Outsourced CFO Journal: Capital Allocation

Whether or not you consciously think about capital allocation, you are making decisions about how you allocate your capital every day. Whether you are a Wall Street or Main Street CEO, capital allocation is a major part of your role. As such, at least part of your success as an entrepreneur will be directly tied to your strategy in allocating capital.

The good news is, there are blueprints and models to follow. These guides have shown to be successful in the past and continue to be successful today. While there are some more advanced math requirements in order to master capital allocation, the overall concepts are not too difficult. If you partner with your financial professional and have a strong operational team, basic capital allocation strategies can be successful.

When you get down to the basics, a business owner has only a few ways to raise and spend capital. How the owner decides to do this will have a great impact on the long-term value they create within their business. While the topic of capital allocation is one that is mostly discussed when talking about major companies, small business owners have the same decisions to make, albeit at a smaller level.

Think of capital allocation as a toolkit. You can pick certain tools to raise and spend capital. The result will either be a house that stands the test of time, or one that crumbles after the first big storm (that is dramatic, but I think you get the point).

There are three basic ways to raise capital – issue stock, obtain debt, or tap internal cash flow (essentially create capital from operations). While issuing stock can be a quick fix for capital issues, it also means decreasing shareholder value (think of yourself as the only shareholder, you dilute your position for every share of stock you sell). While raising debt can also be a quick fix, it comes with restrictions on your future cash flows. By far, the most preferable method of raising capital is to tap into internal cash flow. Essentially this is taking cash flow from operations and investing it back into the business.

There are five ways in which you can allocate capital – pay dividends or distributions, repurchase stock, pay down debt, acquire another business, or re-invest into current operations. A few of these options have shown to be far greater in building shareholder value than others. For instance, some of the great CEOs today and in history refused to pay dividends because of the double taxation nature of them. While this might differ from a small business owner who usually does not operate in the C-Corporation environment, the general lessons are the same.

The story of Teledyne is well known to some, but for the large part has been ignored by the mainstream media. In his book The Outsiders, William Thorndike makes a case that Teledynce CEO, Henry Singleton may be one of the greatest CEOs in history. His assertion is based in part by the brilliance of Singleton’s capital allocation strategies.

Singleton was the CEO of Teledyne, a conglomerate, for almost 30 years. Thorndike makes this case not by quoting qualitative qualities that Singleton held. Rather, he uses shareholder value and rate of return. If you had invested $1,000 in Teledyne when Singleton took over in 1963, that would be worth $180,000 in 1990. That represents an annualized return of over 20%! That same $1,000 would have only been worth $15,000 had you invested in the S&P 500. So what was Singleton’s secret?

In 1960, along with his colleague George Kozmetzky, Singleton founded Teledyne. They started by acquiring three electronics companies. In 1961, the Company went public. This was the era of conglomerates, which were companies with many unrelated business units. A modern-day list of conglomerates would include Berkshire Hathaway and General Electric. In the time when Teledyne went public, conglomerates were akin to the modern-day hot tech stock such as Uber, Facebook or Twitter.

Taking advantage of a high stock price, between 1961 and 1969, Teledyne purchased 130 companies in a variety of industries such as insurance and specialty metals. Virtually all of these stocks were purchased using Teledyne’s stock which by Singleton’s measure, was inflated. With this additional capital, Singleton went to work acquiring companies. Singleton, however, had a singular focus on acquiring companies with leading market positions. He was not interested in a “turn around” situation, rather he focused on profitable, growing companies. Like most successful CEOs, Singleton was disciplined in his approach. He would not purchase a company if it didn’t meet certain earnings and cash flow metrics.

In 1969, with his stock price falling and prices to acquire companies raising, Singleton quit purchasing companies. From the toolkit we described above, Teledyne eliminated two tools from its’ kit. First, the Company would never make another significant purchase again. Second, they would never issue another share of stock during Singleton’s rein.

During its first full fiscal year of operations ending in October 1961, Teledyne had sales of $4,491,000 with a net income of $58,000. Teledyne sales in 1969 were $2.7 billion and net income was $372 million. While it might seem that this had become a massive company, it had not. Singleton and his COO broke from the norm at the time and emphasized extreme decentralization, breaking the Company into its smallest components and driving accountability and decision making to the operating units (someone could turn this story into a whole book on management strategy).

This didn’t mean that the Company stopped making investments in other companies, however. By the end of the 1970s, Teledyne owned 31 percent of Curtiss-Wright, 24 percent of Litton, as well as significant portions of several other well-known companies.

However, much more significantly, Singleton began to buy massive amounts of Teledyne stock back during the 1970s. While the Company’s cash flow kept growing, their earnings were not as strong which led to a decreased stock valuation by the market. This was not of concern to Singleton because he had long emphasized cash flow metrics over earnings. Wall Street, however, was another story. In 1972, these practices led to the Company’s stock being cheaply priced. This triggered Singleton to begin to repurchase Teledyne stock at remarkable discounts.
Starting in 1972, Teledyne would eventually repurchase 90% of their outstanding stock. Singleton, who did not believe in dividends, believed that stock repurchases were a far more tax efficient way to return capital to shareholders. Singleton’s buybacks were often done at attractive prices for shareholders and the tenders were often oversubscribed (more buyers than the original offer was made for).

What Singleton effectively did was purchase Teledyne’s stock back at a low value while revenues and cash continued to grow. He was able to more accurately calculate his company’s true value and therefore understand a price at which he could repurchase the stock at a discount. While Singleton was not always a believer in repurchases, as evidenced by his earlier issuance of stock, he did convert to a true believer in using buybacks to drive shareholder value.

I made a quick mention of Teledyne purchasing stock of other companies in the mid-1970s above. Teledyne had an insurance entity in which most of these investments were made. Singleton was not concerned about purchasing only a few companies where he felt he understood their business models, even if they were in the same industries. He was fine putting all his eggs in one basket, so much so that 70% of the portfolio was made up of just 5 companies. However, he understood these businesses and as such, understood their true value.

Small Business Take-Aways
As you were reading this story you might have thought “How in the world does this apply to my small business?” don’t worry, we’ll review that. That was my initial reaction reading stories about giant companies. However, while some of the actions taken may not apply, the rationale certainly does.

Singleton was a master at exploiting tax efficiencies. In fact, all of the CEOs detailed in Thorndike’s book eschewed dividends in favor of more tax friendly ways of distributing earnings to their shareholders. As a small business owner, you may be the only owner or one of a few. This doesn’t change the lesson of finding the most tax efficient ways to distribute money out of your business.

Teledyne stayed away from the issuance of debt and did not restrict their cash flows from operations. While small business owners may require debt from time to time, they must be careful in how they choose to use this debt, preferably using it only for assets with a much greater return than the cost of debt. This simple philosophy can help maximize earnings in a business of any size.

While there are so many other lessons a small business owner can take away, the last one I will mention is the discipline Singleton showed when acquiring another business. Statistics say about half of those small business owners reading this will at one time acquire another business. This might be as simple as buying out a cleaning company to get their accounts. Nevertheless, the principles Singleton applied should be the same for your small business. There must be an approach that is rooted more in math than qualitative items. If the initial investment and valuation don’t meet your criteria, then you need to move on.

The lessons of capital allocation can be intimidating for those owners who are not well versed in accounting and finance. For most people, these lessons do not come naturally and you may not have the first-hand experience with it. However, there may be someone who can help you. You can work with your financial advisor/accountant to make sure the strategies you are putting in place are sound and your business is set up to execute on them. There needs to be a long-term plan in place; a focus on the long horizon. Companies that use capital allocation to meet long-term goals are much more likely to be successful than those going for the quick buck.

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