Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 13

Capital allocation and management ability – Part 2

In last week’s Cuffelinks, I showed this table, where a company with a profit of $50,000 was trading on a price to earnings ratio of 10, to give a market capitalisation of $500,000. It did not pay a dividend, and in the second year, it made a return on equity of 5% again, giving it $52,500 in net profit. I left you with the question, with profits and market capitalisation rising, what’s the problem?

Table 1: How to lose money despite profits and capitalisation rising

On the surface things look rosy. The company is growing, equity and profits have increased and management is no doubt drafting an annual report that reflects satisfaction with this turn of events. But not all is as it first appears. Indeed management has, perhaps unwittingly, dudded shareholders.

Dividends and capital gains

As a shareholder your return is made up of two components – dividends and capital gains. If two dollars is earned and you don’t receive one of those dollars as a dividend, then you should receive it as a capital gain. If, over time you don’t, it has been lost and management may be to blame. Every dollar that a company retains by not paying a dividend should be turned into at least a dollar of long-term market value through capital gains.

The company has not achieved this and unfortunately lost its investors money. Even though the company appears to have grown – remember equity and profits are indeed growing – the reality is that as a shareholder you have lost money. How? The company ‘retained’ all of the $50,000 of the profits it earned in Year 1. You received no dividends. All you got was capital gain but the capital gains were only $25,000. In other words the company failed to turn each dollar of retained profits into a dollar of market value. And so investors have lost $25,000. If the situation were to continue, you should insist that the company stop growing and return all profits as dividends and if that is not possible, the company should be wound up or sold.

What happened to the other $25,000? You didn’t get the money as a dividend and you didn’t get it as a capital gain. It was lost. The only way of receiving it is if the price earnings ratio went up. That would require people to pay more for the shares and hoping for that to happen would be like betting on number 5 in race 7 or betting on black. And that is speculating not investing. It might happen but there is no way of predicting it. The worst business to own is one that consistently employs growing amounts of capital at very low rates of return. This is because for a low-return business demanding incremental funds, growth harms the investor financially.

By retaining money, the company is hurting investors as it expands. The reason for retention of profits is largely irrelevant because, either the money needs to be retained which makes it a poor business or management chooses to retain which makes them poor decision makers.

Many investors don’t understand this very real way of losing money even when the company is reporting profits. But investors aren’t the only ones for whom this lesson is lost. A large number of company directors don’t understand this ‘loss’ either or, if they do, they apply their knowledge with a dose of schizophrenia. Inside their businesses, they employ managers in a variety of divisions, who in turn conduct analysis to determine whether to expand their domain. If the returns aren’t high enough they don’t invest in expansion, instead sending the profits back to head office to be invested elsewhere for higher returns. But when the whole business isn’t earning a high return on equity, those same directors often don’t send the money back to the owners to be invested elsewhere. They keep the money! They find something to buy or they pay themselves more. And some, even if they do pay the profits out as a dividend, replace what they paid out by raising money through a dividend reinvestment plan or some other form of capital-raising. This is not a problem for a high return business, but it is reprehensible for a low return business with few prospects of improving its earning power (return on equity).

Back to our company above, many chief executives will present its results in the annual report as reflective of a great year. What they won’t say is that they have lost half of your money!

Thanks to return on equity, we are able to assess management’s treatment of shareholders and discern whether they are favoured or flouted.

Management act like owners

It is important to look for businesses where management act like owners and treat shareholders like owners. Keeping funds for growth when the returns are low is not acting like an owner. A manager who behaves this way is not treating you like one either. As Adam Smith observed in 1774, it is almost impossible to align the interests of a manager with those of the owner when the manager is merely employed to manage the company on the owner’s behalf.

The decision by management to pay dividends or retain profits falls under the heading of ‘capital allocation’ and when managers are making capital allocation decisions, it's essential that they increase the intrinsic value of the company on a per-share basis and avoid doing things that destroy it. In Part 3 of this guide, I will show how allocation decisions can have a material impact on the per share intrinsic value of a company. For executive directors, while it is important they understand how to run the business to its full potential, this knowledge and the positive results are wasted if the board knows little about capital allocation.

The above example demonstrates that a company with a low rate of return on equity will lose money for its shareholders if profits are unwisely retained. As Warren Buffett further observed, if profits are unwisely retained it is likely that management have been unwisely retained too.

 

Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund.

 


 

Leave a Comment:

RELATED ARTICLES

Companies crying wolf

Equity income investors should focus on reinvestment rates

Not all growth is good

banner

Most viewed in recent weeks

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Welcome to Firstlinks Edition 606 with weekend update

The boss of Australia’s fourth largest super fund by assets, UniSuper’s John Pearce, says Trump has declared an economic war and he’ll be reducing his US stock exposure over time. Should you follow suit?

  • 10 April 2025

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

Investment strategies

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Investment strategies

Does dividend investing make sense?

Dividend investing offers steady income and behavioral benefits, but its effectiveness depends on goals, market conditions, and fundamentals - especially in retirement, where it may limit full use of savings.

Economics

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Strategy

Ageing in spurts

Fascinating initial studies suggest that while we age continuously in years, our bodies age, not at a uniform rate, but in spurts at around ages 44 and 60.

Interviews

Platinum's new international funds boss shifts gears

Portfolio Manager Ted Alexander outlines the changes that he's made to Platinum's International Fund portfolio since taking charge in March, while staying true to its contrarian, value-focused roots.

Investment strategies

Four ways to capitalise on a forgotten investing megatrend

The Trump administration has not killed the multi-decade investment opportunity in decarbonisation. These four industries in particular face a step-change in demand and could reward long-term investors.

Strategy

How the election polls got it so wrong

The recent federal election outcome has puzzled many, with Labor's significant win despite a modest primary vote share. Preference flows played a crucial role, highlighting the complexity of forecasting electoral results.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.