Motley Fool Hidden Gems Investing - Capital Allocation: The Superpower of (Some) Public Companies

Episode Date: May 14, 2022

After a company pays its expenses, it has some decisions to make – pay a dividend, buy back stock, make an acquisition, or just hold on to the money. That's capital allocation, and not every company does it well. Motley Fool senior analysts Bill Mann, John Rotonti, and Auri Hughes discuss six companies handling capital allocation in a Foolish way, including: - How a stock with a slow-growing top-line can become a long-term compounder - One company that was built to make acquisitions - When it’s a “crime” for a company to pay a dividend - How to water-proof your shoes Stocks discussed: CSU, CNSWF, BRK.A, BRK.B, ACN, WDFC, TXN, ADYEY, MQ, CHD, HD Bonus resource - https://www.fool.com/investing/2016/09/07/interview-with-broad-run-investment-management.aspx Host: John Rotonti Guests: Bill Mann, Auri Hughes Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. This is why capital allocators, the superior capital allocators, tend to generate excellent long-term returns. They're hiring. They're hiring at a point in time in which their competitors are static or letting people go or are retrenching. These are the times in which the winners are made in the market. It's not times in which capital is as cheap as can be. It's the times in which chat capital is dear. I'm Chris Hill, and that was Motley Fool senior analyst Bill Mann. How good a company is at handling its cash says a lot. Do they

pay a dividend, buy back stock, make an acquisition, or maybe just hold on to the money? These are decisions that long-term investors pay close attention to. Today, Bill joins fellow analysts Ari Hughes and John Rotonti to talk about six companies handling capital allocation in ways we like to see. Hi, Fools. I'm John Rotonti. I'm joined by Ari Hughes and Bill Mann. We are talking capital allocation and we're going to share with you some of the companies that we think excel at capital allocation. Before I ask Ari for his first pick. I just want to quickly go through what we mean by capital allocation. And so, a business generates sales, and then it chooses how to allocate the gross profits,

really, that it generates from those sales. And some of the allocation can be into long-term growth investments, into things like research and development. Even some sales and marketing may be considered long-term investment, and then capital investment, property, plant, and equipment, capital expenditures. Those are all long-term growth investments that can be considered capital allocation. When a company runs out of high return on capital investments that it can make, either through, like we just said, research and development, capital expenditures, etc., then it has to decide what to do with its excess free cash flow. In that case, it can either pay down some debt, make an acquisition, buy back stock, or pay a dividend. Really, a rule that I

try to live by when I'm analyzing corporate management teams, Bill and Ari, is if a company has high return on invested capital investment opportunities, then it should invest every single penny that it can into those high return investments, into those high return opportunities. It's a crime if a company is paying a dividend when it has high return on invested capital opportunities that it could be investing in. But on the other hand, if a company doesn't have any high return on invested capital opportunities, then it's a crime not to return capital to shareholders, either through dividends or intelligent share purchases. With that framework in mind, Ari, what is an example of a company and its management team that you think excel

at capital allocation? I'm going to go Constellation Software. This is just a company I love and I continue to get to know and learn. I think it's a wonderful company to study for your business education in general. I think they've mastered M&A, essentially mergers and acquisitions. It was started by a gentleman named Mark Leonard in 1995. He was a venture capitalist 11 years. He acquired small software plays. Then he continuously did this for long periods of time. The business has just grown tremendously over years. It's compounded something like in the high 20s or 30% for over 10 years. He's done this with an M&A strategy. I think this is profound because a lot of companies essentially destroy value with M&A, and they're

not great capital allocators, or they overpay, or they promise synergies and things that don't materialize. We see that later. He has this wonderful strategy. One of the things I think is unique is, in CapIQ, the share count when they went public was 21 million shares. Today, it is still 21 million shares. They've earned a return on equity in the high 30s for a consistently long period of time. I think this is one of the best companies in the world a lot of people don't know about. They're very disciplined, and they have this process as well. And I think the other unique thing to mention is, as you get larger, you have to do more acquisitions to generate the same amount of earnings and return on equity

because your capital base is growing. So, they've consistently been able to do this for a long period of time. So, I think Mark Leonard is just a master at capital allocation. Bill, this is one you know pretty well. I know it pretty well, and Ari is exactly right. And if you ever get a chance to go to the Constellation Software front page of their website, they are first and foremost interested in getting introductions to vertical management software companies that are interested in selling. This company is built for capital allocation. Because if you think about it, there's no such thing as, hey, let's go upload the Constellation software suite. It doesn't exist. They are a

series of small companies, and they use the returns from those companies as force multipliers for other companies that they are interested in buying. And they do them by the dozens each year at this point. Yes, Constellation has excelled at making these acquisitions. They do 100 of them a year. They literally do hundreds of these small acquisitions a year. But we don't want people to think that any company making acquisitions is going to be the next Constellation. There is research showing that two-thirds of corporate M&A, two-thirds of corporate mergers and acquisitions either destroy value or create no value. It just so happens that Mark Leonard and team at Constellation are exceptional. They are one of the exceptions. Berkshire Hathaway

is an exception to this rule. Accenture is an exception to this rule. Accenture makes 40 or 50 acquisitions a year as well. And they also, like Ari said, maintain extremely high returns on equity and returns on capital. And when you see a company making lots of acquisitions a year, when you see a company where acquisitions are a part of their growth strategy, are a part of their capital allocation strategy, and they're not diluting their returns on equity and their returns on invested capital, you know you may have found a winning company. But those are rare. We can go even more cynical than that. In two-thirds of the cases, the only constituency that has a positive correlation with mergers and acquisitions is the compensation of the

management team. They have a larger company upon which to be compensated. That's cynical. It also happens to be true. Because sometimes the compensation is just based on growing the size of the business as measured by sales or EBITDA. Yeah. Look how big we are now. Yeah. Look how much EBITDA we have now, even though it's diluting returns on invested capital. Absolutely. So, Ari, such a great one to start with. Bill, what you got for us? All right, John, we're going to start with a game, and it's completely unfair. This company has grown since the year 2000, on average, 5% per year. What has its share price done in the same period of time? I mean, I'm guessing much better than 5%. That's such a weasel answer.

It's a weasel answer and probably an understatement. Ari, what do you say? 5% per year for 22 years. Let's go 13% per year. Not bad. It's 8X what it was. 8X. 5% per year growth on the top line. 8X return for shareholders. The company, it's an exciting one. It's WD-40. WD-40, you know its core brand. It also makes, try to withhold your excitement, They make toilet bowl cleaners under the X14 brand. They also make lava soap. The way to think of this company, the reason that a company can grow at their shares by 8X, growing only 5% per year, is by virtue of how careful and how cautious they are with the capital that comes in. When they

reinvest that capital. They do an absolutely wonderful job. This is a company that maintains as a branded cleaning company, operating margins of nearly 20%. And they have had this for decades. That's just incredible that a company that is that, you know, yeah, we put it in the slow growth category can 8X its stock price through superior allocation. You can use WD-40 on just about anything. I've heard some weird uses of WD-40. Not just for squeaky wheels and squeaky remote control gates and stuff like that. Yeah, they were 100% supportive of all of these weird uses. But WD-40, if you think about it, you would never think of this as being a growth company or a high-growth company. You don't necessarily need a high-growth company to

generate spectacular returns on the stock. If you have a company that has a management team that is very, very careful for how it reinvests its capital. And Gary Ridge and his team at WD-40 are absolutely that. I mean, I just Googled it really quickly. Remove chewing gum from hair, wd-40 stop wasp nests wd-40 clear up crayons wd-40 remove dog mess loosen a stuck ring piano keys i mean it's not you know waterproof your shoes here we go so wd-40 as fish bait yeah fish bait pike pike are attracted to wd-40 wow wow uh so mine is gonna is gonna be no surprise uh it is one of my favorite companies and it's texas instruments and so texas instruments they allocate capital in several ways. One is they are entering a massive CapEx investment cycle

in order to drive 7% annualized revenue growth over the next 15 years. That's their goal. And so to give you an idea of what I mean by massive, in the five years from 2016 through 2020, Texas Intraman spent about $771 million per year in CapEx. $771 million. Then in 2021, their CapEx jumped to $2.5 billion. And from 2022 through 2025, they are guiding for CapEx of $3.5 billion per year. After 2025, going forward, so starting in 2026, they're saying their CapEx will average 10% of sales per year. Their historical CapEx, back when I said it was $771 million per year. Historically, their CapEx was about 5% to 6% of sales. Over the long term, they're doubling their CapEx to sales ratio because there is so much increased demand for semiconductors in the

digital world. They invest in CapEx. They also spend about $1.5 billion per year on research and development. They spend about 11% of their sales on research and development. Investing heavily into growth, but they also are committed. So, these growth investments are before you get free cash flow. So, you invest in R&D, you invest in CapEx, you invest in some other things, and what's left over is free cash flow. So, they make these growth investments, but they're committed to returning 100% of their free cash flow to investors through dividends and buybacks. Their formula is to pay out 40% to 80% of their annual free cash flow as a growing dividend, and then use the remainder to buy back stock when they think it's trading at a discount

to intrinsic value. As far as the dividend, it currently yields 2.8%, and they've increased that dividend for 18 consecutive years. Since 2004, Texas Instruments, its dividend per share has compounded at a 25% CAGR, or compounded annual growth rate. More recently, over the last five years and the last 10 years, dividend per share has compounded at over 20% per year. This is a massive dividend growth company, compounding that dividend over 20% per year. The dividend yield is 2.8%. Then if you like buybacks, by the way, they've reduced their shares outstanding by 46% since 2004. And it's still a high-margin company. This is what's incredible to me about Texas Instruments, the fact that they have made so many capital decisions

that essentially both return capital to shareholders and self-liquidate in terms of reducing the share count. And yet, what they're using that capital for are things that don't necessarily add to the operations of the company. But at the same time, the money that they are putting to the operations of the company is also returning at a very, very high rate. It's an incredibly high-margin business. So, John, why wouldn't you want to see them reinvest more capital into the business rather than share buybacks? Like I said, they've committed to going in CapEx from $770 million a year to $3.5 billion That's a pretty big commitment.

Yeah, they're not starving the business. Yeah, they spend $1.5 billion per year on R&D. But, Bill, you're right. I just think that Rich Templeton, the CEO, he fundamentally believes in returning capital to shareholders above and beyond what they need to grow the business. And so, they are investing. I mean, they're entering a massive investment cycle. But, yeah, I mean, you're right. maybe there's an argument to be made to invest above and beyond what they are doing now,

take on more debt to do so. It's a possibility because, like you said, the margins and the returns on that investment are so remarkably high. Rich Templeton, you know, he has this great idea that, and it's the right way to look at it, buybacks are a way to reward continuing shareholders, right? I mean, if you're selling out, you don't get rewarded. If the company's buying stock from you, adios, amigo. You're not getting rewarded. But if you're a continuing shareholder, then buying back stock at discounts to intrinsic value is one of the best things a company can do. It's one of the highest return on invested capital moves a company can make. And so, yeah, I mean, if you like dividend growth, if you like nearly 3% yield and you like buybacks,

Take a look at Texas Instruments. Ari, over to you. Round No. 2. This is in the organic growth. There's business out there, we're going after it, we're going to get bigger, essentially. Most of the decision is going to be, the investments are going to be internal to the company. I recently researched Adyen. They had a capital markets day. Wow, this company is executing on all cylinders. It's getting better, and the stock has been hammered. I think people that hold on are going to be greatly rewarded. But essentially, what they have going on is their payments business, this unified commerce. Essentially, if you do business in multiple geographies, and you have an e-commerce platform,

and you have POS, their system has been built so that you can use both of those items. It's easy to scale and grow with your business. You don't have to have multiple providers, like one for e-commerce and one for in-store point-of-sales purchases. Now, they're also innovating their products. They're coming up with new solutions to better serve their customers. I think this is where we think about R&D, new products. Some of the new things that are coming up with it, I think this is brilliant, is Adyen Capital. They have all this information about these people that do business on their platform. They have insights into their financials. Let's say you're a coffee shop and you need a loan for a new espresso machine. Adyen has insights on all your data

when cash comes into your business, when you make payments. Now, they're going to start getting into the lending business. They have the information to probably do that competitively. That's a new innovative thing, where they're going to put the cash on their balance sheet to work. Ideally, it doesn't just sit there, even though they have net cash. Then they're going to get into card issuing. If you're a business and for some reason you want to issue debit cards, which I think Marketa is in that business, and that's a growing business as well. So, I like that. That's a good, I think, example of organic growth where there's just more business out there, and we're going to hire FTEs, engineers to come up with these innovative

products. So, that's my kind of organic growth capital allocation example. I love that Ari's bringing an organic growth and an acquisitive growth. I mean, he's spreading the love. Just two on the opposite spectrum. I love it, though. You're spreading the love. And like I said, far too many investors think of capital allocation, all they think of is the return of capital and not the growth investment part of it. Here's why this matters. And Adyen has long been one of my favorite companies. I was delighted to see that Ari brought it to the table and also not delighted because I would

have brought it myself had he not done so. What we're seeing right now, particularly in tech and particularly in payment technology, is a real consolidation, a retrenchment. One of the most interesting things, this is why capital allocators, the superior capital allocators, tend to generate excellent long-term returns. They're hiring. They're hiring at a point in time in which their competitors are static or letting people go or are retrenching. These are the times in which the winners are made in the market. It's not times in which capital is as cheap as can be. It's the times in which capital is dear. And so, the fact that Adyen is out buying growth, continuing to innovate, continuing to hire for R&D, to me, is a really outstanding signpost for

what this company can be. I just pulled up Morningstar really quickly to look at their returns on invested capital. Ari, I mean, they're generating 29% returns on invested capital on that organic growth. I mean, that's exceptional. That's exceptional for a company growing 50% a year. Are you kidding me? Like I honestly, I could maybe think I can, no, I don't, I don't think I can, I don't think I can think of another company, maybe one or two that are growing 40 to 50% generating near nearly 30% returns on invested capital. I don't know if I can think of another company growing that fast generating returns that high. I mean, maybe, maybe a few, but that's, It's, it would be hard for me to do, you know, like SMB global and MasterCard and Visa, they

have, they have comparable returns on capital and, and operating margins that are, that are even higher, but they're not growing 50%. So it's like, really, it's going to be hard to think of, think of a business with Adyen's economics. Such a, such a, such a great one. Bill, do you want to go? Well, I talked about degreasers and things of that nature earlier. We're now going to talk about a company that's growing a little bit faster,

9% over the last 20 years, but it's just as boring. It's Church & Dwight from Princeton, New Jersey. They make Arm & Hammer baking soda and all of the different products that you see Arm & Hammer's label on, including kitty litter, detergents, road cleaners, OxyClean. They make Trojan condoms. They make first response brand home pregnancy kits. One of the ways that I think about capital allocators is a pretty simple way to do it is to measure their goodwill, which is basically the amount of money that they have paid on top of asset value for companies they've acquired as a function of their assets, and measure it against their operating margins. the higher the operating margins for a company that has a fairly high level of goodwill should

tell you that they have been allocating capital really, really well. And in the case of Church and Dwight, their operating margins are 19%, which is, for a company that essentially makes branded commodities, an incredibly high number. That's awesome. That's incredible. I mean, how is this company growing 9% average? That's actually a pretty good growth rate for a consumer products company like that. What they've done is they've gone out and they found bolt-on acquisitions that they were able to buy very cheaply. They bought Origel, for example, and the Waterpik brand is actually now owned by Arm & Hammer Baking Soda, owned by Church & Dwight. So, they've done so, which is why they have that goodwill number,

because when you see a company with a goodwill number, that means that they've gone out and have acquired other companies. And so, they have done so by very smart acquisition of other brands. And then also by thinking of different ways that Arm & Hammer baking soda can be added to other products in either a branded or a non-branded way. Awesome. Another bolt-on acquisition story. I love it. So, my last one is Home Depot, another surprise, surprise. And they have a very, very balanced capital allocation strategy. And so, they invest $2.5 billion a year in CapEx, and that goes towards omni-channel retail. And so, everything that is involved in building out the computing power that they need for homedepot.com,

which they completely revamped. It's supply chain and logistics, whether it's fulfillment centers, whether it's delivery capabilities, they want to be able to deliver with everyone in the U.S. within two days or less. And so, you know, they're investing a lot in omni-channel retail. And then, like Texas Instruments, they return excess cash to shareholders through a dividend and a buyback. So, first, the dividend. They've paid a dividend every single year since 1990, and they've increased the dividend for 13 consecutive years. You may say, why only 13? It's because during the great financial crisis of 08-09, they just kept their dividend stable at $0.90 a year for one year. So, during the housing crisis, rather than increase the dividend,

They just kept it the same. But they've paid a dividend every single year since 1990. They have not cut the dividend. And they've increased that dividend every single year for the last 13 years. And over those 13 years, the dividend has compounded at a 17% growth rate. The current dividend yields 2.6%. So it's another pretty substantial yield you're getting. and then for buybacks in 2003 it had 2.3 billion shares outstanding and these are fully diluted shares in 2003 2.3 billion shares now it has about a billion so it has reduced its shares outstanding by over 50 percent at prices much much lower than today's stock price the average price at which they bought in 50% of their shares is much, much, much lower than today's stock price.

And that's the ultimate test to see if they are getting a higher return on those buybacks, is what price did they pay for the buybacks versus where the stock is trading today. And John, one of the most interesting things about Home Depot is that it actually is a test of both sides of good capital allocation and poor capital allocation, because there was a stretch in its history from the period of about 2004 to 2007, in which it was being managed by a poor capital allocator. It cost the company a lot of money to get him pushed out the door. Once Frank Blake came in as the new CEO, the ship was steadied, and they began making really the same kind of decisions that they'd been making since Arthur Blank founded the company a couple

decades prior to that. And Lowe's, by the way, their largest competitor, another very, very, very high-quality business, is in the midst of a turnaround the last two years or so under their amazing CEO, Marvin Ellison. So, Bill Mann, Ari Hughes, always thank you for your time sharing your experience and your wisdom with us. Fools, this was fun. Yeah, this was fun. Thank you. I'm John Rotonti on behalf of The Motley Fool. Thank you for listening. Fool on. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against,

so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow. Thank you.