Wednesday, May 11, 2016

Cash Flow and Capital Allocation

I recently heard a Youtube lecture delivered by William Thorndike, author The Outsiders, a study of CEOs who beat the S&P and their segment competitors over decades. He found that they weren’t genius inventors, superb marketers or salesmen, or the charismatic leaders that appear on the covers of business magazines. They were frugal, humble men, who focused on cash flow and capital allocation beyond all other measures of business success. I was intrigued enough to order a copy of the book, using a $15 discount coupon. After all, I do have to watch my cash flow.

Should this be all that surprising? Running a company or a family do have similarities. It is necessary for both to live on a budget, allowing for the creation of free cash flow after all the basic expenses are covered. Now that you have some free cash to allocate, where should it go? Shall we build the most luxurious and extravagant corporate headquarters building in New York City or increase the dividend to the shareholders and buy a small business that might greatly increase our future profitability? Think Google buying Youtube. Should I drive this old car for a few more years so I can pay down my mortgage, or should I lease a new Lexus?

These men were not ideologues. They were pragmatists. If something ceased to work, they would change directions and try something else. The author tells the story of the manager of a sexy go-go conglomerate of the ninety sixties. When the early seventies proved that diversification was often actually worsification, this manager fired his business acquisitions department en masse. He then set about optimizing his existing businesses for efficiency and profitability. Instead of issuing new shares of stock to underwrite corporate purchases, he instituted a buy back program that ultimately pulled 90% of company shares off the market. The investors who stayed with this manager through two business cycles saw a fantastic return on their investment, even as similarly structured corporations faced bankruptcy or became mere footnotes in corporate history books, cautionary tales for future managers intent on building their own corporate empires. When I couldn’t find a job with a liberal arts degree, I went back to school and earned a degree in mechanical engineering.

Another interesting discovery made by the author is that the younger employees mentored by these boring old men also frequently became successful corporate executives in other businesses. Like NFL owners, the boards of corporations should look at the “coaching tree” that produced that potential coaching hire. If you want to run a 3-4 Defense, look for someone trained by Bill Belichick. If you want to run the West Coast Offense, hire a student of Bill Walsh. This isn’t so different to families. Often the apple doesn’t fall far from the tree. If a child is taught the value and meaning of money, there is a good chance she will carry those lessons into her adult life.

As is so often the case, important things are simple, but simple things can be hard. Managing cash flow over the course of a lifetime gives one capital that can then be allocated. How individuals choose to allocate this capital, whether for consumption, as a down payment for future indebtedness, or for investment, as a down payment for future wealth will make a huge difference in the outcome of their financial lives.

Time and compound interest can work for you, or against you.

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