As
some of you may have realized from my disclosure above one of my favorite types
of companies is what is sometimes referred to as a “capital allocator”. These companies focus on generating strong
returns through allocating their capital wisely. The most well-known capital allocation company
is Berkshire Hathaway which is managed by legendary investor Warren Buffett as
well as Charlie Munger. Other popular
companies include Loews and Leucadia National.
Capital allocation decisions involve whether to grow organically by
plowing money into current businesses, purchasing new companies, selling
businesses or business units, paying dividends, buying back stock, and I would
also include financing decisions. I love
these types of companies because a good capital allocator is a great investment
to own over 5, 10, or 20+ years as they are constantly looking to add value for
shareholders. Also, they are somewhat
like a focused mutual fund only without the annual expenses. Most good capital allocators look to grow
organically, but they do so in an intelligent and disciplined manger. Most projects they undertake should create
strong returns using conservative estimates.
These companies will do M&A transactions, but are very selective and
pay a lot of attention to valuation and industry fundamentals. There are quite a few capital allocators that
also focus on buying back shares; however, they do so differently than your
typical company. Most companies that buy
back shares do not pay enough attention to valuation and often over pay. Capital allocators only buy back their shares
if they feel that they are undervalued using conservative estimates. The biggest waste of capital is to buy back
shares when they are trading at a premium to the actual value of the company,
but on the other hand buying back shares at a discount to intrinsic value is
highly beneficial to shareholders over the long-term. Some capital allocators do pay regular
dividends, while others only pay them when they cannot find enough organic
growth, M&A deals are being over priced, and the stock is trading at too
high of value. Dividend payments create
taxes for shareholder so it is more efficient to use capital in other ways if possible. However, some companies do use dividend
payments as a way to force capital discipline which is a laudable goal.
Many
capital allocation companies are diversified holding companies, such as Berkshire,
Leucadia, and Loews. However, a company
does not have to be a diversified holding company to be a strong capital
allocator. Redwood Trust, for example,
is in a niche business although they do have more than one source of value
generation. Capital allocation companies
also have a tendency to own large financial services business. For example Berkshire Hathaway owns several
large insurance companies and Loews also owns a large insurance company. Leucadia National just purchased an
investment bank and has owned insurance companies in the past. Markel, White Mountains, Alleghany Corp, and
Fairfax Financial Holdings Ltd are primarily insurance companies, although some
of them do have non-insurance business such as Markel with their Markel
Ventures businesses. Redwood Trust is a
unique mortgage REIT and Brookfield Asset Management is a physical real estate
firm. So, trying to build out a diversified
portfolio can be difficult as you may end up with a large allocation to the
financial sector. There are capital allocators
out there that do not have financial businesses, such as Seacor Holdings which
owns shipping services (inland marine, offshore service vessels, oil tankers)
and a few other businesses. I have also
had people argue that Canadian Natural Resources is a good capital allocator in
the energy sector.
Just
like any other company, however, they can become overvalued so you still have
to pay attention to the price you pay for them. That being said if you can buy one at a fair
valuation you should be able to generate strong future returns. If you can get your hands on a capital
allocator at a cheap valuation then allocate a lot of capital to it. Also, just because a company says they are a
good capital allocator doesn’t mean you should trust them. I have found several companies that were
supposed to be the next “Berkshire” but after digging into them there is no way
I would invest in them. Make sure to
verify that potential capital allocators are growing book value/share and cash
flow at above average rates. If you are
interested in a more detailed look at many capital allocators you should vies
the Brooklyn Investor Blog (http://brooklyninvestor.blogspot.com/). The author does a superb job on just about
every post and he mostly covers capital allocation companies.
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