How to Find Firms That Turn Savings into Shareholder Profits

It's no secret that the quality Warren Buffett admires most in a business manager is rationality. Buffett is particularly concerned with a manager's ability to rationally allocate capital. He has good reason: Capital allocation determines long-term shareholder value. If managers are making wise decisions with shareholders' money, proof of their wisdom will eventually be reflected in the increased market value of their company. If, on the other hand, they plow capital into unprofitable ventures, the market will justly price their company's shares disappointingly.

Our goal as long-term investors, therefore, should be to partner with managers who make smart capital-allocation choices. Sounds straightforward enough. But how can we begin to identify such folk? In this article we'll describe (and put to work) one handy but commonly overlooked tool for just this purpose.

Capital Allocation: An Exercise in Rationality
Managers of a profitable firm face two choices: reinvest in the business or return capital to shareholders. When presented with the opportunity to earn above-average rates of return, the only rational course is to reinvest earnings. When, on the other hand, available investments offer lower prospective returns than shareholders could achieve elsewhere, reinvestment is irrational. The only prudent course is to return money to shareholders and let them decide what to do with it. Managers who follow this logic, or as Buffett puts it, who "think like owners," earn the Oracle's highest praise.

Unfortunately, some managers--particularly in the later stages of their company's life cycle--don't behave rationally. Rather than return capital to shareholders, they embark on acquisitions or new projects in the belief that, with managerial skill, they can sustain growth (recall  Coca-Cola's (KO) infamous foray into shrimp farming). Other managers withhold capital in the hope that market conditions will someday improve, if only the firm can hang in there for a while. In either case, they have an exaggerated sense of their company's prospects. And, in either case, shareholders are ill-served.

One useful way to begin sorting the rational from the irrational is to check whether returns on invested capital have exceeded, or at least matched, the company's cost of capital over time. Consistent excess returns point to attractive business economics and rational capital allocation. But this check involves estimating a firm's cost of capital, which is an uncertain variable. Is there a more objective way?

The One-Dollar Premise
Buffett offers a characteristically simple alternative: the one-dollar premise. The premise holds that, over sufficiently long periods of time, stockholders should expect at least one dollar of market value to be created for every dollar that management retains for reinvestment or share repurchases. This test can be applied to any company with a sufficiently long operating history--say, 10 to 20 years (market prices are too volatile in the short term to make the test meaningful). While far from being definitive, the one-dollar premise can be a good starting point in screening potential investments.

The test easy to perform:

1. Sum a company's net earnings over the chosen time horizon.

2. Subtract dividends payments in order to arrive at the sum of retained earnings (again, "retained earnings" in this context includes funds that could be used in share buybacks).

3. Take the difference in the company's market value between the beginning and the end of the period, and divide total "retained earnings" into this number.

A result greater than $1 is a sign that the business possesses strong economics and rational management. If the result is less than $1, it suggests that retained earnings have been deployed nonproductively.

To illustrate, we highlight four firms that pass the test with flying colors--and one that falls short.

Value Creators
 Fastenal (FAST)
Moat: Wide | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.79
Management at this fastener seller has been an outstanding steward of shareholder capital. Over the past 10 years, Fastenal earned $1.16 billion for its owners. From those earnings, the company paid shareholders $232 million in cash and made reinvestments and share repurchases totaling some $926 million.

In 1998, the total market value of Fastenal was $395 million. In the 10 years hence, its market value grew to $5.7 billion, implying a difference of $5.3 billion.

$5,300 m � $926 m = $5.76

For every $1.00 Fastenal has not paid in dividends, it has created $5.76 in market value for its shareholders.

Fastenal (Figures in $ Millions)
	Net Income	Dividends	Retained Earnings	Market Value
1998	53	-1	52	395
1999	66	-2	64	--
2000	81	-3	78	--
2001	70	-3	67	--
2002	76	-4	72	--
2003	84	-16	68	--
2004	131	-30	101	--
2005	167	-47	120	--
2006	199	-61	139	--
2007	233	-66	166	5,730
Total	1,158.3	-232.4	925.9	--

 Sysco Corporation (SYY)
Moat: Wide | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.84
This food distributor appears to be another good capital allocator. Over the past 10 years, every $1.00 dollar that Sysco has not paid in dividends has translated into $3.66 in market value.

 Sempra Energy (SRE)
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.82
Energy firm Sempra also passes the test, having created $2.58 for every $1.00 not spent in dividends over the past 10 years.

Value Destroyers
  Eastman Kodak 
Moat: None | FV Uncertainty: Medium | Price/Fair Value Ratio*: 1.10
The one-dollar premise reveals a stark contrast between the above performers and value destroyer Eastman Kodak. From 1998 through 2007, the photography firm earned $4.6 billion for its owners. Of that, $3.75 billion was paid in dividends. Over this period, Kodak's market value decreased by $9.7 billion. For every $1.00 not allocated to dividends, Kodak destroyed $11.86 in market value.

*Price/Fair Value Ratios calculated using Morningstar's Fair Value Estimate and closing prices as of Aug. 6, 2008.