Ideas for wise capital allocation, corporate incentives, and accounting & its limitations

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      Some ideas from Will Thorndike's Outsiders for Management with additional points

     1. The capital allocation process should be CEO led, not delegated to finance or business development personnel.

2   2.  Start by determining the hurdle rate—the minimum acceptable return for investment projects (one of the most important decisions any CEO makes).

Hurdle rates should be determined in reference to the set of opportunities available to the company, and should generally exceed the blended cost of equity and debt capital (usually in the mid-teens or higher). NPV, actual cash flows is better than IRR, which takes into account a lot of assumptions.

3   3. Calculate returns for all internal and external investment alternatives, and rank them by return and risk (calculations do not need to be perfectly precise). Use conservative assumptions.

Projects with higher risk (such as acquisitions) should require higher returns. Be very wary of the adjective strategic—it is often corporate code for low

returns.

4   4.  Calculate the return for stock repurchases. Require that acquisition returns meaningfully exceed this benchmark.

While stock buybacks were a significant source of value creation for these outsider CEOs, they are not a panacea. Repurchases can also destroy value

if they are made at exorbitant prices.

5. Focus on after-tax returns, and run all transactions by tax counsel.

6. Determine acceptable, conservative cash and debt levels, and run the company to stay within them.

7. Consider a decentralized organizational model. (What is the ratio of people at corporate headquarters to total employees—how does this compare to your peer group?)

8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate.

9. If you do not have potential high-return investment projects, consider paying a dividend. Be aware, however, that dividend decisions can be hard to reverse and that dividends can be tax inefficient.

10. When prices are extremely high, it’s OK to consider selling businesses or stock. It’s also OK to close under-performing business units if they are no longer capable of generating acceptable returns

11. Consider incentives and the proper compensation based on what would be fair and what would be pertinent to that industry. You get what you reward. If you’re in the insurance business, you don’t want to reward based on volume, so you can’t fire people just due to seasonal changes. If certain industries are cyclical, then you have to make your compensation scheme adapt to that.

12. Punish immediately for theft or immoral acts.

13. Set up an accounting system specific to that industry.

Charlie Munger: In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries—which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.

And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, “This is asinine.”

So he threw all of his accountants out and he took his engineers and said, “Now, we’ll devise our own system of accounting to handle this process.” And in due time, accounting adopted a lot of Carl Braun’s notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.

14.  Always explain why you’re doing a certain task to your colleagues. Don’t just do something for the sake of process.

He (Carl Braun) had another rule, from psychology, which, if you’re interested in wisdom, ought to be part of your repertoire—like the elementary mathematics of permutations and combinations.

His rule for all the Braun Company’s communications was called the five W’s—you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn’t tell him why, you could get fired. In fact, you would get fired if you did it twice.

You might ask why that is so important? Well, again that’s a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they’ll understand it better, they’ll consider it more important, and they’ll be more likely to comply. Even if they don’t understand your reason, they’ll be more likely to comply.

So there’s an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it’s obvious, it’s wise to stick in the why.