Growth, returns and cash: Are management incentives aligned?

What exactly does capital allocation mean, why is it so important, and how do we analyse it?

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One of our three key criteria for what constitutes a durable business is an assessment of management, particularly their record of capital allocation and the incentives under which they operate. We feel these factors are underappreciated and under-analysed by many investors as a consequence of their relatively shorter investment horizon compared to ours.

Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter … And I’ll say, ‘Thank you, but that quarter was baked three years ago. I’m working on a quarter that’ll happen in 2021 right now.'
Jeff Bezos

Today’s capital allocation decisions make little difference to business fundamentals tomorrow or even next year. But over longer periods? A business earning a twelve per cent return on equity that retains all of it will have doubled the equity base in just six years, even if the firm is a hundred years old. Put differently, in just six years the CEO will be responsible for overseeing the allocation of half of all the equity capital ever invested in a century-old business.

Unfortunately, while capital allocation is one of the most important responsibilities of senior executives, most do not know how to do it effectively. Through no fault of their own they typically advance through the organisation as a result of their sales or operations prowess. When it comes to the merits of paying a special dividend versus executing a share repurchase, they frequently rely on (often) woolly or conflicting from institutional shareholder feedback or consultant opinions. 

The objective of a management team should be the increase of value on a per share basis by improving competitive advantage and pursuing growth opportunities at attractive returns, while maximising the cash generation of the business. We therefore pay particular attention to evaluating the economic incentives of company management, assessing the strength of alignment with long-term minority shareholders. The key criteria we look for is some linkage between growth, returns, and cash.

Assessing management ability is a subjective task, however. Historical track records, including growth rates and margin trends, and how these compare to industry peers, are crucial. We also assess the success or otherwise of acquisitions as much as the disclosure permits. The communication around dividends and share repurchases provide insights into how management regard their role. It is useful to compare previous statements of intent and how closely they match subsequent reality, and whether any deviations were due to factors inside or outside management’s control.

Emphasising the quality of management in our process is an element that helps to position for positive surprises that are unanticipated by consensus opinion. 

Key risks

For further information on the risks and risk profiles of our funds, please refer to the relevant KIID and Prospectus.

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Emerging markets risk

The fund invests in emerging markets; these markets may be volatile and carry higher risk than developed markets.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Illiquid securities risk

Certain assets held in the fund could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Concentration risk

The fund invests in a small portfolio of securities. Losses from a single investment may be more detrimental to the overall fund performance than if a larger number of investments were made.

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Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at November 2019. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. 

Past performance is not a guide to future performance. 

The Prospectus and Key Investor Information Document (KIID), are available, together with the Report and Accounts of the SICAV, free of charge from Aviva Investors Luxembourg, 2 rue du Fort Bourbon 1st Floor.L-1249 Luxembourg, Grand Duchy of Luxembourg R.C.S. Luxembourg B25708, Aviva Investors, St Helen’s, 1 Undershaft, London EC3P 3DQ The Prospectus is available in English and German. Where a sub fund of the SICAV is registered for public distribution in a jurisdiction, a KIID in the official language of that jurisdiction will be available.

Issued by Aviva Investors Global Services Limited, the Investment Manager to the Fund registered in England No. 1151805.  Registered Office: St Helens, 1 Undershaft, London, EC3P 3DQ.  Authorised and regulated by the Financial Conduct Authority (Firm Reference No. 1191780).