Capital allocation is essentially what companies do with their financial resources to maximize shareholder value. Generally, growth companies plow cash into research and development, while companies past the growth stage initiate programs like buybacks and issue dividends that return profits to shareholders.

In this week's episode of Industry Focus: Tech, Sean O'Reilly and Dylan Lewis explain what investors need to know about capital allocation, dividends, and share buyback programs. Also, they give two examples on either ends of the buyback spectrum -- one company that executed their program beautifully, and one that couldn't have chosen a worse time.

A full transcript follows the video.

This podcast was recorded on April 15, 2016.

Sean O'Reilly: Welcome to the capital allocation station, on this tech edition of Industry Focus.

Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is Friday, April 15th, 2016. Happy Tax Day! And with me in studio is the incomparable, the snappy dresser, Dylan Lewis. What's up, man?

Dylan Lewis: Doing alright. I will say, I think Capital Allocation Station is probably the worst sounding ride in an amusement park.

O'Reilly: (laughs) It's almost as bad as the band name for the fake band you were going to have editorial head up.

Lewis: The Inefficient Market Hypothesis?

O'Reilly: Oh my god. It's so good.

Lewis: It's such a good finance nerd joke, but it's one of those things that everyone else is like, "Ugh, come on."

O'Reilly: I like it. Anyway, just so everyone knows, we're going to be talking about capital allocation in the tech sector. It's a little bit more boring than what we usually talk about, but we're going to make it snappy and cool. And the other alternative I was going to mention was, this is basically you and I telling companies how to run their businesses, and their treasury departments.

Lewis: Yeah. We'll do a little run-through on capital allocation, some of the different forms of might take, how you might hear about it on the news, one company that did not do such a great job with their capital allocation, and another company that's done a great job.

O'Reilly: So, Dylan, for those who may not know, what is capital allocation?

Lewis: Capital allocation is basically how a company decides to divvy up their financial resources, the goal of course being to maximize value for shareholders. So, it might be unfamiliar as an umbrella term for some people. Investors will generally recognize the different actions businesses can take, though. So, think about things like share repurchases, initiating a dividend or growing that dividend, plowing money into research and development, purchasing new property and equipment, making an acquisition, something like that, these are all the types of things that play into the idea of how a company allocates its capital.

O'Reilly: And obviously, it requires making a judgement as to future returns to any of those initiatives. There needs to be a hurdle, and all that stuff needs to be done. How would you say, for the laymen, a business should make those decisions, given where they are in their business cycle, or anything like that?

Lewis: The things that are most predictable, and I think, probably the things you hear about most as an investor, are repurchase programs and dividend payments. It's really hard to anticipate something like an acquisition. Research and development is obviously this ongoing thing behind the scenes, and you don't get a ton of insight into it. So, those are the two that really stand out. And for those two, I think it really depends on the business profile. So, you have your high-growth company, they're in a phase where they're plowing money into R&D, they're trying to build out sales force to better sell their products, grow the top line, they're going to be looking to hold on to their capital, push it into different types of innovation.

O'Reilly: Because, theoretically, the money that could be made with their fast-growing operations and forming out a niche market is better than paying out a dividend to shareholders.

Lewis: Exactly. If you're growing your top line at 30% or something like that, you shouldn't be passing along a 3% dividend yield to investors. The money is much better-spent investing it internally and just growing that engine. And typically, these will be your mid and small cap companies. They also tend to have less stable cash flows.

O'Reilly: Or lack thereof.

Lewis: (laughs) Yes. You don't want to be committing to a dividend program in particular, because once you initiate something like that, game on, people are expecting it all the time. Or, even just announcing share repurchases, if you don't have the money set aside to continue to grow your business and also handle those other operations.

O'Reilly: It's amazing to me, and I think it's been a real treat, particularly for the tech sector, over the last 20 years, to see the high-flying tech bubble names like the Ciscos and Microsofts (NASDAQ:MSFT) and all those, these things have multiples of 300-400 times earnings, they had no cash, it was just crazy. And now, heckApple has more money than the federal government of the United States, Microsoft has been a steady dividend paid since 2003, Cisco -- which, I remember multiple write-ups in 1998, 1999, and 2000, that we studied in my business school classes, and 2004, that was just ... egregious valuations, this company should not have been valued that way, this is crazy, and now they have a $50 billion bank account, they pay a dividend, it's a value stock by any metric, as I've highlighted in previous episodes. So, the dichotomy there and the change that's occurred is crazy to me.

Lewis: And all those names you've highlighted have made that transition from being that high-growth company, to now this second class of companies.

O'Reilly: We've seen them grow from crazy, wild teenagers to mature adults. (laughs) 

Lewis: Right. So, they're in more of a steady growth phase, probably somewhere more in the single digits in top line growth. Generally, that's where you tend to see these. Consistently profitable, nice reliable cash flows. These are all companies that are going to be more likely to return capital to shareholders via repurchases or dividends.

O'Reilly: Right. Do you have any companies that come to mind that you really like that have done this over the past ...

Lewis: I think a case in point in tech companies maturing is Google (NASDAQ:GOOG) (NASDAQ:GOOGL). We talked about, maybe, two earnings reports ago, they authorized a share repurchase program to the tune of, I think, like $5 billion or something like that.

O'Reilly: And that was the first one ever.

Lewis: Yeah. And this is a company that's been notoriously growth, growth, growth. 

O'Reilly: Throwing money at everything.

Lewis: Side-stepping being friendly to Wall Street. Their new CFO is much more Wall Street-friendly, Ruth Porat, but that's just an example of a company that invested in growth for such a long time -- and was profitable for such a long time -- but only recently decided, "Alright, we're going to give a little hand out to our shareholders via share repurchases, and kind of reign in what's been going on in terms of shares outstanding."

O'Reilly: Yeah, one of my favorite examples, and this is going back a while, when we were coming up with the ideas for this show, and it sounds crazy that Buffett would do this, but Buffett actually bought a tech stock in the 1970s.

Lewis: Did he?

O'Reilly: Yeah. You grow up, and you're like, "Oh yeah, Buffett doesn't buy tech stocks, he buys Coca-Cola."

Lewis: Yeah, he likes boring companies.

O'Reilly: Yeah. It's because they're steady and predictable, Dylan, come on! But, it's specifically for the reasons we're talking about. They made this really great shift to being a responsible capital allocator in buying back shares and all that good stuff. Under the leadership of Henry Singleton in the 1970s, Teledyne Technologies (NYSE:TDY), this was like a quasi-defense contractor tech firm. It was actually a remnant, it was originally founded in 1960 and was part of the 1960s conglomerate boom. We're going back 40 years here, but finance doesn't change much. But then, the 1970s bear market happened, and if you thought that 2008-2009 was bad, 1973-1974 were equally as bad. The average multiple on the S&P 500 was like seven. It was low, it was a really bad.

Lewis: It sounds like you're leading to a buying opportunity.

O'Reilly: Yeah, no, so, what Singleton did was, their stock dropped from like $40 to $8, and he had issued a ton of shares into the conglomerate boom, they had all this cash lying around, they had all these arguably stable, great defense contractor-y type stable business. They started buying back tons of stock. Over the ensuing 10 years, earnings went up 89%, shares went up--

Lewis: Individual share price?

O'Reilly: Yeah. This is really good. Annual income increased by 89%, and net income increased by 315%. The stock, on the other hand, went from $8 -- now, remember the high previously was $40 -- to, by the end of the decade, $175.

Lewis: Wow!

O'Reilly: Because of all these share buybacks. This is better than a 17-bagger. And it was all just because this engineer CEO of a tech firm was smart enough to know, "Yeah, we probably shouldn't buy other businesses, we probably shouldn't invest in R&D, we should probably just buy back our shares, because we're trading at a ridiculously low valuation compared to where we should be."

Lewis: And of course, part of that share price appreciation is the fact that the pie is being split in much fewer slices, once business prospects turn around.

O'Reilly: Yeah. The share count goes down, and even if your net income stays the same, the piece of the pie is increasing, and your earnings per share go up, and the earnings that you own or have claim on, are higher.

Lewis: And I think that perfectly highlights one of the big advantages of repurchase plans and that style of capital allocation, where you have the opportunity to opportunistically buy when shares are low and take advantage, possibly, of the market under-valuing a company. Obviously, who should know better about the prospects of a business over the next couple years than the people managing it?

O'Reilly: Yeah.

Lewis: One would think. I do think, one of the things that tends to get overlooked with capital allocation, and the theory with dividends is that, by issuing dividends, becoming a dividend payer, you are essentially saying, "We're doing this, every quarter, every year, whatever the term is," and you're kind of locked into that. And that attracts a certain type of investor. When you commit to a dividend program, you're going to get people who are income-oriented, and you're signaling to people, in a lot of ways, that they can set and forget their investments. They'll collect that yield over time--

O'Reilly: And not only that, but they're saying, "We think our shareholders can do better with this money, even after paying taxes on those dividends, than we can, at least this chunk."

Lewis: Yeah. And I think it does offer the stock a lot of stability, because people are buying and holding.

O'Reilly: Yeah. Well, after the break, we're going to profile two different companies -- one we think was smart with its capital allocation decisions, and one that wasn't. Before that, I wanted to highlight to our listeners, as I have in the past, that for those of you looking for more great, Foolish content, a special offer on The Motley Fool's Stock Advisor newsletter is available to all Industry Focus listeners, that works out to $129 for a full two-year subscription. To take advantage of this offer, just head over to Focus.Fool.com. Once again, that is Focus.Fool.com. So, Dylan, who's going first?

Lewis: Rock paper scissors shoot?

O'Reilly: Okay. Ready? Rock paper scissors shoot!

Lewis: Rock paper scissors shoot. Alright, I won, I'm going to go first.

O'Reilly: Darn it. You knew I was going scissors, didn't you?

Lewis: Yeah, I had you read. I'm taking the company that did not do such a great job. I'm going to talk about GoPro (NASDAQ:GPRO). So, based on profiling, like we talked about in the first half of the show--

O'Reilly: Why are you hating on GoPro, Dylan?

Lewis: I mean, I'm an Ambarella shareholder, so I want to see GoPro do well. But, based on what we talked about in the first half of the show, by all indications, GoPro is in that growth phase, and they should be fueling R&D.

O'Reilly: They just went public.

Lewis: Yeah, within the last two years.

O'Reilly: They do not have a dominant market position, they are not minting cash flow.

Lewis: Yeah. They're in a nascent consumer tech market. But, in the fiscal Q3 call last October, they announced, "Our board of directors has recently approved a stock repurchase plan of up to $300 million. Our newly authorized class A share repurchase program runs for 12 months, allowing us to remain opportunistic buyers and return cash to shareholders." So, at the time that they announced this in late October, they had about a $2.5 million market cap, trailing P/E in the mid-20s.

O'Reilly: Not high.

Lewis: Not crazy. And, I do understand, I think they were at 16% year-over-year growth in 2015 overall. I do understand seeing that P/E, seeing that valuation, and wanting to be a little opportunistic and having the flexibility to do that. But, I do think there were some major red flags that should have been present at the time.

O'Reilly: Especially to management.

Lewis: Yeah. So, during that announcement, this was also the same quarter that they missed guidance for the first time as a publicly traded company.

O'Reilly: Dun-dun-dun. And, very early in their history as a public company.

Lewis: Yes. And Nick Woodman, the CEO, in attributing that misguidance, said, "Looking back, we now believe that we under-funded marketing in the second and third quarters of the year, which affected demand. To address this, we're taking a more aggressive advertising approach in the fourth quarter, which includes a return to television following a one-year hiatus." So--

O'Reilly: Not good. (laughs) 

Lewis: (laughs) Yeah. You're talking about how you should have allocated internally to selling and advertising, and then you're also announcing that you're going to be buying back shares? It just seems like you're mis-prioritizing where money needs to be going. Of course, the following quarter, Q4 2015, they went on to miss guidance again. And ultimately, in that call, they provided an update on what the repurchase program was looking, how much had been executed--

O'Reilly: This is going to be bad.

Lewis: They said, "We've repurchased 1.5 million shares at an average of approximately $23 for a total of $35.6 million through December 31st. We have a remaining share repurchase authorization of $264.4 million." And, if you remember correctly, they IPO-ed for right around $24.

O'Reilly: And, they're about $13 or $14 right now. (laughs)

Lewis: Yeah. So, they didn't get a huge discount on what they had originally sold those shares for. They also, based on that cost basis, clearly executed that first 10% of the share repurchase authorization immediately after they announced it. And the shares they bought are down 40% since they executed it.

O'Reilly: The dichotomy here between this and -- by saying this, I am not advocating that GoPro start an online bookstore -- but, the dichotomy there between them and Amazon, that literally says, "We're not buying back any shares, we're not going to pay out dividends, we're just going to keep investing in operations until we win." Big black-and-white difference there.

Lewis: And, I do understand, a lot of tech companies issue equity as--

O'Reilly: Compensation, often, yeah.

Lewis: Yeah. And I do understand wanting to have this as a way to mitigate against shares outstanding getting crazy out of hand and diluting existing shareholders. But, this is not a company that is entrenched in this very stable space. Like I said, they're in consumer tech, they're making pushes into virtual reality capture and drone capturing. Both of these markets barely scratched the surface. It just seems odd to me that they're prioritizing something like this, and I mean, the fact that they timed it so poorly shows that management doesn't have a very good finger on the pulse of what's going on in the business.

O'Reilly: Yeah, and actually, that's a great segue to the company that I wanted to highlight, which is Microsoft. They have arguably had a monopoly since the late 80s. (laughs) Like, 90% market share the entire time, of the PC market, probably higher. They didn't start paying out a dividend until 2003. As I'm going to point out in a second here more in depth, they didn't really start buying back shares in earnest until the mid-2000s. They bought back a few, I think we looked earlier, it was like a couple hundred million dollars, in the 90s. And that was clearly just to take care of the dilution from all the options they were giving employees. They have a monopoly, they're generating billions of dollars in free cash flow, and they didn't even do what GoPro did until way later. I mean, that's just ...

Lewis: It's baffling.

O'Reilly: Guys, what are you doing?

Lewis: So, what else do you have, in terms of Microsoft's strengths in capital allocation?

O'Reilly: So, bringing it around, what I wanted our listeners to know was, most of us probably know, Microsoft shares have kind of languished a little since the bubble popped in 2000. The stock was at huge multiples, and they didn't really go anywhere until very recently, until Ballmer stepped down and they got the new CEO, Satya Nadella. After the bubble popped, they bought back anywhere from 3 to 6.5 billion worth of shares in 2001 and 2005. The stock kept languishing, and they were like, "We're making more and more money every year." Profits went from $7 billion in 2001, they were $12 billion in 2005, they kept growing over $20 billion by the early 2010s. So, the business is doing fine this whole time, but the shares just aren't going anywhere. So, clearly, as responsible capital allocators, they're going to be like, "Maybe we should buy back some shares."

Lewis: Yeah, let's slice this pie a few less times.

O'Reilly: Exactly. That's what they started doing in 2005, in a big way. In 2005, they bought back $8 billion shares. In 2006, $19 billion. 2007, $27 billion, and all of this is after paying that $32 billion special dividend in 2003. It's really funny to see huge $2-3-4--

Lewis: Boop!

O'Reilly: Yeah, it's like boom. $12 billion in 2008 and 2009, $11 billion in 2010, and this whole time, at the depths of the Great Recession, the year when Microsoft bought back $9 billion worth of shares, and the previous year they'd bought back $17 billion, the P/E on Microsoft got as low as 9. This is crazy awesome purchases that they are making. The stock went from the mid-teens, it touched bottom in 2009 at $15 per share. All those repurchases were made over the last 10 years, and now Microsoft is at $55. That is awesome!

Lewis: And looking at their history as a company, they didn't start buying back shares -- it probably goes back to somewhere in the early 90s, their share buybacks.

O'Reilly: Right. And even then, it was just like $200 million a year.

Lewis: Yeah, it was to offset a lot of equity grants. But, I think that they were in a much better position when they did that to continue to fuel the growth that they were needing to push, and also take care of shareholders. It wasn't all or one. Not to say that it was with GoPro, but they seem much more in the, "We need to grow, we need to innovate, we need to invest in that R&D to eventually get to this point." It just seems kind of premature on their end.

O'Reilly: When GoPro is generating billions upon billions of dollars in free cash flow every year that you don't know what to do with to expand your market position, then do what you did. Cool. Well, thank you for your thoughts, Dylan!

Lewis: Always a pleasure. I will say, Sean, if listeners are interested in hearing a little bit more on this, one of our fool.com writers, Evan Niu, has put together an excellent article looking at GoPro's share repurchase program and some of the dynamics at play since their IPO. The headline is, "Why I Hate GoPro Inc's Share Repurchase Program and You Should Too."

O'Reilly: He is not beating around the bush about that.

Lewis: No, he's making it very clear how he feels about it. If you go to fool.com, you can find it there, a little bit more insight than we scratched on the show.

O'Reilly: Cool, alright. If you're a loyal listener and have questions or comments, we would love to hear from you, just email us at IndustryFocus@Fool.com. Once again, that's IndustryFocus@Fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I'm Sean O'Reilly. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Dylan Lewis owns shares of Alphabet (A shares). Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and GoPro. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.