Asset allocation is how the Chief Executive Officer (CEO) manages to spend the earnings from the business. Simply He/She takes a temporary role of a fund manager inside the firm to determine where to invest in itself to improve growth and refine margin parameters. After the commencement of business certain years demand high capital investment which never stays alive as cash to support the year’s liquid segment. The income is aggressively invested known as Capital Expenditure, the big negative number reduces cashflow. Unlike, sectors like manufacturing, some business will usually stop investing huge on its business and starts accumulating cash. With a stable growth and quality of earnings the management gets piled up with cash without knowing how to spend the money.
No management escapes from this problem after attaining certain stage of business maturity, which makes them do unusual corporate activities which are harmful to the shareholders. Once the business is loaded with cash, the growth diminishes, share price drops, poor economics, all are key factors to expect a corporate raider to pass on, The corporate treat. The both rational and irrational choices are:
- Buying growth- Inorganic way of growing.
- Investing in itself to produce above average results.
- Returning the money to the share owners.
- The wisest of all- Corporate buybacks.
Buying an expensive penny stock
Inorganic way of growing branches into same and different sector. Most of the artificial growth is by acquiring a business in its own territory, which keeps them together with the core business (Paints for Asian paints, Syrup for coke). The path to destruction is buying a business far away deviating from the main business. Stepping into a new business which is totally new to the existing authority is fatal and destroys shareholder’s wealth. The annual report gets mixed up, unclear image of the subsidiaries, partial disclosure of the performance every other turn downs load up the report. Whenever the deal is from the management side, the buyout is often expensive because the price quote is from the other side. Also, when individuals have more cash in hand, are ready to pay any amount quoted without giving a second thought to the intrinsic value.
Quality of earnings
Most of the CEO’s concentrate only on earnings growth and leave untouched the refinement of earnings. Return on Capital Employed (ROCE), Return on Equity (ROE) are main concerns of a highly conditioned business, which directly implies the quality of earnings. Earnings move in tandem with revenue, the margin is same as the before, but filling gaps would refine the earnings which most institutions fail to do as like the industry is poised with the margins they operate.
On any occasion, reinvesting is a better choice for a business with above average return which most businesses are kept away from. So, the management continues to invest in the average earning business every year to avoid the hypothetical dilemma.
Attracting by paying
In the above stated gesture somehow the money is within the institution doing better or good, in case of a dividend the cash flows out which is of no use to the management other than attracting risk averse “Know something” investors who build a dividend portfolio. The parameter of consistent increasing dividend is still on the checklist, which makes investors think even though the price isn’t forwarding dividends provide them certain form of cover to the investment.
Sustainable Growth rate= Return on Equity X (1- payout ratio)
Sustainable Growth rate (SGR) is the original growth rate without additional equity or debt requirement. The return on equity moves up with the use of debt, which is prevalent in any industry.
A well known fact is, price corrects for a dividend payment, which is not evident, proves earning from a security is limited (apart from value appreciation). If this is true the retained earnings should reflect in value appreciation i.e., price appreciation. This is what Warren Buffett indirectly quoted as “One Dollar Premise” in which every retained dollar should increase the market capitalization by or more than a dollar. If the price corrects to the amount of dividend paid, the retained earnings should ascend the price.
If a management resists from paying dividends and concentrate on ROE the SGR would drastically increase. Since the expenditure comes from earnings, debt is of no purpose. The institutional imperatives cease to exist when the officials blatantly copy what the friend does paves a way to corporate catastrophes. Failing to reflect in price even after retaining the earnings, the internal investment made is squandered or acute level of price appreciation tells the below average returns of the investment.
Money today is worth less tomorrow. Rather than getting cents on a dollar in a future date, better to chop it off some gains today which has more value than the former.
Business, which are run for many years and exploring all possible ways of growth opt for this option. The exposure to equity is decreased in a buyback and increases ROE. Instead of paying dividends the retained earnings are utilized in an effective manner benefitting the management and indirectly the part owners. This initiation is more advantageous if the price is lower than the intrinsic value, double positives. The share price increases with a concrete belief as owner’s confidence in the business.
Unrealistic amount as dividends forces the management to leverage. Even companies with high liability weight do pay dividends, which can be used to free themselves of the debt- Interest coverage. In the sake of pulling shareholders towards them, institutions take common imprudent routes which also increases the stock price temporarily which is baseless. Managements like aggressive corporate actions which they believe keeps them alive, highly unstable businesses fluctuate the most which are considered as lunatic behaviour. Exact imitation of the players, ushers no ways of differentiating themselves from competitors. Some of the nasty errors are made by simply imitating the close competitor or the early successor.
Cupid is one company which is under the radar having enough cash for a buyback. Both margin and ROE are above average, paid dividends for a long time and growing with a genuine pace.
The best example of a business which never paid a dividend is Berkshire Hathaway, which lived up to the principles of Warren Buffett. The company never paid a dollar as dividend, but the price compounded in unusual rates. Even though Berkshire spends every dollar with wisdom the huge cash in the portfolio still drags the performance. One reason is market inefficiencies are infrequent and Buffett never steps down from his evaluating criteria for a good business.