Capital Allocation is About Alternatives

I once had a large and successful farmer ask me, “What is better than owning farmland?”

Caught in the moment, I did not have an alternative answer for him.  Farm ground was appreciating rapidly (12%+/year), as was year to year earnings (6%+ ROA.)  This was especially true for the profit oriented professional operator at the time.  However, I did think about saying a software-as-a-service (SaaS) business was pretty good (which I owned at the time)… but then I figured that would have only received an annoyed chuckle and potentially a lost customer… which would not have been particularly valuable for either of us!

Today, if asked, I would say that decision was fundamentally about capital allocation.  And, capital allocation is all about alternatives. What is the highest return investment option you have?  Ideally, an individual or business would consider all alternative investments and rank-compare their future returns. The more options you have and the better your assumptions, the more likely you are to select the best.

I believe that small business owner was asking me if I had better alternatives. As a shrewd manager that is an excellent question that is not asked often enough.  Asking this question does not mean you have to act on it, but it is good to increase your awareness by asking.  What insights do you have?  (please, comment below!)

Specifically, what are the areas that a person or business can invest?  There really are only a few broad categories to allocate capital and I built the following table to simplify the decision at a holistic view for myself when I get confused:Capital Allocation by LEV

If you knew expansion of your current business was the best return (and not the only) it is likely you would plow back your earnings to grow that business.  Most of the world’s wealthiest individuals have done this exceptionally well.  However there are absolutely risks that the all-consumed entrepreneur faces with loving the vision and the idea, too much.  What is that risk?  Ignorance.  They know no other alternative.

I am not claiming this is all bad.  In fact, I fall victim to it myself.   It is important to our economy to have entrepreneurs compete with this mindset because sometimes their persistence finds value that others miss.  However, it is not always the wisest to limit your options to what you knew yesterday.  Isn’t it better to increase what you know today, even if just a little?

What of diversification (as it relates to capital allocation?)  I am sometimes asked if I am comfortable with all my eggs in one basket.  I have a tendency to like to know where my eggs are and watch them closely, no doubt. However, I also like to have the odds in my favor.  If I were ever 100% confident in something, I would put 100% of my net worth in that thing. Since I am not, I figure the best practice is to allocate proportionate to the likelihood of that return occurring. Furthermore, I like to have chickens laying eggs while I am caring for the existing egg basket.  So… it is not all about the eggs you have today, but investing in that which makes eggs!  (Maybe we should change the cliche to how many chickens are you willing to hold onto at once?)

Finally I believe it is important to establish a hurdle rate.  For LEV, we do not spend much time on ideas which we cannot derive at least a 20% IRR with conservative/reasonable assumptions.  Ideally, we want to recover our investment in less than two years (~41%+ IRR for those of you who like to stay on the same denominator.) [no promises!]

We then elevate the remainder of alternatives (few) who have lower than usual risk of permanent loss… challenging ourselves to de-risk the investment so moving forward becomes obvious.

Thanks for reading this snippet of thought on the subject of capital allocation.  There is obviously much more, but as a general guideline, I have found the chart above a helpful way to guide my thinking and normalize across diverse alternatives.

(by the way, I sold my farmland shortly after that conversation… “afraid of heights” and expecting a regression to the mean…. plus better alternatives.)

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