Contrary to popular belief, firms that pay return on capital to investors are better investments than those that reinvest capital back into the business

A recent paper by James Montier brilliantly highlighted this issue.

For example, a recent McKinsey paper showed that corporate executives know 17% of their invested capital went toward underperforming investments that should have been terminated and 16% of their investments were a mistake to have financed in the first place.

Many corporate managements do a terrible job of investing corporate capital.

When asked how accurately such executives could forecast corporate investments, 70% of managers said they were too optimistic about the time to complete a project, 50% said they were too optimistic about the impact an investment would have, and 40% were too optimistic about the costs involved.

It’s not surprising that management is overly optimistic about their pet projects.

Even worse, 40% of managers admitted that they “hide, restrict, or misrepresent information” when submitting capital investment proposals, and 50% of subordinates working on such capital investment projects said it was important to avoid contradicting superiors.

No wonder most companies are bad capital allocators–managers are rarely honest with themselves about their pet projects, and they discourage dissent when discussing potential results.

In other words, companies that retain capital instead of paying dividends or buying back stock and debt tend to be worse investments than those that tend to pay out return on capital to shareholders. Here’s the proof:

A study by Anderson and Garcia-Feijoo showed that low capital expenditure companies outperformed high capital expenditure companies by up to 10% per year.

The companies that returned capital to shareholders beat the companies that pumped capital back into the business.

Another way to look at it was highlighted in a study by Cooper, Gulen and Schill, who showed that companies with low asset growth, in terms of cash, property, plant, equipment, etc. returned as much as 20% per year more than companies with high asset growth.

I think these findings are counter-intuitive to what most investors believe, and certainly to what many professional investors think, too.

It’s a rare company that can allocate capital effectively, and the proof is clear that companies, on average, that retain capital for investing aren’t necessarily good investments. It’s important to realize, too, that not all companies are bad capital allocators.

This is why I pay so much attention to return on incremental capital invested when I research businesses to invest in.

I stay away from any company that rewards management for retaining capital, especially when management has a bad track record of effectively reinvesting those dollars.

But, I love to see a management that wisely returns capital to investors when they don’t have opportunities and have great track records for adding value when capital is retained.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.