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10 Key Principles for Effective Capital Deployment: Part 1

Here are the principles that provide a foundation for establishing an enduring capital deployment process to drive long-term value creation.

This is the first of two articles addressing capital deployment.

Capital deployment decisions are among the most important strategic choices facing managements and boards. However, it can be difficult to choose between investing organically or acquisitively in the business versus paying down debt, building cash, or distributing capital via dividends or share repurchases.

Some companies are better off distributing more while others should emphasize investing. But many find the tradeoffs to be unclear, because companies often use different metrics for evaluating the different options. This complexity is best dealt with by establishing principles to guide management and designing processes to rigorously follow those principles.

We’ve identified 10 key principles for effective capital deployment that provide the foundation for establishing an enduring capital deployment process to drive long-term value creation. The first five principles appear below; the other five will be covered in the second article of this report.

Principle 1: The Top Priority Is Survival

To have an opportunity to achieve success, company leadership must first circumvent complete failure by ensuring business survival. Management must avoid excessive risk-taking, provide adequate financing capacity and liquidity, and protect important tangible and intangible assets, including key personnel, brands, technologies, and other essential differentiators.

Many business failures are avoidable with adequate forethought and planning, but most truly difficult challenges come from underestimating change.

For example, companies producing record albums when CDs were introduced in 1984 probably expected a more gradual transition, but what they got was an abrupt upheaval. By 1990, most music was purchased in the form of CDs. And then CDs were replaced by electronic content ownership, which has now been replaced by streaming. What’s next?

Survival is obviously the top priority, but most managements don’t pay enough attention to change. Management must devote resources to identifying potential threats to survival and then act to get ahead of change and turn these potential threats into opportunities.

The biggest obstacle, of course, is short-termism, which is reinforced by overconfidence, procrastination, and a distaste for cannibalizing existing products or services. It also doesn’t help that many managers feel they can readily influence their own short-term compensation but often view long-term incentives as a bit of a lottery.

Management processes and incentive compensation must be structured to explicitly address and reduce the impact of each of these obstacles.

Principle 2: Buy Low and Sell High — Really

To emphasize net present value in capital deployment requires a mindset of always buying low and selling high. In the movie “Caddyshack,” Rodney Dangerfield bellowed into his golf bag phone, “What’s that? Then sell! Oh, they’re selling? Then buy!” Audiences laughed because of the absurdity, but also because of the cliché.

Still, clichés are clichés for a reason, and the value of selling when others are buying, and vice versa, is obvious to the vast majority of investors. But corporate executives tend to do the opposite. It can sometimes be difficult to tell when prices are too high or low, so executives must pay careful attention to cycles and rely on thoughtful analysis to actually buy or sell assets when prices are favorable.

One important way to do this is to explicitly factor the expectation of operational, financial, and other cycles into planning and decision-making.

One oil and gas CFO explained how he uses the same midrange oil price when considering the acquisition of new oil and gas reserves, regardless of where the industry is in the commodity price cycle. That way, he tends to buy more reserves when they are cheap and fewer when they are expensive.

For companies in industries that don’t experience much cyclicality in financial performance, it’s still important to pay attention to market cycles.

From the 2007 peak to the trough of the market in the 2009 financial crisis, the median utility company suffered TSR of –41%. Utilities are not viewed as being cyclical. Indeed, the median utility, Exelon, saw its EPS increase slightly from $4.03 to $4.09 from 2007 to 2009, while its EBITDA increased 9.5%.

Sp why was its TSR–41%? Market fear. Exelon acquired no competitors that year, but perhaps it could have improved its long-run performance by buying a very stable competitor that would have essentially been on sale.

Principle 3: Don’t Follow the Crowd

Make it a strong policy to never select capital deployment choices because some loud shareholders ask you to do it, or because bankers say everyone is doing it, or because you overheard on the golf course…

Gregory V. Milano

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