One of the most important responsibilities of a company’s management team is capital allocation – the decision of where to deploy the firm’s excess capital.

As shareholders, it is our job to ensure that management is making intelligent decisions for capital allocation, as it can have a profound effect on our long-term investment returns.

Case-in-point: some of the most successful CEOs (as measured by the per-share increase in their company’s intrinsic value) have viewed themselves primarily as capital allocators.

Warren Buffett of Berkshire Hathaway (BRK-A) (BRK-B) is the most well-known example, but there are others: Jeff Bezos of Amazon (AMZN), Henry Singleton of Teledyne Technologies, Tom Murphy of Capital Cities, and Bill Anders of General Dynamics (GD) also come to mind.

If capital allocation has such a strong impact on investment returns, then it is our job as shareholders to ensure that we understand the impact of various capital allocation techniques.

This article will define the five priorities of corporate capital allocators and describe their quantitative impact on intrinsic value.

Organic Reinvestment

Organic reinvestment is likely the most simple and straightforward form of capital allocation.

Instead of diverting funds away from a core business line to make balance sheet improvements, perform acquisitions, or return capital to shareholders, managers opt to reinvest excess capital into the operating business that originally generated it.

The decision on whether or not to reinvest funds is completely dependent on two factors:

Business unit leaders can proxy the returns from organic reinvestment by multiplying their reinvestment rate by the business’ return on capital. So if a business reinvests 50% of capital at a 20% ROIC, then a 10% incremental return can be reasonably expected.

It is important to keep in mind that many businesses have no choice about whether or not to reinvest.

Some businesses are so capital-intensive that almost all operating cash flow must be reinvested just to maintain their current competitive position. These businesses are not generally fantastic investments. Since capital must be continuously reinvested to maintain the business, there is no excess capital to fund more aggressive growth projects or diversify the enterprise’s operations.

Warren Buffett once mentioned the airline industry as an example of a sector with these characteristics, although his opinion has now changed since Berkshire Hathaway’s investment portfolio has a significant stake in the 4 major U.S. airlines.

“Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.”

– Warren Buffett in Berkshire Hathaway’s 2007 Annual Report

The opposite business is much more attractive: one that requires very little reinvestment (although reinvestment is certainly an option if growth prospects are bright). Capital-light business models with minimal reinvestment requirements make fantastic investments because they offer more optionality.

In other words, it is up to the management team – rather than the economics of the business – to decide whether organic reinvestment is the path to building long-term shareholder value.

Berkshire Hathaway’s decentralized operating structure with Buffett & Munger acting as capital allocators is one example of the fantastic use of the capital-light characteristics of various industries.

The following Munger quote illustrates why.

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.” – Charlie Munger at the 2008 Berkshire Hathaway Annual Meeting

Importantly, a business does not need to have strong organic growth prospects in order to make a compelling investment.

For example, if you could buy an 8% yielding bond from a AAA-rated company, you would jump at the opportunity. While the fixed income security has zero growth prospects (coupon payments are constant over time), its combination of high returns (8% yield) and low risk (AAA credit rating) make it a compelling long-term investment.

The same logic applies to the ownership of full operating businesses. A stagnant business can make a solid investment if:

Again, Berkshire Hathaway is a phenomenal example of a company that sometimes purchases slow-growing businesses because of their ability to generate high levels of excess cash flows that can be reinvested in other growth projects.

In fact, Warren Buffett once warned about the perils of mindlessly investing money back into the company that generated it:

“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” – Warren Buffett in Berkshire Hathaway’s 2007 Annual Report