Q&A: How do you evaluate capital reinvestments?
Many companies reinvest their cash flow or new capital back into the business. Sometimes that strengthens the business, and sometimes it goes nowhere. How do you discern smart capital reinvestments from dumb ones that will hurt the business in the future?
I don’t want to overcomplicate this discussion, so let’s start with a simple definition of reinvestment as money a company spends today in the hopes of generating future revenue growth. Fundamentally, this is a question of capital allocation. And, as Warren Buffett says, “Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”
To that end, companies spend money on research and development (R&D), expansion, acquisitions, innovation, etc. in the hopes of strengthening their competitive position and creating future value.
Think about how Netflix spends money (an expected $17 billion this year) on developing content in the hopes of attracting more subscribers. Microsoft acquires startup after startup (a dozen billion-dollar acquisitions alone since 2000, the most of any tech giant) to expand its service offerings. Apple spends money on R&D (to the tune of nearly $20 billion annually) to ensure they outpace the technological improvements of their competitors. In fact, Apple spells out their reasoning in their 10-K statement to the U.S. Securities and Exchange Commission in a way that pretty much summarizes why any company reinvests cash flow:
“The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the company’s core business strategy.”
But not all reinvestments are smart or well-executed, and not all companies have the same reinvestment “runway” (meaning opportunities for reinvestment).
As Buffett says, this is often a question of skill, and poorly handled capital allocation can be devastating to a company’s value. Just ask 2000s era Bank of America, whose overpriced acquisitions and over-expansion led to grim financial losses.
After a high of $54.77 per share in November 2006, Bank of America’s stock began tumbling. It was down by more than half before the Great Recession even began in late 2008.
How can the average investor tell the difference?
It is genuinely difficult to gauge whether the money organizations spend today will actually produce future growth. This puts investors in a quandary: reinvesting capital can be a sign of future value and, furthermore, one that the market hasn’t priced for yet (and therefore offers prime opportunities for a value investor). But it can also be a money pit that drains the company of future value.
Complicating matters, these issues can change rapidly in dynamic markets. Even companies that have seen past success with their capital allocation strategy can begin to have problems if they’re investing on autopilot even when market conditions begin to change.
In general, investors need to make a careful assessment of the company’s behavior and the environment in which they’re making these decisions. Let’s start with some of the fundamental questions we need to ask.
What’s the “reinvestment runway”?
This concept means how expansive the reinvestment opportunities are. Having many reinvestment opportunities means a long runway, few mean a short runway.
There are certain businesses that get competed out and don't have much opportunity for reinvestment; but if the runway is long enough, then you might have something. It's the businesses with a long runway that are special because they’re few and far between.
What’s the larger context in which the reinvestments are being made?
To figure this out, you have to look at the size of the industry, where the company is, where the market share is, what the strategy is, and how past reinvestments have played out (their track record).
Sometimes organizations must reinvest in certain ways just to keep up. Amazon and Netflix seem to be in a race to produce more original streaming content than the other, and other players have gotten in on the act too (like Apple and Disney), in addition to the now-streaming channels that always had original content (HBO). This is a situation where a company basically must reinvest some of its cash flow just to stay competitive.
It’s not just the quality of the reinvestment decisions that matters. It's whether the market is correctly pricing the value produced by those decisions.
Ultimately, however, the math has to work out. If recent reinvestments have been producing slowing returns, that’s a red flag. We want companies that get better as they get bigger. In general, that means you need more than just raw opportunity for reinvestment. The totality of the circumstances must be conducive to producing value.
Think of Facebook, which has spent years buying up companies that could have turned into potential competitors in the social space (like Instagram) as well as those offer more value for users (Oculus virtual reality gaming). Those acquisitions would be worthless if they meant spending money just to spend money, which can happen with companies with too much capital on hand. But, in Facebook’s case, such acquisitions can build on and extend the network effect to strengthen Facebook’s market position.
Is the management team making smart decisions here?
Initial successes with reinvestments can also be derailed if the capital allocation strategy is poorly managed. A company that tries to overdiversify, for example, can find itself spending more money on lower and lower returns on the invested capital. That can indicate a company that’s losing value.
Worse, instead of building a moat against competition, they might be inadvertently increasing their competition because suddenly they’re competing in brand-new sectors where they’re a relative newcomer, don’t entirely know what they’re doing, and aren’t positioned well competitively.
If the strategy isn’t there, the reinvestments will be risky. For example, if 2000s-era Bank of America had been able to acquire Merrill Lynch and Countrywide at a steep discount rather than paying a premium, they might have had a very different experience with those investments, rather than losing money.
Is the market pricing them correctly?
The added dimension to this discussion is the fact that it's not just the quality of the reinvestment decisions that matters. It's whether the market is correctly pricing the value produced by those decisions.
As investors, we don’t make money off insights everyone else already has. We don’t want to invest in a company that’s making bad decisions; but we also don’t want to invest in a company that’s making great decisions unless the market is underpricing relative to the intrinsic value those decisions will produce.
Even great companies can be un-investable if the market is correctly pricing them or, worse, overpricing them.
Back to Bank of America: within just a few years after its stock prices cratered, it turned into the exact kind of company I look for: a major player that is under-earning but is under new management with a clear path to improved revenues in an industry with long-term viability, but also a business the market hadn’t yet rewarded for its improved position.
So, that’s the last question to consider: how does the market currently view that company? If you can find companies that haven’t yet reached maturity and are getting better day by day, but the market is just overly shortsighted, that's a great opportunity.