It goes without saying that Warren Buffett rocks this lesson. No one has proven to have a better eye for value over long periods of time than Mr. Buffett. Yet if you look at the sorts of businesses he invests in railroads, electric utilities, candy stores, housing fabricators, these businesses are staples in the mainstream economy. You don't see technology or biotech names and his list of investments. Nor is Berkshire Hathaway, a venture capitalists looking for the next Google, Facebook or Apple. The investment of capital requires discipline and knowing the full portfolio of investment opportunities available.

Investment opportunities arise both inside and outside a company. organic growth opportunities may be presented by the managers of various business units. However, equally as valid is the opportunity to acquire another business. The acquire business may have strategic fit with our own or Maybe unrelated. The bottom line is that the CEO is not beholden to invest in only an existing business or an existing industry. in later lessons, we'll talk about another option for the CEO and that is to invest in his own stock.

So the reason that capital allocation is a centralized function is to ensure that the capital is deployed to the highest returning opportunity. However, to ensure long term shareholder value is created. It is simply not a prioritization of the opportunities. There also needs to be a consideration of generating a return in excess of the cost of capital. Once again, the CFO plays a critical role in understanding and explaining to the CEO, the company's cost of capital. The absolute return is not as important as the return relative to the company's cost of capital.

When you evaluate opportunities using relative and absolute screens, you may well recognize that there are periods of time, which you will forego making further investments. Warren Buffett has been a strong contrarian throughout history and is famously quoted as saying be fearful when others are greedy and be greedy when they are fearful. Which is to say the best investment opportunities come when there's panic in the markets and the valuations are depressed. Berkshire Hathaway was aggressively investing throughout the great recession in 2008, when everyone else was holding on to whatever cash they could find. companies that have generated supersized returns for shareholders have occasionally made oversized bets relative to the size of their existing business. This flies in the face of risk management theory that suggests risk tolerance and risk appetite be considered.

The bottom line is if the right deal appears and there's a high margin of safety simply based on the valuation discount, regardless of size pursue it as we did discussed in the last lesson, the preferred metrics of master capital allocators are all cash based investment opportunities would be screened using cash based metrics such as payback and internal rate of return. The projections need not be complicated. In fact, Warren Buffett does barely any due diligence on acquisitions he makes. The key is to focus on a handful of the key variables such as market growth and competitive positioning and potential operating improvements and proven cash generation. Keep the math simple exercise extreme patience and deals will appear when you're using a long term horizon. The pitfalls of many CEOs is to only seek out deals when times are good and cash flow is strong.

Unfortunately, this is often the worst time to be shopping for deals because the valuations are higher as everyone has excess cash looking for reinvestment opportunities. These are times when organic growth and internal research and development Maybe more attractive by preserving financial capacity on the balance sheet mergers and acquisition opportunities tend to be more attractive when the capital markets are weaker and fewer buyers are looking for deals. This contrarian approach takes discipline. The issue of diversification is another consideration where theory practice and popular opinion vary. In the model we are talking about where the CEO is only responsible for optimizing capital allocation. akin to Warren Buffett and Berkshire Hathaway.

The nature of the underlying business is merely a secondary consideration has is the number of positions that are held. far more important is the cash generating characteristics and return of the opportunity. conglomerate strategies have come into favor and out of favor throughout periods of time. The argument against diversification of a company's investment portfolio is that it's a decision best left for the investor the argument For diversification is that I can help a company stabilize its cash flows in different phases of market cycles and reduce volatility. Neither approach is right or wrong. However, the master capital allocator will not allow the whims of the market to distract them from allocating capital to the highest forms of return.

The pitfall of diversification happens when the CEO attempts to split his roles between capital allocation and running up the operations. Very few CEOs had done this successfully. Think of the amount of time and energy jack welch expanded using his hands on CEO approach at GE. Instead, Master capital allocators use extreme forms of decentralization hiring capable managers to run the investments autonomously. This frees up the CEO to just focus on capital allocation. Warren Buffett is now in his mid 80s and Charlie Munger in his 90s the two of them are still Running Berkshire Hathaway today.

Keep this in mind the next time you or your CEO feel compelled to add value to your business units. Another tool in the master capital allocators bag of tricks is to recognize when an investments value inside the portfolio isn't being recognized by capital markets. By carving out businesses that are currently in favor in the market. The master capital allocator is able to maximize shareholder value, opportunistically taking advantage of the capital market conditions. There are two strategies to unlock this value. First is to divested the business and capitalize on the favorable valuation, you may structure the sales consideration as either cash or shares.

However, you don't even need to sell the business outright. The business unit could be spun off and separately run as a public entity. The company could hold on to sufficient shares to maintain control of the business or the shares of the new entity provided to the existing shareholders. Not only are you maximizing value, but you can often minimize taxes when share consideration is used in a divestiture or a spin off. Finally, Master capital allocators don't fall into the trap of throwing good money after bad. When you're stuck with a long term low return business.

Consider the words of Warren Buffett should you find yourself in a chronically leaking boat energy devoted to changing vessels is likely more productive than energy devoted to catching leaks. In this lesson, we covered three important points of capital allocation. First, capital investment decisions are centralized to ensure that the highest return opportunities above a minimum return threshold are pursued. Second, diversification is not evil. But generally speaking, the more diversified your lines of business, the more decentralized your organizational structure will need to be And third, Equally important as knowing when to buy is recognizing when to sell, which may include strategies that hold on to the business, but allowed to be separately valued by the capital markets, such as a spin off. In the next lesson, we're going to look at sources of cash raised from finance.

Until then,