Monday, February 2, 2009 0 comments ++[ CLICK TO COMMENT ]++

Poor Capital Management Example 1: Sandisk

I think anyone who is a follower of Buffett, or even Edward Lampert, is likely aware of the fact that the allocation of capital can contribute for as much as 50% of the returns. What management does with profits--whether it is re-invested into some wasteful project, or paid out as dividends, used to buy out other firms, etc--is of grave importance to an investor. After all, if say 50% of the profits are retained and management wastes it on some dumb acquisition or internal project, you are down 50% per year compared to another investor whose management didn't waste it.

Well, most people always think management's actions when it comes to excess cash flow, but just as important for some companies is how management raises capital when needed. Unfortunately, a lot of shareholders are starting to feel the pain of poor decisions. Not only are shareholders being burnt on stock price declines, we also have a new 'trend' of companies issuing shares at low prices. We have seen this happen with financials and we are starting to see it happen with commodity businesses (as a side note, dilution is almost equivalent to locking in a permanent loss.)

Companies in the technology sector are starting to issue shares at low prices. An example is Sandisk, which just announced that it may raise capital. Sandisk is calling it a "prudent insurance policy" but shareholders might prefer to call it dumb management:

As you can see from the chart, they are literally issuing it near multi-year lows. They haven't finalized anything so they may choose not to issue shares now but, nevertheless, it does beg the question why they weren't raising capital an year ago, or even 6 months ago.

Sandisk clearly should have issue shares an year or two ago. However, it's very difficult for management to do that when things are rosy; doing so would have required you to go "contrarian" and the market doesn't reward you for that. But imagine, instead, you had an almost identical firm that didn't have to do this now. Guess what the returns to shareholders on that firm will be compared to Sandisk?

One of the reasons some invest in Sears Holdings is because they claim that Edward Lampert is one of the best capital allocators out there. He is nowhere near Buffett but in a world with shortage of good capital allocators, he is supposed to be good. Who knows if Sears is a sinking ship but at least one can be certain that we are not going to get really dumb decisions. I'm not recommending Sears by any means (I have no position in it) but I'm just bringing that up because the difference in capital allocation can end up being very large in the long run. Stockpickers would do well to pay attention to how well management allocates capital, or perhaps more importantly in the current climate, how well management raises capital.


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