Warren Buffett's Words Of Wisdom On Capital Allocation

Warren Buffett, Chairman and CEO of Berkshire Hathaway BRKA, is arguably the greatest investor of our time. With a focus on buying undervalued companies with durable competitive advantages, Buffett earned excellent returns for Berkshire’s shareholders.

In the past 20 years, Berkshire Hathaway generated total returns of 9.1 percent per year, while the S&P 500 Index returned 7.6% in the same period.

Berkshire’s outperformance can be attributed to Buffett’s investing success. The Oracle of Omaha popularized the concept of buy-and-hold investing. One of his most famous quotes describes his long-term focus: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

There is no shortage of Buffett quotes that can be very useful for investors. One particularly important consideration for investors is capital allocation, a topic Buffett has occasionally commented on throughout his investing career.

Breaking Down Capital Allocation

Capital allocation refers to how a company decides to spend money. There are five major forms of capital allocation, which are:

• Organic growth initiatives
• Mergers & acquisitions
• Debt repayment
• Stock buybacks
• Dividends

There is no “right answer” when it comes to capital allocation. Some companies utilize a mix of all five capital allocation methods, while others prefer to focus on one or two. That said, understanding how a company decides to allocate capital is a critical component of the decision-making process for investors.

If a company manages capital well and delivers strong revenue and earnings growth, the stock will likely generate high returns to shareholders over the long-term. While Buffett does not strongly favor any specific capital allocation method, in general he believes that companies should always use capital to the long-term benefit of its shareholders:

"Unrestricted earnings should be retained only where there is a reasonable prospect — backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future — that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

This can mean different things for different companies. In some instances, growth investments are the right course of action. Other times, shareholders would be best off with direct cash returns such as buybacks and dividends.

In any case, if a company mismanages its capital, perhaps by spending too much on an acquisition or investing lots of money in a project that fails, shareholders can lose money. As a result, investors should favor companies that have a successful capital allocation track record.

Why Capital Allocation Matters

There are a few steps an investor can take to steer away from companies that are likely to waste shareholders’ money. First, selecting a company with a strong management team is paramount. Buffett has preached the merits of investing in well-run companies: “I try to buy stock in businesses that are so wonderful that an idiot can run them because sooner or later, one will.”

Another step that investors can take to improve their odds of long-term success is to resist the herd mentality. In other words, never succumb to the two worst emotions an investor can have: fear and greed. Investors tend to sell after markets decline and buy when markets rally. Meanwhile, Buffett has had a simple focus on buying high-quality companies at fair prices, and holding on for the long run.

“You need to divorce your mind from the crowd," Buffett has said. "The herd mentality causes all these IQ’s to become paralyzed. I don’t think investors are now acting more intelligently, despite the intelligence. Smart doesn’t always equal rational. To be a successful investor you must divorce yourself from the fears and greed of the people around you, although it is almost impossible.”

An example of this is the behavior of many investors during bear markets and bull markets. When markets are declining, many investors will sell all their stocks out of fear. Then, when markets are rallying, investors might take greater risks than they otherwise would. Investors should resist the urge to buy high-flying stocks during bull markets out of fear of missing out, as many of these speculative stocks will burn investors once the next downturn comes.

Lastly, investors should avoid companies with too much debt. The past 10 years has been characterized by monetary policy of extremely low interest rates. This has caused some companies to load up on debt. But there is a clear danger to this, which is that eventually this debt must be repaid. If the money raised was wasted, too much debt can lead to disastrous results.

Final Thoughts

Capital allocation is an important subject for any company management team. It can have a major impact on the stock’s long-term returns. Investors need to determine whether a company’s capital allocation program fits their particular investment goals.

For example, growth investors concerned primarily with seeing a stock price rise, may be primarily interested in making sure the company is investing sufficiently for growth. On the other hand, income investors such as retirees might be primarily interested in receiving dividends.

No matter what your goals are, Buffett recommends investors keep a long-term focus, and invest in companies with clear competitive advantages and strong management teams.

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Warren Buffett with former President Barack Obama. White House photo by Pete Souza.