Ever wondered why some businesses thrive while others struggle? Why some businesses have longevity and others wither away after a burst of success? Often, it comes down to capital allocation – a concept that’s crucial yet frequently misunderstood. At its core, capital allocation is about doing more with less to create value for customers. And when we talk about customers collectively, we’re really talking about society as a whole.
At the most basic level, it’s how you decide to spend money. But it’s even deeper than that. Successful capital allocation means converting inputs like money, materials, energy, ideas, human effort, into more valuable outputs. It’s that transformation process.
Let’s break this down with an analogy. Imagine we all have a set of locks inside us, each representing something we want or need – food, shelter, entertainment, you name it. Now, think of each business project as creating a key. The goal? Make a key that fits a specific lock.
So, a restaurant makes a key for your hunger lock. An apartment? That’s for your shelter lock. Shoes protect your feet – another lock, another key. Here’s the tricky part: businesses need to create these keys using as few resources as possible. It’s like solving a puzzle, but the prize is efficiency.
When companies get good at this, something interesting happens. They free up resources that can be used to make more keys for other locks. That’s why profit isn’t a dirty word – it’s a sign that a business figured out how to provide value without wasting resources.
Now, imagine a world where all businesses are ace capital allocators. More locks get opened, fewer resources get wasted, and society as a whole benefits. That’s the power of good capital allocation. It’s what technology is all about, really – finding ways to open more locks with fewer, cheaper keys.
This brings us to Jacob L. Taylor’s book, ‘The Rebel Allocator‘. Taylor takes this complex idea and turns it into a compelling story. He introduces us to Nick, a young journalist turned investor, who learns about capital allocation from a savvy billionaire called Mr. X. Through their chats, we see these principles in action, applied to Mr. X’s burger chain.
‘The Rebel Allocator‘ covers a lot of ground – from corporate finance to mergers and acquisitions. But instead of dry financial jargon, Taylor presents these ideas in a cheesy feel-good story that’s easy to digest and apply to real life.
‘The Rebel Allocator‘ gives us a fresh perspective on how businesses create value, or how they should create value. Through Nick’s journey, we get to see how capital allocation works in practice, not just in theory. It’s a chance to understand the decisions that shape companies, industries, and ultimately, our everyday lives.
What Did I Get Out of It?
“The Rebel Allocator” gave me a crash course in corporate finance, but with a twist. It’s like Taylor found a way to distill years of business school into one engaging story. It’s corporate finance 101, but without the boredom.
The Profit Constraint
Revenue minus PROFITS equal expenses.
“Don’t wait to see if there’s anything left over for a profit. By carving out a margin before you address expenses, you create a constraint on the resources available. This constraint unlocks your creativity to meet customers’ needs, streamline operations, and only spend money on that which truly generates value.”
It’s really about maintaining your margins. It’s a reminder that growth at any cost isn’t always the best strategy.
Many companies fall into the trap of chasing revenue growth while letting their margins slip. They might cut prices to gain market share or take on unprofitable customers just to boost their top line. But this approach can be dangerous.
By setting a profit target first, companies are forced to grow in a sustainable way. They have to find efficiencies, improve their value proposition, or target more profitable market segments rather than just expanding for the sake of expansion.
More so, by setting profit targets first, companies create a form of artificial constraint. This constraint, like hunger for a falcon, can spark creativity and drive efficiency. It pushes businesses to find innovative ways to meet customer needs while staying within their resource limits.
The concept of yarak doesn’t apply to only falconry. Have you heard of the personal finance idea of ‘Pay Yourself First?’ Basically, you take money out of your account every month in an automated way to save for the future, and then you live on whatever’s left. Pay yourself first before you pay everyone else. Sometimes you have to get creative to make ends meet and not dip into your savings. You create an artificial constraint, a hunger, this state of yarak in yourself. Yarak sparks a creativity that can only be unlocked when your back is against the wall. You become the bird that has to hunt.”
“Yarak also applies to running a business. Most businesses hustle to create revenue, pay out their various expenses, and with any luck, there’s a little profit left over for the owners.”
Companies in yarak are always looking to improve, even when things are going well. They’re not complacent due to past successes, nor are they desperate and making rash decisions. Instead, they maintain a healthy tension that keeps them sharp and adaptable.
This approach combines financial discipline with a culture of continuous improvement. It’s not just about hitting profit targets, but about doing so in a way that makes the company stronger and more competitive.
In personal finance, this translates to focusing on your savings rate rather than just your income. It’s not about how much you make, but how much you keep. One practical life hack is to set aside your savings first and then spend the rest. This approach eliminates the need for a detailed, bottom-up budget that can become cumbersome to create and monitor. By ‘paying yourself first’, you ensure your savings goals are met, and you’re free to spend the remainder without constant tracking.
By ‘paying yourself first’ and living on what’s left, you create your own yarak state. You’re pushed to be creative with your spending, potentially leading to better financial habits and increased resilience.
The key is finding that balance – being hungry enough to drive growth and improvement, but not so constrained that you can’t function effectively. It’s a powerful way to align financial goals with overall performance, both in business and personal life.
Strategy ROIC vs Project ROIC
Strategy ROIC (Return on Invested Capital) versus Project ROIC is about thinking bigger and longer-term in business decisions.
We prefer to assess and fund strategies and not individual projects for several reasons. First, we’re aiming to succeed in the long term.
While Project ROIC focuses on the return of individual initiatives, Strategy ROIC looks at the overall, long-term return on investments. It’s more fluid and dynamic, considering how each project fits into the company’s broader goals and competitive advantage.
This is where the idea of strategic and non-strategic expenses is introduced. Strategic expenses directly contribute to delighting customers and advancing the company’s overall strategy. These are the investments that build a moat around the business, making customers want to stick around. Companies should be willing to outspend competitors on these strategic areas.
“We also have something we call strategic expenses. These expenses advance our strategy of delighting the customer. For strategic expenses, we seek to outspend the competition by a long shot. Strategic expenses build a moat around our castle so the customer only wants to do business with us. We aren’t afraid to spend in those categories. We view them as investing in the happiness of our customers.”
On the other hand, non-strategic expenses don’t directly contribute to customer satisfaction or strategic goals. These are the costs that need constant trimming, like fingernails.
“Will this expense go toward delighting our customer? If the answer is no, then we’re ruthless about cutting it. We call these non-strategic expenses because they don’t advance our strategy of making the customer happy. We’ve found these expenses to be like fingernails; they always need trimming.”
A company might choose a project with a lower immediate return if it opens up new markets or builds valuable capabilities for the future by focusing on Strategy ROIC. It’s about making decisions that create more value in the long run, even if they don’t show the highest Project ROIC on paper.
We pursue a strategy together, not pet projects that make an individual champion look good. Innovation is often best done in teams by combining ideas in novel ways.
This approach encourages businesses to build a cohesive strategy where each part contributes to a greater whole. It’s not just about the profitability of individual projects, but how they fit into the bigger picture of delighting customers and achieving long-term success.
This principle applies to career and decisions in personal life. It’s about investing heavily in areas that align with your long-term goals (strategic expenses), while being ruthless about cutting costs that don’t contribute to your overall life strategy (non-strategic expenses).
Zero-Based Budgeting
…zero-based budgeting,” he said. “Basically, every expense needs to be justified each year. Nothing just rolls over mindlessly without passing inspection.
Zero-based budgeting challenges traditional budgeting methods. Instead of starting with last year’s budget and making adjustments, it starts from zero each year, requiring every expense to justify its existence.
In the book, Mr. X talked about the key being the ‘delight’ test. Each budget item needs to answer the question: Does this expense contribute to delighting our customers? If the answer is no, it’s considered non-strategic and becomes a candidate for trimming or elimination.
The legendary leader of Capital Cities/ABC, Tom Murphy, illustrated this concept with his “fourth wall” analogy. In theater, you don’t waste paint on the unseen fourth wall. Similarly, in business, you shouldn’t spend money on things that don’t directly impact customer satisfaction or contribute to your strategic goals.
This forces businesses to really think about where their money is going. It prevents the accumulation of unnecessary expenses over time and keeps the focus on what truly matters – creating value for customers.
Zero-based budgeting can be challenging. It requires more effort than simply carrying over last year’s budget. But it keeps a company lean, focused, and customer-oriented.
In our personal lives, we can apply this by regularly reviewing our expenses and asking if they truly contribute to our happiness or goals. It’s about being intentional with our spending, rather than just continuing habits or subscriptions because “that’s what we’ve always done.”
Iron Law of Economic Survival
A fascinating concept that ties together cost, price, and value.
“In order for a business to thrive, the value delivered to the customer, V, has to be greater than the price the customer is charged, P, which has to be greater than the cost of that good or service, C. V is greater than P is greater than C,”
This law is based on a triangle model of cost, price, and value. Each of these elements has some nuances:
Cost here refers to true economic cost, not just accounting cost. This means considering all resources used, including opportunity costs.
Every cost should be included in that C number. The more comprehensive your list, the better your calculation of true economic cost. It’s very easy to use accounting tricks to make C be whatever you want by shifting costs into different time periods. Always be wary and ask yourself, does this represent every true cost?
Price isn’t just the sticker price but can be based on lifetime revenue from a customer. This takes into account future purchases, referrals, etc.
if you have more than five competitors in your fishbowl, don’t expect to be able to control the price of anything. Also, I’ve noticed that in the long run, a mature market becomes a two-horse race. Usually an old, reliable brand versus an upstart battling it out.
Value is the trickiest part. It’s subjective, depends on context, and can vary from person to person or even for the same person at different times
“There are three ways to make the brand triangle bigger: Be the cheapest. Be the most convenient. Or be the best. Good companies aim for at least one of those objectives. Great companies find a way to achieve two. Doing all three is a rarity.”
The interesting part is the trade-off between profit (price minus cost) and brand (value minus price). Companies can choose to maximize short-term profits by pricing close to value, or they can price lower to build brand equity.
Or, a company might be able to store value in their brand, which exists in the customer’s mind, by “flying under the radar” with lower profits. This stored value can be a powerful asset, even if it doesn’t show up on traditional balance sheets.
There’s a strategic element here too. Lower profits might not attract competitors or regulatory attention, allowing a company to build a strong market position quietly.
One way to measure this stored brand value is through Net Promoter Score surveys. These compare the percentage of customers who are superfans against those who are ambivalent or detractors.
Net Promoter Score. We use it at Cootie to ballpark the health of our Value straw. At least we can track changes over time. We ask the customer one simple question: ‘On a scale of one to ten, how likely would you be to recommend us to a friend?’ This question lets us group people into three buckets. The nines and tens are loyal, enthusiastic fans. They tell everyone they know and buy more as repeat customers. They’re the lifeblood of any business.
…here’s how we calculate it,” he said. “We take the percentage who voted either nine or ten, then subtract the percentage who voted zero through six. We throw out the lukewarm sevens and eights.
In our personal lives, we can apply this by thinking about our own “brand” – our reputation and the value we provide to others. Sometimes, doing more than expected without immediate reward can build long-term value in our relationships and careers.
Understanding Opportunity Cost
Fundamentally, effective capital allocation is about evaluating all options and understanding opportunity costs. This is a crucial skill that goes beyond just choosing between obvious alternatives.
“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.”
– Charlie Munger
Capital allocation decisions are rarely straightforward. They require a comprehensive view of all possible uses of capital, including options that might not be immediately apparent. This could involve various strategies like:
- Investing in new projects or expanding existing ones
- Acquiring other companies
- Returning capital to shareholders through dividends or buybacks
- Paying down debt
- Holding cash for future opportunities
All financial assets can be made economic equals: “It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota–nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”
– Warren Buffett
The key is to consider the full spectrum of possibilities. Your next best option is your opportunity cost – what you’re giving up by choosing one path over another. It’s crucial not to define your options too narrowly, as this can lead to suboptimal decisions.
Good capital allocation also involves understanding that sometimes the best action is inaction. If current options don’t offer sufficient returns, waiting for better opportunities can be a valid strategy.
Moreover, effective capital allocation isn’t just about maximizing returns. It’s about finding the best balance of risk and reward. In some situations, a slightly lower return with significantly less risk might be the better choice.
This principle applies to how we allocate our resources – time, money, and energy in personal finance. Whether it’s choosing between job offers, deciding on investments, or planning for retirement, considering a wide range of options and their opportunity costs can lead to better financial decisions.
We can make sure we’re not missing out on better opportunities by always asking “What else could I do with these resources?“. This mindset is central to effective capital allocation, both in business finance and in our personal lives.
Appreciating Redundancy
… we have two kidneys for a reason—increasing our chances of survival. In the business case, we’re talking about more than just the company’s survival. Well-run corporations serve a critical social function. They need to be financially strong enough to act as economic shock absorbers to protect employees, suppliers, and customers from the volatilities of capitalism. Free markets can do strange things to find the right price level. It’s unfortunate, but it’s still the best system we have for coordinating human action. You need a conservative balance sheet to be a healthy shock absorber. Business done well actually protects the little guys from natural fluctuations.”
We have two kidneys in our bodies, even though we can survive with just one. This redundancy isn’t about efficiency – it’s about survival. If one kidney fails, we have a backup.
This means managing trade-off between efficiency and survival. Many businesses and investors focus on maximizing efficiency, trying to squeeze the most profit out of every dollar. But this approach can be risky.
Having cash reserves and maintaining low leverage (debt) is like having that second kidney. It might seem inefficient to have “idle” cash or to avoid using debt to boost returns. But this financial cushion provides a safety net that can help a company survive unexpected shocks or downturns.
Think of cash as the oxygen of a business. During normal times when cash is plentiful, it’s easy to ignore and take for granted. But when it’s suddenly missing, it’s hard to think about much else.
Cash gives you options. It allows you to weather tough times, take advantage of sudden opportunities, or make strategic moves when others are struggling. Having less leverage means you’re not at the mercy of creditors and have more flexibility in your decisions.
This principle challenges the idea that businesses should always be “lean and mean.” Sometimes, it’s wise to prioritize resilience over short-term efficiency.
In personal finance, this might mean keeping an emergency fund or not maxing out your credit cards, even if you could potentially earn more by investing that money. It’s about finding the right balance between pursuing returns and ensuring your financial survival.
Remember, in business and in life, you don’t have to win every day. You just have to survive to keep playing the game. Having that financial “second kidney” can make all the difference.
Knowing Your Edge
Understanding your edge is a crucial principle in business strategy and capital allocation. It’s about identifying where your business can generate the highest returns and focusing your resources there.
In any business model, different components will have varying returns on investment. Some aspects might offer returns just above inflation, while others could yield significantly higher returns. The key is to recognize which parts of your business provide the best returns and to concentrate your efforts and capital in those areas.
“The franchisee, whom we carefully screen, has responsibility for the real estate side of the business. They get help from us on the operations and get to use the Cootie name and systems. In exchange, we get a percentage of their restaurant’s revenue. Cootie makes more money with less invested capital through franchising. Our invested capital goes into designing better systems and building our brand–not buying more real estate. That’s how our returns on invested capital are around twenty percent and not three percent.”
This leads to strategic decisions about what to keep in-house and what to outsource. Companies might choose to focus on high-return activities where they have a unique advantage, while partnering with others or franchising out lower-return aspects of the business.
Understanding your edge also means knowing what you do better than anyone else in your market. It’s about identifying your unique strengths and leveraging them to maximum effect. This could be anything from specialized knowledge, proprietary technology, brand strength, or operational efficiency.
By focusing on these high-return areas, companies can achieve better overall performance without necessarily taking on more risk. It’s a way of optimizing capital allocation by putting resources where they’ll have the biggest impact.
This principle applies equally well in our personal lives and careers. It’s about recognizing our unique skills and strengths and finding ways to apply them in situations where they create the most value. This could mean specializing in certain areas of our profession or structuring our work to focus more on our high-impact activities.
Understanding Market Cycles
Growth isn’t infinite and markets move in cycles.
…pine trees release cones that fall to the ground, tumble a bit, and then just sit there. Sometimes for years and years. Big deal, right? But here’s where nature gets interesting. Eventually a fire comes along. The flames introduce a new environmental dynamic. 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. The heat from the fire opens up the seed pods and releases into the fertile environment where the fledgling pines quickly take hold. Their usual competition has been wiped out–it’s a whole new ecological ball game. The pine cones on the forest floor wait to take advantage of the eventual disruption, and it’s proven a very effective survival strategy. But it requires extreme patience.
This principle encourages a long-term view. It suggests that sometimes, the best action is to wait for the right conditions rather than forcing growth in a saturated market.
Understanding market cycles influences how we allocate capital. During boom times, it might be wise to hold some resources in reserve. This could mean maintaining cash reserves or avoiding overinvestment in a single area.
Conversely, during downturns, those who have preserved capital may find opportunities to invest at favorable prices. This could involve acquiring assets, expanding market share, or investing in new technologies when competitors are constrained.
In this context, effective capital allocation isn’t just about maximizing short-term returns. It’s about positioning resources to take advantage of the entire market cycle. This might mean accepting lower returns in the short term to be prepared for future opportunities.
For businesses, this could translate to diversifying investments, maintaining flexible capacity, or investing in research and development even during lean times. For individual investors, it might mean maintaining a balanced portfolio and not chasing every market trend.
Remember, in capital allocation, timing and patience can be as important as the amount of capital deployed. Understanding that “trees don’t grow to the sky” helps in making more balanced, long-term decisions in resource allocation.
Simple Models Outperform Experts
We often encounter situations where the problem is complex, information is incomplete or ambiguous, goals are shifting, and stress is high due to time constraints or high stakes. Surprisingly, these are precisely the conditions where simple models can shine.
Simple models thrive when…
- the problem is ill-structured and complex.
- the information is incomplete, ambiguous, and changing.
- the goals are ill-defined, shifting, or competing.
- the stress is high, due to time constraints and/or high stakes.
- decisions rely upon an interaction with others.
It suggests that sometimes, a straightforward approach based on a few key principles might yield better results than an intricate analysis or expert opinion.
For instance, a simple checklist or decision tree might prove more effective than a complex financial model when evaluating investment opportunities or making strategic decisions. This doesn’t mean we should always choose simplicity over complexity, but rather that we should consider whether we’re overcomplicating our approach.
In practice, this might mean using basic financial ratios alongside more sophisticated analyses or creating simple rules of thumb for asset allocation. It’s about finding the right balance between depth of analysis and simplicity of execution.
This lesson also applies to personal finance. Sometimes, when making decisions about investments, budgeting, or major purchases, a simple pro-con list can be more effective than agonizing over every detail.
The key takeaway is that in capital allocation, as in many areas of life, the most sophisticated solution isn’t always the best one. Sometimes, keeping it simple can lead to better decisions, especially in uncertain or rapidly changing environments.
Compounding Improvement
The idea that 365 days of 1% improvement can lead to a 37x return illustrates the power of consistent, incremental progress. It’s not about making huge leaps, but rather about steady, continuous improvement.
“Humans evolved in a linear environment, so we’re not wired to appreciate the power of compounding. In this lab, we’re looking for tiny one percent improvements that will echo throughout the rest of our restaurant system. Progress that is barely noticeable here starts to really add real value over millions of burgers, fries, shakes, and customer interactions.”
When we invest in initiatives that yield a positive rate of return – where the return on capital is higher than the cost of capital – the effect of compounding over time can significantly increase value. Even small improvements, when sustained, can lead to substantial gains.
Conversely, if the cost of capital exceeds the return, the negative impact of compounding can erode value over time. This highlights the importance of careful evaluation and selection of investment opportunities.
This underscores the value of long-term thinking in capital allocation. It’s not just about immediate returns, but about creating a system or portfolio that can benefit from positive compounding effects over time.
For businesses, this might mean investing in projects or processes that offer consistent, albeit small, improvements in efficiency or returns. Over time, these can add up to significant competitive advantages.
This principle applies to the power of consistent saving and investing in your personal life. Small, regular contributions to investments can grow substantially over time due to compounding returns.
It’s also a reminder of the importance of avoiding negative compounding effects. Just as positive improvements compound beneficially, mistakes or inefficiencies can compound negatively if not addressed.
Integrity, Intelligence and Energy
Integrity is non-negotiable, while all are desirable.
There are three qualities you want: integrity, intelligence, and energy. If you don’t have the first, the other two can kill you.
Not exactly a capital allocation or a corporate finance lesson per se, but integrity forms the foundation of trust in any organization. It’s about being honest, ethical, and consistent in one’s actions. People with integrity are more likely to make decisions that align with the company’s long-term interests rather than seeking short-term personal gains.
Certainly, intelligence and energy are valuable traits, but in business and in life, character often trumps raw talent or drive. It’s a reminder that how we do things is just as important as what we achieve.
Who is This Book For?
“The Rebel Allocator” could be the ideal entry point into the world of finance and capital allocation. It covers the essentials in a way that’s accessible and, surprisingly, entertaining.
What struck me most was Taylor’s ability to convey in one book what often takes several dry financial texts to explain. He’s found a way to teach these topics that’s both effective and engaging.
But don’t let the easy reading fool you – this book packs a punch. This book manages to cover many financial and capital allocation concepts in a narrative format, making it more digestible than traditional finance literature. It could well serve as the go-to introduction for anyone interested in these topics.
I realized that capital allocation isn’t just for big businesses. It’s a concept we can apply to our personal lives too. We’re all constantly making decisions about how to use our limited resources – time, money, energy. Whether it’s choosing between paying off debt or investing, deciding how to spend our free time, or even managing our relationships, we’re all capital allocators in our own way.
The principles Taylor lays out for businesses are just as relevant when we’re managing our personal finances or planning our careers – doing more with less, creating value, thinking long-term.
The book provides a toolkit for decision-making, one that’s useful both for understanding the business world and for navigating our own life choices.
The Rebel Allocator Checklist
All the lessons covered in the book are summarized in the form of a checklist at the end of this book. You can download the PDF version of the checklist here.
- Respect the Iron Law of Economic Survival: Cost < Price < Value.
- Value is perceived by the customer, focus on what doesn’t change for them, engineering doesn’t always have the right answer because of the customer’s subjective perception.
- Small, incremental improvements really add up.
- Push decision-making down as close to the customer as possible.
- Choose your strategy: differentiated product or lowest-cost producer?
- Appreciate the tradeoffs between profit and brand. Are you storing fat or glucose?
- Practice zero-based budgeting.
- Strategic costs delight the customer and build a moat around your business. Invest in them.
- Non-strategic costs sap your resources and should be eliminated.
- Don’t “paint the fourth wall.”
- Cash is the oxygen of business. Don’t cut it close.
- Fund strategies, not individual projects.
- Returns on invested capital tell you if you’re providing value. It’s your weight-lifting form. Only add the plates of growth when you can maintain good form.
- Growth isn’t necessarily good or bad, it’s just “more.”
- Be patient like the pinecone. Everything moves in cycles.
- Be confident to zig when everyone else is zagging.
- Lay out all of your capital allocation options into a single menu before you decide.
- Keep your balance sheet conservative. One of your responsibilities is to serve as an economic shock absorber and protect various stakeholders.
- Imagine all the different ways to “put a roof over your head.”
- Perform the 11-Star Experience exercise to push the boundaries of what’s possible to delight customers.
- Don’t do mergers and acquisitions for the BBQ Factor, don’t expect synergy miracles.
- Using shares for M& A is like selling part of your business.
- Get back at least as much value as you’re giving up. Chances are, you’re overpaying.
- The dumbest activity occurs late in the cycle. Tread carefully.
- Be conservative with healthy margins of safety on all projections.
- If you can’t create value by reinvesting in operations, M& A, or creating a new business line, you should return capital to shareholders.
- You have a fiduciary responsibility to your shareholders to keep your stock trading as close to intrinsic value as possible. This helps prevent incoming and outgoing shareholders from taking advantage of each other.
- Having publicly traded shares are like having your own currency. Respect them as such.
- Use share buybacks to put a floor under your stock. You never know why a partner needs liquidity.
- Tell your partners/ shareholders everything you’d want to know if your roles were reversed so they can arrive at their own fair value of the company.
- Paying a dividend should be a last resort.
- Never forget you are a fiduciary for your shareholders. Treat them like partners.
- Thoughtful allocation of resources is one of the most important societal functions entrusted to you. It’s important for customers, employees, boards, management, and the environment. Give it your best effort.