The Importance of capital allocation and the need to communicate

April 20, 2020

History has shown that companies which achieve a high return on invested capital outperform the market and achieve a premium rating. To a large extent, this is symbolic of management’s track record in allocating capital. Investors trust management to do this optimally based on their expert understanding of the inherent opportunity within their business, the sector and the broader landscape in which they operate.

 

 

Capital allocation is the process of distributing a company’s financial resources with a view to enhancing the company’s long-term financial stability. It should be focused on value creation and providing fair returns to providers of risk capital. Capital allocation decisions are made by the company’s board and management. These decisions will contribute to the pace of growth and the risk profile of the business, and may have a profound effect on its long-term health and long-term investment returns for its shareholders.

 

Understanding the importance of capital allocation, Aprio Investor Relations was commissioned by a long-standing and established client to engage their shareholders in this regard.

 

 

Capital allocation increased in importance as the company emerged from a period of high gearing and supressed sector dynamics. The business is capital-intensive and highly cyclical in nature, with long project-lead times that often take years to generate returns. This presented the board and management with a difficult decision as to which opportunities were best positioned to build long-term value.

 

 

Although much of the feedback was company-specific, the research revealed insights relevant to all companies.

 

 

1. Companies should focus on generating value by being responsible and, to some extent, conservative in how capital is deployed. There was resounding support for returning cash to shareholders. Similarly, there was resounding resistance to dilution from equity raisings. Summary indications are that the highest return on investment and effort would be achieved by:

 

• Maintaining sustainable operations by optimising the current asset base and growing through extension rather than acquisition
• Enhancing margins by reducing costs
• Leveraging the current cycle to strengthen the balance sheet and reduce debt
• Most importantly, returning cash to shareholders

 

 

2. Environmental, Social and Governance (ESG) aspects are becoming increasingly relevant in capital-allocation decisions, with higher demand for transparency regarding quantum, returns as well as direct and indirect long-term benefits.

 

 

Participants viewed allocation of capital as management’s primary objective, and critical to the success of sustainable value creation by companies.  To this end a holistic and coherent communication of the company’s strategy is key, particularly how it will drive long-term sustainable returns for shareholders and other stakeholders.

 

 

Improving communication and enhancing dialogue between companies and investors can lead to mutual understanding between providers and users of capital, resulting in reasonable and informed expectations from investors. Moreover, it brings the long-lasting benefit of building trust between management and investors, allowing both to focus on the long-term.

 

Reference: ICGN Viewpoint, International Corporate Governance Network, July 2019