Motley Fool Money - 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

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is at handling its cash says a lot. Do they pay a dividend, buyback 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 Rotante to talk about six companies handling capital allocation in ways we like to see. Hi, fools. I'm John Rotanti. I'm joined by Ari Hughes and Bill, man. 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. 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. a 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, et cetera, then it has to decide what to do with its excess free cash flow. And then 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 of purchases. So 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. And I think it's a wonderful company to study for your business education in general, because I think they've mastered M&A, essentially merges in acquisitions.

So essentially it was started by a gentleman named Mark Leonard in 95, and he was an venture capitalist 11 years, and he acquired small software plays. and then he continuously did this for long periods of time. And the business has just grown tremendously over years. It's compounded something like, I think, in the high 20s or 30% for over 10 years. And he's done this with an M&A strategy. And 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, and we see that later. But he has this wonderful strategy. And one of the things I think is unique is in CAP IQ, the share count when they went public was 21 million shares, and today it is still 21 million shares, and they've earned a return on equity in the high 30s for a consistently long period of time. And I think this is one of the best companies in the world a lot of people don't know about, and 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 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 buy 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 murders and acquisitions either destroy value or create no value. It's 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 $4.4.5. of your 50 acquisitions a year as well. And they also, like already 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, or 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,

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. Look how big we are now. Yeah. Look how much EBITDA we have now. You know, 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. Okay. 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. A really good idea is probably an understanding. 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 WD40. And WD40, you know its core brand. It also makes, try to withhold your excitement. They make toilet bowl cleaners under the X-14 brand. They also make lava soap. The way to think of this company, the reason that a company can grow at their shares by ADEX,

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 percent, 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. And, you know, I've heard of some, I've heard of, you know, you can use WD40 on just about anything. I've heard some weird.

Breakfast cereal? Whatever. Maybe not cereal. But I've heard of some weird uses of WD40. Yeah. For squeaky wheels and, you know, squeaky remote control gates and stuff like that. Yeah, they were 100% supportive of all of these, of all of these weird uses. But WD40, 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 reinvest its capital. And Gary Ridge and his team at WD40 are absolutely that. I mean, I just Googled it really quickly. Remove chewing gum from hair, WD40. Stop, wasp nests, WD40.

Clear up crayons, WD40. Remove dog mess. Loose in a stuck ring. Piano keys. I mean, it's not, you know, waterproof your shoes. Here we go. So WD40 is... As fish bait.

Yeah, fish bait. Pike. Pike are attracted to WD40. Wow, wow. So mine is going to be no surprise. 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 CAP-X 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 what I mean by massive, in the five years from 2016 through 2020, Texas Intraments 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 CAP-X of 3.5 billion per year. After 2025, going forward, so starting in 2026, they're saying their CAP-X will average 10% of sales per year. Their historical CAP-X, back when I said it was 771 million per year, historically, their CAP-X was about 5 to 6% of sales. So over the long term, they're doubling their CAP-X-to-s sales ratio,

because there is so much increased demand for semiconductors in the digital world. So they invest in CapEx. They also spend about $1.5 billion per year on research and development. So they spend about 11% of their sales on research and development. So investing heavily into growth, but they also are committed. So these growth investments are before you get free cash flow, right? 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 are committed to returning 100% of their free cash flow to investors through dividends and buybacks.

And 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 investment. 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% CAGER, or compounded annual growth rate. And more recently, over the last five years and the last 10 years, it dividend per share has compounded at over 20% per share. per year. So this is a massive dividend growth company. Compounding that dividend over 20% per year. The dividend yield is 2.8%. And 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? You know, 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 to be. 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 number two. Okay, so this is in the organic growth. Just there's business out there. We're going after it. We're going to get bigger, essentially. So most of the decision is going to be the investments are going to be internal to the company. And I think I recently researched Adion. They had a capital markets day. And wow, this company is executing on all cylinders. And it's getting better. And the stock has been hammered. And I think people that hold on are going to be greatly rewarded. But essentially, what they have going on is their payments business, so this unified commerce. So essentially, if you do business in multiple geographies and you have an e-commerce platform and you have a business. have POS, their system has been built so that you can use both of those items. And it's easy to

scale and kind of grow with your business. And you don't have to have multiple providers, like one for e-commerce and one for in-store point-of-sales purchases. Okay. Now, they're also innovating their products. So they're coming up with new solutions to better serve their customers and I think this is where we think about R&D new products right so some of the new things are coming up with that I think this is brilliant is adion capital so they have all this information about these these people that do business on their platform there they have insights into their financials so let's say you're a coffee shop and you need a loan for a new expresso machine adjun has insights on all your data when cash comes into your business

when you make payments. So now they're going to start getting into the lending business. And they have the information to probably do that competitively. So that's like a new, innovative thing where they're going to put the cash on their balance sheet to work. So ideally it doesn't just sit there, but even though they have net cash, and then they're going to get into card issuing. So if you're a business, and for some reason you want to issue debit cards, which I think Marquetta 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 is bringing an organic growth and an acquisitive growth. I mean, he's spreading. Just too 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 Adjian 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 Agen is out buying, you know, 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, that's exceptional. For a company growing 50% a year? Are you kidding me? Like, I honestly, I could maybe think, no, I don't think I can think of another company, maybe one or two that are growing 40 to 50% generating 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 a few, but it would be hard for me to do. You know, like, S&B Global and MasterCard and Visa, they have comparable returns on capital and operating margins that are even higher, but they're not growing 50%. So it's like, really, it's going to be hard to think of a business with Adyans economics. 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 and Dwight from Princeton, New Jersey. They make Arminhammer baking soda and all of the different products that you see Arm and Hammers label on, including kitty litter, detergents, road cleaners,

oxy-clean. 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 Orygel, for example, and the Waterpick brand is actually now owned by Armandhammer baking soda, owned by Church of Dwight. So they've done so, which is why they have that goodwill number, because that is, you know, that 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 Armandhammer baking soda can be added to other products in either a branded or a non-branded way. Awesome. Another Bolton 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 two and a half billion dollars a year in CAPX,

and that goes towards Omnichannel retail. And so everything that is involved in building out the computing power that they need for Home Depot.com, which they completely revamped, it's supply chain, 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 0,8, 2009, they just kept their dividend stable at 90 cents 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% 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. And it cost the company a lot of money to get him pushed out the door. And once Frank Blake came in as the new CEO, the ship was steady 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 the last two years or so under their

amazing CEO Marvin ellison so bill man are a hughes always thank you for your time sharing your experience and your wisdom uh with us fools this is fun yeah this was fun thank you i'm john retanti 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 ourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening.

We'll see you tomorrow.