Why capital allocation is critical to investor success
When you walk into Diploma’s head office in London, there’s nothing inherent in its décor to suggest that the company has produced extraordinary shareholder wealth over the past two decades. Its unassuming and humble visage in Charterhouse Square is consistent with what, at first blush, could be mistaken for an unexciting business: the company distributes a variety of small parts, such as hydraulic rings and gaskets for capital equipment; wiring, nuts and bolts for planes and cars; as well as various instruments and reagents for hospitals and labs.
Yet, Diploma’s stock price currently trades at more than 50x from where it stood 20 years ago. One possible explanation for this exceptional return is that it was merely commensurate with the degree of risk inherent in the investment. But a much more plausible explanation, and one of our enduring beliefs, is that investors serially underappreciate the long-term value of strong management teams. And through that lens, Diploma is a perfect case study.
Over the years, Diploma has built and acquired a collection of niche, seemingly disparate distribution businesses with the following common characteristics among its segments:
- Recurring revenue: Diploma distributes mission-critical consumables in product categories that are generally low cost and paid out of their customers operating expenses (as opposed to more cyclical capital expenditures).
- Scale and focus: Diploma has developed leading industry positions in the vast majority of its niches—a combination of SKU breadth and excellent technical service—leading to high switching costs for their fragmented customer base and rock-solid margin stability.
The combination of these two factors has led to a business model that exhibits strong organic growth and that has generated high returns on invested capital over a long period of time. All the while, Diploma’s management team has redeployed this excess capital by executing on a disciplined roll-up strategy, one that has deprioritized upgrading its office space in favour of acquisitions that complement their existing business at attractive internal rates of return.
Our investment process puts a big emphasis on evaluating management teams’ ability to effectively allocate capital. This is critical not only because we are long-term investors, where decisions compound over time, but perhaps more importantly because our investment philosophy orients us toward wealth-creating businesses—those that earn a return on invested capital greater than their cost of capital. The question that naturally follows is: what should these companies do with the excess cash flows that are generated?
These decisions can make or break a business over the long-term. Management teams have a variety of ways to redeploy this capital:
- They can reinvest in their base business
- They can make acquisitions
- They can choose to pay down debt
- They can return capital to shareholders by paying out dividends our buying back shares
- They can adjust their compensation
While all of these are perfectly reasonable ways to allocate capital, they’re not necessarily appropriate for every business or situation. If a company has opportunities to earn high returns by purchasing inexpensive companies and efficiently integrating them into their wider operations, then why pay out dividends? If a management team has intentionally created tremendous shareholder value, shouldn’t they be fairly compensated for such actions? And if opportunities to redeploy capital at attractive rates of return are scarce, we’d prefer they return that capital to shareholders.
Unfortunately, many management teams make poor capital allocation decisions. Take GE, which has had its fair share of issues over the last few years. It used to fly its former CEO to meetings on a corporate jet. But it had another jet—with no passengers—trailing behind just in case the first plane broke down. The board, and the company’s shareholders, had no idea this practice was going on.
While that may be an egregious case of capital allocation gone awry, consider a contrasting string of recent decisions made at Enghouse, a Canadian company that provides software used in contact centres, telecom networks, and transportation systems. Two years ago, Enghouse deliberately sought to upgrade its internal enterprise resource planning system and re-organized its personnel to bring a greater degree of focus to both operations and acquisitions. Enghouse’s management team was clear on its intentions: by improving its own capabilities in both people and systems, they claimed this would allow them to integrate its acquisitions faster and more efficiently, and, ultimately, realize better rates of return.
Subsequently, in early 2019, Enghouse acquired two sizable but unprofitable software businesses. And sure enough, late last year, Enghouse revealed that they had raised EBITDA margins in both businesses close to the company average of 31% in less than a year – an impressive achievement. Only then did the stock have an outsized reaction.
The Enghouse example ticks the boxes on a number of basic tenets that we seek to evaluate when it comes to a management team’s ability to allocate capital effectively:
- Is their strategy sensible?
- Were their actions deliberate?
- Have they demonstrated discipline?
- Have their decisions added value?
Given the short-term nature of many market participants, it is not uncommon for management teams to make decisions based on how they think the market will react in the short-term, even if it’s suboptimal for their business prospects and/or competitive advantages longer-term. These market dynamics are a challenge for longer-term investors but represent an enormous opportunity.
Of course, management teams change, companies lose sight of their goals, and the difference between skill and luck isn’t clear cut. And, Diploma’s head office is likely overdue for a renovation. But, for the most part, identifying strong management teams who know how to allocate capital has consistently proven to be a recipe for success over time.