Manage Your Finances Like An Outsider CEO!

I recently finished reading a great book called The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. The main idea of the book is that companies become great because of superior capital allocation decisions by management. After seeing the results, I can't argue! The market returns for the companies run by the Eight Outsider CEOs featured in the book were over 20 times the returns of the S&P 500, which is known as a difficult benchmark to beat.

While this book should be required reading for anyone in charge of capital allocation decisions for a large company, there are many great takeaways for household finances.

If you are not familiar with the term “capital allocation,” it is essentially deciding where your money should go. For companies, incoming cash from products sold is used to pay employees, buy equipment, pay taxes (unless you're Amazon!), and any other expense associated with the daily functioning of a business. Compare these expenses to your day-to-day expenses, such as food, utilities, automobile expenses, entertainment. Capital allocation refers to the cash leftover once the day-to-day cost of living is covered, referred to as free-cash flow and there are four main uses of free-cash-flow for a company:

1. a) Expansion & b) Acquisition – the classic examples are building a new manufacturing facility or buying a competitor.
2. Paying down Debt: companies borrow money and pay it back over time.
3. Buying back equity: When companies buy their stock back they shrink the available share pool. All things being equal, Fewer shareholder means more benefit for those with shares.
4. Issuing Dividends: Companies allow shareholders to participate in the prosperity of the business by sharing part of the profit through dividends.

Application to personal finance:

It might not be obvious at first, but there are many similarities between the options faced by a CEO in charge of capital allocation for a business and you, the CEO of your family. I have listed the personal finance equivalent of free cash flow uses below.

1. Expansion/Acquisition = Investing in real estate or growth assets: When you invest in public markets, you decide to take an ownership stake in growing businesses. You are not a part of the day-to-day management, but ideally, you agree with the decisions of management. You can also purchase rental real estate. Investing will grow or expand your net worth, long term.

2. Paying down debt = Paying off a mortgage or other debt: Just like companies borrow to expand, people do the same. We buy house, cars, and other goods with borrowed money. If you have debt, it is always best to pay back high-interest debt like credit cards first. Most people view debt as a bad thing, but low-interest borrowing to acquire assets with a high potential rate of return is something that corporations often do, and more families should think this way in certain situations.*

3. Shares Buybacks = Investing in yourself or your family: Investing in yourself does not always have to be expensive, but like many other things in life, you often get what you pay for. We should all look for ways to add new skills. For example, taking a course in public speaking can have an exponential return in building confidence; the same goes for learning how to negotiate or developing mastery of Adobe's suite of products if you are in a creative field. Developing new skills not only raises the ceiling on your earning potential but can also give you a tremendous sense of personal satisfaction. The same is true for investing in your family. The difference between unlocking your child's love for science may be investing in a good tutor. Installing a basketball hoop might lead your son to become the next Michael Jordan (or maybe just a basketball scholarship and free education). Home improvements and drafting will fit into this bucket. Share Buybacks are a highly controversial topic in corporate finance, but there is nothing questionable about investing in your personal growth!

4. Dividends = Treat yourself! Most retirees have an irrational attachment to dividends. Yes, it is nice to have a dividend cheque come in quarterly that you totally forgot about, but dividends are the least efficient way to allocate capital. From a tax standpoint, they are taxed at two levels, the corporate level and personally. The combined tax rate of dividends at these two levels is higher than that of capital gains, and unlike regular income, you cannot offset dividend income with expenses. Normally companies pay a dividend when they do not have attractive opportunities to use the capital in the first three buckets, which usually means the company's best growth days are behind it. When a company shares its profits with you in the form of a 5% dividend, it is giving away more than 5% (after tax) of its value to its shareholders. All things being equal, your remaining share is worth 5% less than it was before the dividend. For these reasons, dividends tend to be the last resort for well-managed, growing companies (not always). To be clear, we are not against investing in companies that pay dividends, but often, investors think that a company generates superior returns because of its dividends. The reality is that it is a quality company and happens to pay a dividend.

Similarly, it would be best if you only treat yourself once you have exhausted any opportunities in the first four allocation buckets. If you're maxing out your RRSP, RESPs, and TFSA, you have paid off any high-interest debt and invest in yourself or in your family; you can buy that new fancy boat or take that luxury vacation.

Special Payments: Vacations may also fall into the share buybacks category. You cannot put a price on spending quality time, creating lasting memories with loved ones. The return on investment in this area can’t be measured. Just remember, it does not always need to come with a high price tag.

How can you use this framework to be a better capital allocator?

RESPs are a great personal finance example of a non-obvious Capital Allocation decision. If you have not maximized your RESPs for your children, it can make sense to use a secured line of credit, borrowing to make an RESP deposit.* You receive a guaranteed match from the government of 20%. You may be borrowing at 5% but borrowing at 5% to invest at 20% is an easy choice. The risk is that if the beneficiary doesn’t go on to a post secondary education, the grant must be repaid and the growth could become trapped in the RESP. The strategy of using a line of credit to maximize RESPs works best when the beneficiaries are age 14 or 15 because you may have a better sense of their post-secondary plans, and you’ll be much closer to making withdrawals from the account.

Another counterintuitive decision is to go to almost any length to participate in a company matching investment plan, even if that means using a line of credit. For example If your company offers a 100% match for contribution up to $10,000 to an RRSP, and you can't commit the amount required to get a full $10 K match, you'd be better off borrowing the $10 K even at a high-interest rate like 10%. Even though it will cost you $1,000 interest, not getting the match will cost you $10 K for the lost opportunity, not to mention the tax savings you wouldn’t get. We should note that you should have a plan for how you'll repay the loan anytime you're borrowing money.*

There are several other similar decisions like this to improve your long-term financial picture. We find that people are naturally averse to debt, which likely comes from experiences that may no longer apply to the current economic reality. For example, if you bought your first home anytime between 1970 to 2000, you may remember double-digit interest rates on mortgages. Since 2000, the decrease of interest rates has happened gradually; we are now sitting between 2- 3%. All things being equal, a 12% mortgage should be treated differently than a 3% mortgage. If you receive a $10 K bonus at the end of the year, it may make more sense to invest this into an RRSP if you're in a high tax bracket, whereas in 1981, it would have made more sense to pay off your 21.25% mortgage¹.

Think Creatively

It is important to think creatively any time you have free-cash-flow. It can also be helpful to consider the liquidity of all your assets. Investors tend to have rigid ideas of what certain assets should be used for, but it helps to think outside the box. RRSPs don't have to be used only for retirement; RESP can be used for more than just children's education, for more information on how to access your RESPs, check out a related post on our blog. Home equity can be used to invest in certain situations.*

* Using borrowed money to finance the purchase of securities involves greater risk than using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines. A homeowner who withdraws equity from their home to purchase securities should fully understand this risk.

¹https://www.ratehub.ca/prime-mortgage-rate-history