This article was featured on The Business Times.
Any decision to grow should be based on how much capital is needed, the expected returns, and the time taken to achieve these returns. Business growth is often celebrated. Yet, not all growth is good for shareholders.
Tom Murphy, the former CEO of Capital Cities, once summed up this approach with a metaphor: “The goal is not to have the longest train, but to arrive at the station first using the least fuel.” Here, the train symbolises a company’s size while the fuel represents the capital required to grow.
The essence, then, is not about building a business empire but making prudent decisions about capital investment to achieve optimal returns.
The price Starbucks paid for growth
Starbucks’ (NASDAQ: SBUX) aggressive push for growth in the 2000s serves as a poignant case study.
The coffee brewer’s rapid growth led to internal competition among its stores for the same customers, diminishing returns, and also eroded the unique Starbucks experience.
Things came to a head in 2008 when Starbucks announced the closure of over 660 outlets, or 4% of its store base, leading to restructuring costs of US$267 million.
In another sweeping move, the company temporarily closed all 7,100 outlets for extensive employee training.
Shareholders paid the steep price for its haphazard pursuit of growth, as Starbuck’s stock price plummeted 54% in 2008 due to concerns over its overexpansion and a looming global recession.
Unfortunately, the above was not the end of Starbucks’ bad capital allocation decisions.
In 2012, the company attempted to diversify – or rather “diworsify” – into other business lines.
This initiative included a US$100 million acquisition of La Boulange, only to shutter the brand three years later. Similarly, a hefty US$620 million was spent on Teavana, which led to the closure of all 379 locations by 2018.
These decisions to grow and “diworsify” despite diminishing returns is a timely reminder that shareholders would have fared much better had the coffee chain concentrated on its core competencies – coffee and customer experience.
Starbucks’ missteps serve as a prelude to Warren Buffett’s $1 test, a critical tool for assessing whether management’s decision to reinvest retained earnings actually improves shareholder value.
Buffett’s $1 test
Buffett’s test is based on a simple idea: a company should only retain earnings if they can create at least a dollar of market value for every dollar retained.
This criteria ensures that the money kept by the company works as hard as, or harder than, it would in shareholders’ hands.
Suppose you own a 10% risk-free bond with an unusual feature, each year you are given the option to either take the 10% coupon in cash or reinvest it in more 10% bonds.
Assuming you don’t need the money, your decision to take the coupon in cash or reinvest it should be based on one factor—what’s the latest interest rates offered by these risk-free bonds today?
If the prevailing rate falls to 5%, then reinvesting into your existing 10% bonds is the better move because this 10% interest rate is more than what the market currently offers.
However, if the prevailing rate rises to 15%, then you wouldn’t want to reinvest in the 10% bond. Instead, you should take your coupons and invest them in new bonds with a 15% interest rate.
This bond analogy applies to a company’s earnings too.
If the profits can be reinvested at higher returns than the shareholders could earn themselves, then the earnings should be retained.
On the flip side, companies should return these earnings to shareholders through dividends or share buybacks if they are unable to deliver better returns.
Henry Singleton’s masterclass in capital allocation
Another example to follow is Dr. Henry Singleton, the former CEO of Teledyne Technologies (NYSE: TDY).
Singleton exemplified exceptional capital allocation, earning praise from Buffett as the business leader with “the best operating and capital deployment record in American business.”
In the early 1960s, during a time of market exuberance, Teledyne was well-regarded as a disruptive player in the semiconductor and aerospace industry; hence, its share price soared.
At this point, Singleton could have bought into the narrative that the laws of valuation don’t apply to his company, similar to dozens of CEOs of “disruptive companies” today. But he didn’t.
Instead, Singleton recognized the inflated valuation of Teledyne’s stock, which was trading as high as 50 times earnings back then.
Astutely, he used the overvalued stock to acquire other companies, effectively building Teledyne’s diverse portfolio at a fraction of the cost.
However, when market sentiment shifted and conglomerates fell out of favour, Teledyne’s stock price plummeted.
Adapting to these new circumstances, Singleton initiated a massive share repurchase program when its stock was trading below 10 times earnings.
From October 1972 to February 1976, Teledyne’s shares outstanding decreased by 64%. By 1984, Singleton had retired about 90% of Teledyne’s stock.
This strategic shift in capital allocation paid off handsomely.
Investors who bought Teledyne stock in 1966 would have enjoyed an annual return of nearly 18% over 25 years, or got back 53 times of their investment versus less than seven times for the S&P 500.
The end-result is a testament to Singleton’s unparalleled capital allocation skills.
The key to steady compounding: wise capital allocation
Increasing shareholder value is not just about growth, but judicious capital allocation. The Starbucks and Teledyne case studies serve as a reminder that growth is not an end in itself, but rather a means to an end – with the desired result being the creation of shareholder value.
We should always scrutinise management’s capital allocation decisions, applying Buffett’s $1 test: are they creating at least a dollar of market value for every dollar retained?
Take note: our returns are inextricably linked to these capital allocation decisions.
As Buffett quips, “over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”
In the end, it’s how efficiently capital is used to pursue growth that drives shareholder value, and not the size of the company alone.
In the absence of good reinvestment opportunities, shareholders are better off if management simply returns excess capital via dividends or share buybacks.
Disclosure: Thomas Chua does not own any of the stocks mentioned.
The writer is the founder of Steady Compounding (https://steadycompounding.com/) a website that aims to empower investors with lessons from super investors, stock analysis and market insights.