One of the recurring themes that you hear from many of the great investors is that one of the most important elements they track when evaluating management performance is what managers do with their retained earnings.
Oh, sure, top- and bottom-line growth are great. But what good are buckets of earnings when management squanders the proceeds with non-performing acquisitions, uses them to buy back overpriced shares, or does any one of a number of things that simply destroy capital? Companies that have been guilty of this in the recent past have included Vivendi
Shareholders who focused on the top and bottom lines for these companies without considering what was happening with the retained earnings were shocked to find out later on that it was indeed possible for companies to be both growing and mismanaged at the same time.
Fortunately, there are really only a few things you can do with a retained dollar if you're a manager: You can reinvest it into the business by increasing or updating your asset base, you can hold onto it in the form of cash or other liquid investments, you can make an acquisition, you can pay dividends, or you can buy back stock. Oh, sure, plenty of managers do some subset, such as investing in equity or assets like real estate that aren't core to operations, and some do things like increase their current or post-retirement benefits for employees, but such expenditures still fall broadly under one of the five groupings above.
Put money to its optimal use
Every once in a while you'll see some insane commentary where a writer says "dividends are for losers," which implies that every cent paid out in a dividend is one that cannot be used to reinvest in a company's growth. This is dirt-poor logic: Some companies simply require very little reinvested capital, with any additional (beyond optimal capital structure) at risk for being wasted. Why not give it back if you don't need it? That was the story when Microsoft
The great thing about focusing capital allocation is that the past record of management is fairly easy to track. Yes, it's tough to say "X" investment generated "Y" return, but a company that has a negative return on invested capital, in aggregate, is pretty easy to spot. One of the big elements that led me to believe that Krispy Kreme
Let's take a look at each of the five choices.
1. Buy back shares. We can see the good -- like when companies like UST
Some people love share buybacks, and some don't like them at all. I think they are fantastic, so long as they are rational deployments of capital, and so long as the shares are bought at a price below the company's intrinsic value. Purchasing shares to cover options dilution at extremely high prices does not apply in either regard.
2. Redeploy into assets. This is usually a pretty good option if your goods are in demand. Costco
3. Pay dividends. This one may be the untouchable for most companies: Once a regular dividend is instituted, there's a pretty strong incentive to never, ever, cut it, or worse, eliminate it. These things happen, of course. In 2003, Kodak
4. Hold cash or short-term paper. This has become the default for Berkshire Hathaway
5. Make an acquisition. Some companies are masterful at acquiring growth, like General Electric
Earnings are great. Earnings that are deployed in a way that maximizes investor benefit are even better. Managers who are capable and culturally geared toward doing so over long periods of time are best of all.
Bill Mann's life ambition is to become a railbird. OK, it isn't, but still, he likes the word "railbird." At time of publishing, he held shares in Berkshire Hathaway, Costco, and UST. The Motley Fool is investors writing for other investors and has a disclosure policy.
The Fool's own capital allocation wizard is Income Investor newsletter editor Mathew Emmert. He seeks companies that offer both large dividends and large margins of safety. Acomplimentary issueis yours for the asking.