Geoff Gannon December 5, 2012

Capital Allocation Discounts

Value and Opportunity has an excellent post on holding company discounts. The key point of the post is the division of holding companies into 3 types: value addingvalue neutraland value destroying.

Excellent point. I would take it a step further. The issue with the discount that should or shouldn’t be applied to holding companies is capital allocation. Capital allocation has a huge influence on long term returns in a stock.

But not just holding company stocks. All stocks. A company that buys back stock when it’s cheap deserves to trade at a premium to other stocks. A company that issues stock when it’s cheap deserves to trade at a discount.

I recently looked at a list of good, cheap U.K. businesses. I passed on most of them. Not because they were too expensive. Most were cheaper than similar quality U.S. companies. I passed on the U.K. companies because they tended to issue shares over the last 10 years.

Some of these U.K. share issuers traded around enterprise values of 6 times EBITDA for much of the last decade. Interest rates were not high during the last 10 years. Issuing stock at 6 times EBITDA is criminal. I don’t care what you were acquiring. You can’t make money doing it by issuing such cheap currency.

Capital allocation at non-holding companies is critical. And often overlooked. Because it’s complicated. Take Western Union (WU). Western Union made several acquisitions over the last few years. They overpaid.

That’s the bad news. The good news is that Western Union never stopped buying back its stock. And when they needed money – they borrowed. They didn’t issue stock.

Let’s take a look at CEC Entertainment (CEC). This is Chuck E. Cheese. The stock has returned 8% a year over the last 15 years – versus 4% for the S&P 500. That’s impressive for 2 reasons. For most of the last 15 years, Chuck E. Cheese’s operations have been getting worse – not better. Margins have dropped virtually every year for the last decade. And the stock is cheap right now. EV/EBITDA is about 5. It’s hard for any stock that cheap to show good past returns – an incredibly low end point is incredibly hard to overcome.

I doubt anyone is applauding CEC’s board. But they should be. It would’ve been very easy to deliver returns of zero percent a year over the last 15 years.

Operating income peaked 8 years ago. Earnings per share kept rising for the next 7 years. Shares outstanding decreased 57% over the last 10 years. Those are Teledyne like number.

Some might argue the return on those buybacks has been poor. And they would have been better off paying out dividends. Maybe. But let’s consider another alternative – the one most companies actually take. CEC could’ve invested that cash – not in buybacks or dividends – but in expanding the business.

Investors make an arbitrary distinction between operating companies and holding companies. They blame CEC for bad operations. And don’t applaud them for good capital allocation. The truth is that your return in a stock is the product of both those factors – how operations are managed and how capital is allocated.

There should be a discount applied to many conglomerates, holding companies, etc. But it has nothing to do with their structure. I apply a discount to most large tech companies based on the dumb acquisitions they will make in the future.

Should you apply a discount to Google (GOOG) the corporation that you wouldn’t apply to Google the search engine?

I think so. I’d be willing to pay more for outright ownership of the search engine if I could allocate the free cash flow it generates. The rest of the company is likely to be value destructive.

Finally, I would caution every long term investor about assuming standard discounts for holding companies, conglomerates, etc. Historically, there is no such thing. It’s a matter of taste.

A half century ago, there was a conglomerate premium. In the early part of the 20th century, some insurance companies traded at discounts to book value simply because they were valued on the dividends they paid. If you didn’t pay big dividends and you were a bank, insurer, etc. – it didn’t matter how much book value you had – Wall Street marked you down. Financials were supposed to be priced on yield.

This leads to a related issue. And it’s a big one for modern investors. Can we drop “dividend yield” from our lexicon.

When most companies didn’t use buybacks the idea of a dividend yield had some validity. When companies followed unorthodox capital allocation policies – it was a poor measure. But for companies following the accepted payout policies, it made sense.

Does dividend yield make any sense today? Some companies pay dividends. Some companies buy back stock. Some companies do both.

Why is it that when I type in a ticker symbol I’m immediately shown the dividend yield? And there’s no mention of stock buybacks?

Because of tradition. That’s the only reason. It’s become customary to show the P/E ratio and dividend yield for a stock. Neither measure is as important as its prominence on stock websites suggests. But tradition says it belongs there.

I want investors to think for themselves when it comes to things like holding companies. A standard discount is just a tradition. In the 1960s, conglomerates traded at a premium, stocks paid dividends, and men wore hats.

Those were historical facts. Not immutable laws.