Spotlight: Capital Allocation – Part 1

What’s interesting about moat is that if a moat needs to be continuously built, it isn’t a moat at all. How do you know if you’re paying up or overpaying for the moat? This time we invert the conundrum of moat to explore the symptoms of false-moat trap.

Proper allocation of capital is an investor’s number one job.” ~ Charlie Munger

“Charlie and I have only two jobs…One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.” ~ Warren Buffett

One of the great skills that any investor or businessperson can have is a talent for capital allocation. And when it comes to capital allocation skills, one of the people even supposedly the world’s best capital allocators, Warren Buffett, looks at is Tom Murphy.

“Who’s Tom Murphy?” you may wonder.

Well, I’ll discuss more on my key learnings from Mr. Murphy some other day. But here’s what Buffett once told Lawrence Cunningham, the author of Berkshire Beyond Buffett1 about this man – “Most of what I learned about management and capital allocation, I learned from Murph. I kick myself, because I should have applied it much earlier.”

In fact, Mr. Murphy has been such a great inspiration for Buffett that when you study what the latter has said and written about managing a business, in many cases you are learning indirectly from the former. That is a good thing since Mr. Murphy did not say or write very much in comparison to Buffett. Like many great capital operators (like Henry Singleton) and managers he mostly let his business results speak for themselves, and did not spend any significant time seeking to be noticed by the public.

Along with Buffett himself, Murphy is one of eight CEOs praised in The Outsiders, a cult business classic, which attempts to define what differentiates a small number of leaders who massively outperform the market through their capital allocation skills.

Buffett is quoted in that book as saying that “Tom Murphy and [his long-time business partner] Dan Burke were probably the greatest two-person combination in management that the world has ever seen or maybe ever will see.”

As you can read in the book, the capital allocation formula that Mr. Murphy practiced and what made him so successful, was – focus on industries with attractive economic characteristics, selectively use leverage to buy occasional large properties, improve operations, pay down debt, and repeat.

Anyways, contrast what Buffett says about Mr. Murphy’s capital allocation skills with what he wrote in his 1987 letter3…

“…the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

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