Allocating Capital When Interest Rates Are High

Over the past decade, interest rates were near zero, capital flowed freely, and business executives lined up to fund dream projects. Financial markets could not seem to get enough of this action: rewarding the “dreamiest” leaders, ventures, and concepts to an almost unfathomable degree.

But times have changed. Interest rates, the gravity anchoring capital allocation to reality, are now back with a vengeance. Markets are swooning. And leaders at many companies, looking back at their capital commitments, are thinking: “What have we done!”

Indeed, rash capital allocation can have painful consequences: business failures, bankruptcies, layoffs, write-offs, etc. Once mistakes are made, the path to recovery is often a hard one. But there is one idea that can help, not only with the recovery process but also with avoiding future regrets: consider adding more value-oriented thinking to capital allocation decisions.

Most famously associated with investors from the school of Benjamin Grahamthis way of thinking is highly applicable to business managers in the corporate setting. It provides a general, rational, disciplined framework for all capital allocation — a framework that is arguably most useful in times like the present. Yet it’s also one that is difficult to find in businesses nowadays, having been steadily worn down by a decade of unfettered risk taking. Pushed aside, as it were, by the recent dominance of what I will call the “moonshot” approach.

Here are five defining characteristics of value oriented capital allocation and, for contrast, parallel characteristics of the moonshot approach:

Risk vs. Returns

• Value — Risk first: Question #1 is always “how can things go spectacularly wrong?” Followed closely by “are we protected against irreversible, game-over losses if that happens?”
• Moonshot — Returns first: Question #1 is “how can things go spectacularly right?” Followed closely by “are we positioned to win big if that happens?”

Caution vs. Vision

• Value — Margin of safety: Commit capital only when reasonable and verifiable analysis makes a clear case for it — with some room for error, and without reliance on heroic assumptions. As Warren Buffet puts it: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it.”
• Moonshot — Power of vision: Commit to a game-changing, futuristic vision with enormous untapped potential. Today’s assumptions and analysis will not matter much if one can execute against such a vision.

Wisdom of the Crowd

• Value — Ignore the crowd: Avoid the temptation to pile into whatever business fad may be fashionable at any point of time. Have the courage to run against the herd and, when warranted, do the opposite of what everyone else seems to be doing.
• Moonshot — Evangelize the crowd: Drive excitement, belief, and the “fear of missing out” to get others to buy into the big vision. Inspire the herd to follow our lead and run alongside.

Reality vs. Dreams

• Value — Separate dreams from reality: Focus on dispassionate, rational analysis of unit economics and capital efficiency. Does the math demonstrate that the return on capital invested comfortably exceeds the cost of the capital required? Only then focus on growth and scale.
• Moonshot — Make dreams real: Focus on figuring out what it will take to overcome hurdles and quickly grow and dominate the market. Trust that unit economics and capital efficiency will fall into place along the way, even if we don’t yet know exactly how.

Timing

• Value — Patience: Avoid the urge to always be “doing something.” Be comfortable operating at relatively low intensity levels for long periods of time while waiting for the right opportunities to emerge.
• Moonshot — Now or never: Every moment is precious, and there is no time to waste sitting around waiting. Achieving the dream requires constant action, experimentation, and nonstop, high-energy effort.

It’s fair to look at the moonshot attributes above and ask: But aren’t these good characteristics? Things we want to see in our organization? Absolutely. I am not suggesting otherwise. Indeed, such thinking has helped create some of the most exciting, world-changing businesses of today: Amazon, Tesla, Netflix, Zoom, Uber, and so on. And the leaders behind these amazing success stories have become household names, capturing the imaginations of managers worldwide.

But this moonshot way of thinking seems to have become almost too successful. Over the past decade it has come to dominate corporate capital allocation to such a degree that such decisions have become increasingly untethered from reality. Proposals that would once have been dismissed as outlandish have been rationalized using tempting arguments from the moonshot template. And even companies with perfectly sound, durable business models have convinced themselves that they will somehow get left-behind unless they urgently go “all-in” on some disruptive futuristic vision (e.g., involving AI, crypto blockchains, virtual worlds, the cloud, space exploration, and so on). All of this has created a desperate competitive scramble to build and/or buy assets, resources, and talent in such areas — seemingly at any cost.

In contrast, value oriented thinkers — contrarian voices at the best of times — have been labelled worrywarts, timid, short-sighted, or worse. The case studies they like to cite — like Teledyne’s focus on capital efficiency (in the 1970s and 80s), Danaher’s leadership development via its disciplined business system, Alleghany Corporation’s 90-plus years of flexible yet prudent value creation through numerous market cycles, and Berkshire Hathaway’s renowned model of sound capital allocation — seem to be increasingly thought of as outdated relics of a bygone era. As a result, many naturally “hard wired” value-oriented thinkers seem to have been numbed into silent acceptance as the everything-goes spirit around risk taking over the past decade kept proving them “wrong.”

But time (and the end of easy money) has now shown that maybe they were not so wrong after all. And that perhaps the checks-and-balances their voices could have provided were in fact deeply missed. Importantly, such checks-and-balances would not have meant abandoning big, bold, futuristic growth bets. But they could have helped ensure that these bets were ones actually worth staking precious capital on. As the economist Daniel Kahneman puts it: “Courage is willingness to take the risk once you know the odds. Optimistic overconfidence means you are taking the risk because you don’t know the odds. It’s a big difference.”

So it’s worth considering: Should your organization get more value-oriented thinkers back into the rooms where capital allocation decisions are made? Should there be more of them on your analysis teams, due-diligence task forces, steering committees, and boards? These people need to be intentionally found, appreciated, nurtured, and listened to, particularly when they offer a rational dissent to some tempting and fashionable, yet dangerously risky idea. Why? Because they provide a necessary balance — a sanity test — that can help keep your organization’s capital commitments grounded in reality. And in doing so, they can not only help your organization face the pressing economic realities of the present but also prevent mistakes of the past from being repeated in the future.