Manager Insight: When studying stocks, follow the money

Acquisitions

Shannon says the most successful acquisitions tend to be smaller ones that complement the core business. It’s important to pay attention to management’s explanation of why they are making the acquisition and what benefits they expect to reap.

To that end, one takeover worth watching is the 2014 acquisition by Loblaw Co. Ltd. (TSX:L) of Shoppers Drug Mart. “They’re talking more about revenue synergies,” says Shannon, “so we’ll be able to watch that acquisition in real time for the growth in value of Loblaw.”

An obvious example of takeover synergies is the 2013 acquisition by Empire Co. Ltd. (TSX:EMP.A), parent of the Sobeys grocery chain, of the Safeway grocery chain in Western Canada. The two similar businesses are coming together to form a national grocer, says Shannon. “The studies would suggest that Empire’s strategy is more likely to create additional value to investors in the long run than might Loblaw with Shoppers. And we’ll have fun watching the results.”

Dividends

As a form of capital allocation, dividends come in and out of favour among investors, depending on the market environment. Over the last five to 10 years, Shannon notes, dividend-paying companies have become very popular. So much so that she and her team are a little concerned that companies paying generous dividends may be over-priced as a group.

Even so, Shannon recognizes the importance of dividends. She cites research that estimates two-thirds of the long-term returns from investing in equities are derived from the dividend yield.

Wary of special dividends paid with surplus cash, Shannon favours “old-fashioned dividend yields” that are paid out of the earnings generated by the business. “They’re less subject to being gamed and incentivized.”

Share buybacks

A company may allocate capital to invest in itself through share buybacks. This strategy is used when a company thinks its stock is so undervalued that a buyback is a better use of capital than making an acquisition, investing in the business or paying down debt.

“But human beings are not always rational in what they do,” says Shannon, suggesting that buybacks may be a poor form of capital allocation when markets are expensive. For example, she says that last year, when the U.S. market was riding high, coincided with one of the highest amounts of share buybacks in U.S. financial-market history.

By contrast, in years like 2009 when stocks were very inexpensive, there was much less share repurchasing. “So clearly, (a buyback) is not always the true cheap alternative,” says Shannon.

Reinvestment

Effective capital allocation may involve acquiring or upgrading physical assets such as property, buildings or equipment. Shannon cites as an example the management of Vancouver-based methanol producer Methanex Corp. (TSX:MX). “They are very slow and careful about how they spend their cash,” she says, praising management for setting up facilities in low-cost areas and getting them up and running.

Shannon, who counts Methanex as one of her holdings, says the company has also made effective use of other capital-allocation strategies. It has repurchased about 45% of its shares outstanding since 2000, and has also increased its dividend nine times since 2002.

Debt paydowns

In today’s environment of low interest rates, debt is less of a burden, so debt paydowns may not be considered an effective use of capital. “You’re actually seeing management teams,” says Shannon, “particularly in the U.S., borrow money, put that debt on their balance sheets, and then do share repurchasing.”