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Ideas Farm: Use it and lose it

Companies that appear to display a use-it-or-lose-it attitude to cash at their year-end tend to underperform, and especially if they are flush with cash and tight with dividends
Ideas Farm: Use it and lose it
  • Management find it hard to overcome their growth ambitions and return cash
  • Low-risk, higher-yielding shares often deliver
  • But shareholder value is created by right capital allocation choices, not prescriptive rules
  • Loads of new idea-generating data

There are many factors that determine whether a company is well-managed. But zooming out for a top-level view, it all basically boils down to the quality of capital allocation. Shareholder value is created when a company gets money to where it can do most good. The ability of companies to do this is the alchemy not only of "compounding" but also of capitalism itself. 

But even for the most ardent free-marketeer, neither the corporate world nor the capitalist system can genuinely be regarded as entirely perfect. For investors that means a key task is to try to understand companies' capital allocation skills. Is capital being allocated well and will it continue to be? Or is there room for improvement and is management moving in that direction? Or, as sadly is quite often the case, has the rationale of past capital allocation decisions disappeared along with any good future options?

For many companies, including excellent ones, there just aren’t enough worthwhile opportunities into which management can funnel all the cash a business generates. There are always options. But they may offer returns that are too low and risks that are too high.

Management teams in such a situation face the test of whether they can bear to overcome growth ambitions and hand money back to shareholders. Allowing shareholders to try to find superior returns from a company's surplus capital is frequently the top allocation option.

Nevertheless, listed companies regularly pursue the glories of growth over all else. No action is perhaps as infamous for destroying value as the “transformative acquisition”. Even companies with exemplary track records for allocating capital can come a cropper when it comes to big deals. Protection equipment maker Avon Protection (AVON) has been a high-profile case in point for UK investors this year.

A recent study from academics Michela Altieri and Jan Schnitzler has shone some light on how shareholder returns are impacted at companies that appear to feel compelled to spend rather than pay out cash. The researchers looked at US companies between 1985 and 2020. They compared the 30 per cent that increased their spending significantly in the final quarter of the year with those that didn’t. The idea was to find companies that looked as though they may have found themselves with extra cash on their hands and quickly found a way to spend it - eg those with use-it-or-lose-it departmental budgeting or questionable glory projects waiting to be greenlit. 

Across a range of measuring methodologies, shares in companies indulging in big fourth-quarter spending blow-outs underperform the lowest end-of-year spenders. And very interestingly, the phenomenon was most pronounced among companies with strong cash generation, strong balance sheets but low dividend yields.

This may be a ying to the yang of research that has found higher-yielding, low-risk stocks tend to outperform. For example, Pim van Vliet, a quant pioneer of this approach and author of the book High Returns from Low Risk, outlined in a 2018 paper with his Robeco colleague David Blitz that a strategy based on the principle would have produced an annual return of 15.1 per cent since 1929. This suggests that companies that demonstrate they are conservative in their internal capital allocation habits often make a good choice. Higher yields can also suggest that such dull capital allocation decisions (ie foregoing growth) are underappreciated by the market.

Still, dividends are by no means always the best answer. This is why some people have recently become riled by the prescriptive dividend yield rules of equity income funds. The arguments for and against are explored in more detail on page X of this week’s magazine. 

But regardless of which side one finds oneself on in that particular debate, it is usually a good thing if management can conquer sketchy growth ambitions and simply return cash. At the very least, this should certainly not always be seen as defeatist. It is probably normally sensible.


Links to research mentioned in this article:

Michela Altieri, Luiss Guido Carli, and Jan Schnitzler, Grenoble Ecole de Management, "Quarterly Investment Spikes, Stock Returns and the Investment Factor", Oct 2021

Pim van Vliet and David Blitz, Robeco Quantitative Investments, "The Conservative Formula: Quantitative Investing Made Easy", Mar 2018