Analyze capital allocation in 10 easy steps
The case of Koshidaka. Estimated reading time: 28 minutes
Disclaimer: Asian Century Stocks uses information sources believed to be reliable, but their accuracy cannot be guaranteed. The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. You are advised to discuss your investment options with your financial advisers and to understand whether any investment is suitable for your specific needs. From time to time, I may have positions in the securities covered in the articles on this website. Full disclosure: I hold a position in Koshidaka when publishing this article. Note that this is a disclosure and not a recommendation to buy or sell.
Summary
The Essays of Warren Buffett remains one of the best books ever written about capital allocation.
In this post, I discuss ten factors mentioned in the book that help you analyze a company's capital allocation.
These factors are management’s ambitions, management incentives, return on equity, debt, retained earnings, dividends, assessment of intrinsic value, share buybacks, mergers and acquisitions, and equity issuance.
I use the example of Japanese karaoke bar operator Koshidaka to demonstrate how you can analyze a company’s capital allocation.
I find that Koshidaka’s controlling shareholder is aligned with minorities through a sizeable stake in the company, has been able to reinvest capital at high rates of return, has engaged in sensible M&A and also added value to shareholders through Japan’s first-ever spin-off after tax laws were revised in 2017. In a Japanese context, Koshidaka’s capital allocation appears to be strong.
Capital allocation is a major issue among Asia’s publicly listed companies. They simply do not act in the best interests of shareholders.
But there are exceptions. And in this post, I will help you identify them. To that end, I’ve spent the past few days re-reading The Essays of Warren Buffett. This book is the gold standard when it comes to understanding capital allocation.
I then apply the key learnings from the book on Japanese karaoke bar operator Koshidaka (2157 JP - US$637 million). The purpose is to show how you can analyze a company’s capital allocation yourself.
If you’re not familiar with Koshidaka, I suggest reading my May 2024 update on the company here:
In any case, here’s the agenda for today:
Table of contents
1. Management's ambitions
2. Management incentives
3. Return on equity
4. The balance sheet
5. Growth capex
6. Dividend payments
7. Intrinsic value
8. Share buybacks
9. Mergers, acquisition & divestitures
10. Share issuance
Conclusion1. Management's ambitions
In Buffett’s view, the goal of management is to maximize the intrinsic value of the company.
In reality, many management focus on increasing the size of their empires. Perhaps to justify higher salaries on the Forbes 500 list:
“For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders — to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc.”
So if a manager simply tries to maximize the size of his company, you might end up with value-destructive acquisitions and reinvesting capital in low-return business areas.
In Buffet’s view, targeting EBITDA is even worse, since it ignores certain costs that will ultimately be borne by shareholders (depreciation & amortization):
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That's nonsense.”
Also check whether management is providing specific earnings targets. Buffett is not a fan of such earnings targets:
“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly.”
Why? Because earnings projections tempt management teams into playing accounting games to meet the numbers:
“Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.””
So, let’s look at how Koshidaka stacks up. In a recent interview with Nikkei, founder Hiroshi Koshidaka said that his goal is to reach a 30% market share in Japan:
“The goal is to increase this to 30% in the future… I want Manekineko to become the unrivaled name when it comes to karaoke, and will open more stores in the Kinki region and elsewhere in the future.”
Further, in the company’s latest earnings report, it an earnings per share target for the fiscal year ending 31 August 2025 of JPY 92 per share.
So it doesn’t look like the Koshidaka is focusing on the right metrics here. I’d say this is a common problem with Japanese companies. An ameliorating factor is that Hiroshi Koshidaka does seem to care about improving the customer experience through innovation and providing a unique value proposition.
When it comes to capital allocation, there is a risk that once the market becomes saturated, that Koshidaka will continue to expand despite lower returns on reinvested capital. I’d prefer to see management target specific return hurdles rather than reaching a, say, 30% market share.
2. Management incentives
In Buffett’s view, management should be compensated based on profitability, adjusting for the amount of capital employed in the business. In his own words:
“Executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it.”
So, what does the ideal compensation structure look like? In one of his letters, Buffett praised the approach taken by shoe company HH Brown:
“A distinguishing characteristic of H.H. Brown is one of the most unusual compensation systems I've encountered—but one that warms my heart: A number of key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners.”
If management compensation is solely focused on earnings, it will be tempted to reinvest as much capital as possible, returns be damned:
“If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO's reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld.”
Buffett is also critical of stock options. He thinks that fixed-price options incentivize management teams to retain earnings rather than pay them out as dividends. They also ignore the cost of capital.
“Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital”
And what’s perhaps even worse is that fixed-price stock options provide incentives for excessive risk-taking. Management will make money on the upside and not get penalized on the downside.
“No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside.”
Stock options are also problematic if granted to individuals who are not responsible for the overall company’s performance, for example to mid-level managers.
“First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should be awarded only to those managers with overall responsibility. Managers with limited areas of responsibility should have incentives that pay off in relation to results under their control”
Looking at Koshidaka, the disclosures regarding its compensation structure are close to non-existent, but there are clues in its prior disclosures.
Before the spin-off of its sister company Curves, Koshidaka justified the transaction by stating that it wanted to link management’s compensation to the value of the shares:
“Enabling the introduction of equity compensation linked to the value of the shares of the spun-off company.”
Koshidaka has been much more cautious when it comes to granting share options. Koshidaka’s financials show that the number of Treasury shares was exactly flat from 2020 to 2023, with no stock options provided to its management team during that time.
However, in July and August 2024, Koshidaka targeted share buybacks of 660,000 shares for the specific purpose of granting employee stock options. This number is, however, small compared to the total shares outstanding of 82 million.
The latest balance sheet statement also shows provisioning for future bonus payments. These bonus payments have an almost 1:1 correlation with Koshidaka’s earnings per share, suggesting that they’re based primarily on earnings without any adjustment for the incremental amount of capital employed. But in absolute terms, total bonuses of ~US$2 million are not material.
In any case, founder Hiroshi Koshidaka and his family own 14% of the company, so at least he’s aligned through share ownership.
So to summarize, I think Koshidaka’s alignment with minorities is decent. There’s a controlling shareholder who manages the company with an iron fist, and I don’t see any excessive issuance of fixed-price stock options.
3. Return on equity
In Warren Buffett’s view, the best businesses are those that can invest large amounts of capital at high rates of return for extended periods of time:
“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite—that is, consistently employ ever-greater amounts of capital at very low rates of return.”
So what you’ll want to see is that the return on equity stays high even as the management increases the total capital employed in the business.
A high return on equity can be explained by two factors:
Competitive advantages
Strong capital allocation
So, if you find a company with a high return on equity, be careful concluding that it’s necessarily good at allocating capital. It may simply be an exceptional business with poor capital allocation. In Buffett’s own words:
“Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere.”
Koshidaka’s historical return on equity has been strong over time:
Koshidaka’s main business of operating karaoke bars is not a monopoly. There’s no reason to think that it’s an exceptional business. That leaves capital allocation as an explanatory factor for its high return on equity.
The decline in Koshidaka’s return on equity until 2014 was due to a saturation in its key markets. Hiroshi Koshidaka then shifted the company’s strategy by opening stores around key train stations. He also revamped the stores with bright lights and soundproof doors. Around this time, Koshidaka’s Manekineko karaoke chain became a pioneer of “solo karaoke” which has now gone mainstream.
After this shift in strategy, Koshidaka’s return on capital started rising. While COVID-19 was undoubtedly a tough period, the karaoke business has now recovered and is stronger than ever.
So to conclude, Koshidaka has reinvested most of its earnings, and done so at high returns on capital. This does seem to suggest that its capital allocation has been strong.
4. The balance sheet
Buffett is careful with leverage, and especially full-recourse leverage:
“We use debt sparingly. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.”
At Berkshire Hathaway, debt has only been used for three purposes:
“Gearing up low-risk securities: Repos as a part of certain short-term investing strategies that incorporate ownership of U.S. government (or agency) securities. Purchases of this kind are highly opportunistic and involve only the most liquid of securities.
Borrowing against receivables: Borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand.
Non-recourse debt: Subsidiaries, such as Berkshire Hathaway Energy, may incur debt that appears on Berkshire's consolidated balance sheet, but Berkshire does not guarantee the obligation.”
Buffett has also stated that he wants Berkshire Hathaway to acquire companies earning a high return on equity while employing little to no debt. Such conservatism is a recurring thread in his letters.
Today, Berkshire Hathaway holds almost $300 billion in cash. Buffett likes to sit on cash for two separate reasons: to withstand potential insurance losses and be able to acquire companies quickly during times of dislocations:
“We customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses (our largest to date having been about $3 billion from Katrina, the insurance industry's most expensive catastrophe) and quickly seize acquisition or investment opportunities, even during times of financial turmoil.”"
Berkshire’s cash is typically invested in risk-free securities, such as short-term US government bills:
“We keep our cash largely in U.S. Treasury bills and avoid other short-term securities yielding a few more basis points, a policy we adhered to long before the frailties of commercial paper and money market funds became apparent in September 2008”
A company like Koshidaka does not need as much of a cash buffer. While it has done bolt-on acquisitions in the past, these have been small. And there are no contingent liabilities that could lead to major losses in the future. Even during COVID-19, it remained close to cash flow positive.
Koshidaka’s balance sheet looks clean, with almost no debt:
JPY 4.4 billion is equivalent to US$29 million, a small number compared to Koshidaka’s operating income of around US$70 million per year.
Koshidaka’s convertibles and warrants can be seen as equity rather than debt. Once converted, Koshidaka will again be in a net cash position. While I don’t like dilution, these were issued as payment to Advantage Advisors to help Koshidaka improve its digitalization strategy. I think the deal was probably in the best interests of shareholders.
Koshidaka’s interest expenses have been tiny, at just JPY 37 million per year. It’s unclear how they managed to secure such cheap debt, but I certainly cannot fault them for it. Koshidaka’s balance sheet looks clean, indicative of strong capital allocation.
5. Growth capex
In Buffett’s view, earnings should only be retained if they increase the market value of the company:
“Each dollar of earnings should be retained if retention will increase market value by at least a like amount; otherwise it should be paid out. Earnings retention is justified only when capital retained produces incremental earnings equal to, or above, those generally available to investors.”
In practice, this means that earnings should only be retained if they generate a return on reinvested capital above the cost of capital. For example, if a company’s return on equity is consistently around 5% and still retains the majority of earnings without paying out dividends, it’s clearly doing shareholders a disservice.
If a company has two business divisions, it should stop reinvesting in the lower-return division and allocate more capital to the higher-return one. The remaining capital should then be used to buy back shares or pay out dividends:
“In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses)”
Management might be tempted to reinvest earnings to expand their empires and, in the process, justify higher salaries for themselves. We should, therefore, be careful with companies with low dividend payout ratios.
In deciding whether to retain earnings, a company should think about where it is in its corporate life cycle. Companies with products that are finding new ways to please customers will find it easier to achieve a high return on invested capital. Meanwhile, mature businesses should probably retain less earnings and pay them out as dividends instead.
Note that during inflationary periods, earnings in commodity businesses are often overstated as depreciation charges are based on historical cost rather than current cost.
Conversely, as Buffett says, during inflationary periods, companies with strong economic moats will be able to earn very high returns on capital:
“In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return.”
In Koshidaka’s case, it has successfully reinvested capital at high rates of return. The company’s historical return on equity is clear evidence that its current strategy is working. A low dividend payout, therefore, makes sense.
But eventually, we should hope for the payout ratio to rise as the company gets closer to saturation in its home market of Japan.
6. Dividend payments
Most companies target a set dividend payout ratio. And they typically don’t explain exactly how they arrived at that number. As Buffett explains:
“A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that's it—no analysis will be supplied as to why that particular policy is best for the owners of the business”
A better approach is to make lists of potential projects capital can be invested in and then exclude those that don’t meet strict return on capital hurdles:
“A company's management should first examine reinvestment possibilities offered by its current business—projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.”
Another consideration is the tax environment. If dividends are highly taxed, then reinvesting them might be a better course of action:
“A shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested.”
In Asia, dividends are typically subject to withholding taxes and income taxes for the shareholders who receive them. The exception is Hong Kong, which doesn’t impose withholding taxes on either residents or non-residents.
Koshidaka has historically not been generous with its dividends. Its payout ratio bottomed at 8% in 2011 and reached 31% by 2016. Back in 2024, when Koshidaka found a new growth model that worked, it made sense for the company to retain more capital for growth. From that perspective, the decline in the dividend payout ratio can probably be justified.
7. Intrinsic value
Next, we’ll be calculating the company’s intrinsic value.
Why? By doing so, we’ll understand whether corporate transactions such as stock-for-stock mergers and share buybacks are value-additive or not. Compare the intrinsic value with the price of any transaction, and you’ll understand whether the company loses or benefits from it.
Buffett defines “intrinsic value” as the cash that can be taken out during its life:
“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
In practice, that means projecting cash flows and discounting those cash flows with a rate that represents the opportunity cost of capital.
Which cash flows should you discount? In Buffett’s view, you should discount the company’s “owner earnings”:
“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”
In most cases, net profit = owner earnings. But in inflationary environments, since depreciation & amortization are based on historical cost, maintenance capex will exceed that depreciation and amortization. In such situations, owner earnings will end up being lower than net profit.
The same is true for companies selling obsolescent products. They’ll find it difficult to maintain unit volumes without significant capex. In other words, owner earnings will be adjusted downwards if the product sold requires costly capital expenditures or greater R&D to maintain unit volumes.
Since the spin-off of Curves, Koshidaka’s capital expenditures have exceeded depreciation and amortization. One contributing factor is the spin-off of Curves in 2020, causing aggregate depreciation and amortization to drop. But a more important factor is that Koshidaka used the COVID-19 pandemic as an opportunity to secure new leases for karaoke bars in high foot traffic areas. I am not worried about Manekineko’s competitiveness: unit volumes as measured by Google search queries and as measured by same-store sales continue to go up.
Let’s calculate an intrinsic value for Koshidaka. I believe that net profit is a good proxy for owner earnings. So I discount net profit at a 10% discount rate, assuming growth hits zero by 2036. My intrinsic value estimate for Koshidaka then ends up being JPY 130 billion or JPY 1,470 per share.
Bear in mind that this estimate is not precise. Who knows how fast Koshidaka will grow, and what discount rate to use. In Buffett’s words:
“Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base”
But the JPY 1,470 is good enough for our purposes. We can now put its share buybacks and equity issuance into perspective.
8. Share buybacks
In Buffett’s view, share buybacks are a great demonstration of shareholder and management alignment:
“By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders”
He thinks that you should back your shares whenever they trade below intrinsic value:
“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds—cash plus sensible borrowing capacity—beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated.”
However, with major one caveat:
“Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth.”
In other words, as long as management is forthright and not withholding information from minorities, share buybacks are fair play.
In Buffett’s view, if a company can buy back its own shares at a 50% discount to intrinsic value, then it should just go right ahead and do it. Share buybacks certainly add more value than dividends in such a scenario. In Buffett’s own words:
“The purchase of a share priced at $1 but with a value of $2 would rarely be inferior to any other use of corporate funds. Alas, as often happens, the imitators stepped in and now you frequently see companies paying $2 to buy back shares worth $1. These value-destroying share repurchases often are intended to prop up a sagging share price or to offset the simultaneous issuing of stock under stock options exercised at much lower prices.”
Conversely, if a company refuses to buy back shares despite a large discrepancy between price and intrinsic value, it may not have shareholders’ best interests at heart:
“A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season's favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth—and, after a while, neither will the market.”
If you’re a long-term shareholder, you’ll want the share price of the company buying back shares to be low for as long a period as possible, as that will enable a maximum amount of shares repurchased below intrinsic value:
“First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well.”
If the share price is above intrinsic value, then share buybacks will be value dilutive. Share buybacks are often done, not because the share price is low, but because management wants to offset the dilution from stock options:
“Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised.”
A final caveat has to do with greenmailing. In some cases, management buys back shares directly from activist investors to make them disappear. In such instances, value is essentially transferred from selling shareholders to the activists and management itself:
“Our endorsement of repurchases is limited to those dictated by price/value relationships and does not extend to the “green-mail” repurchase—a practice we find odious and repugnant. In these transactions, two parties achieve their personal ends by exploitation of an innocent and unconsulted third party. The players are: (1) the “shareholder” extortionist who, even before the ink on his stock certificate dries, delivers his “your-money-or-your-life” message to managers; (2) the corporate insiders who quickly seek peace at any price—as long as the price is paid by someone else; and (3) the shareholders whose money is used by (2) to make (1) go away.”
Let’s now look at Koshidaka’s record in terms of share buybacks. I get this information from its cash flow statement.
Most of these share buybacks occurred around 2014 when Koshidaka traded at 15x P/E and was starting to see success in its new strategy of expanding stores close to railway stations. To me, these share buybacks seem to have been well-timed.
I am less positive about the 660,000 share buyback program in July and August 2024 to support a new employee stock option program. But the numbers were small, all things considered.
9. Mergers, acquisitions & divestitures
In Buffett’s view, mergers & acquisitions typically do not add value to the acquiring company’s shareholders:
“When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.”
So what’s driving M&A activity? In his view, it’s the excitement of dealmaking:
“Talking to Time magazine a few years back, Peter Drucker got to the heart of things: I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . dealmaking is romantic, sexy. That's why you have deals that make no sense.”
Acquisitions are also ways for company management teams to expand their empires and in the process justifying higher salaries:
“Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick.”
So who benefits from M&A? Mostly the acquisition targets, management and the investment bankers and professionals representing each side:
“The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent”
There are exceptions to the rule. For example, Berkshire Hathaway has largely grown through acquisitions. In Buffett’s view, there are two categories of acquisitions that have added value to the acquirer:
“Some acquisition records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.”
The second category involves the managerial superstars—[those] who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise.”
So if a company is able to identify acquisition targets with franchise characteristics or buy turnaround cases at cheap valuations, then M&A can indeed add value.
Buffett has tried to combine these two strategies, with great success. In author Lawrence Cunningham’s words:
“Berkshire's acquisition policy is the double-barreled approach: buying portions or all of businesses with excellent economic characteristics and run by managers Buffett and Munger like, trust, and admire”
How can you judge whether an acquisition makes sense or not? According to Buffett, the only valid benchmark is whether an acquisition is dilutive or not when it comes to the company’s intrinsic value.
“What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value (a judgment involving consideration of many variables). We believe calculation of dilution from this viewpoint to be all-important (and too seldom made).”
An acquisition being earnings accretive is simply not enough. An acquisition can be earnings accretive yet still end up destroying value, as the earnings were simply not sustainable.
“In corporate transactions, it's equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, a different mix of operating and non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value.”
So using Buffett’s approach, analyzing mergers & acquisitions is simple: just ignore earnings per share, and instead look at whether the target was acquired above or below its intrinsic value.
Koshidaka has been careful in its M&A activity. Hiroshi Koshidaka has undertaken a number of bolt-on acquisitions within the karaoke segment that seems to have added value. For example, in 2021, it acquired the karaoke business of Daisyo with 43 stores. The price was not disclosed, so it’s difficult to say whether it was value-accretive to Koshidaka or not. But it seems that many of these stores were in excellent locations.
The 2018 acquisition of Curves US business cost JPY 34 billion (US$312 million). It paid half of that amount through the issuance of new shares and the other half through cash. While it’s difficult to say whether this transaction made sense, I do see the potential for Curves to grow internationally. And acquisitions in related businesses tend to be more successful than those in completely unrelated areas.
A positive sign for Koshidaka’s capital allocation is that it spun off Curves back in 2020. This was the first spin-off in Japan since the law was revised in 2017.
Before the spin-off, the combined company had a market cap of JPY 130 billion. Today, the combined market cap of the two companies is JPY 165 billion. So not only does the transaction seem to have been in the best interests of shareholder, it also seems to have added value to them.
10. Share issuance
When it comes to share issuance, Buffett believes that new shares should only be issued if the company gets more in value than it gives:
“Our share issuances follow a simple basic rule: we will not issue shares unless we receive as much intrinsic business value as we give”
Share issuance is akin to the company is selling part of itself:
“Clearer thinking about the matter would result if a more awkward but more accurate description were used: “Part of A sold to acquire B”, or “Owners of B to receive part of A in exchange for their properties”.”
But management rarely thinks in those terms. They consider share issuance as being almost costless. But if they’re not willing to sell the entire company, why would they want to sell a part of it?
“Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it. And if it isn't smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion.”
If the company trades above its intrinsic value, then you could argue that it should indeed issue shares. Some serial acquirer have have employed this strategy to great success, and Buffett seems to think it’s a great idea.
“The second route presents itself when the acquirer's stock sells at or above its intrinsic business value. In that situation, the use of stock as currency actually may enhance the wealth of the acquiring company's owners. Many mergers were accomplished on this basis in the 1965-69 period. The results were the converse of most of the activity since 1970: the shareholders of the acquired company received very inflated currency (frequently pumped up by dubious accounting and promotional techniques) and were the losers of wealth through such transactions.”
But the greatest companies, such as Berkshire Hathaway, rarely trade above their intrinsic value. So I’d personally be cautious of any company issuing shares on a regular basis.
In Koshidaka’s case, they’ve been reluctant to issue shares. They only did so to acquire Curves’ international business － a transaction that, in my view, holds significant promise in terms of future expansion. Share issuance has otherwise been sparse, as evidenced by near-zero share count dilution historically.
Conclusion
The Essay of Warren Buffett remains the gold standard for understanding capital allocation. The key lessons from the book are that you’ll want the company to retain earnings and invest them in the projects with the highest return potential, or else pay them out as dividends. If the stock trades below its intrinsic value, it should buy back shares. And if it trades above, potentially issue shares. M&A is usually value-destructive, but there are exceptions of managers who indeed can add value through acquisitions.
In Asia, capital allocation tends to be weak. But by going through the above list of ten points, I think we can find the needles in the haystack: companies where management acts in the best interests of shareholders.
In my experience, a high return on equity, opportunistic share buybacks at low levels, generous dividend payouts and low share count dilution can help us identify the out-performers.
Thank you for reading 🙏
If you’d like to get smarter about Asian equities and get 20x high-quality deep-dives per year, try out the Asian Century Stocks subscription service － all for the price of a few weekly cappuccinos: