The Capital Allocation Playbook (Part 3)

Jacob Levy writes in “The Rebel Allocator”:

At the most basic level, [capital allocation is] how you decide to spend money.  But it’s even deeper than that.  Successful capital allocation means converting inputs like money, materials, energy, ideas, human effort, into more valuable outputs.  It’s that transformation process.

… Capital [can be viewed] as goods, both tangible and intangible, that were previously produced that aren’t directly satisfying a human need yet.  Capital is whatever bits, atoms, or energy that are available to eventually produce something that delights a customer.

… Businesses that make great capital allocation decisions deliver higher returns for their shareholders.  They earn higher returns on capital and they don’t squander the money once they earn it.  In fact, it’s hard to imagine a higher-leverage effort for an investor than improving management’s capital allocation skills.

… When leaders choose projects, employees come naturally attached.  When management makes the wrong decision and is forced to change course, the collateral damage rains down on the helpless employees.  Writedowns, restructurings, and layoffs represent failures of past decisions, of bad capital allocation.

… Good capital allocation means doing more with less to create happier customers.  The pressure to continually deliver value is one of the wonders of the free market.

… Imagine that inside you are all of these different locks.  Each lock represents one of your wants or desires … Now imagine that each capital allocation project creates one key.  Ideally, the entrepreneur knows the lock their key will fit beforehand.  A restaurant provides you food, a hotel gives you shelter, shoes protect your feet.  The role of business is to use the least amount of resources to create the key that fits a certain lock.  Doing a proper job spares resources to create more keys for other locks.  In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so.  When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.  That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.

He quotes Warren Buffett from his 1987 letter to Berkshire shareholders: “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes, institutional politics. Once they have become CEOs, they now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall, but instead, to be named Chairman of the Federal Reserve.”

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Rajesh Jain

An Entrepreneur based in Mumbai, India.

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