Capital allocation is a crucial management duty. Getting it wrong can destroy value, but wise capital allocation policy can immediately – and often permanently – enhance the value of a company. As the cost of capital rises in this monetary environment, this discussion is even more urgent.
The economic fundamentals and unique prospects of a business are the primary attraction for investors. Investors want to see management investing in the business, growing earnings, and making smart decisions with the company’s capital. Management teams have a series of choices to make: When and how much to expand capacity? What are appropriate levels of debt, equity, and cash? Should growth be organic or by acquisition? How should the company be positioned – as a steady cash producer, as a high-R&D innovator, as a compounder, or something else?
That said, here are some common capital allocation elements:
1. Dividends
High dividend payers have outperformed globally by 3-4% per year over the last 20 years, according to Credit Suisse. Another study showed that dividends contributed 48.9% of the total return of the S&P 500 since the 1940s and 75% in the two low-growth decades of the 1940s and 1970s. Dividends also hold up in recessions: in 5 recessionary periods, EPS dropped 42% on average peak-to-trough but dividends only 8%. This is not limited to the Developed Markets (DMs). Since 2000, more Emerging Market (EM) companies began to pay dividends and now a higher percent are dividend payers than in DMs. The aggregate dividend payout ratio and dividend yield are also higher than in DMs. The nature of the business could make a difference. Predictable firms with good earnings visibility can be rewarded for clear guidance. In keeping with predictability, Cartica’s experience is that having a dividend payout ratio policy is key.
“Companies paying steady dividends from free cash flow show discipline and prudent financial management. They deserve a higher multiple.” – Portfolio Manager
2. Buybacks
Over 20 years, buybacks yielded only 1/3 of the contribution to stock return that dividends did. Buybacks generally take place when the stock is trading at a low price, perhaps due to market uncertainty or specifics like an investor overhang, expected regulatory changes, potentially negative interest rate or election scenarios, etc. Buybacks theoretically make sense if the ROI on the buyback exceeds the ROI on investing in the business. But, especially in EMs, investors often seek out businesses where management still sees investment opportunities. Another drawback is lowering the liquidity of the stock. And Cartica has seen already-illiquid firms harm themselves with buybacks that make their stock almost unbuyable. Buying one’s own shares to increase the compensation of management teams based on the ROE metric is not good practice, despite its ubiquity in the US.
“EM stocks often suffer from low free float and low liquidity. It is almost a crime to compound that with buybacks.” – Investment Analyst
3. Dividends versus buybacks tax concerns
In the US, a new law proposes to tax buybacks (in part due to misuse). This might help to put dividends (immediately taxed) on a similar footing as buybacks (stock appreciation is not taxed until realization, so the investor account can grow tax-free).
In many EMs, according to our research, dividends attract no tax or taxes lower than long-term capital gains levies. No dividend-tax markets include: Brazil, Hong Kong, Singapore, and Malaysia. Lower taxes on dividends than on capital gains are found in: Chile, China, Egypt, Greece, Indonesia, Mexico, Philippines, and Thailand. We would expect to see fewer buybacks in these countries. We found three cases where dividends are generally taxed while capital gains are not (South Korea, Turkey, Czechia). In India long-term capital gains are taxed less than dividends. So, buybacks may be somewhat tax advantaged in these four countries. Elsewhere tax rates are roughly equal between dividends and long-term capital gains (Colombia, Peru, Poland, South Africa, Taiwan, USA).
Note that many tax systems are complex, so the above is a stylized snapshot. But it shows that dividends are often favored by tax authorities.
4. Cash position
EM companies have improved in avoiding cash drag. We find that family-owned businesses and companies that suffered through debt crises (local and global) often keep excess cash. As EM investors, we understand the desire for a cushion. But if low-return cash dilutes the return on equity markedly, the cash cushion should be reduced.
5. Using equity versus debt
This central financial question is well covered in textbooks. Many EMs have scary inflation histories and therefore shy away from excessive debt. Due to inherent uncertainties in the EMs, Cartica tends to prefer lower-debt companies or ones improving their debt ratios. We model debt ratio scenarios for target companies and favor reasonable but not-too-high leverage to improve returns on equity, especially in cash-generating firms.
6. Asset-heavy or asset-light
Different business models have differing requirements. But in Cartica’s experience, investors prefer asset-light models when all else is equal. We have had some success with grocery chains that own real estate, but generally we look for chains that rent. The large hotel chains have been steady “compounders” in part because they let professional investors own the real estate while they simply manage. Their service fees go straight to the bottom line. As investors, we must see significant other unique advantages to choose an asset-heavy company over a competitor with much better use of capital and higher ROEs.
7. Taking advantage of a high valuation multiple
Agile teams take advantage of high multiples to raise equity and deleverage. This can be extremely accretive. Or they can use the funds for acquisition if they are skilled at candidate selection and post-merger integration. Tapping capital markets when they are open can also add to the free float and liquidity of the stock, which can increase the potential investor universe.
Management teams are continually faced with choices on the best use of scarce resources, and capital is at the top of the list. Markets will judge a company favorably if its policies are clear and it safeguards investors’ interests.
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