The North Star of Value

In 2014, Michael Mauboussin and his team at Credit Suisse published a research report focused on the importance of capital allocation. In that report, he discussed a concept that he refers to as “the North Star of value” (bold added for emphasis):

“In our experience, very few CEOs, and CFO’s for that matter, have what we call the ‘North Star of value.’ The North Star is not the brightest star, but it doesn’t move much throughout the night or year. As a result, it provides a reliable sense of direction. Likewise, companies that have a North Star of value have an unwavering view of value no matter what is going on. It is common for executives to solicit input from a range of stakeholders, hear varying points of view, and walk away confused and unsure about the proper course of action. This doesn’t happen to executives with the North Star of value, especially since they may have better information about their company’s prospects than the market does.”

I think that hits the nail on the head. There’s a small percentage of CEOs that truly understand and appreciate the importance of capital allocation. They have a reliable sense of direction and they are 100% focused on the objective: long-term, per-share value creation.

As Warren Buffett (Trades, Portfolio) noted in his 1987 shareholder letter, many CEOs don’t come to the job with an appreciation for the importance of capital allocation – and that’s a real problem:

“The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such ‘help.’ On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

If you’re invested in a company where the CEO is an ineffective capital allocator, you have a real problem – and it only gets worse with time. And if you’re relying on the board of directors to address this issue, you have more confidence in the average board member than I do. As investors, how can we align ourselves with leaders focused on long-term, per-share value creation?

Shareholder communications

I like to start by reading shareholder letters and conference call transcripts. From these sources, you can at least get a sense for the capital allocation framework that management aspires to (whether they live up to it is another question). As an example, here’s some commentary from Amazon (AMZN, Financial) CEO Jeff Bezos in his first shareholder letter as the CEO of a public company:

“We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.”

“We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”

“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows.”

“We aren't so bold as to claim that the above is the ‘right’ investment philosophy, but it's ours, and we would be remiss if we weren't clear in the approach we have taken and will continue to take.”

Those are just a few examples, but they are telling. When you’re reading the letter, you have a sense that Bezos has spent a long time thinking about his idea of success and the risks associated with trying to get there. Said differently, he sounds like an intelligent, level-headed CEO focused on long-term value creation. It’s the same sense that you get when reading Buffett’s letters. Unfortunately, I’ve read plenty of shareholder letters where I walked away thinking the CEO was nothing like Bezos or Buffett. If you’re planning on being someone’s partner for years or decades, that’s important.

Cockroaches in the kitchen

My next step is based on Buffett’s warning that there is rarely just one cockroach in the kitchen. When I spot red flags that make me question whether management shares my focus on long-term, per-share value creation, I don’t forget it.

Here’s a good example from United Technologies (UTX, Financial), where CEO Greg Hayes said this on a November 2014 conference call (bold added for emphasis):

“So we'll be able to deliver on the numbers that we had talked about earlier in the year, which essentially was in a range. We started out at $6.55; we're now at $6.75 to $6.85. We'll be right around $6.85 when the year is said and done. Still some puts and takes, some headwinds around currency. But top line looks solid at $65 billion; bottom line looks solid around $6.85. I'd just point out, tax extenders is not in our numbers for the year. Who knows if we're going to get extenders here in the last couple of weeks of the year. My own view is that if we get extenders, we'll probably just restructure against that benefit or do something else, as opposed to trying to pass along another dime that's probably not going to give anybody much of a benefit. So I think we're done at $6.85.”

That’s quite a blasé attitude toward “cookie jar” accounting. This probably goes without saying, but this isn’t the kind of behavior I expect from a CEO (and if it’s happening at the top, my concern is that it may be trickling down throughout the organization). It suggests that company is laser-focused on beating expectations in the short term, even if that means forgoing investments that may create long-term value for shareholders. Unfortunately, this way of thinking is common: a survey of 400 executives that was published in the Journal of Accounting & Economics showed that “a surprising 78% of our sample admits to sacrificing long-term value to smooth earnings.”

If you have reason to believe management may be included in the 78%, watch out.

“Value neutral” capital allocation

Another red flag that I look for is an indifference toward capital allocation. I find this most often on share repurchases because it’s often viewed as a residual use of cash. Inevitably, that results in the largest dollar volume of repurchases near the top of the cycle (when business is booming and stock prices are high) and little or no repurchase activity at the bottom.

Based on the way some management teams discuss repurchases, it’s almost as if this is a perfectly acceptable outcome. For example, here’s what a former chief financial officer of The Coca-Cola Co. (KO, Financial) said when he was asked about the company’s share repurchase activity:

“Our view on share repurchases is that share repurchases are value neutral. It is not something that grows value. It does for the short-term holder, so maybe you can get a buck in the share price, but for the long-term holder it is not something that's value enhancing.”

You have to wonder if this gentleman has ever read Buffett’s thoughts on the topic (remember that Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) owns nearly 10% of Coca-Cola). For example, here’s what he said in his 1994 shareholder letter:

“When managers are making capital allocation decisions - including decisions to repurchase shares – it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious, but we constantly see it violated. And when misallocations occur, shareholders are hurt.”

Conclusion

There are other considerations, such as material equity ownership by top executives and logical compensation practices, that encourage long-term, per-share value creation. But this is already a lengthy article, so I think this is a good stopping point. As always, I look forward to your thoughts.

Disclosure: Long BRK.B.