 50 acquisitions a year as well. They also already said, maintain extremely high returns on equity and returns on capital. When you see a company making lots of acquisitions a year. When you see a company where acquisitions are a part of their growth strategy, are a part of their capital allocation strategy, and they're not diluting their returns on equity and their returns on invested capital, you know, you may have found a winning company. But those are rare.

Bill Mann: We can go even more cynical than that. In 2/3 of the cases, the only constituency that has a positive correlation with mergers and acquisitions is the compensation of the management team. They have a larger company upon which to be compensated. That's cynical, [laughs] it also happens to be true.

John Rotonti: Because sometimes compensation is just based on growing the size of the business as measured by sales or EBITDA.

Bill Mann: Look how big we are now.

John Rotonti: Yeah, [laughs] look at how big we are right now.

John Rotonti: [LAUGHTER] Even though it's diluting returns on invested capital.

Bill Mann: Absolutely.

John Rotonti: Such a great one to start with. Bill, what do you got for us.

Bill Mann: All right, John, we're going to start with a game, and it's completely unfair. This company has grown since the year 2000, on average five percent per year. What has its share price done in the same period of time?

John Rotonti: I'm guessing much better than five percent

Bill Mann: That's such a weasel answer. [laughs] Auri, what do you say, five percent per year for 22 years?

Auri Hughes: Let's go 13 percent per year.

Bill Mann: Not bad. It's 8x what it was. 8x five percent per year growth on the top line, 8x return for shareholders, the company. It's an exciting one, it's WD-40. WD-40 you know it's core brand, try to withhold your excitement, they make toilet bowl cleaners under the X14 brands. They also make lava soap. The way to think of this company, the reason that a company that can grow at their shares by 8x growing only five percent per year is by virtue of how careful and how cautious they are with the capital that comes in when they reinvest that capital, they do an absolutely wonderful job. This is a company that maintains as a branded cleaning company, operating margins of nearly 20 percent at and they have had this for decades.

John Rotonti: That's just incredible that a company that is that, we put it into slow growth category, can 8x its stock price through superior allocation. You can use WD-40, just but I think.

Bill Mann: Yeah, practice area? [laughs].

John Rotonti: Maybe not cereal, but I've heard some weird uses of WD-40 for spanky wheels and squeaky remote control gates and stuff like that.

Bill Mann: They were 100 percent supportive of all of these weird uses. But WD-40, if you think about it, you would never think of this as being a growth company or a high-growth company, you don't necessarily need a high-growth company to generate spectacular returns on the stock. If you have a company that has a management team that is very careful for how it reinvest this capital, and Garry Ridge and his team at WD-40 are absolutely that.

John Rotonti: I just Googled it really quickly. Remove chewing gum from hair. WD-40, stop wasp and nest. Wd-40, clear-up crayons. Wd-40, remove dog mess, loosing a stuck ring, piano keys, water proof your shoes. Here we go.

Bill Mann: As fish bait.

John Rotonti: Yeah, fish bait.

Bill Mann: Pike are attracted to WD-40.

John Rotonti: Mine is going to be no surprise, it is one of my favorite companies, and it's Texas Instruments. Texas Instruments, they allocate capital in several ways. One, is they're entering a massive CapEx investment cycle in order to drive seven percent annualized revenue growth over the next 15 years. That's their goal. To give you an idea of what I mean by massive, in the five-years from 2016 through 2020, Texas Instruments spent about 771 million per year in CapEx, 771 million. Then in 2021, their CapEx jumped to 2.5 billion and from 2022 through 2025, they're guiding for CapEx of 3.5 billion per year. After 2025 going forward, so starting in 2026, they're saying their CapEx will average 10 percent of sales per year.

Their historical CapEx back when I said it was 771 million per year, historically their CapEx was about five to six percent of sales. Over the long term, they're doubling their CapEx to sales ratio because there is so much increased demand for semiconductors in the digital world. They're investing CapEx, they also spent about 1.5 billion dollars per year on research and development, so they spent about 11 percent of their sales on research and development. Investing heavily into growth. These growth investments, Fools, these growth investments are before you get free cash flow. You invest in R&D, you invest in CapEx, you invest in some other things that what's left over is free cash flow. They make these growth investments, but they are committed to returning 100 percent of their free cash flow to investors through dividends and buybacks.

Their formula is to pay out 40 percent to 80 percent of their annual free cash flow as a growing dividend and then use the remainder to buy back stock when they think it's trading at a discount to intrinsic value. As far as the dividend, it currently yields 2.8 percent, and they've increased that dividend for 18 consecutive years. Since 2004, Texas Instruments, its dividend per share has compounded at a 25 percent CAGR, or compounded annual growth rate. More recently, over the last five-years and the last 10 years, its dividend per share has compounded at over 20 percent per year. This is a massive dividend growth company. Compounding that dividend over 20 percent per year, the dividend yield is 2.8 percent. Then if you like buybacks, by the way, they've reduced their shares outstanding by 46 percent since 2004.

Bill Mann: It's still a high-margin company. This is what's incredible to me about Texas Instruments. The fact that they have made so many capital decisions that essentially both return capital to shareholders and self liquidate in terms of reducing the share count. Yet what they're using that capital for are things that don't necessarily add to the operations of the company, but at the same time the money that they are putting to the operations of the company is also returning at a very, very high rate.

John Rotonti: It's incredibly high-margin business.

Bill Mann: John, why wouldn't you want to see them reinvest more capital into the business rather than share buybacks?

John Rotonti: Like I said, they've committed to going in CapEx from 770 million a year to 3.5 billion. That's a pretty big commitment.

Bill Mann: They are not starving the business.

John Rotonti: They spend 1.5 billion per year on R&D. But, Bill, you're right. I just think that Rich Templeton, the CEO, he fundamentally believes in returning capital to shareholders above and beyond what they need to grow the business. They're entering a massive investment cycle. But you're right, maybe there's an argument to be made to invest above and beyond what they are doing now, take on more debt to do so. It's a possibility because like you said, the margins and the returns on that investment are so remarkably high. Rich Templeton, he has this great idea that, and it's the right way to look at it. Buybacks are a way to reward continuing shareholders. If you're selling out, you don't get rewarded. If the company's buying stock from you, adios amigo, you're not getting rewarded. But if you're a continuing shareholder then buying back stock at discounts to interest the value, is one of the best things a company can do, it's one of the highest return on invested capital moves a company can make. If you like dividend growth, if you like nearly three percent yield and you like buybacks, take a look at Texas Instruments. Auri, over to you. Round Number 2.

Auri Hughes: This is an organic growth, just there's business out there. We're going after, we're going to get bigger essentially. Still, most of the decision is going to be the investments are going to be internal to the company. I think I recently researched Adyen, they had a Capital Markets Day. This company is executing on all cylinders and it's getting better and the stock has been hammered. I think people that hold on are going to be greatly rewarded. But essentially what they have going on is their payments business, so this unified commerce. Essentially if you do business in multiple geographies and you have e-commerce platform and you have POS, their system has been built so that you can use both of those items and it's easy to scale and grow with your business and you don't have to have multiple providers, like one for e-commerce and one for in-store point-of-sales purchases.

John Rotonti: They are also innovating their products. They're coming up with new solutions to better serve their customers. This is where we think about R&D new products. Some of the new things that are coming out with that, and I think this is brilliant, is Adyen Capital. They have all this information about these people that do business on their platform. They have insights into their financials. Let's say you're a coffee shop and you need a loan for a new espresso machine, Adyen has insights on all your data when cash comes into your business and when you make payments. Now they're going to start getting into the lending business and they have the information to probably do that competitively. That's a new innovative thing where they're going to put the cash on their balance sheet to work. Ideally, it doesn't just sit there, but even though they have net cash. Then they're going to get into card issuing. If you're a business and for some reason you want to issue debit cards or which I think Marquetta is in that business and that's a growing business as well, that's a good example of organic growth route where there's just more business out there and we're going to hire FTEs, engineers to come up with these innovative products. That's my organic growth capital allocation example.

Bill Mann: I love that Auri is bringing in organic growth and acquisitive growth.

Auri Hughes: It's too on the opposite spectrum. [laughs]

Chris Hill: I love it though. You're spreading the love. Like I said, far too many investors think of capital allocation, all they think of is the return of capital and not the growth investment part of it.

Bill Mann: Here's why this matters and Adyen has long been one of my favorite companies. I was delighted to see that Auri already brought it to the table and also not delighted because I would've brought it myself [laughs] had he not done so. What we're seeing right now, particularly in tech and particularly in payment technology is a real consolidation, retrenchment. One of the most interesting things, this is why capital allocators, the superior capital allocators can generate excellent long-term returns. They're hiring at a point in time in which their competitors are static or letting people go or are retrenching. These are the times in which the winners are made in the market. It's not times in which capital is as cheap as can be. It's the times in which capital is dear. The fact that Adyen is out buying growth, continuing to innovate, continuing to hire for R&D, to me is a really outstanding signpost for what this company can be.

John Rotonti: I just pulled up Morningstar really quickly to look at their returns on invested capital. Auri, they're generating 29 percent returns on invested capital on that organic growth. That's exceptional for a company growing 50 percent a year? Are you kidding me? Honestly, I don't think I can think of another company, [laughs] maybe one or two, that are growing 40-50 percent, generating nearly 30 percent returns on invested capital. I don't know if I can think of another company growing that fast, generating returns that high. Maybe a few, but it would be hard for me to do. S&P Global, MasterCard, and Visa, they have comparable returns on capital and operating margins that are even higher, but they're not growing 50 percent, so really, it's going to be hard to think of a business with Adyen's economics, such a great one. Bill, do you want to go?

Bill Mann: Well, I talked about degreasers and things of that nature earlier. We're now going to talk about a company that's scoring a little bit faster, nine percent over the last 20 years, but it's just as boring. It's Church & Dwight from Princeton, New Jersey. They make Arm & Hammer Baking Soda and all of the different products that you see Arm & Hammer's label on, including kitty litter, detergents, road cleaners, OxiClean, they make Trojan condoms, they make first response brand home pregnancy kits. One of the ways that I think about capital allocators, a pretty simple way to do it is to measure their goodwill, which is basically the amount of money that they have paid on top of asset value for companies they've acquired as a function of their assets and measure it against their operating margins. The higher the operating margins for a company that has a fairly high level of goodwill should tell you that they have been allocating capital really, really well. In the case of Church & Dwight, their operating margins are 19 percent, which is for a company that essentially makes branded commodities, an incredibly high number.

John Rotonti: That's incredible. How is this company growing nine percent average? That's actually a pretty good growth rate for a consumer products company like that.

Bill Mann: What they've done is they've gone out and they've found bolt-on acquisitions that they were able to buy very cheaply. They bought Orajel, for example, in the Waterpick brand is actually now owned by Arm & Hammer Baking Soda owned by Church & Dwight. They've done so which is why they have that goodwill number because when you see a company with a goodwill number, that means that they've gone out and have acquired other companies. They have done so by very smart acquisition of other brands, and then also by thinking of different ways that Arm & Hammer Baking Soda can be added to other products in either a branded or a non-branded way.

John Rotonti: Awesome. Another bolt-on acquisition story, I love it. My last one is Home Depot, another surprise. They have a very, very balanced capital allocation strategy. They invest $2.5 billion a year in CapEx and that goes toward omnichannel retail and so everything that is involved in building out the computing power that they need for homedepot.com, which they completely revamped its supply chain and logistics, whether it's fulfillment centers, whether it's delivery capabilities, they want to be able to deliver with everyone in the US within two days or less. They're investing a lot in omnichannel retail. Like Texas Instruments, they return excess cash to shareholders through a dividend and a buyback. First, the dividend, they paid a dividend every single year since 1990 and they've increased the dividend for 13 consecutive years.

You may say why only 13, it's because during the great financial crisis of '08/'09, they just kept their dividend stable at $0.90 a year for one year. During the housing crisis, rather than increase the dividend, they just kept it the same. But they've paid a dividend every single year since 1990. They have not cut the dividend and they've increased that dividend every single year for the last 13 years. Over those 13 years, the dividend has compounded at a 17 percent growth rate. The current dividend yields 2.6 percent. It's another pretty substantial yield you're getting. Then for buybacks, in 2003 it had 2.3 billion shares outstanding and these are fully diluted shares. In 2003, 2.3 billion shares. Now it has about a billion. It has reduced its shares outstanding by over 50 percent at prices much, much lower than today's stock price. The average price at which they bought in 50 percent of their shares is much lower than today's stock price. That's the ultimate test to see if they are getting a higher return on those buybacks. It's what price did they pay for the buybacks versus where the stock is trading today?

Bill Mann: John, one of the most interesting things about Home Depot is that it's actually is a test of both sides of good capital allocation and poor capital allocation because there was a stretch in its history from the period about 2004-2007, in which it was being managed by a poor capital allocator and it cost the company a lot of money to get him pushed out the door. Once Frank Blake came in as the new CEO the ship was steady and they began making the same kind of the decisions that they've been making since Arthur Blank founded the company a couple of decades prior to that.

John Rotonti: Lowe's by the way, their largest competitor, another very, very high-quality business is in the midst of a turnaround the last two years or so under their amazing CEO, Marvin Ellison. Bill Mann, Auri Hughes, always thank you for your time sharing your experience and your wisdom with us. Fools, this was fun.

Auri Hughes: Yeah, this was fun. Thank you.

John Rotonti: I'm John Rotonti. On behalf of The Motley Fool, Thank you for listening. Fool-on. [MUSIC]

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening, we'll see you tomorrow.