CAPITAL ALLOCATION IN ACQUIRING OTHER BUSINESS AND RETAINED EARNINGS

It becomes a serious problem when the management of a great company neglects its wonderful base business and purchase other business that is/are not profitbale or commodity type or even worse. Loss of focus is what worries most when Berkshire Hathaway contemplate investing in businesses that in general look outstanding.

Acquisition decisions should aim at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. Why should the shareholders of Company A(cquisitor) want to own an interest in Target Company at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?

Very few companies that have purchased only businesses that are particularly well adapted to an inflationary environment; these enterprises should possess the following both characteristics:

(1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and

(2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.

Retained Earnings and  Acquisitions

In the long run, the market price of stock will be determined by future earnings. The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.

If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incremental invested in the core business.

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least. Asset-heavy businesses generally earn low rates of return rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

A disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. During inflation, Goodwill is the gift that keeps giving.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisition of businesses that have inherently mediocre economics).

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock.

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