Capital allocation—an ignored factor in corporate governance

It serves to put the spotlight on an often ignored area of capital allocation in the context of governance

At a recent event, Anil Singhvi, a director of Institutional Investor Advisory Services Ltd, presented a radical idea. He suggested that instead of shareholders approving the dividend that the board of directors have recommended, company law should require that the board of directors recommend retaining a portion of the profits in the company giving justification for the same and it should be put out for approval by shareholders. In the absence of shareholders approving profit retention, it should be paid out to shareholders by default.

While the idea is too radical in my view, it serves to put the spotlight on an often ignored area of capital allocation in the context of governance. Indeed the renowned investor, Warren Buffett, says that his primary job is capital allocation and that his operating managers have complete freedom in running the operating businesses. He has also recommended a book mainly devoted to capital allocation in practice by William Thorndike, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.

While individual asset allocation gets a lot of attention by financial planners and the media, its corporate equivalent of capital allocation does not get the required attention. The reason why I believe that this area does not get the required attention is this: Analyst reports and the financial media talk about business outlook for the next quarter or a year, and also talk about governance issues such as managerial compensation, related party transactions, insider trading and so on. I am yet to come across many reports talking about how the company plans to utilize the profits.

Broadly speaking, a business can utilize profits in the following options:

• Further investment in the business for future growth

• Acquisitions related to the existing business

• Acquisition/diversification in unrelated businesses

• Dividend payment to shareholders

• Share buy backs

•Keep hoarding cash without any end-use objective

The first five uses of cash profits are neither good nor bad; it depends on the circumstances. If the business can generate good returns on invested capital in further investment or in related acquisitions it is great. If, however, the business is not generating good returns or if investment opportunities are not there, it will be better to return the cash.

In general, unrelated businesses/diversification is always looked at with suspicion. Success in one business does not automatically translate into success in another business. Wide shareholder approval and consultations should be mandated before any such steps are taken. It should be clearly explained why the management feels that the new business is something that they have a capability to understand and manage well and how it will generate superior shareholder returns.

In case there are no or limited investment opportunities for the company to invest, the money should be returned to shareholders by way of dividends or share repurchases. There cannot be a standard decision as to which route is better. While share buy backs are more tax-efficient, they should not be undertaken if the shares are overvalued. Shareholder wealth is created only if buy backs are done when the shares are undervalued.

The last use is unambiguously bad as equity investors who wish to earn higher returns compared with bonds are forced to invest their returns into low yielding deposits. Surely I am not recommending that the cash profits each year are fully exhausted. Acquisition or share buy back opportunities do not come every day. One has to wait for the right opportunity. However, if the company keeps hoarding cash year after year, and does not invest/acquire/return cash even when opportunities are there, it is in my view an act of wealth destruction.

The information technology (IT) services space has been stellar in many areas and they have improved governance standards in India. Where some of companies have failed, in my opinion, is in the area of capital allocation. We hear of many ex-founders of IT companies investing in technology start-ups or acquiring stakes in existing companies. One wonders why such investments could not have been done when they were at the helm of affairs at the companies they founded? It is time that shareholders started asking the well-managed IT and automobile companies as to why they continue to hold thousands of crores in cash, and ask the well-managed fast-moving consumer goods companies whether taking profits from a great business and investing in low return businesses is the best use of shareholder money or is it just empire building?

Rajeev Thakkar is chief investment officer and director, PPFAS Asset Management Pvt. Ltd.