Arguably one of Warren Buffett’s most important criteria for an investment is proper allocation of capital. A recent literary adventure of mine summarizes a great deal of examples of bad allocation. The book, entitled “Focus: The Future of Your Company Depends on It”, explains through numerous examples that companies, once they have excess capital, often decide to defocus and begin investing outside of their concentrated business area. The word ‘conglomerate’ comes immediately to mind. The word, first used by the Federal Trade Commission in a 1948 public warning, meant at the time “the unusual practice of acquiring unrelated business entities.” Unfortunately, the practice is no longer considered unusual.
Although Warren Buffett does not speak at length about capital allocation within the companies he invests, the concept is clearly paramount in his examination. I will review one example here, probably the most famous, but I urge you to read ”Focus” written by Al Ries, the famous marketing guru. You will learn about many companies and how they properly or improperly allocate capital. By learning and internalizing these examples, I believe you will be better able to understand how capital allocation effects investing and better screen companies for possible investment.
Warren Buffett has loved Coca-Cola (KO, Financial)since he sold six packs of Coke for a small profit when he was a young boy in Omaha. Oddly enough, Buffett did not purchase a sizeable amount of Coke stock until his late 50’s, now nearly twenty years ago. In typical fashion, Buffett bought more than a sizeable share. He bought two hundred million shares over a period of a few months. Why did he wait fifty years? Partly because of improper capital allocation and a lack of focus. The company was investing profits in a Hollywood studio and other non-beverage businesses. Buffett knew these investments were not likely to produce the same returns as if the company had placed the money back in the beverage business. In fact, one could have reviewed the investments and seen that they were likely to produce mediocre returns at best. Instead, Buffett sat and waited.
In the late 1980’s, Buffett saw a major decline in the sock price because of the failed launch of New Coke. The value remained. Buffett knew Coke would soon return to the original formula and the stock would rebound. All non-beverage assets had been sold.Â
A quick glance at Buffett’s portfolio will prove proper and focused capital allocation is a must. Every single company is focused on a specific business area. Coke does not only have to allocate capital toward their current line up of beverages. Rather, Coke should increase their market share through product development as they have with the recent introduction of Enviga.Â
Unfortunately, as Warren Buffett has discussed in the past, CEO’s are not natural or even experienced at capital allocation. Many work their way through the company in a specialty department such as marketing or sales and have no experience with capital allocation. Thus, when a new CEO is appointed, they will sometimes rapidly defocus the company. The new CEO believes the only way to grow the company is to expand into other sectors. Wrong. The impact on the company and your investment can be severe and quick. Keep in mind that you should invest because you are a fan of the company’s brand and business. If you are investing in Coke, you want your money to go to the Coke brand; if you want to invest in film studios, invest in a production company, not Coke. Investing in companies to invest indirectly in another business is usually detrimental to a portfolio.
An outstanding way to check the focus of a company is to open to the first page of the latest 10-K. There, under Part I, Item I will be a section entitled General. The business should be precise. For instance, “The Coca-Cola Company (KO) is the largest manufacturer, distributor, and marketer of nonalcoholic beverage concentrates and syrups in the world.” Certainly the first sentence is only one indicator, but if the explanation of what the company does is unfocused, then the company is likely the same.Â
Interestingly enough, asset allocation or capital allocation is often not referred to as so. Even the book discussed above is written more from a managerial point of view. Many other authors recognize the importance of focus. Charles Brandes, another disciple of Benjamin Graham includes a section in his book “Value Investing Today” entitled “A Bigger Pie is Not Necessarily a Better Pie”. The book goes on to cite a study by two Texas A&M University professors who found “takeovers are usually bad for acquiring companies, depressing their share prices and reducing their long term profitability… as a rule, the higher the premium paid, the greater the losses for the acquiring firm’s shareholders.” Furthermore, Columbia University professors Hayward and Hambrick write, “Acquisitions may have less to do with a cunning business calculation than with inflated managerial egos.” Defocusing a company is bad for the company as well as bad for its investors.
Simply put, focus is discussed everywhere. Some examples are more obvious then others, but many make the same point. Greenblatt uses a quantitative type of focus in his “Magic Formula”. Buffett, Brandes, and Ries all use focus in slightly different ways. Focus is a must. Instead of a ticker symbol, I give you a rule. I fervently believe a review and quick extermination of decentralized companies will drastically improve your portfolio far into the future.Â
Also check out:
Although Warren Buffett does not speak at length about capital allocation within the companies he invests, the concept is clearly paramount in his examination. I will review one example here, probably the most famous, but I urge you to read ”Focus” written by Al Ries, the famous marketing guru. You will learn about many companies and how they properly or improperly allocate capital. By learning and internalizing these examples, I believe you will be better able to understand how capital allocation effects investing and better screen companies for possible investment.
Warren Buffett has loved Coca-Cola (KO, Financial)since he sold six packs of Coke for a small profit when he was a young boy in Omaha. Oddly enough, Buffett did not purchase a sizeable amount of Coke stock until his late 50’s, now nearly twenty years ago. In typical fashion, Buffett bought more than a sizeable share. He bought two hundred million shares over a period of a few months. Why did he wait fifty years? Partly because of improper capital allocation and a lack of focus. The company was investing profits in a Hollywood studio and other non-beverage businesses. Buffett knew these investments were not likely to produce the same returns as if the company had placed the money back in the beverage business. In fact, one could have reviewed the investments and seen that they were likely to produce mediocre returns at best. Instead, Buffett sat and waited.
In the late 1980’s, Buffett saw a major decline in the sock price because of the failed launch of New Coke. The value remained. Buffett knew Coke would soon return to the original formula and the stock would rebound. All non-beverage assets had been sold.Â
A quick glance at Buffett’s portfolio will prove proper and focused capital allocation is a must. Every single company is focused on a specific business area. Coke does not only have to allocate capital toward their current line up of beverages. Rather, Coke should increase their market share through product development as they have with the recent introduction of Enviga.Â
Unfortunately, as Warren Buffett has discussed in the past, CEO’s are not natural or even experienced at capital allocation. Many work their way through the company in a specialty department such as marketing or sales and have no experience with capital allocation. Thus, when a new CEO is appointed, they will sometimes rapidly defocus the company. The new CEO believes the only way to grow the company is to expand into other sectors. Wrong. The impact on the company and your investment can be severe and quick. Keep in mind that you should invest because you are a fan of the company’s brand and business. If you are investing in Coke, you want your money to go to the Coke brand; if you want to invest in film studios, invest in a production company, not Coke. Investing in companies to invest indirectly in another business is usually detrimental to a portfolio.
An outstanding way to check the focus of a company is to open to the first page of the latest 10-K. There, under Part I, Item I will be a section entitled General. The business should be precise. For instance, “The Coca-Cola Company (KO) is the largest manufacturer, distributor, and marketer of nonalcoholic beverage concentrates and syrups in the world.” Certainly the first sentence is only one indicator, but if the explanation of what the company does is unfocused, then the company is likely the same.Â
Interestingly enough, asset allocation or capital allocation is often not referred to as so. Even the book discussed above is written more from a managerial point of view. Many other authors recognize the importance of focus. Charles Brandes, another disciple of Benjamin Graham includes a section in his book “Value Investing Today” entitled “A Bigger Pie is Not Necessarily a Better Pie”. The book goes on to cite a study by two Texas A&M University professors who found “takeovers are usually bad for acquiring companies, depressing their share prices and reducing their long term profitability… as a rule, the higher the premium paid, the greater the losses for the acquiring firm’s shareholders.” Furthermore, Columbia University professors Hayward and Hambrick write, “Acquisitions may have less to do with a cunning business calculation than with inflated managerial egos.” Defocusing a company is bad for the company as well as bad for its investors.
Simply put, focus is discussed everywhere. Some examples are more obvious then others, but many make the same point. Greenblatt uses a quantitative type of focus in his “Magic Formula”. Buffett, Brandes, and Ries all use focus in slightly different ways. Focus is a must. Instead of a ticker symbol, I give you a rule. I fervently believe a review and quick extermination of decentralized companies will drastically improve your portfolio far into the future.Â
Also check out:
