The twitter thread by @LAForeverHall is full of interesting ideas. One topic that she mentioned a few times is capital allocation. But rather than discussing it in the typical sense of looking at it from the perspective of financial statements, she took a more qualitative approach to how to analyze it. Most interesting was the idea of using capital to shape the world to conform to the company’s ideals.
Known/Known Opportunities
The easy and most prevalent way a company allocates capital is to look at the current economic landscape, analyze the current opportunity set of investments a company can make in that landscape, and allocate capital to the ones that will generate the highest return. The return analysis on these investments usually involves assuming the current economic environment will remain roughly the same for the next several years and the industry will remain roughly the same. Executing on these investments is still difficult and takes skill, but it’s a more quantitative skill and qualitative. It’s also an easy sell to investors. The returns generated by these investments will likely have little effect on a company’s future cost of capital. It’s unlikely that the expectations built into a company’s stock price is much different than the return expectations of known/known opportunities.
Known/Unknown Opportunities
The next scenario is when the company has a set of investments opportunities in front of it but the returns are less assured due to a changing economy and/or an industry in the midst of change. The company, unless it is the dominant player in the industry (simply has greater influence but not immune), is at the mercy of change. Rather than simply examining the highest returning investment possibilities, the company now must run scenario analysis on how each investment will react depending on the outcome of the fluid economic environment. These investments will require a greater margin of safety in order for them to generate returns greater than the company’s cost of capital. It is also going to require a greater amount of qualitative skill for managers to sell the investments to investors. In a fluid economic environment, the manager has to convince investors that a) the company understands the current environment, b) has a strong understanding of the possible outcomes and the probabilities of those outcomes, c) the assumed returns of the investment have a margin of safety associated with them, and d) these investments will place the company in a strong position once the environment has settled.
If a company can execute, both situations can lead to wonderful investment opportunities. But real magic happens when as @LAForeverHall puts it “Narrative management + capital allocation alters intrinsic value.”
Unknown/Known Opportunities
This scenario is when the company doesn’t know the exact set of investment opportunities but it knows how it wants the industry/economy to look going forward. This is Netflix, Uber, Tesla (also see Wait But Why), Amazon, Ford in the early 20th century, Walmart in the 70’s and 80’s. Each company is an example of not knowing what the exact investment opportunities are going to be but a clear understanding of how it expects the world to look once the company has made those investments. This is essentially what venture capital is investing in. But public market investors were making the same type of investment at the IPO of Netflix, Tesla, Amazon, and Walmart. These type of investment opportunities don’t work nicely with a typical DCF model.
