What Everybody Should Know: Avoid Big Fool in Capital Allocation

When your business generates cash from operations, you must use it to fuel further growth. Simply holding cash will make your company stagnate and eventually decline.

There are six options for cash allocation: paying dividends, share buybacks, holding cash, paying off debt, mergers and acquisitions (M&A), and investing in operations (like R&D or sales and marketing).

M&A often fails, as seen with Lululemon’s Mirror acquisition, Elon Musk’s Twitter purchase, and SoftBank’s WeWork investment.

It’s not just big companies; smaller firms are now engaging in M&A too. Smaller companies are generally cheaper, with price-to-earnings ratios (P/E) calculated by company price/net profit often below 10, compared to 20 or more for large public companies.

There are two types of investment:

1. Creating new markets: Examples include Amazon’s AWS, NVIDIA’s AI chips, Tesla’s robotaxis, or Meta’s metaverse. If successful, these would be disruptive innovations. This category also includes buying declining companies for turnaround or loss-making companies for potential synergies. However, in many cases, these ventures fail; their profitability is unproven.
2. Buying cash-generating companies at a low price: This is a more reliable strategy. For instance, in 2008, Apple’s stock traded at 5.8 times free cash flow (operating cash minus purchase of fixed assets like equipment) despite rapid growth. During recessions, you can find bargains even among large companies, while smaller ones might trade at just 3 times free cash flow. Recession is the only opportunity to invest, heavily.

Another example is Meta’s stock crash in 2022, when its P/E ratio fell to virtually around 5.

Profits may temporarily drop during recessions, but remember recession will end and profits typically recover within years. However, it’s crucial to check debt levels, cash reserves, and cash flow, as cash shortages can be fatal before recovery.

Also, verify that the business’s competitive advantage (we call it ‘moat’ or ‘unique selling proposition’) remains intact. Increased competition or superior alternatives can force price cuts and harm the business.

The second type of M&A doesn’t require turnarounds or synergies; the company independently generates cash. You only need to put your cash while existing staff handles operations.

Must always have a checklist for M&A, most importantly, the price to free cash flow ratio. For example, a company priced at 5 times free cash flow is a no-brainer buy (but also, check the business can keep its sales price in the future and other things).

These bargains are rare, occurring once a decade. Patience is key. During recessions, most people are afraid to buy, but it’s the only chance to buy a company. Don’t follow the herd; go your own path.