Analysing Portfolio Capital Allocation

When analysing a potential investment, the Fairlight process evaluates quality across three broad categories; industry, business and durability. Within business quality Fairlight assesses the track record of management both as operators and as capital allocators. While allocating the profits of the business is an integral part of management’s remit (and a critical determinant of long term shareholder returns), often CEOs rise through the ranks by excelling as operators and therefore have little capital allocation experience. Similar to investment portfolio management, capital allocation can be a particularly difficult endeavor as it suffers from the familiar paradox that the same course of action can either destroy or create value based on the price being paid. As a result, it is our experience that management teams who can consistently create value via astute investments are exceedingly rare while examples of hard-earned profits being incinerated via poor allocation decisions are rife.

Reviewing Fairlight portfolio capital allocation

As investors our preferences on capital allocation are ultimately driven by the different business characteristics exhibited by our two investment types. For High Quality Growth companies we prefer businesses with scope to deploy large amounts of capital at high rates of return (be that capital expenditures to drive organic growth or a pipeline of tuck in acquisition targets). In these situations, we generally prefer management not to return profits given the high rates of return on offer through internal reinvestment. On the other hand, Stable Compounders are usually more mature businesses with limited ability to reinvest capital, instead opting to return profits via dividends and buybacks. While Australian investors can often be myopically focused on dividend yields (and franking credits), we are cognisant that over the long term it is businesses that can reinvest capital at high rates of return for many years that have delivered the best returns (one of the key attractions of a small cap portfolio is the long runway for reinvestment).

This balance between reinvestment and returns is illustrated when looking at capital allocation decisions for the Fairlight portfolio in aggregate. In 2022, for each $100 of profits generated the portfolio reinvested $60 (comprised of $20 on capital expenditures and $40 on acquisitions) and returned $62 to shareholders (comprised of $41 via share repurchases and a $21 dividend). Noting that the parts sum to $122 due to the favourable portfolio characteristic of high cash conversion and some modest use of debt. This profile is in line with the long-term averages for the portfolio, excluding 2020 where most companies opted to pause capital returns in light of the COVID-19 outbreak.

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Investments in organic growth

Despite capital expenditures (including spend on both tangible fixed assets and capitalised R&D/software development) commanding the smallest allocation at only $20, they are generally considered the highest priority amongst our portfolio companies. The rationale for this is clear when one considers that the average Price/Book across the portfolio is 8x (i.e. the market is willing to pay $8 for each $1 reinvested) and the  Return on Equity is 30%. On a company-by-company basis, nearly half the portfolio spends less than 10% of profits on capex, a level we would classify as extremely capital light. This isn’t necessarily an indication of meagre future growth, instead it is a reflection of the types of businesses the strategy focusses on. Many of these businesses are software or technology businesses that invest entirely through the P&L or require no capex to grow (Scout24, Morningstar and Softcat are good examples).

Reinvestment via acquisition

The second reinvestment option available to management is to acquire other businesses (inorganic growth). The dangers of M&A are well known in the market with common wisdom suggesting that most acquisitions transfer value from the buyer to the seller and our experience suggests this is the most well-trodden path for management to destroy shareholder value. When explaining the disparity one can point towards a myriad of behavioral biases and principal/agent issues at play, however of particular note is that management are generally compensated based on the size of their organisation, hence it is generally unwise to give them a cheque book.

Somewhat surprisingly, given our aversion to dealmaking, acquisitions were the second largest allocation with the Fairlight portfolio in aggregate spending $40 for each $100 of profits. On a stock-by-stock basis the data is more nuanced, with more than half the portfolio eschewing acquisitions entirely ($0 spent), with a small subset that we label Acquisitive Compounders (profiled here) spending on average $101 on small tuck in acquisitions. This subset boasts a return on capital of 16%, a level at which we hope management can continue to reinvest shareholder capital at for many years to come.

‍Dividends

The simplest lever available to management to return capital to shareholders is via dividends. Generally the Fairlight process is focused on businesses that have reinvestment avenues available to them, resulting in the relatively small dividend payout of $21. The double taxation of dividends (once at the corporate rate and once at our investors’ personal rate), generally leads to management opting for share repurchases when returning capital, a conclusion we are supportive of.

Buybacks

Stock repurchases are currently in particular focus given the Biden administration’s recently passed Inflation Reduction Act included a 1% tax on buybacks, with a further recently announced proposal to raise it to 4%. For the Fairlight portfolio buybacks commanded $41 per $100 of profits, the largest allocation across the four options. While we view buybacks as a tax efficient means to return capital to shareholders, we are wary that management teams can be prone to overpaying, which ultimately transfers value from remaining shareholders to the departing shareholder. The propensity for management to overpay for their stock is not surprising when one considers the behavioral biases at play (availability, salience, overconfidence), with some surveys indicating 80% of all CFOs believe their stock is currently undervalued. With this in mind, Fairlight analyses the historical track record of management teams to develop a view on their ability to repurchase shares without destroying value. Given we are long term investors it is too soon to tell if the money spent in 2022 was value accretive, however it is instructive to revisit 2019:

• 16 out of 33 portfolio companies conducted a buyback program in 2019, spending 56% of cash profits on average

• Adjusting for the price management paid to repurchase the shares, the average return over the ensuing 3 years across the buyback programs was a pleasing 46%

• Of the 16 companies, only two repurchased shares at higher values than today’s market price, delivering returns of -8% and -5% respectively (one of which was a supplier into the aerospace industry, where we are inclined to give some leeway to management for not foreseeing the events of March 2020).
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The outcome of our full analysis on management’s buyback histories suggest that the portfolio has a handful of management teams with truly exceptional capital allocation abilities and the remainder who are aware of their shortcomings and consequently employ dollar cost averaging strategies, a reasonable risk mitigation strategy in our view. Importantly, Fairlight’s investment process results in a portfolio that excludes management teams suffering from delusions of grandeur with regards to their investing abilities.

The Fairlight View

We view the management teams of our portfolio companies as stewards of our and our clients’ capital. While management are traditionally viewed as operators of the business, the decisions made around reinvesting and returning capital form an equally important part of their responsibility and ultimately drive the returns generated for long term shareholders. The Fairlight portfolio is balanced across companies with opportunities to invest organically (CapEx), inorganically (acquisitions) and Stable Compounders that are focused on returning profits via buybacks and dividends. Importantly, we generally look for companies that specialise in one of these options, as we believe that experience and focus are key ingredients for outperformance. Ultimately, in order to meet the quality criteria for the Fairlight portfolio a company will need to demonstrate a value accretive capital allocation strategy and display a track record of consistent execution for many years.

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