In aggregate, companies earn well above their cost of capital on their investments, so although it often takes time for the results to appear, a dollar invested will create greater than a dollar of market value more often than it doesn’t. As Steve Chazen of Occidental Petroleum said at the company’s investor day last year, “Our goal is to double your money. Every dollar we keep, [we aim to] give you back $2.00 in stock-market value. Share-repurchase programs simply will not do that.”
To make matters worse, cash flow and market cycles often result in poor timing for share repurchases. Most of us learned to buy low and sell high when we were young, but the share-repurchase patterns of most companies seem at odds with that axiom. Many companies employ some form of pecking-order capital-deployment strategy in which they consider the deployment of capital first for organic investments, then for acquisitive investments, then for building cash and paying down debt, and finally for share repurchases. While this strategy seems sensible, it leads to buying back more shares when the market value has increased significantly in response to stronger cash flows.
So what’s a CFO to do?
Corporate financial policies for target leverage, cash balances, dividends, and share repurchases should not be the inadvertent outcome of a series of haphazard events. Instead, they should be deliberately and holistically designed to maximize value in the context of the chosen corporate business strategy and the desirability, size, and timing ambiguity of investment opportunities.
For a stable company with investment opportunities that are limited or appear with regularity, the value of financial flexibility is not high. So it is appropriate to institute more aggressive leverage and distribution policies. But too often, management puts its company in this category when in fact it has peers making successful large investments in their future. If a company has sizable growth investment opportunities with uncertain timing, more flexibility may be required. That justifies lower leverage and holding on to extra cash.
One thing is clear: companies need to fully integrate their capital allocation and financial policies with their corporate strategy. This holistic view of strategy, capital allocation, and financial policy should be clearly communicated with the market, and companies should target investors that value their strategy appropriately.
In the absence of a clearly defined corporate and financial strategy, investors will likely be skeptical and fearful that the company will misuse its cash at the expense of shareholders – and will demand their capital be returned so they can redeploy it elsewhere.
Gregory V. Milano is co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm.