Why a Company’s Management and Capital Allocation Matter

Any investment opinion about a company is also about the efforts of the people who work for and manage it.

Keep this in mind when you evaluate companies as investment opportunities. That can help you gain valuable perspective on some of the qualitative factors you should focus on.

At Morningstar, we believe capital allocation—how management uses excess profits—is a fundamental driver of shareholder returns.

Therefore, we capture our analysis of a company’s management in the Morningstar Capital Allocation Rating, which measures how management handles balance sheet health, investment efficacy, and shareholder distributions.

Here, we cover some of the most important questions you can ask and sources you can use to evaluate the people who run public companies and their approach to capital allocation.

Why Management and Capital Allocation Matters

Technically, the management team of a public company works for the company’s owners: its investors, also known as its shareholders.

But in practice, as corporate and investing cultures have evolved, the relationship between shareholders and company managers has become ritualized and more distant.

We believe that by identifying and investing in companies that have demonstrated their commitment to treat shareholders well, individual investors can reassert their influence on the day-to-day choices and priorities that companies set.

Let’s imagine you have decided to start a lemonade stand with your neighbor. When you meet to go over your plans, your neighbor brings a pound of sugar for the lemonade. Such a gesture demonstrates they are committed to following through on their part of the deal.

Similarly, when you view a home for sale, you expect it to be orderly, and that the owner will arrange for you to see it. In this way, the seller has demonstrated his commitment to doing the things that are necessary for you to be comfortable buying the home. If it’s a hassle to view the home, or it’s disorderly when you view it, that should prompt questions about how the later stages of negotiation and closing will be handled.

Now imagine that you are considering buying part of a business, potentially to keep and to profit from for a long time. What signs should you look for that the company’s managers are interested in doing business with you?

Investors should look for companies that offer clear communication about the business, have established a clear separation between business and personal relationships, and have set clear goals for measuring progress in conducting the business. In practice, these goals often involve raising barriers or instituting policies meant to inhibit human nature.

By examining the outward signs of how a company’s management team behaves and rewards itself, we can surmise how committed they are to honoring their role as stewards of investor capital.

What Is Capital Allocation?

We believe that the three elements of a company’s management outlined above—balance sheets, investment, and shareholder distribution—are the key inputs that can help investors answer this question.

• Balance sheet management. A firm’s financial health directly affects its ability to invest in future growth opportunities, return cash to shareholders, or even remain a going concern (that is, continue operating indefinitely). The ability to remain a going concern is the lowest hurdle that investors need to consider for an equity investment.
• Investment efficacy. This describes either reinvestment in a business or acquisitions. Investment contributes to future shareholder returns, particularly if a firm is investment-intensive. The success of that new investment—that is, the return on invested capital that it generates—increasingly drives overall returns.
• Shareholder distributions. We consider the appropriate amount to return to shareholders, and the form.

We use these inputs to assign companies a Capital Allocation Rating of Poor, Standard, or Exemplary. These ratings reflect how confident we are that management will use the company’s excess profits in a way that maximizes the firm’s efficiency and serves investors.

Below, we describe what each of these inputs looks like in practice.

Number One: Balance Sheet

Morningstar analysts pay close attention to how companies manage their balance sheets. They consider if a firm has reasonable or excessive financial leverage and how the balance sheet will likely evolve.

Our top considerations for balance sheet assessment include:

• Prioritization of debt repayment.
• Sufficient cash flow to make meaningful improvement.
• Adaptability in the event of an economic downturn or material company-specific risks.

This helps signal that the company can make the necessary and appropriate investments to set it on a path to add value and build its moat.

The specifics of our standards for a balance sheet will vary by firm and industry—but if a company’s balance sheet is solid, that doesn’t automatically give it an Exemplary rating. Rather, the other two inputs—investments and shareholder distributions—become decisive in determining its rating.

Number Two: Investments

The second input to our Capital Allocation Rating is an assessment of the investments a company makes. These investments—and, in turn, the return on this invested capital—are what drive a company’s earnings and typically what drive future shareholder returns.

We evaluate the efficacy of these investments and how likely they make it for a firm to grow earnings materially. We include an assessment of:

• Strategy: Does this investment stand to help a firm enhance its economic moat?
• Valuation: Is the company investing at the right price?
• Execution: Do we think this strategy is achievable?

If we determine that a company’s investments are poor or will erode value for shareholders, this doesn’t only affect a company’s Capital Allocation Rating—it may also have consequences for the firm’s fair value estimate or Morningstar Economic Moat Rating. Conversely, a promising investment could justify positive changes to these other ratings.

Number Three: Shareholder Distribution

Finally, our assessment of shareholder distributions evaluates if dividends and/or share buybacks are taking the appropriate size and form.

Morningstar analysts’ ratings are not necessarily a judgment on the virtues of dividends versus buybacks, but on whether the distribution adds shareholder value.

We consider:

• Should funds be distributed to investors, or could they be put to better use in an upcoming investment?
• What is the state of a company’s balance sheet? Should a company prioritize strengthening its balance sheet over maximizing distributions?
• Can a firm generate better returns by buying back shares than it can by investing?
• At what price is the firm buying back its shares? Above or below fair value?
• What is the tax-effectiveness of share buybacks versus dividends?

The Capital Allocation Rating in Practice

To understand what this rating looks like in practice, let’s look at a couple examples in the healthcare sector.

Consider Bristol-Myers BMY, which features a Capital Allocation Rating of Exemplary.

• Balance sheet: Bristol holds a sound balance sheet with low risk in relation to its amount of debt, level of business cyclicality, and outlook for debt maturity. Bristol’s strong balance sheet should also support it through any product litigation challenges.
• Investments: Bristol has been aggressively investing in research and development for the past several years, and this has yielded one of the best drug pipelines on the market. This pipeline also benefits the firm’s moat.
• Shareholder distributions: Bristol pays out a high dividend, which we think makes sense compared with the patent losses on the horizon in the next few years.

Compare that with Bayer BAYRY, which has a Capital Allocation Rating of Poor. Bayer does have a sound balance sheet and fair shareholder distributions, but this is a case where concerning investments have shifted its capital allocation downward.

Damien Conover, Morningstar’s director of equity research, North America, says of Bayer’s investments:

The company only spends on drug R&D at the low-double-digit range as a percentage of sales (below the industry average of high teens). Further, the company has shown low productivity with poor execution in pipeline development. The lower productivity is limiting the returns on invested capital.

On the acquisition side and partnership side, Bayer has executed poorly. The largest recent acquisition of Monsanto for over $65 billion had diversified cash flows and looked like a reasonable acquisition at the time, but mismanagement and the misunderstanding of the glyphosate risk have made the deal more problematic and have likely taken capital away from needed R&D investments.

The Bottom Line on Management and Capital Allocation

Although competitive positioning remains extremely important to a company’s long-term fortunes, so does the quality of the company’s capital allocation. After all, even the most attractive ship can be run ashore by a misguided leader.

It’s worth understanding these aspects of a company’s management to make sure you are investing your money with people that you can trust.

This article includes updated content that originally appeared in Morningstar’s stock investing course, which was distributed by The Professional Education Institute.