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Phil has a long track record of leadership and value creation. Phil was formerly the Chief Executive Officer of Aimia (TSX: AIM) and a member of its Board of Directors from 2018 to 2024. Prior to that role, Phil was the CEO and President of Mittleman Investment Management (MIM), a value-oriented SEC-registered investment adviser, which was acquired by Aimia. As CEO of Aimia, Phil monetized over $1 billion in assets and transitioned it into an investment holding company. Prior to founding MIM, Phil was Managing Partner of three venture capital funds with liquidity events of over $1 billion during his tenure. Phil began his career at the Kushner-Locke Company after attending Kent School and Trinity College. He has also served on the Board of Directors of Providence House, and volunteered for 12 years as a Big Brother in the Big Brother program.
Eugene began his career in 2005 at Citco Fund Services as a fund accountant. Over his six-year tenure at Citco, he held positions as senior accountant, supervisor and manager where he led teams responsible for the administrations of multi-billion dollar private alternative investment funds. In 2011, he became an outsourced controller for emerging fund managers, assisting with their formations and developing their accounting, operations, and compliance processes. In 2012, he joined Mountain Lake as Chief Financial Officer overseeing the firm’s operations, including accounting, legal and compliance. Eugene holds a Bachelor of Science in Business Administration from the University of California, Riverside and an MBA from the University of San Francisco.
A capital allocation framework applies primarily to the free cash flow which is generated by a business. Let’s start with Warren Buffett’s description of owner earnings:
[Owner earnings] represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included)…
The most successful allocators are the ones with a combination of clear logical guidelines, and maximum flexibility for capital allocation. However, there is pressure by the forecasting community for companies to offer easy-to-model frameworks which precisely allocate capital to different buckets. This is not optimal for long-term corporate returns. It is self-evident that companies which are run for their owners, not the forecasting community, prefer the degrees of freedom necessary to optimize their returns. If well executed, those companies compound investment value at the highest rate and attract long-term shareholders.
To execute this approach, all investment alternatives should be ranked according to the expected internal rate of return of each potential investment. This includes the returns of each project opportunity within the existing business (beyond what is necessary to maintain competitive position), merger activity, potential new businesses, holding more cash, paying off debt and/or share repurchases.
Laying out the array of returns by IRR from highest to lowest, is sometimes referred to as stacking returns. Ideally, assuming the balance sheet is at its target leverage, the executive team uses all available owner earnings for the highest risk adjusted return opportunity and moves down the list, stopping when they have exhausted the free cash flow. If there are limited high return investments available and none contemplated or expected for the foreseeable future, the capital should be returned to the owners.
This requires judgment, not just financial analysis. The value of retiring debt by an over leveraged company is greater than the interest expense avoided as the risk of insolvency is mitigated and future opportunities may require a strong balance sheet.
The value of cash is not only the interest earned, but includes the value of investment opportunities which may arise in the future.
Nonetheless, the highest returns should generally be pursued and the lowest avoided. It is that simple.
When companies make acquisitions for “strategic reasons,” (read: expensive) the stock price suffers permanently. This is usually the case for acquisitions to get to “critical mass.” Sometimes, there are strategic reasons provided that appear to make sense. For example, a low return acquisition might be deemed necessary to avoid the significant deterioration of a company’s competitive position. In that case, it is really that the base business’s value was overestimated, or it had been underinvested in. The apparent free cash flow was not really owner’s earnings.
Acquisitions which are expected to boost the company’s competitive position should be accompanied by a suitably high return. Since IRR is a perpetuity calculation, it is never justifiable to knowingly purchase an inferior IRR. The best companies audit all their acquisition activity for years post-acquisition to learn whether their estimated IRRs were exceeded or missed and to learn from any mistakes. Some companies even attempt to audit the returns on acquisitions they did not make. The expenditure of the free cash flow is not the sole discretion of the company’s executives; it is deployed or disbursed consistent with the views of the owners’ representatives, the board of directors. Therefore, a board which sits in the shoes of the investors is an often-hidden piece of this equation.
The decision about whether to return capital to shareholders varies depending on the opportunity set the company is facing. Rational shareholders want the free cash flow distributed if they believe that they can do a better job with the capital than the company can. As a rule of thumb, if a company cannot achieve at least a risk adjusted 10% unlevered return on its owner earnings, they should return the capital. Conversely, rational shareholders should not want a distribution if the company can do better than they can.
Many management teams (and politicians) harbor the incorrect notion that share repurchase is a “one time benefit” or even destructive of value of the enterprise. They think that only capital deployed in a business offers enduring value. But the rational long-term owner and their agents are only concerned with the growth of value on a per share basis. This can be modeled to see the compounding effect of share repurchase today on future owner earnings per share in a growing business. The share retired today gives a gift into perpetuity. If the shares are inexpensive (the IRR expected is high) the returns to shareholders are often superior to what the shareholders are likely to do with the funds, and it is more tax efficient to buy back the stock than pay a dividend and have the investor buy more shares. In some cases, share repurchases produce a superior risk adjusted return to that which the management can earn with the funds through other investments. Unfortunately, management and board incentives are often not aligned with owners, sometimes creating a conflict when these decisions are made. The agency incentive problem is one reason many skilled long-term investors prefer to invest with companies whose management teams and boards of directors hold personally significant amounts of stock which they have bought with their own funds, whether augmented with stock-based compensation or not.
Dividends are rarely desired by rational owners of businesses which have high incremental returns on capital. When they are preferred, it is often because the investors don’t trust the boards and managers to hold or invest their money. Owners will want the money if the opportunity set facing a business is inferior to their own. There are a few unusual reasons to pay dividends, for example when businesses face unpredictable sudden existential risk (tobacco lawsuits, for example). Then, continual share repurchase may not be optimal for long term shareholders if the entire company may be suddenly overtaken by lawsuits.
The sell side community is destructive to a company which does not frequently need capital markets. At best, they are a management distraction. Investor relations is a large subject that may be worth talking about at some point. The general point is that the management team ought to choose to be clear and transparent about its objectives but not its tactics since it best serves the owners but not the street. At company-hosted investor presentations, or conference calls if they are pursued, the company can demonstrate what it did with its free cash flow previously, and what the policy is. If the company’s view is that it will deploy capital consistent with that which produces the highest long-term returns that is sufficient information for owners. If the balance sheet has a target leverage amount or ratio, it is useful to indicate the target and that other uses of free cash flow will be constrained until that target is hit. Specificity beyond that or sharing where the management thinks the best opportunities are, limits the degrees of freedom of the company to pursue what it may view as the best future opportunities.
Nothing says you are on the same page as investors as one CEO who said to us. “When I became CEO, I bought $8 million worth of stock with my own money from my prior career”. We know he cares about the IRR on every dollar of owner’s earnings generated.
There are other related topics one might discuss. These include investors who require dividends, fixed vs variable dividends, dividends vs share repurchase, taxes on share repurchase, hostile bids for the company, share repurchase with large holders, share repurchase with illiquid stocks, and many more. Here are a couple of common mistakes CEOs, CFOs and boards often make as illustrations:
1) It is always a mistake for a management team to focus on and compare a company’s yield to similar companies; it reeks of promotion rather than information. If it is attractive, it can only mean one of two things: either the payout is too high, or the stock price is too low.
The payout is too high if the management team can reliably invest in the business, balance sheet repair, or their own shares at a return greater than their owners as discussed earlier. It also is a transparent attempt to drive the stock price up in the short term.
If the stock price is too low, all long-term shareholders will be better off with the return available from repurchase.
If it has been determined that there is a reason to return cash to shareholders through a regular dividend, yield should still not be trumpeted. Better to discuss the (hopefully low) payout ratio and reinvestment opportunities of the business. If the company had a stable ROE, then the reinvestment rate would provide sufficient funds to allow the company to grow without needing external financing.
2) There are some obvious mistakes in capital allocation that suggest the board and management don’t think about it well. A common example might help with thinking about the problem generally. This example was a pet peeve of the legendary Ralph Whitworth, of Relational Investors. When CEOs indicated they were going to buy back stock to offset the dilution from stock options, Ralph would say to them, “Buyback is either a good idea or it isn’t. Making an investment for reasons other than the returns is thoughtless.”
The primary financial goal of a management team is to maximize the (future) net present value of the owner earnings per share. If share repurchase is not additive to the NPV, it is not a good decision even if it improves owner earnings per share. Again, the selection of the discount rate to be used for the NPV calculation should be at least as high as the IRR (typical) shareholders can otherwise generate on their capital with a comparably risky asset.
If management buys stock back when the likely IRR on owning a share of stock is 5% per year for example, while the owners can earn more, the cash should instead be returned to shareholders. On the other hand, if the situation is reversed and the corporate opportunity set is large with high returns, no capital at all should be returned. Share repurchase should only be undertaken if it ranks high enough in the alternatives that there are owner earnings available after investing in every higher return opportunity.
ABC Co. may be fortunate to be a stable high return company that perennially sells for a low multiple of company’s owner’s earnings. The most successful common stocks over many decades are when those types of companies, through a disciplined capital allocation framework, consistently repurchase large amounts of their stock. NVR and Autozone, like Teledyne before them, are legendary to their owners and in the investment community.
The underpinning of capital allocation is always arithmetic. Thinking about it in other terms misses the opportunity to be successful on behalf of your owners.
**The information on this page contains opinions, which should not be interpreted as factual statements. This material is provided for informational purposes only and should not be construed as investment advice. There is no guarantee that the views and opinions expressed in this material will come to pass. Investing involves the risk of loss and may not be suitable for all investors.
**The information on this page contains opinions, which should not be interpreted as factual statements. This material is provided for informational purposes only and should not be construed as investment advice. There is no guarantee that the views and opinions expressed in this material will come to pass. Investing involves the risk of loss and may not be suitable for all investors.
