Why analysing capital flows can deliver great investment ideas

The capital allocation framework is based on the idea that companies need to invest in their businesses at a high rate of return in order to really create intrinsic value over time and to essentially improve their stock price, and become more valuable.

How does your capital allocation framework work?

We're measuring where companies are investing and what is the return on that investment over time and looking for those companies accelerating the investment. So that could mean CapEx where they're actually building out additional brick and mortar capacity. It could be R&D. If you're a tech company where you're investing in new research, in new products, it could be sales and marketing or hiring, depending what type of business you're in, right? So it could be people.

And so we're looking at all those different categories, seeing what's happening with the spending within those companies and measuring the return on that over time to see who is really making the right investments to benefit in the future. And we're measuring that against their peers as well to get a true picture of what's happening at the industry level.

The best setup is your company's making great investments, they're ramping their spending, we're seeing the return flow through, and you have peers that either can't or won't invest because they're too short-term focused, they're over-levered or, or whatever it might be. It's pretty clear who the winner will be within that space over an extended period of time. So those are the types of names we're looking for.

Monolithic power (NASDAQ:MPWR)

You know, really one of the first companies we bought that was really the textbook capital allocation framework name. So it's a company that makes semiconductors, they make power management chips. They go into all kinds of electronic devices. They're used by Nvidia, they're used by Tesla. They're sort of best in class from a technology standpoint.

What they do is they have invested very, very aggressively on the R&D side, really starting about four or five years ago. And we saw that R&D spend tick up because we're always measuring this across thousands of companies. What were they doing on CapEx, R&D, SG&A (Selling, General, and Administrative expenses)? We saw that spend tick up. We looked historically and said every time they go through a large spike in R&D, you see really attractive returns follow that.

You know, we spoke with management, did all the due diligence. It was pretty clear they had a very visible opportunity where that R&D was going. At the same time, their peers were cutting costs and not investing. And so as things rolled out over time, it turned out they were investing behind Nvidia. And so we of course didn't know that at the time, but history repeats itself.

The investments were there, the returns were there and they've outclassed all their peers because they made the investments early. The investment was the key. It was the indicator and seeing the returns come through on that investment really played out quite well where you have the winner in the space essentially and everybody else trying to catch up.