The best shareholders and savviest CEOs have the same top priority: effective capital allocation. They prize putting every corporate dollar to its highest use, from organic or acquired growth to share buybacks or dividends. They do so with an investors’ mindset that all managers and shareholders would profit from understanding.
An elite group of 167 exceptional capital allocators is identified in new research by Professor George Athanassakos of Canada’s Ivey Business School, Western University. The study ranks companies by capital allocation success and then compares portfolios comprised of those at the top versus the bottom. On average, the superior allocator portfolio outperformed the inferior one by 33%, in terms of cumulative three-year returns, over several recent decades.
According to a separate study by the Quality Shareholders Initiative at George Washington University (QSI), the superior allocators attract the most patient and focused shareholders. These are shareholders with the longest average holding periods and most concentrated portfolios — neither traders nor indexers. Warren Buffett dubbed this cohort “high-quality shareholders” (QSs for short) and high densities of them in a company are associated with superior corporate performance.
QSI ranks more than 2,000 large public companies by QS density, including most of the outstanding capital allocators in the Athanassakos study. Among companies on both lists, the capital allocators rank disproportionately high for QS density: more than one-quarter in the top decile of QS density; more than half in the top quarter; and three quarters in the top half.
“ The shrewdest capital allocators among CEOs go hand-in-hand with the highest quality shareholders ”
In other words, the two rankings together show that the shrewdest capital allocators among CEOs go hand-in-hand with the highest quality shareholders. Here is a sampling of companies topping the combined lists of deft allocators and QS density:
• Amphenol Corp. APH, -3.07%
• Ansys Inc. ANSS, -4.38%
• Balchem Corp. BCPC, -2.83%
• Danaher Corp. DHR, -3.20%
• Illinois Tool Works ITW, -2.99%
• Jack Henry & Assoc. JKHY, -1.09%
• Moody’s Corp. MCO, -1.62%
• Roper Technologies ROP, -6.86%
• Stryker Corp. SYK, -3.98%
• Texas Instruments TXN, -2.82%
What sets these managers and shareholders apart? Their emphasis differs from quarterly earnings per share (EPS) favored by traders or market capitalization that’s of interest to indexers. They stress instead intrinsic value, long-term performance metrics such as return on invested capital (ROIC), and analytics like internal rate of return (IRR).
ROIC is a good way to measure capital allocation effectiveness. At the corporate level, a useful proxy takes bottom line performance, such as annual net income, as a percentage of average capital invested by shareholders. Individual projects are evaluated in terms of IRR, starting with capital expenditures to expand existing businesses as well as research and development budgets.
Successful capital allocators are especially cautious when it comes to acquisitions. They insist on paying a price below a target company’s intrinsic value and delivering an expected return that exceeds a preset hurdle rate. Such an investor mindset guards against managerial appetites for empire building and temptations of rosy forecasts about synergies, which often lead to acquisitions that destroy capital.
On share buybacks, some favor them because they increase EPS, simply by reducing shares outstanding. That may boost incentive-based pay for managers and spur stock price for traders ready to cash in. But capital allocators see buybacks as investments. To them, buybacks are rational only when price is below a conservative estimate of per share intrinsic value. (That’s why they shun buyback quota programs.)
Finally, on dividends, many capital allocators see them as rational only whenever other uses of capital — such as reinvestment, acquisitions or buybacks — are unattractive. To many, all excess capital should be returned to the shareholders — no cash hoarding.
Others recognize that dividend policy is useful in shaping the shareholder base. A no-dividend policy may suit a largely taxable shareholder base while regular dividends give shareholders a reason to stay put in troubled times. Regular dividends can lengthen holding periods, marginalizing transients, and induce larger positions, marginalizing indexers. All of the few companies that have paid consecutive annual dividends for five decades rank highly in QS density, including Dover DOV, -2.02% , Genuine Parts GPC, -4.45% , and Hormel Foods HRL, -2.81% .
Many exemplars of capital allocation state their philosophy explicitly, as the details of capital allocation vary by company. For a classic statement, take Texas Instruments, which includes a 10-year summary of capital uses and rationales: reinvestment in existing businesses with the greatest return potential; acquisitions only where expected ROIC exceeds the cost of capital; share buybacks only when price is below value — and the rest paid to shareholders in dividends.
TI’s succinct capital allocation philosophy pervades operations and helps explain its impressive historical returns. Unsurprisingly, TI is in the top fifth of QS density in the QSI rankings. Here is a sampling of the company’s quality shareholders:
• Alliance Bernstein Holding AB, -2.82%
• Bessemer Group
• Capital World Investors
• Davis Selected Advisers
• Generation Investment
• Henderson Group
• Massachusetts Financial Services
• Prime Capital Management
• State Farm Mutual
• T. Rowe Price Group TROW, -3.62%
Companies have many ways to attract a high density of QSs, from avoiding quarterly earnings guidance to stressing long-term performance metrics, according to research of the Quality Shareholders Initiative. But of all the many practices that appear to connect the savviest managers to the best shareholders, the most important may be skillful capital allocation.
Lawrence A. Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University. He owns shares of Berkshire Hathaway. His new book is Quality Shareholders: How the Best Managers Attract and Keep Them. Register for his upcoming free book talk hosted by the Museum of American Finance and Fordham University here.