Principles of Capital Allocation

by Daryl B. Starr

What is “capital allocation?” Why is understanding the first principles of this discipline important? Allow me to pontificate.

Investment is a choice to bear uncertainty with an intention to realize a profit. The actions that proceed from this choice are allocation. Allocation is defined as resource assignment for a given purpose. All resources available to the decision-maker are capital. Thus, investment is the allocation of capital. Capital allocation is a decision to move resources for a given purpose, and capital allocation is investment.

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Why does an understanding of the principles of capital allocation matter?

I believe we are defined by the choices we make. You cannot proceed through life without choices. Even delaying a decision is a choice to wait. Business is simply life with currency, order and objectives of creating tradable value. What are the trades you are willing to make? What are they based upon? How do you identify error and resolve your mistakes? Is there truth at your core or are you without foundation? Without principles?

With solid footing, you can move the world. Without it, you are moved. Your choice.

I have a very high internal locus of control. I am not immovable, but I do believe I have –and demand as much as I am able– control over the events of my life. This permeates my business decisions as well. Ownership provides this right and is rooted in my creative existence. I possess the right to shape the world around me for the duration of my life.

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Capital comes in many forms. The first division can be defined as cash or personnel. The use of cash to acquire real estate, machinery or materials is a series of interconnected choices. The people you employ to use these materials matter. What skills or talents must they possess? How does this change with the location of the tools and materials? Can you create value by acting with sound judgement? Can you employ management to discern finer techniques? Be a more perfect craftsmen than you? Perhaps. But, the business owner is ultimately responsible for all resource assignments. We are owners. We judge uncertainty for the purpose of obtaining investment profits.

Business ownership is the assembly of material, people, tools and processes to deliver a product or service –which derive a result– valued by a customer. If the price paid by the customer for the result is more than the price paid to assemble the value, then an operating profit is accrued to the owner. However, not all costs of assembly are accounted for on the company ledger. Most noteworthy is the opportunity cost to employ resources in a different manner. We call this the cost of capital. When judging the assembly of the business the owner must weigh alternative procedures to obtain the given result. Must you own the real estate to produce the widget? Does the rental income exceed your alternative investments? What of the trucks that transport your raw material? Or your finished goods? What components should you “rent”? Which should you own? Are you clearing your cost of capital?

The cost of capital functions as rental income assigned to the capital resources employed by the business. That is, the employment of resources bears a cost that should produce a given result. If the result is less than the alternatives, then the allocation can be judged as poor. Achieving a return at the cost of capital is not necessarily investment profit, nor a good investment.

Only an owner earns an investment profit. This portion of profit is derived from the wise allocation of resources that exceed the cost of capital. Wise allocation applies each resource to its best utility… ideally in novel or proprietary manners that are not easily replicated by competitors. This allows the investment profit to be extracted time and again.

An investment profit can be obtained in two ways. First, by acquiring a valuable asset at a price less than the value. If proven correct, this is a good and profitable investment. This is the professional investors bailiwick. The second way to obtain an investment profit is by improving the value of an asset by shrewd management. This is the entrepreneur’s siren song. In both cases, success is found if the cost of capital is exceeded. The first achieves success at the time of purchase. The second is realized over the lifetime of the company.

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Yesterday we hosted our managers at the Little Engine Ventures office for pizza and discussion. Our primary topic was the risk associated with business model changes and how that differs from the increase or decrease of various items within an existing business model. I asked each to identify a type of each in their businesses in which they would most like to see improvement. We then discussed two cases. We could have talked all day. My goal however, was to form some common language and mental framework to aid in decision making. We can also more quickly distinguish what aspects are within the realm of each individual. Synchrony here is important because of how fast we are evolving and confronting new decisions daily. Understanding the principles of capital allocation allows us to judge swiftly what is good and right, and throw out or pass quickly by that which is in error or without form.

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