The Six Different Asset Types The Hierarchy of Capital Allocation We Use at Our Companies By Joshua Kennon
Friday, March 21, 2014
All assets, whether a gold nugget or a bottle of cologne, can and should be compared to others when making purchasing or investing decisions. In the past, I've used some of my own private company investments such as Mount Olympus Awards and Kennon Green Enterprisesto illustrate basic concepts such as profit margins, financial ratios, investment returns, and more. Today, I'm going to share part of the theoretical basis a proprietary capital allocation hierarchy we use in-house to determine every potential capital expenditure and expense. My hope is that it will help you put together you own portfolio and structure your financial life to achieve what you want out of your portfolio.
Asset Type #1: Those that generate high returns on capital, throwing off substantial cash on very little capital investment but that can be grown by reinvesting profits into the core business for expansion.
Think of a business like Microsoft or Coca-Cola where the underlying company can earn 20% to 30% on shareholders' equity so that each dollar of retained profits is generating an enormous return the following year. During their growth phase, these are companies such as Wal-Mart, Hewlett-Packard, Best Buy, etc. The best course of action is to pour as much money as prudently possible, whether contributed capital through equity or debt through borrowing, into the main business so it can expand and earn huge rates of return.
Asset Type #2: Those that generate high returns on capital, throwing off substantial cash on very little investment but that cannot be expanded by reinvesting in the underlying asset.
These are the second best investment because you can earn large returns on very little money. The downfall is that you have to pay out all of the profits as dividends or reinvest in lower returning assets because the core business can't be expanded through capital infusions alone.
Think of a patent to a device that generates hundreds of thousands of dollars per year. There are little to no investment requirements once the cash starts coming in but you can't invest it in more patents at the same rate of return. Unlike the first asset type, you can't put that money to work at the same level (you get your patent royalty check and have to find something else attractive whereas Ray Kroc at McDonald's simply built another location, generating roughly the same return.)
At some point all #1 type businesses will become #2 type businesses. This normally happens at saturation. At that point, management will likely repurchase huge amounts of stock to increase the remaining shareholders' equity in the business or pay out cash dividends.
Asset Type #3: Those that appreciate far above the rate of inflation but generate no cash flow.
Think of a coin collection or fine art. If your great grandparents owned a Rembrandt or a Monet, it's going to be worth millions of dollars today versus a relatively small investment on their part. Over the years, however, you wouldn't have been able to use the appreciation in the asset to pay the rent or buy food. That is why these types of assets are often best left to those who can either A.) Afford to hold because they have substantial wealth and liquid assets elsewhere so that tying the money up in the investment is not a burden or hardship on the family and / or B.) Those who have an intense passion for the underlying subject and derive considerable pleasure from the art of collecting whatever it is about which they are interested (oil paintings, wine, coins, baseball cards, vintage Barbie dolls – the list doesn’t end). The huge investment returns are merely gravy for them.
Asset Type #4: Those that are "stores of value" and will keep pace with inflation
This asset type can include certain brands of furniture such as Baker, Henkel Harris, Bernhardt and more. These are companies that charge $18,000 for an armoire but for centuries, many of them have kept pace with inflation (and if they are extremely well cared for, actually exceeded it). These are brands bought by the average American millionaire because they will hold value, always be able to be sold for at least what they paid for on an inflation-adjusted basis (provided its not an emergency liquidation), and they have businesses and other income sources so they aren't worried about tying up capital in fixed assets. Most Americans buy furniture that has little or no economic value when they pass it on or it falls apart. That's not the case here. A good dining set by one of these companies is often worth more than a used Mercedes and, unlike the car, can keep going up in value.
