By Jacques Cornet, Will Swett, & Alex Loughnane
Capital allocation is among the most used terms across the public markets — at times, a vague and imprecise term. If you ask 10 CEOs what it means to them and what they are doing about it, you’d likely get 10 different answers.
It can be one of the most elusive financial concepts to be considered in how a company communicates its strategy to investors. Despite that, there is a lot of data out there to be used and analyzed that can provide a sense of what publicly traded companies are ACTUALLY doing to use capital to further their strategic priorities and value creation objectives. This data offers a window into capital allocation approaches and presents meaningful conclusions.
There are many ways to look at and evaluate capital allocation. We’ve taken one approach — using the publicly available financial data to provide a high-level sense of where the largest companies in the United States are directing their capital. Certainly, there are nuances to each company’s financials, but our goal is to keep it simple: to stick to the audited financial statements. Much to the chagrin of CFOs everywhere, we aren’t adjusting for non-recurring items or any pro forma presentations. Simply put, just the facts.
We looked at the S&P 500 to get a broad sense of what the 500 largest companies as measured by market cap have been doing with their cash over market cycles. Our findings are in Figure 1. For illustrative purposes, we went back to 2006, just before the Great Financial Crisis, to get a sense of how the decision making has changed through cycles.
Figure 1
We applied a simple concept: look at the amount of capital the business generates (Cash Flow from Operations taken straight from the Statement of Cash Flows). At a high level, what can a company do with that cash? They can reinvest it internally in the business (CapEx); they can invest it externally in acquisitions (M&A); or they can give it back to shareholders in the form of dividends or share buybacks.
If the sum of those four alternatives is greater than the cash generated from operations, the company, in theory, over time is accessing the capital markets, whether by using existing cash, issuing equity or debt or a combination – they are raising funds. If the opposite is true, and the sum of the four alternatives is less than the cash generated, then the company is effectively accumulating cash or repaying debt. While this is a simplistic framework, and there are nuances for sure, at a high level we believe the trends are insightful.
For instance, if we go back to the Great Financial Crisis, it is clear from Figure 1 that the collective S&P 500 at that time was behaving in a very conservative way. For the majority of 2008 to 2013, companies were accumulating cash, not reinvesting what they generated. This type of environment has implications for what returns on stocks could be reasonably expected. Looking at the period after the Great Financial Crisis, since 2014, the S&P 500 has for most of that time been allocating capital in excess (above 100%) of what it generates. Was this behavior the result of the abnormally low, near-zero interest rate environment? Perhaps.
It is worth noting that in 2023, the collective S&P 500 turned more conservative when faced with rising interest rates and high inflation. As we look forward, there are questions we should all be asking. What will companies do? What should we expect with inflation persisting, albeit at lower levels than the prior year, and with an interest rate environment that seems more normalized if we take a wide view of markets over decades?
Will this environment change behavior? We will see. Will this environment and the resultant behavior have implications for share valuations and expected returns? Absolutely.
Whether an investor or an issuer, it is very important to understand what the market is doing, what peers are doing, and to evaluate how a company’s approach can be effectively communicated to the markets. As advisors, we help our clients work through formulating plans on how to convey their own investment narrative. Get in touch to learn more.
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