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Musings on the Cost of Capital, with advice from Omaha
Investment Strategy | 3 Comments | Wed 03 Sep 2014
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What is the most sensible way to think about the cost of capital? How should an analyst appraise an investment opportunity? This article steers clear of the ground breaking research of Litner, Sharpe and Treynor, instead drawing on investment practitioners' experience combined with some wise words from Munger, Cote and Keynes.



Comments

1.
On 06/09/2014 20:32:46, Robert Karas wrote:
Great article! I like the work you guys are doing. Keep it coming!

2.
On 11/09/2014 11:50:16, Brent wrote:
The excellent managers of cyclical companies are easy to identify, they are named Private Equity. They borrow at cycle lows from the bond market, they sell at cycle highs to the investor market.

You are right that well run companies allocate capital using some measure of future return. In my experience working with the leadership of hundreds of companies it quickly became obvious who understood this, whose employees actually had the knowledge required to estimate investment costs and returns and which companies were being run by the in power dying market SBU's.

This is why companies with deteriorating markets are so dangerous - the managers allocate the capital in desperation or with shrinking opportunities for return, but rarely to return it to shareholders or break up the company and sell its parts. We can hardly ask them to do so when we have ignored their compensation packages.

My experience suggests that companies with excellent management set an internal capital hurdle rate much higher than the street - 17% was not unusual- and they forced projects to demonstrate high rates of return over and above this capital hurdle. The worst companies used their short term borrowing rate as a cost of capital - 4% to 6% and over time this has proven to be a good indicator of performance.

Most companies use stock buy backs as a way to disguise a portion of employee compensation. If they do reduce share count it is a way to increase per share everything (except cash). for the few who consistently reduce share count it returns cash to shareholders and rewards long term holders with tax advantages. Beware of managements that only repurchase shares at cycle tops - they are usually trying to manipulate the share price to meet their own compensation measures and are fully aware the cycle is falling out from under them.


3.
On 10/11/2014 05:13:35, Dan R wrote:
Brent,

Private Equity is not the only or best solution. The most important job for a CEO is capital allocation. More than likely he will have a track record that an investor can check on. There are a lot of imprudent uses of capital, those who turn $1 of today's earnings into 50 cents tomorrow. Every investor should look out for those and stay clear.

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