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How “agile allocators” boost long-term value

Dave Poniatowski

Principal, Strategy and Transactions, Ernst & Young LLP

7 minute read 30 Apr 2022
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Strategy and Transactions

High-performing companies take an agile and aggressive approach to capital allocation – which can help lead to excess returns.

In brief

  • Capital allocation may need to be more than a pro forma exercise. Agile allocators actively move capital to high-return opportunities.
  • An agile allocation strategy can generate higher TSR than passive allocation in industries like health care, consumer and technology, EY research shows.
  • Organizational inertia and the lack of having an individual accountable for evaluating investment opportunities on a level playing field are common barriers to agile allocation.

While capital allocation is one of the CFO’s more important return-generating responsibilities, many companies still approach it as a pro forma exercise. They vary little in the proportion of capital deployed to different categories, such as organic investments, mergers and acquisitions (M&A), and returns to shareholders each year.

How EY can help

Particularly during a market upturn, and with a clearer view of future cash flows, now is the time to be an “agile allocator.”

Agile allocators move capital aggressively to high-return opportunities, rather than sticking to fixed allocations each year. This can help them meet long-term strategic goals and lift total shareholder returns (TSR). For example, agile allocators are more willing to consider M&A when market prices are low or invest more heavily in innovation rather than expansion of capital expenditure (Capex) for a declining product.

 

So why aren’t more companies agile allocators? One obvious reason is organizational inertia. But another is that many companies lack an individual accountable for evaluating investment opportunities on a level playing field. This can lead to, for example, budgeting research and development (R&D) based on a benchmark, such as percentage of revenue, rather than evaluating the investment against alternative opportunities.

 

Agile allocators can generate excess returns

A recent EY analysis of more than 800 companies’ capital allocation strategies shows that agile allocators can generate excess shareholder returns. We analyzed TSR data¹ over three distinct periods: 2008 to 2011, 2012 to 2015 and 2016 to 2019. While there was no significant difference during the global financial crisis, agile allocators generated a median TSR of 60% from 2012 to 2015 and 49% from 2016 to 2019. These returns exceeded the TSR of passive allocators over the same time periods of 35% and 43%, respectively.

 

It appears that companies might be more focused on preserving, rather than deploying, capital during periods of financial distress. But during periods of macroeconomic expansion, companies that deploy agile capital allocation strategies are rewarded by the market. This held particularly true during the early stages of the macroeconomic recovery from the global financial crisis.

 

Agile allocators may reap enormous returns because they move capital quickly at key moments to capture market opportunities. This may include investing in attractive adjacencies, such as an athletic apparel manufacturer entering the golf equipment market.

 

How different sectors deploy capital

The analysis also shows that agile allocation is the exception, not the rule, as shown by the small standard deviations (Stdev) for each line item within the capital budget, as detailed in Figure 1. However, each sector has deployed a different capital allocation strategy depending on its level of capital intensity, technology investment required and investor expectations. 

 

Figure 1 - 2008-2019 Average capital allocation strategy by sector

Sector-specific dynamics can impact the agile allocator benefits. In the same analysis,² we noted that agile allocators drove higher TSR in the consumer, health care and technology sectors by adapting to quickly changing industry dynamics. In the technology sector, for example, agile allocators outperformed passive allocators by 32% and 14% in median TSR from 2012 to 2015 and from 2016 to 2019, respectively. One semiconductor company, for example, shifted capital aggressively from Capex to R&D and M&A and saw a substantial increase in TSR as a result. Health care and technology companies, in particular, can operate under an asset-light model with shareholder returns largely determined by future growth prospects. Given this fact pattern, 33.4% and 30.2% of the historical average capital allocation budgets for the health care and technology sectors, respectively, have been allocated to research and development.

However, agile allocators in the manufacturing and energy sectors did not significantly outperform passive allocators. One potential reason for this is that these sectors tend to invest much more heavily in Capex than other industries, given their asset profiles – which could dampen the benefits of reallocation. Sufficient data to analyze this in depth is not publicly available, but we suspect that companies that practice more agile allocation within their Capex investments would tend to outperform as well. Another potential reason is that investors have been more focused on broader structural changes in those industries, such as the emergence of electric vehicles in manufacturing and the impact of climate change in the energy sector. Shareholders may give these broader industry dynamics more weight – at least recently – than looking at the results of capital allocation.

Dividends and agility

Another difference between sectors is how they return capital to shareholders. Given that companies are reluctant to reduce dividends to avoid negative signalling, the percentage of a sector’s capital allocation budget allocated to dividends vs. share buybacks can be a telling sign. Share buybacks offer a company more flexibility in that they can be deployed only when opportunities to build or buy new capabilities do not offer sufficient returns. As a result, the fastest growing sectors (technology and health care) deploy the smallest allocation to dividends as a percentage of their overall capital structure. Slower-growing sectors, such as energy, manufacturing and consumer, allocate north of 20% of their capital allocation budgets to dividends, providing investors with sure income and stability.

Median TSR by sector, agile vs. passive allocators

Source: Capital IQ 2008-2019
(Note: Agile allocators are defined as companies whose standard deviation on either Capex, R&D and M&A was greater than 25% from 2008 to 2019.)

Key steps to being an agile allocator

Becoming an agile allocator takes more than merely moving budget each year. Successful allocators of capital can follow several steps:

  • Appoint an executive accountable for agile capital allocation: This person can develop, refine and monitor a rigorous, comprehensive process – and have visibility over all potential capital uses. This individual can also provide the CFO with timely information to challenge and reward business leaders’ investment decisions, as well as make informed and unbiased judgements when needed.
  • Evaluate investment options on an even playing field: Using common metrics and key performance indicators when evaluating different types of investments can add speed and confidence in decisions to move capital – particularly from one investment type to another.
  • Educate stakeholders about agile allocation: A shift from static allocation might be jarring to some stakeholders who are used to seeing a specific percentage each year. Shareholders and other stakeholders are more likely to react favorably when they see how a capital allocation decision fits into the long-term, value-creation strategy.
  • Monitor investments more actively: This process can include budget to actuals, as well as reviews of forecasts and business plans. A shift in the project outlook may necessitate a course correction to obtain the expected returns or shutting down the project entirely. Many companies are not willing to “fail fast”; more active monitoring can make the case for redeployment.
  • Conduct post-mortem reviews: Company leaders should review the results of capital allocation decisions and adapt the process going forward to drive more effective decision-making.
Amol Singhal, Banipreet Kaur and Taru Agrawal of Ernst & Young LLP contributed to this article.

Summary

CFOs need to move their companies toward agile capital allocation now in order to capitalize on changes across industries and outperform peers. Strategically reallocating capital to the areas that drive long-term value, rather than a static process that puts the same percentages in the same buckets each year, can help boost TSR.

About this article

Dave Poniatowski
Principal, Strategy and Transactions, Ernst & Young LLP
Client-focused principal advising companies on valuation, corporate finance, and operational considerations for their largest and most strategic deals. Dedicated husband. Father of four.
Related topics
Strategy and Transactions

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