Can capital be allocated intelligently?

Capital allocation is an important business for an investor. For an investor, his long term returns are controlled by answers to these two questions- where to invest and how much to invest.Most of the portfolio allocation done in contemporary financial scene is based on individual conviction of the idea and cash at hand .

Little thought is given to opportunity cost and the end goals in mind. However investors like Warren Buffett and Charlie Munger, they approach the question of portfolio allocation in a different way. Their allocation strategies revolve around opportunity cost and quality of the business.  They have become so adept at valuing businesses that their conviction decides whether to conduct the investment operation at all or not. Thus with one of the big factors taken care of, they focus on the quality of business. Cash for Berkshire Hathaway can be assumed to be in abundance which it mostly is.

When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us.  It may not be risky for someone else who understands the business… However, in that case, we just give up. 

-Charlie Munger

However for the rest of us, all the factors play their part. So the question remains, how to do portfolio allocation intelligently? I would like to answer it in a different vein.
Intelligent Investment is always done with an end goal in mind. Intelligent investing also involves an objective study of an investment’s quality and the numerous costs involved. Most of the costs are quantitative in nature and is visible. However the opportunity cost is something which is invisible and not tangible. Hence an ideal portfolio allocation strategy should take care of opportunity cost.

Keeping this idea in mind, it will be worthwhile for an investor to see himself not as an investor but one running a company. As a result he being the manager has to make capital allocation decisions on different sectors of the business where each such sector will fetch different returns.

In corporate decision making the desirability of these decisions are made in terms internal rate of return(IRR). In this case it can be measured through the company’s return on capital employed (ROCE). Thus all things equal, the investor must try to maximise his portfolio’s ROCE, by investing in high roce businesses and ignoring low ROCE businesses. This will automatically move towards minimization of opportunity costs.

 “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” 

-Charlie Munger

However acquiring ROCE also has its own cost, and an investor has to shell out monies to acquire that investment vehicle. As a result, his investment returns are indirectly proportional to the original principal he invested.

Imagine a company with excellent business fundamental and high ROCE. However it is trading at a very high premium. So even with such business fundamentals no tangible returns are made for the the next, few years. Hence there is a fall in time value of money and this is a cost.(since 100 Rupees today is not the same as 100Rs 5 years later).

Thus an investor should aspire to maximise his portfolio’s ROCE at the minimum cost. For an investor, the ROCE of his investment operation will be the weighted average roce of the constituent companies in his portfolio. As for the financial cost to acquire such investment vehicles, a weighted average of the ratio of enterprise value to maintenance free cash flow should be the the other parameter of such a portfolio.

Hence if we imagine a portfolio to be uniquely identified by its ROCE and Cost, then a portfolio with higher ROCE should outperform in the long run  the portfolio with a lower roce, given everything else being equal.Similarly, a lower cost portfolio will outperform a costlier portfolio for the same ROCE. However for the interesting case, of high ROCE and higher cost, a portfolio consisting of such stocks in generally outperforms another portfolio of lower ROCE and lower cost(provided the premium of the first portfolio is not very high). This perhaps can be explained using two concepts.

The growth in book value can be found by, multiplying the amount invested with the excess of ROCE over the weighted average cost of capital. As a result, this excess is the rate at which the invested capital compounds. Since compounding is a nonlinear phenomenon and a 100bps change in the compounding rate can create disproportionate effects over the long run, hence the effect of higher ROCE dominates over the effect of higher cost.

A related an interesting extention of the idea can be found here, by Shyam Pattabiraman: http://bit.ly/PpQTaN

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