Deep Research Insights

The cho­ices a com­pany makes when it comes to all­o­c­ating its res­o­u­rces not only impact the firm’s value, but may even put its sur­v­ival at risk. The fol­l­o­wing Ins­ight dives deeper into the opt­ions that man­a­g­ement has in all­o­c­ating cap­ital and out­l­ines what our pre­f­e­rences are.

At its core, a com­pany is a group of ind­i­v­iduals that, thanks to a wide array of skills and cap­a­b­ilities, are able to gen­e­rate gre­ater value tog­e­ther than if they were to ope­rate on their own. If pro­f­i­table, such value gen­e­r­ation can tra­n­s­late into sur­plus cash. We define sur­plus cash as the money a com­pany earns beyond what it needs to sus­tain its cur­rent ope­r­a­tion. This sur­plus cash can be used freely and in a var­iety of ways. Some of those ways fur­ther enh­ance the com­p­a­ny’s value, while others act­u­ally lower it. In this Ins­i­ght, we exa­mine the dif­f­e­rent opt­ions a com­pany has to use its sur­plus money and how those opt­ions may either fur­ther inc­r­ease the value of the com­pany or des­troy it.

Let’s start with an ove­r­view of opt­ions that man­a­g­ement faces once a bus­i­ness rea­ches pro­f­i­tability. We are wri­ting this Ins­ight under the ass­u­m­ption that pro­f­i­tability is only rea­ched after paying fair sal­a­ries and ini­t­i­atives such as waste red­u­c­tion, qua­lity imp­r­o­vement, good cus­t­omer ser­vice or gen­eral imp­r­o­vement of daily ope­r­a­tions are alr­eady bud­g­eted for. In other words, this is no longer a sta­r­t­-up. Sur­plus cash is the­r­e­fore truly extra cash that is not nec­e­s­sarily needed to run the com­p­any.

Man­a­g­ement can choose to uti­lize these extra res­o­u­rces to fur­ther grow the bus­i­n­ess, which might make sense in a market where scale mat­t­ers. It could employ its extra cap­ital to inc­r­ease its pro­d­u­ction cap­a­c­ity, to open new sto­res, or – as we see often in the inf­o­r­mation tec­h­n­ology ind­u­stry – to acq­uire ano­ther firm in pur­suit of syn­e­r­gies, pat­ents or tec­h­n­ology kno­w­how. A second option might be to devote its sur­plus cash to lower the debt burden the com­pany is car­r­y­ing. By low­e­ring its debt, the com­pany red­uces its dep­e­n­dency on banks and the cap­ital mar­kets as a whole. As a third opt­ion, a firm could decide to give back some of the ear­n­ings to its sha­r­e­holders. The two con­v­e­ntional met­hods used to return cap­ital to the owners are paying a div­i­dend and buying back its own sha­res.

Las­tly, the com­pany may opt to simply retain the sur­plus cash on its bal­ance sheet. These four opt­ions are not mut­u­ally exc­l­u­sive and indeed most com­p­a­nies choose some com­b­i­nation of them. How to all­o­cate cash among these cho­ices is a cru­cial task that man­a­g­ement faces. In aca­d­e­mics, this is called the pay­-out puz­zle.

1. Re-­i­n­vest into the bus­i­ness

2. Pay down debt and lower dep­e­n­dency on cap­ital mar­kets

3. Give to owners thr­ough share buy­b­acks and/or div­i­d­ends

4. Keep within the com­pany

Let’s start from Option 4. One reason for a com­pany to simply keep a hea­lthy amount of cash on its bal­ance sheet is that it pro­v­ides one of the best pro­t­e­ctions aga­inst an unc­e­r­tain fut­ure. Just think back to 2019. Would you have seen the COV­I­D-19 pan­d­emic com­ing? It has rem­i­nded us that we can model a number of dif­f­e­rent future sce­n­a­rios, but the only sure dev­e­l­opment will be that our pre­d­i­ctions will be wrong. In face of such unc­e­r­tainty, com­p­a­nies need to mai­n­tain a con­s­e­rvative cap­ital str­u­c­ture, which pro­v­ides them with time to react and ind­e­p­endence from the cap­ital market and keeps all their opt­ions open.

The value of a sur­plus cas­h­-­based safety buffer is dif­f­i­cult to com­pute qua­n­t­itatively, but it is easier to und­e­r­stand con­c­e­ptually, as bri­efly shown by the fol­l­o­wing exa­m­ple.

In rea­c­tion to COV­I­D­-19, com­p­a­nies wit­hout a proper cap­ital cus­hion were forced into red­u­cing costs whe­r­ever pos­s­i­ble. As a res­ult, a number of com­p­a­nies hea­vily dec­r­e­ased their mar­k­e­ting spe­n­ding or scr­a­t­ched their mar­k­e­ting budget ent­i­rely in an effort to lower exp­e­n­ses. Con­s­e­quently, cost per mille (“C­P­M”), the sta­n­dard metric used in adv­e­r­tising to ref­lect the price to get a cer­tain adv­e­r­tisement one tho­u­sand views or imp­r­e­ssions, dec­r­e­ased rap­i­dly. In July 2020, the cost of adv­e­r­tising on tel­e­v­ision in the UK dec­r­e­ased by rou­ghly 50 % com­p­ared to the year bef­ore. In other words: com­p­a­nies could get the same reach at half the price. For com­p­a­nies enj­o­ying the fre­edom of suf­f­i­cient cash pro­v­i­sion, this pre­s­e­nted an opp­o­r­tunity. If a com­pany alr­eady had a com­f­o­rtable cash cus­hion to con­s­ider itself on the safe side even in light of all the unc­e­r­tainty that the pan­d­emic bro­u­ght, man­a­g­ement could decide to keep the mar­k­e­ting spe­n­ding going. The com­pany could then acq­uire unu­s­u­ally cheap adv­e­r­tising space, which led to higher exp­o­sure to the public for the same amount of money, inc­r­e­ased brand awa­r­e­ness and ult­i­m­ately a pot­e­n­tial gain in market share com­p­ared to com­p­e­titors.

Sim­i­l­arly, the abi­lity to mai­n­tain normal levels of R&D may lead to faster tec­h­n­ological adv­a­n­cement com­p­ared to com­p­e­titors that had to cut costs. Dep­r­e­ssed mar­kets also pro­vide an opp­o­r­tunity for str­a­t­egic acq­u­i­sitions at che­aper pri­ces. It is con­s­i­derably che­aper to buy a com­pany when its price is down due to the ove­rall neg­a­tive sen­t­i­ment in the stock mar­ket. If a com­pany has ex-cess cash ava­i­l­able, it can act qui­ckly and inc­r­ease its cha­nces of acq­u­i­ring a com­pany or assets at a dis­c­o­unt.

These short exa­m­ples bri­efly ind­i­cate why we prefer com­p­a­nies in our Deep Res­e­arch Fund that carry more cash than nec­e­s­sary for day­-­t­o-day man­a­g­ement and sho­r­t­-term ope­r­a­tions. In our opi­n­ion, the value that some extra cap­ital pro­v­ides in dif­f­i­cult times, or when other opp­o­r­tunities pre­sent the­m­s­elves, out­w­e­ighs the opp­o­r­tunity cost of hol­ding on to cash in good times.

From value ret­e­n­tion, and even cre­a­t­ion, we now pass to the unf­o­r­tunate sit­u­a­tion in which man­a­g­ement des­t­roys value thr­ough use of unn­e­c­essary div­i­d­ends and/or share buy­b­acks (“S­B­B”). In other words, an ine­f­f­icient use of Option 3. When com­p­a­nies enter the mature phase of their ope­r­a­tions and reach a point in their dev­e­l­opment pro­cess at which the cash earned from normal ope­r­a­tions cannot be org­a­n­ically rei­n­v­ested at a sat­i­s­fying ret­urn, they usu­ally start to give that cash back to sha­r­e­holders. This con­cept is deeply rooted in the theory that a pro­ject with a lower return on cap­ital than the cost of cap­ital should not be rea­l­i­zed. Since cash itself has a very low return – esp­e­c­ially in recent years – this theory sug­g­ests that it should be ret­u­rned to sha­r­e­holders. How­e­ver, there are sev­eral pro­b­lems with that. One issue arises when the div­i­dend pay­-out policy is no longer opp­o­r­tunistic, but rather turns into the exp­e­c­tation of a con­s­i­stent div­i­dend pay­ment thr­o­u­ghout the rest of the com­p­a­ny’s exi­s­t­ence. This con­s­i­stent div­i­dend pay­ment can lead to a false sense of sec­u­rity when inv­e­s­tors start com­p­a­ring these div­i­dend paying com­p­a­nies to bonds. Many inv­e­s­tors irr­a­t­ionally panic when firms cut their div­i­d­ends, imp­l­ying that ope­r­a­tions are no longer able to sus­tain suf­f­i­cient cash gen­e­r­ation to fuel the div­i­dend pay­-­out. But con­c­e­ptually, an inv­e­stor should req­uire the com­pany to stop paying a div­i­dend if the com­pany has pro­j­ects with a return on inv­e­s­tment above the com­p­a­ny’s cost of cap­i­tal.

A com­pany that fails to pay int­e­rest on its bonds is con­s­i­dered in def­a­ult. On the other hand, com­p­a­nies that stop a div­i­dend pay­ment may simply have a better inv­e­s­tment opp­o­r­tunity.

It is log­ical to expect that a firm which rea­ches a point in its life where good rei­n­v­estment opp­o­r­tunities are harder to find would give back part of their ear­n­ings to sha­r­e­holders. How­e­ver, the com­p­e­titive lan­d­s­cape in which the firm ope­r­ates may change and req­uire the com­pany to react and adapt. New tec­h­n­ologies may arise and cus­t­omer pre­f­e­rences could shift, pro­v­i­ding the com­pany the opp­o­r­tunity to inc­r­ease the cash pro­d­uced by its ope­r­a­tions. To do so, the firm may need to go back to inv­e­s­ting cap­ital and have the fle­x­i­bility to lower its div­i­dend pay­m­e­nts. Should Nokia have con­t­i­nued to pay out a div­ided when the first iPhone came out? Ins­t­ead, dep­l­o­ying cap­ital to inc­r­ease the R&D eff­orts in order to cou­nter App­le’s new pro­d­ucts could have been the better choice in terms of value cre­a­t­ion.

Div­i­d­ends may also be fin­a­nced by iss­uing debt, with the con­s­e­quential inc­r­ease in the com­p­a­ny’s lev­e­r­age: but why not lower, or cancel all tog­e­t­her, the div­i­dend pol­icy? Why inc­r­ease dep­e­n­dency on the cap­ital market above opt­imal levels just to pay div­i­d­ends? It is sur­p­r­ising how often man­a­gers start lev­e­ring up their com­p­a­nies in fear of dis­a­p­pointing cer­tain sha­r­e­holders with a div­i­dend cut.

Let’s take the US tel­ecom AT&T as an exa­m­ple. Figure 1 shows the total amount of div­i­d­ends paid out since 2005 opp­osed to the amount of debt raised in the same time per­iod. The com­pany raised 178.5 bn USD in debt and payed out 163.1 bn in div­i­d­ends. Eff­e­c­tively, the stream of div­i­d­ends AT&T has payed out has not been a ref­l­e­ction of the com­p­a­ny’s ope­r­a­tion, but rather that man­a­g­ement fin­a­nced the div­i­dend by rai­sing debt. But debt comes at a cost. Even worse tho­ugh, AT&T’s cap­ital str­u­c­ture det­e­r­iorated. In Figure 2 we show AT&T’s ratio of the net amount of debt car­ried com­p­ared to its ope­r­a­ting profit (here con­s­i­dered as EBI­T­DA).

AT&T con­s­i­stently wor­s­ened its lev­e­rage pro­f­ile. Today, it would take the firm about 5 years to pay down its debt, com­p­ared to about 2 years in 2005. This in turn has an inf­l­u­ence on banks’ wil­l­i­ngness to lend more money to AT&T and the int­e­rest rate they cha­rge, the credit rating the com­pany rec­e­ives and ult­i­m­ately the fin­a­n­cial fle­x­i­bility and str­a­t­egic opt­ions of the firm.

A sim­ilar dis­c­u­ssion can be held for share buy­b­a­cks. Alt­h­o­ugh, in our exp­e­r­ience, the rep­u­r­chase of shares seems to be done on a more opp­o­r­tunistic basis, this does not shield sha­r­e­holders from value des­t­r­uction. Figure 3 shows the stock price and SBB dev­e­l­opment of Amp­l­i­fon, a global hea­ring aid man­u­f­acturer. The com­pany dep­l­oyed a large amount of cash to share buy­b­acks in 2007, then com­p­l­etely sto­pped bet­ween 2008 and 2015, when the stock was tra­ding at low lev­els. Once the price began to rise again, Amp­l­ifon re-­i­n­stated the share pur­c­h­asing pro­g­ram. “Buy low, sell high” is a phrase often used in the world of inv­e­s­tment; that is not what the com­pany did. Amp­l­ifon did not pur­c­hase any stock at low prices and only began buying when the price inc­r­e­ased. The opp­o­site action would have pro­v­ided con­s­i­derably gre­ater return on inv­e­s­tment on the cap­ital spent on the share rep­u­r­chase.

Spe­c­i­fically, Amp­l­ifon spent a total of 112.4 m EUR on SBBs. The ave­rage price of the shares acq­u­ired was 9.79 EUR and lead to a total of 13.5 m shares being rep­u­r­chased. How­e­ver, during the period where no cap­ital was dev­oted to the SBB pro­g­ram, the ave­rage price was 3.80 EUR. If the 112.4 m EUR had been imp­l­e­mented during this time, the total share red­u­c­tion would have been equal to 29.6 m. This means that the com­pany pot­e­n­tially could have rep­u­r­chased more than double the shares by imp­l­e­menting a cou­n­t­ercyclical str­a­t­egy.

What would have hap­p­ened if man­a­g­ement had simply kept the buy­back con­s­tant thr­o­u­ghout the years? Given the ave­rage price of 6.10 EUR, the result could have been a pot­e­n­tial 18.4 m shares being rep­u­r­chased, or 1.4 times as many as were act­u­ally bought back. The com­pany imp­l­e­mented a cyc­l­ical cap­ital all­o­c­ation str­a­t­egy, which res­u­lted in the worst value dis­t­r­ibution to sha­r­e­holders. Man­a­g­ement bought high and did not take adv­a­n­tage of the low. Of cou­rse, we are ana­l­y­zing the fact in hin­d­s­ight, but we que­s­tion the gen­eral idea that share buy­b­acks and div­i­d­ends are only val­u­e­–additive to sha­r­e­holders. This is par­t­i­cularly true for cyc­l­ical ind­u­s­tries that exp­e­r­ience eco­n­omic cycles to a higher deg­ree.

Each ind­u­stry is dif­f­e­rent, and there is a wide number of sce­n­a­rios – each jus­t­i­fying a dif­f­e­rent way of uti­l­i­zing cash. It is exa­ctly bec­ause of this unc­e­r­tainty in pos­s­ible out­c­omes that we bel­ieve man­a­g­ement should truly be able to fle­x­ibly and opp­o­r­tunistically use the value gen­e­r­ated from the com­p­a­ny’s ope­r­a­tions.

The below chart pro­v­ides a visual rep­r­e­sentation of the int­e­r­action bet­ween market cyc­l­i­cality and man­a­g­ement’s fre­edom to act.

Cyc­l­i­cality is rep­r­e­sented on the x-a­xis: we con­s­ider cou­n­t­er-cyclical action by man­a­g­ement to be pos­i­tive and des­i­red. The y-axis ind­i­c­ates the level of dis­c­r­etion exe­c­u­tives have in dep­l­o­ying earned cash: a higher level of dis­c­r­etion, in our opi­n­ion, allows man­a­g­ement to truly employ val­u­e­-additive mea­s­u­res. The top­-­r­ight qua­d­rant ind­i­c­ates the most des­i­r­able sit­u­a­tion: a man­a­g­ement team able to take cou­nter cyc­l­ical dec­i­s­ions. Exa­m­ples would inc­lude ini­t­i­ating a share buy­back pro­gram when the stock of the com­pany is und­e­r­valued, or con­s­e­rving cash and ref­r­a­ining from merger and acq­u­i­sition act­i­v­ities when the gen­eral prices are ove­r­v­alued. Making the right cap­ital all­o­c­ation dec­i­s­ions at the right time in the cycle has an eno­r­mous impact on the value of a com­p­any.

We cle­arly want com­p­a­nies to pro­v­i­sion for the unk­nown fut­ure. The value of such a safety net is dif­f­i­cult to assess qua­n­t­itatively, though this does not make it less rel­e­v­ant. This is why ide­a­lly, we not only look for com­p­a­nies with low debt lev­els, but also truly opp­o­r­tunistic share buy­back pro­g­rams and a man­a­g­ement team both wil­ling and able to lower or cancel div­i­dend pay­m­ents if inv­e­s­ting in the growth and/or sta­b­i­lity of the bus­i­ness pre­s­ents a better return opp­o­r­tunity. And in case a div­i­dend pay­ment is hal­ted, or a share buy­back pro­gram is sto­p­ped, we will not react by pan­i­c­king.

During the period imp­a­cted by COV­I­D­-19, 52 % of our com­p­a­nies either sto­pped or low­ered their div­i­d­ends and share buy­back eff­orts in order to pre­s­erve cash. Oth­ers, given the alr­eady strong fin­a­n­cial pos­i­t­ion, simply did not have to. The net debt to EBITDA ratio is one of many ind­i­c­ators that we can use to gauge the fin­a­n­cial pos­i­tion of a com­p­any.

The median por­t­f­olio ND/­E­B­ITDA ratio of 0.3× in Q2 2020 ref­l­ects both the low debt levels and the con­s­i­stent high pro­f­i­tability of our hol­d­i­ngs. This fact is fur­ther put in per­s­p­ective when com­p­ared to the 2.4× ND/­E­B­ITDA rep­o­rted by the MSCI World Index. This is one of the rea­sons for which bet­ween 2020 and 2021, the Deep Res­e­arch Fund inc­u­rred in a 44.7 % total ret­urn, com­p­ared to 30.0 % rep­o­rted by the MSCI World Index.

Inv­e­s­tigating cap­ital all­o­c­ation dec­i­s­ions is part of our sta­n­dard res­e­arch pro­cess when ana­l­y­zing sto­cks. Great bus­i­n­esses can become poor inv­e­s­tments when med­i­ocre cap­ital all­o­c­ation dec­i­s­ions are being made. The Deep Res­e­arch Fund inv­ests in com­p­a­nies run by man­a­g­ement that und­e­r­stands the rel­e­v­ance of smart cap­ital all­o­c­ation.

If you would like to see how the Deep Res­e­arch Fund com­p­o­nents of cap­ital all­o­c­ation dec­i­s­ions con­t­r­ibute to the fund’s ret­urn, you can find those num­bers on our web­site under the Return Breakdown.

First release: February 2023
Recent version: December 2024