One big lesson learnt this year is that while people see good management is important, it is not an economic moat by itself. The ability to create a management culture that provides continuity is a competitive advantage [read here].
But a bigger lesson is the importance of identifying management with great capital allocation skills. The skill to value acquisition and assets under management, divest and acquire at right prices, choose between leveraging debts or rights issue at the right time.
For holding companies, REITs, business trusts and management based business, they have not much advantage other than whether they are good capital allocators.
I would like you all to think on that last point.
Geoff Gannon have an interesting article on capital allocation discounts for holding companies. This can be applied to many holding companies or funds like K1 Ventures, Hotung, Global Investments Limited, Keppel Corp, MIIF, Haw Par Group etc.
Some good points mentioned:
Issue shares such as rights issues over leveraging up
Debts seem to be a taboo word, but wise allocation and managing the debt risk in a low interest rate environment may be wise moves.
We have been poisoned by so much rights issue form business trusts, REITs that we think its ok.
I recently looked at a list of good, cheap U.K. businesses. I passed on most of them. Not because they were too expensive. Most were cheaper than similar quality U.S. companies. I passed on the U.K. companies because they tended to issue shares over the last 10 years.
Some of these U.K. share issuers traded around enterprise values of 6 times EBITDA for much of the last decade. Interest rates were not high during the last 10 years. Issuing stock at 6 times EBITDA is criminal. I don’t care what you were acquiring. You can’t make money doing it by issuing such cheap currency.
Capital allocation at non-holding companies is critical. And often overlooked. Because it’s complicated. Take Western Union (WU). Western Union made several acquisitions over the last few years. They overpaid.
That’s the bad news. The good news is that Western Union never stopped buying back its stock. And when they needed money – they borrowed. They didn’t issue stock.
Buyback versus Dividends
Let’s take a look at CEC Entertainment (CEC). This is Chuck E. Cheese. The stock has returned 8% a year over the last 15 years – versus 4% for the S&P 500. That’s impressive for 2 reasons. For most of the last 15 years, Chuck E. Cheese’s operations have been getting worse – not better. Margins have dropped virtually every year for the last decade. And the stock is cheap right now. EV/EBITDA is about 5. It’s hard for any stock that cheap to show good past returns – an incredibly low end point is incredibly hard to overcome.
I doubt anyone is applauding CEC’s board. But they should be. It would’ve been very easy to deliver returns of zero percent a year over the last 15 years.
Operating income peaked 8 years ago. Earnings per share kept rising for the next 7 years. Shares outstanding decreased 57% over the last 10 years. Those are Teledyne like number.
Some might argue the return on those buybacks has been poor. And they would have been better off paying out dividends. Maybe. But let’s consider another alternative – the one most companies actually take. CEC could’ve invested that cash – not in buybacks or dividends – but in expanding the business.
Does dividend yield make any sense today? Some companies pay dividends. Some companies buy back stock. Some companies do both.
Why is it that when I type in a ticker symbol I’m immediately shown the dividend yield? And there’s no mention of stock buybacks?
Because of tradition. That’s the only reason. It’s become customary to show the P/E ratio and dividend yield for a stock. Neither measure is as important as its prominence on stock websites suggests. But tradition says it belongs there.
[Gannon and Hoang on Investing | Capital Allocation Discounts | Read here]