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Moats Matter: The Importance of Capital Allocation

How allocation decisions are assessed and why they matter so much

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Mar 29, 2019
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How well does management allocate the capital available to it? That question plays an important role in determining the robustness of a moat protecting company profits.

In the book, “Why Moats Matter: The Morningstar Approach to Stock Investing,” contributor Todd Wenning noted how much more competitive the economic world had become. He wrote, “In this increasingly Darwinian corporate landscape, then, it’s absolutely critical to understand how effectively a company’s management team allocates shareholder capital toward moat-widening projects and investments while balancing returns of shareholder cash through buybacks and dividends.”

Wenning, who is in charge of Morningstar’s equity stewardship methodology, along with lead authors Heather Brilliant and Elizabeth Collins, reported they give one of three ratings to companies under the microscope: standard, exemplary and poor. To arrive at these ratings, they consider multiple variables:

  • Investment strategy and valuation: Management has three basic options for retained cash flow or retained earnings: reinvest in the business, save the capital or return it to “claimholders.” Among the questions Morningstar analysts ask is, “Has the firm strayed from core competencies in its pursuit of growth?”
  • Execution: Bad luck happens, even to the best of companies, but moat analysts want to know about management’s role when value was destroyed. For example, British oil company BP (BP, Financial) was involved in the Deepwater Horizon oil spill in 2010, partially as a result of a “consistently poor safety record.” In this case, bad luck was amplified by managerial incompetence. Analysts also want to know how companies under- or overpromise.
  • Financial leverage: In the words of the authors, “Be wary of firms with leverage ratios that are inappropriate for their lines of business.” Companies in industries that are capital intensive and highly cyclical should eschew heavy debt because it exaggerates volatility and risks shareholder capital.
  • Dividends and buybacks: To get an exemplary rating, companies need to find the “Goldilocks” spot when it comes to returning money to shareholders, something between too little and too much. Companies should also avoid taking on debt to sustain their dividends or buybacks.
  • Compensation: While analysts do look at the “relative” size of management compensation, it only becomes a factor if it has a positive or negative effect on capital allocation decisions. For example, GAMCO Investors (GBL, Financial) paid Mario Gabelli (Trades, Portfolio) almost $80 million in 2012, and that represented about 20% of its annual revenue. That pulled down the company’s rating.
  • Related-party transactions: Normally not a part of the rating mix, but could lead to a poor rating when friends and family of management prosper at the expense of shareholders.
  • Accounting practices: In this criterion, analysts are watching for aggressive accounting practices that aim to show allocation decisions more favorably. Companies should use “reasonable” estimates and assumptions.
  • Management background: Does a manager have sufficient experience and enough relevant experience?
  • Health, safety and environment: “Our stewardship ratings are meant to measure one thing and one thing only: how a company’s managers behave on behalf of shareholders. And because we assess stewardship from a shareholder—not a stakeholder—perspective, our default stance on a company’s health, safety, and environment, or HSE, practices is agnostic.”
  • Ownership structure: This screens for undue influence by family, insiders, other companies and government. Also, are there different share classes? In short, the interests of controlling shareholders should be aligned with those of minority shareholders.
  • Stakeholder focus: This applies more to non-American jurisdictions such as Germany and Japan, where stakeholders such as employees share rights similar to those of shareholders. For Morningstar, the interest is in how those stakeholder rights affect shareholders’ interests.
  • Communication with shareholders: Are executives as forthcoming in hard times as they were in good times? For better stewardship ratings, companies should be frank and refrain from changing reporting segments.

Not surprisingly, there is a relationship between the width of a moat and stewardship ratings. Wide-moat companies are more likely to receive exemplary ratings than narrow or no-moat companies. The authors explained the positive correlation by pointing to:

  • Management skill: Executives in already wide-moat companies are more skillful at allocating capital to additional “moat-widening projects.”
  • The magnet effect: Wide-moat companies are more successful at recruiting and retaining top managers.
  • In contrast, managers at no-moat companies may be chasing their tails: Management may feel the need to do something—anything—to keep shareholders off their backs. That may include unforced errors such as selling assets at a discount or buying unrelated companies.

The authors also noted that capital allocation decisions are more important in some sectors than in others. For example, allocation is very important in the energy and financial services sectors. They wrote, “Intuitively, this makes sense, as energy and financial companies’ managers make frequent and meaningful capital-allocation and strategic decisions.”

To that, the authors added details about each of eight sectors (as of 2014, when the book was published):

  • Basic materials: Common themes are investment strategy and valuation as well as the absense of leverage. Eldorado Gold (EGO) was the only company among gold miners to earn a Morningstar moat because management had put together a portfolio of long-lived gold assets at discount prices.
  • Consumer: Common themes include strategy execution, brand investments and balanced growth. An exemplary company in this category was Coca-Cola (KO, Financial). The authors wrote, “We attribute the firm’s consistent execution in the difficult operating environment of the past several years to strong leadership and a very deep bench of executive talent.”
  • Energy: Themes are decisions on portfolio construction and execution. The example company was National Oilwell Varco (NOV, Financial), an exemplary-rated company, based on how well the CEO had consolidated the equipment market to its benefit, and for excellent communication on quarterly analyst calls.
  • Financial services: Common themes are balance sheet decisions, underwriting standards and growth strategies. The exemplar in this category was T. Rowe Price (TROW, Financial). It has allocated capital cautiously, carried little or no debt, made few acquisitions and returned cash to shareholders.
  • Health care: Execution and mergers and acquisitions discipline are the common themes. The exemplary example was Sanofi (SAN, Financial) because its big acquisitions have generated robust returns and improved its competitiveness.
  • Industrials: This sector has three common themes: execution, employee relations and investment strategy and valuation. The exemplar for this category was Rockwell Automation (ROC, Financial). The authors wrote, “Under the current management team’s guidance, Rockwell has moved away from purely being a discrete controls component business to become a respectable competitor in multidisciplinary controls, lifting shareholder returns in the process.”
  • Technology: Innovation success, execution and investment strategy or valuation are the common themes. IBM (IBM, Financial) was the exemplar in this area because its long-term financial improvement came from moving toward distributed open standards.
  • Utilities: Common themes are relationships with regulators and shareholder return policies. Southern Co. (SO, Financial) was the standout here because of its very good relationship with regulators, strong returns on equity and better return on capital than its peers.

As the facts and examples show, excellent capital allocation is the key to establishing a robust moat recognized by Morningstar. And, the key to that kind of allocation lies in the quality of decisions by the senior management team.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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