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The 5 Principles of Quality Capital Allocation

Highlights

What Is Capital Allocation?

Capital allocation in investing refers to the process of distributing and investing financial resources to maximize their effectiveness and efficiency.

It involves identifying investment opportunities, setting financial targets, assessing risk and return, prioritizing investments, allocating resources, and monitoring performance.

By making informed decisions, businesses can optimize their resources, balance short-term returns and long-term growth, manage risk, and create value for shareholders.

Effective capital allocation plays a major part in the business’s overall performance, which drives the price of its stock.

Capital allocation is one of the key metrics I look at when digging into a company, and today I’m going to share 5 things I look for:

Dividends 

When a business is profitable, it can use that money to reward shareholders with dividends.

Dividends are a portion of profits that are paid out to shareholders, and they are typically paid out on some sort of schedule. They could be paid monthly, quarterly, semiannually, or annually.

I mainly search for dividend growth stocks for a few reasons:

• Dividend growth stocks are less volatile

• Dividends are tax-efficient

• Dividends provide me with a recurring passive income stream

• Companies are able to grow their dividends to outpace inflation

• Dividend growth stocks typically beat the market’s returns

• Reliable dividend growth stocks pay dividends through market downturns, helping to mitigate risk

• When reinvested, dividends create a powerful compounding effect that leads to massive returns

Dividends often make up a considerable amount of overall returns, as you can see by this chart:

For a company to pay a dividend, it must have excess cash. Excess cash comes from profitable businesses which are the businesses I choose to own.

Dividend Growth

It’s not enough for me to own a business that just pays dividends, It needs to be growing those dividends at least annually.

Each year money loses purchasing power due to inflation. $100 in dividends last year is not the same as $100 in dividends today and to make up for the effects of inflation, I need the companies I invest in to continue to raise their dividends.

When a company raises dividends, it not only staves off the effects of inflation, it also allows you to buy more shares if you reinvest those dividends.

This creates a powerful compounding effect where your dividends buy more shares and by owning more shares, you get paid more in dividends.

This was a huge key for me to switch to dividend growth investing, It allows your money to make you more money, completely passively.

But not every dividend is guaranteed.

Companies are not required to pay dividends and can suspend them at any time, though it usually results in a huge blow to their reputation.

Although there is no way to combat a company cutting its dividend, there are ways to protect yourself and position your portfolio against this possibility.

Here are a couple of steps I take:

1. Search for businesses with a reliable history of dividend growth. I like companies that have grown dividends for at least 10 years.

2. Make sure the dividend is well covered by profits. I check out the dividend payout ratio which divides a company’s profit by its dividends paid. Anything higher than 60% is a red flag in my opinion, as the company will struggle to maintain its dividend.

Companies that do both are likely to keep paying and raising dividends for years to come.

Share Buybacks

Share buybacks are an alternative way to return capital to shareholders.

Instead of paying a dividend to shareholders, a company can use that excess cash to purchase its own shares.

How does this help you as an investor?

Imagine there’s a lemonade stand with 10 available shares. If you buy one of those shares you become a 10% owner of the business.

Let’s say the lemonade stand has a really good year and they decide to use their extra money to buy back shares. The lemonade stand buys enough shares to lower the share count down to 5.

Now the 1 share you own entitles you to 20% of the business.

Owning companies that increase your ownership stake rather than dilute you is a huge cornerstone of my approach.

Keeping Debt Low

I like companies with low amounts of debt for a few reasons:

• They’re financially stable

• They’re lower-risk

• They have more freedom to allocate capital efficiently (instead of paying debt, they can pay dividends or grow the business)

When a business has high amounts of debt, it's at risk for:

• Higher interest expenses (which reduces profitability)

• Increased vulnerability to economic downturns

• Bankruptcy

Having a good balance sheet is the cornerstone of a stable business. By owning companies with more assets than liabilities, you’re entitled to what is known as shareholders’ equity.

Shareholders’ equity is the assets that are available to all shareholders after all debts have been paid. If the company were to be liquidated, this is what would be divided amongst shareholders.

Avoiding Excessive Acquisitions

The last thing I look at when assessing a firm’s capital allocation policy is its previous acquisitions.

Not all acquisitions are bad, but there are multiple risks associated with them that should be considered.

One risk is the possibility that company cultures can clash. This would create problems for shareholders because management will likely struggle to take the business in one unified direction.

Another big risk when it comes to acquisitions is the risk of overpaying. When companies overpay for acquisitions, a few things happen:

When looking at a firm’s acquisition history I ask myself a few questions to make sure it’s been an effective use of capital:

Does the acquired firm make the business stronger? If so, how?

Will the acquired business help position the company for the future?

Has the return on invested capital increased or decreased since the acquisition?

If acquisitions are done poorly, the company will rack up debt and destroy shareholder value.

Final Thoughts

Management’s ability to allocate capital is one of the key things I look at when digging into a company.

And it can make or break a firm.

While I prefer that a company pays out dividends and grows them annually, not every business in my portfolio has to follow that same strategy.

Other companies can excel at capital allocation by buying back shares at good valuations, avoiding big acquisitions, and by keeping debt levels low.

My A+ stock setups include all of these characteristics and are my highest conviction stocks.

The next time you’re researching a company, be sure to examine how they allocate their capital.

You want to be rewarded as a shareholder, not diluted.

Until next time,

Dr. “Capital Allocation” Dividend

Links & Memes

Here are some of the best things I saw this week:

• The story of magician Harry Houdini’s incredible feat in Boston – this story involves jumping off of the Mass Ave bridge handcuffed and having the confidence to try.

• How some of the most well-known brands got their names – who knew Google was originally called BackRub?

Here are some of my favorite memes from the week:

New Episode Of The Dose Of Dividends Podcast!

This week I sat down with Mike, a 42-year-old financially independent dividend growth investor from Canada!

You may know him as @thedividendguy on Twitter.

Mike and I chat about:

• How he started investing

• His background as an underwriter

• The crazy leap he took to becoming an investor

• How he became "The Dividend Guy"

• What he looks for in an investment

• Why people should consider investing in Canada

• Industries we won't invest in

• Our favorite pizza toppings

• Places we've traveled

• Books we swear by

Listen for free on your favorite podcast player by clicking here.

Let me know what you think of this episode!

If you loved it, please rank it 5 stars! It goes a long way and means a lot to me :)

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