This is Part 6 in a series on the expertise of capital in business. You may read the previous part here.
This is a companion discussion topic for the original entry at https://commoncog.com/build-valuable-business-how-you-spend-it
This is a companion discussion topic for the original entry at https://commoncog.com/build-valuable-business-how-you-spend-it
The idea that every dollar of retained earnings should result in at least a dollarâs worth of added value reminds me of a disconnect Iâve felt when I look at how public companies are treated in the financial press. This comment is a confession of my ignorance, so please read with that in mind.
It makes sense to me that a company might choose to retain earnings and invest at specific points in their lifecycle, as Amazon did early on to grow their overall engine. However, I feel like a lot of companies have no plan to return their retained earnings to shareholders. Dividends are infrequent among major companies and share buybacks also tend to be special occasions rather than a standard operating procedure. Without dividends or buybacks, the investor seems to be expecting to get the entirety of the value of their retained earnings via selling at a higher price. But playing that scenario out, and if a company never pays out dividends, then a companyâs shares would only grow their value if the company exists in perpetuity AND is at least maintaining their cash flows indefinitely. That seemsâŚimplausible when judged against the historical record of publicly traded companies.
I donât know how to reconcile this disconnect, because it seems like the investment community as a whole is just hoping to sell to someone before the bottom falls out, but these folks are very smart and so I feel like I must be missing something.
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On a separate note, I just finished reading The Outsiders and I feel like the book was missing a critical piece. Welch is portrayed as a whipping boy for CEO value creation because he actually was dwarfed by the effectiveness of the outsider CEOs. It is implied, but not argued, that Welch was interested in growth for growthâs sake instead of maximizing shareholder value. I think the argument would have been a lot stronger if there was an exploration of what Welchâs goals were in the various acquisitions he made.
The reason I feel like this is a significant gap is that the thesis is that the outsiders were more effective in deploying capital because they thought differently about value creation. But, the outsiders included several CEOs who grew their organizations through acquisitions that were tremendously successful.
If Welch thought that his acquisitions would get a higher rate of return than his hurdle rate, then the key contrast becomes whether the CEOs were right about their projections, not about how they thought about deploying capital. âWelch could have saved money on operations by shrinking the home office, and was not good at evaluating potential acquisitionsâ might be a true thesis, but itâs substantially less interesting to me than the suggested thesis that Welch was, in effect, thinking about capital deployment wrongly. If the real contrast is that Welch was worse at evaluating potential targets, then I would have liked to learn more about why.
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I took some time to reply to your comments, @colin.hahn, because your questions strike at remarkably deep questions.
This is by-and-large correct with only a few corrections.
In theory a business may be sold for parts and the book value of assets (property, equipment, etc) returned to shareholders. In practice this rarely happens. We have, collectively, agreed to believe in a story, and the story is this: we somehow believe that a âshareâ represents a slice of ownership in a thing that generates a stream of cash, and so therefore the price of that slice should represent a claim of ownership on the stream of cash that the entity will produce from now into the future.
This is what people mean when they say that companies are valued based on the âcash flows discounted back into the presentâ. And, to be clear, there are some companies whose cash flows can grow for a ridiculously long time, resulting in share prices that climb for ridiculously long times: think Costco, for instance, whose moat is large and growing and whose management is dedicated to expanding the entire empire at a slow and steady rate for decades.
But of course thatâs in theory. In practice the price of shares are what people are willing to pay for it, and sometimes stories about the companies (or stories about the future level of cash flows) take hold, and then the prices are dislocated from this âtrueâ level of cash flows that will be discounted back into the present (although what is âtrueâ, really 
).
At which point you might say âgod, this thing is overpriced, the market is crazy, let me just sell because they believe in a story that just isnât trueâ and you take advantage of your superior judgment and their poor judgment.
But, yes, to summarise it cynically, I think:
it seems like the investment community as a whole is just hoping to sell to someone before the bottom falls out, but these folks are very smart and so I feel like I must be missing something.
Is broadly correct. The main caveat here is that there are several companies that are so wonderful and can continue to grow their future cash flows for so long that the bottom doesnât ever fall out during your lifetime. Value investors call these âcompoundersâ or âquality companiesâ or (Buffettâs words) âgreat companies at fair pricesâ ⌠the idea is you just buy and hold, because you believe they cannot ever be killed before you die. This is Buffett with Coca Cola, for instance.
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One other thing to take into account is that the stock price is an amalgam of people playing different games, to use Morgan Houselâs description. Some investors are momentum investors, trying to make money off trends that can play out in days or seconds. Others are value investors, looking for long-term buy-and-hold. Theyâre all in the stock market, but their goals and incentives are vastly different, so summarizing all of those investor types in the one number of a stock price feels hopeless.
That being said, it feels like the great long-term investors do evaluate companies based on long-term defensible cash flows, which may or may not be reflected in the stock price.
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Recently, I have reflected on the insight that part of the excellence of great capital operators is being willing to not make moves just for the sake of activity. Take General Cinemaâs Dick Smith: he is waiting for a decade because he doesnât see an investment that is worth investing the capital he has available. Iâm trying to figure out what this looks like in practical terms: what is he actually doing on a weekly basis for that decade? And how is he articulating the value of what is doing (and what he is NOT doing) to the Board?
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