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By Michael Ide

Credit Suisse managing director Michael Mauboussin explains his framework for analyzing capital allocation decisions

"Capital allocation is always important but is especially pertinent in the United States today given the high return on invested capital, modest growth, and substantial cash on corporate balance sheets. Companies that deploy capital judiciously have a significant opportunity to build value," writes Michael J. Mauboussin, managing director and head of Global Financial Strategies at Credit Suisse Group AG (ADR) (NYSE:CS).

Mauboussin has a lot of practical advice on how executives should approach capital allocation in his recent deep dive on the topic. But he also gives investors a five-point framework (partly based on principles in The Value Imperative by James McTaggart, Peter Kontes, and Michael Mankins) to decide is a company's management is taking the right approach.

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Zero-based capital allocation

People often think about capital allocation both in terms of return on invested capital (ROIC) and return on incremental invested capital (ROIIC). The first tells you what a company is getting for the money it spends (or resources it puts to use), but ROIIC tells you how much extra value you can expect to get by allocating more capital to a specific project or strategy. But Mauboussin says that an overemphasis on ROIIC leads to corporate inertia and the continued funding of disappointing projects. Zero-based capital allocation, which looks for the optimal allocation without reference to what has already been spent, has a history of delivering better total shareholder returns (TSR).

Second, Mauboussin recommends looking for companies that prioritize strategies over projects. Within any given strategy there may be individual projects that can't stand on their own but are essential for other projects to succeed. Similarly, a project with good prospects may also be part of a failing strategy and choosing to fund it could bring a number of weaker projects along for the ride.

About 90% of capital in US companies is internal, generated by operations instead of accessed through funding, compared to 70% in the UK and 50% in Japan, which tends to give management the attitude that capital is 'scarce, but free' leading to overspending when times are good and underspending during a downturn, and Mauboussin's third principle: no capital rationing.

"A better mindset is that capital is plentiful but expensive," writes Mauboussin. "Managers should explicitly account for the cost of capital in all capital allocation decisions. Too frequently, companies select actions that add to earnings or earnings per share without properly reckoning for value."

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Don't tolerate bad growth, know the value of your assets

Mauboussin says that managers should expect to have setbacks and failed projects, but they should also have 'zero tolerance for bad growth,' cutting their losses and moving on as soon as it's clear that returns will fall below the cost of capital. Obviously this frees up capital for some other use, but it also means that talented employees don't have to keep wasting their time (and untalented employees can be let go).

Finally, management needs to have a clear sense of what their assets are worth and be willing to take action on that knowledge. Whether that means buying or selling (and plenty of managers have a bias toward buying), the difference between value and price should always guide management decisions.

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Disclosure: None

Source: Mauboussin's 5 Principles Of Capital Allocation