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All businesses face a fundamental capital allocation question: what's the most effective way to deploy limited resources for maximum returns?
Many executives consider only a handful of options, typically defaulting to what's worked before or what competitors are doing. However, companies that carefully evaluate their full range of capital allocation options tend to create more value over time.
In this post, we'll explore the different capital allocation options from Jacob Taylor's 2018 novel "The Rebel Allocator." Through the teachings of Francis Xavier, the billionaire hamburger chain owner who serves as the book’s mentor character, we’ll discuss eight different ways companies can deploy capital to create value.
📜 Jacob Taylor
Jacob Taylor is the author of "The Rebel Allocator," host of the Five Good Questions podcast, and co-founder of Farnam Street Investments.
The Capital Allocation Dilemma
Many executives fall victim to tunnel vision when evaluating capital allocation options. They view each potential investment in isolation rather than comparing it against all available alternatives.
This narrow approach leads to suboptimal decisions and lower returns.
Here’s Warren Buffett on why many executives struggle with capital allocation:
“The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.”
Xavier argues that true capital allocation skills require three key principles:
Having a diverse menu of options.
Understanding the relative trade-offs between options.
Patience to wait when no option provides adequate returns.
The last point is worth reiterating. Waiting for better opportunities isn't merely doing nothing—it's an active decision with significant implications.
Strategic Frameworks for Capital Deployment
To better understand these ideas, Xavier expands on three important concepts that help business leaders make smarter capital decisions:
1. The Opportunity Cost Principle
Charlie Munger, Warren Buffett's business partner, explains:
"In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That's your opportunity cost. That's how we make all of our decisions."
Every capital allocation decision has an opportunity cost—what you could have done with that same capital instead. The best capital allocators constantly compare all available options before making decisions.
2. The Pine Cone Strategy
Xavier uses nature to illustrate patient capital allocation:
"Pine trees release cones that fall to the ground [...] and then just sit there. Sometimes for years and years. [...] Eventually a fire comes along. [...] The soil becomes richly fertilized by the fire's ashes. Sunlight is suddenly plentiful as trees and brush are burned away. After years of sitting dormant on the forest floor, the patient pine cone springs into action. [...] Their usual competition has been wiped out--it's a whole new ecological ball game. [...] But it requires extreme patience."
Just as pine cones remain dormant until conditions are perfect, patient businesses preserve resources during competitive times to deploy when disruption creates unique opportunities.
3. The Bubble Ultimatum
At market extremes, investors face what Xavier calls "The Bubble Ultimatum":
"Every bubble forces you to make a choice: do you want to look like a fool during the build up as you're missing out? Or would you rather look like a fool after it bursts? There's no getting around looking foolish. But you do get to decide the time frame."
For smart capital allocators, this means preserving cash during bubbles when assets are expensive, then deploying that capital when markets crash and bargains become available.
Eight Ways to Allocate Capital
Xavier introduces capital allocation through a concrete metaphor: deciding how to "put a roof over customers' heads."
For a restaurant business, this literally means creating physical locations where customers can dine. For other businesses, it applies metaphorically to any capital-intensive expansion.
Here are the eight distinct approaches a business can take (from a restaurant-industry perspective):
1. Build Immediately
Strategy: Purchase land and construct a new building immediately.
Advantages: Complete control over location, building specifications, and timing.
Disadvantages: Highest upfront capital investment, longest time to operation, highest risk if location underperforms.
2. Land Banking
Strategy: Purchase land now, but delay construction until market conditions improve.
Advantages: Secures prime locations at current prices; provides future options.
Disadvantages: Capital tied up in non-productive assets; ongoing carrying costs with no immediate return.
3. Manufactured Facilities
Strategy: Use pre-fabricated or modular buildings that can be deployed quickly.
Advantages: Lower capital commitment, faster time to revenue, ability to test locations with less risk.
Disadvantages: Less permanent investment, potentially lower long-term returns, may not build as much brand equity.
4. Conversion/Renovation
Strategy: Buy existing buildings and convert them to meet your needs.
Advantages: Lower cost than new construction; faster time-to-market; often available in established areas.
Disadvantages: Compromises on ideal layout; potential hidden problems with existing structures.
5. Competitor Acquisition
Strategy: Purchase an entire competing business and rebrand their locations.
Advantages: Rapid expansion; acquisition of customer base and skilled staff; elimination of competition.
Disadvantages: Integration challenges; potential culture clash; risk of overpaying, especially late in market cycles.
6. Equity Investment
Strategy: Purchase partial ownership (stock) in competitors or related businesses.
Advantages: Exposure to growth without operational responsibility; strategic insights; typically liquid investment.
Disadvantages: Limited control; returns depend on market valuation changes.
7. Share Repurchases
Strategy: Buy back your own stock, essentially repurchasing some of your existing operations from outside shareholders.
Advantages: Increases ownership percentage of existing assets; attractive when stock is undervalued.
Disadvantages: Doesn't expand operational footprint; creates potential opportunity costs.
8. Cash Preservation (Patience)
Strategy: Hold cash and wait for better opportunities to emerge.
Advantages: Maintains flexibility; prevents value destruction; positions for countercyclical opportunities.
Disadvantages: Cash drag during inflationary periods; potential missed opportunities; shareholder pressure for action.
Identifying Superior Capital Allocators
Here's how to apply these capital allocation concepts when analyzing potential investments:
1. Assess Management's Menu Awareness
Firstly, you should examine whether management:
Explicitly discusses multiple capital deployment options.
Compares returns across different allocation strategies.
Changes its approach based on market conditions.
Demonstrates discipline to wait during overheated markets.
The best capital allocators openly discuss trade-offs between building, acquiring, repurchasing shares, and holding cash.
2. Look For Countercyclical Patterns
Companies that deploy capital counter to market cycles often generate superior long-term returns:
Building aggressively during recessions when costs are low.
Acquiring competitors during distress.
Repurchasing shares during market panics.
Preserving cash during booms.
These countercyclical behaviors often signal management teams that truly understand value rather than following the crowd.
3. Red Flags to Watch For
Be wary of companies that:
Always choose the same capital allocation approach regardless of conditions.
Set arbitrary growth targets (e.g., "we’ll open 50 new locations annually").
Never discuss opportunity costs or alternatives.
Deploy capital at an accelerating pace late in bull markets.
Companies displaying these warning signs typically underperform over the long term. Their capital allocation flaws become glaringly obvious when economic conditions deteriorate.
Balance Sheet Strength as Optionality
Xavier emphasizes one final crucial point—maintaining a strong balance sheet provides optionality:
"I believe a company's balance sheet should be run conservatively, even if it means slower growth. I’ll admit, there's a redundancy to carrying extra cash and very little debt. Yes, it's expensive to maintain and I bet your MBA professors would say it's suboptimal. But we have two kidneys for a reason—increasing our chances of survival."
Companies with financial strength can act as "economic shock absorbers" during market turbulence, protecting employees, suppliers, and customers while simultaneously exploiting opportunities that arise when overleveraged competitors falter.
Thus, strong balance sheets provide both protection during downturns and ammunition for opportunistic moves when competitors struggle.
The best allocators maintain this financial flexibility, knowing that having resources available at the right moment often creates more value than squeezing every last penny during good times.
Thanks for Reading!
