The #1 Job of the CEO: Capital Allocation
Part of our investment process is to evaluate the management team of a company before we invest in it. This can involve speaking with them, assessing their character (or lack thereof in some cases!) and understanding their past leadership experience. However, what’s most important to us is to look back at their track record of capital allocation.
What does that mean? Capital allocation is the process of deciding how profits should be spent as they are generated. Should the profits be reinvested to hire additional people? Should they be used to purchase new equipment? Should they be paid out to the owners? Or even spent to acquire competitors? Good CEOs make decisions that maximize the long-term return on that excess capital (profit).
How do you improve your capital allocation decisions? The key is to understand what they actually return. Meaning: what is the additional profit generated for every dollar spent? If you are going to hire someone for $60K per year, are they going to generate more than that in incremental revenue?
If you are going to upgrade to a new fancy office because you are making more money now, what is the return on the additional money spent? Is it worth it? If you have a business that is heavily dependent on credibility and clients often come to the office to meet you, winning a few more clients as a result of the credibility boost may pay for itself quickly and generate incremental profits. However, if clients never come to your office and you simply want a fancier place to spend your day, would you be able to increase your long-term profitability more by spending that money on hiring someone else that can bring in revenue?
These are all very challenging decisions with a number of unknown variables. No one ever gets them right all the time. However, you can improve your batting average, and ultimately your firm profitability, if you develop a process for evaluating these decisions and comparing them to each other.
When spending money, always ask yourself two questions:
- How much do I estimate this will increase the profitability of my firm?
- Is there a better use of this money that will increase my profitability even more?
The second question is as important as the first, because often there are many ways you can spend money to increase your profitability. But what is the BEST use of those dollars? Which one has the highest return?
One word of warning on this… Never forget to focus on the long-term. Often in business, owners find ways to maximize profits in the short-term that compromise the long-term viability or reputation of their business. Great businesses are built over decades, not months. The best capital allocation decisions are made to maximize profitability in the long-term, not the short-term.
All the best,
Your Fortis Capital Management Team
PS: If you want to read one of our favorite books on capital allocation and the best CEOs of all time you can find it here.