Thelongview wrote: This is exactly where I stand on capital allocation:
Corporations would not exist if you didn’t have shareholders.
Shareholders want to make as much money as possible over the long-term and so the employees hired to run the company and the board of directors put in place to oversee management and approve capital allocation decisions must act with this as their primary function: making the most money possible for their owners over the long-term.
The focus needs to be on the long-term and not the short-term as this would make management not reinvest enough in the Company to maintain and expand its competitive advantage which would invariably lead to less free cash flow for its owners over time.
Management must maximize future free cash flow per share for its owners. This is the only reason a corporation exists. This is not to say that a corporation cannot give to charity. Of course, they can and should. This is only to say that capital allocation decisions must always be made to maximize per share future free cash flow.
Rational capital allocation decisions will produce a better total return – distributions + price appreciation – than just distributions or price appreciation alone. What shareholders want is the best total return possible over the long-term and this cannot be achieved without maximizing future free cash flow per share.
I believe that capital allocation decisions greatly affect the future stock price and so those decisions should always be made rationally and with logic with an eye to maximize free cash flow per share on a long-term basis and by extension maximizing the compounded total return to shareholders over the long-term.
Management should have a checklist with three items on it:
- Debt
- Operations
- Acquisitions
Debt should be the first thing management and the Board should look at when allocating capital. While the use of debt should not be ultra-conservative, it should be low enough so that the company can withstand internal shocks and large external ones as seen in the Great Recession and COVID. The company must be allowed to play the game and debt levels should be low.
Assuming debt is low – again not ultra-conservative but conservative – management and the Board should focus on reinvesting in itself by making its competitive advantage deeper and wider. Without a competitive advantage, free cash flow would decrease over time and so would shareholder total return. All incremental capital that can be reinvested in the business
and earn a high ROIC should be reinvested even if this results in no free cash flow for acquisitions, dividends or stock buybacks. This is often the best use of funds but not always. Take the banks for example: they earn a high ROE but cannot reinvest all of their free cash flow at the same incremental rate of return. If they were forced to reinvest 100% of their free cash flow each year, their ROE would decrease (the return from less appealing investing options divided by a larger equity base).
Assuming that the company has reinvested in itself an has at least maintained the same level of competitive advantage relative to its peers, it should now focus on acquisitions at a reasonable price. If you have to pay too much for an acquisition then you pass. It all comes down to math and maximizing shareholder value. If nothing meets your criteria and there is nothing on the horizon then you should return capital to shareholders.
Once up to here, management and the Board have only two options:
- Distributions
- Buybacks
There is only one rational course of action. If your stock is undervalued, buy it back. If your stock is overvalued, pay a distribution.
If your stock has an estimated intrinsic value of $12.50 - $14.29 but is trading at $15.00, don’t buy it back. You would be destroying shareholder value. Pay a distribution instead.
If your stock is trading at $9.00, buy it back. You are creating shareholder value. Paying a distribution under this scenario would be destroying shareholder value relative to the buyback option.
It’s that simple. It is all just math and logic.
The guiding principle that management and the board should follow is to ask what is best to maximize shareholder total return over the long-term?
Now, this may or may not be popular with the reader depending on whether you want to maximize your total return over the long-term or if you simply want to maximize your income (distributions) over the short-term but the best course of action for management and the Board would be to cut the $0.36 and to buy back stock with all free cash flow that was not needed for items 1 – 3 on the checklist.
Doing so would lead to all shareholders becoming wealthier over time, even those who want to maximize current income only as the lesser shares outstanding from future stock repurchases would lead to a higher distribution per share when the distributions would resume (when the stock would not longer be trading below intrinsic value).
While cutting the dividend is the most logical thing to do as our stock is trading 34% -42% below its estimated intrinsic value (and one that I feel is conservative) and therefore means it must increase by 52% -77% to attain fair value and is much better than having a dividend yield go from 4.36% to 8.72% if the dividend were to double, this dividend cut would never be implemented. That is reality and reality is not always based on logic and rational thinking.
Knowing that rational thinking and logic don’t always win, I am open to the following scenario:
- A base dividend of $0.36/year
- A monthly variable return of capital to shareholders of the remainder of the free cash flow that is not needed under the management checklist options 1 – 3.
This monthly variable return of capital would take the form of a distribution or stock buyback and would be based on the stock price. If $12.50 - $14.29 is fair value then a market price of less than $12.50 would mean stock buybacks and a market price above $12.50 would mean distribution.
Given the fact that a regular dividend of $0.36/share is in place and the cutting of it would give the impression that management and the Board are confused, I would not object to leaving it intact on the condition that all future return of capital to shareholders is to be implemented in a rational manner as in the above example. My wish is still for the dividend to be cut but due to the big discount our stock is trading at relative to intrinsic value and the extraordinary investment opportunity in this stock going forward, would be willing to accept this.
Perhaps a better solution for those looking for a large distribution is to simply sell off a portion of the stock every year and to pay yourself a dividend. If you were looking for an 8% yield then simply sell off 8% of your stock each year. The lack of dividend payment coupled with much larger share repurchases would increase the market value of GH stock more than by getting an 8% distribution. You would become wealthier over time.
Isn’t that the name of the game?