- What is a CFO? – Arguably the most important position within a company.
- What’s the big deal? – Understand the importance of capital allocation.
- Deploying Capital – Fact driven financial decisions.
- Final Thoughts – Top capital allocators.
The 800 Pound Gorilla
A Chief Financial Officer (CFO) is the 800 pound gorilla in the world of finance. Humble peons such as myself can only dream of being a CFO one day.
What does a CFO even do? The defining trait of a CFO is their ability to allocate financial resources and other sources of capital to their most efficient uses. Additionally, CFO’s manage financial risk, financial planning, budgeting, accounting, and reporting. It’s a tough job, which is why they make the big bucks. However, most of the tasks a CFO does is exactly what we should be doing with our own personal finances, especially in regards to allocating our financial resources.
The idea to write this article hit me as I was writing part 2 of How To Analyze Stocks, and I figured it was an important enough topic that I needed to dedicate an entire article to it. I can’t have a personal finance and investing site that doesn’t cover the concept of capital allocation. It’s arguably the most important topic in finance.
Understanding the best uses of your limited financial resources is the key to building your wealth. Simple concepts like understanding how to allocate your monthly income is a task most people never think about, even though its part of our everyday life. According to the Bureau of Economic Analysis, in 2016 the average American saved only 5.2% of each paycheck. That’s pretty low, considering that most financial professionals recommended a savings rate of around 20%. I personally aim to save at least 50% of my after-tax income, and some personal finance guys save even more than me.
The best method I use to track all my sources and uses of capital is through a tool called Personal Capital. It’s a free reporting tool that you should take advantage of. The first step is to understand how much money is coming in and where that money is being allocated. Below is a screenshot, which has a nice layout and is pretty user-friendly.
You will be surprised by how many insignificant expenses add up and eat away at your hard-earned money! For example, I don’t believe in paying for a gym membership anymore. I workout at home so there’s no excuse to skip a workout and for cardio I run outside – for free! The reason why I hate gym memberships is that you might go a lot at the beginning, but then life sets in and you get busy. However, regardless of whether you go or not you still have to pay. It’s little items like these gym memberships, random magazine subscriptions, and others that eat away at your income. Once you have a proper financial reporting tool, like Personal Capital, you can start taking charge of your finances by getting rid of unnecessary expenses and begin allocating that money to more efficient uses. Tightening down your expenses is the hardest part, but once you solidify and implement a spending plan, your finances should be on auto-pilot moving forward.
Once you get your financial house in order, you may have some extra cash lying around. This is where thinking like a CFO will literally start to pay off and grow your wealth. I manage my cash the same way a cop manages a rowdy house party. First, I sit back and scan through all of my options, just like a cop who scans the crowd for potential trouble-makers. The cop only intervenes when he is confident he can bust some poor bastard. In the same vein, I only pull the trigger on investments I have full confidence in, which is done through prudent research. I am a steward of my own money just as a cop is a steward of the law.
When looking at opportunities to deploy capital it really comes down to the return on investment (ROI) that you estimate an asset will produce and the minimum return you are willing to accept. For example, real estate here in San Diego, like most California real estate right now, is really hot and home prices have been skyrocketing. As prices go up, your expected return goes down – which is why you buy low and sell high. I firmly believe in homeownership, but my analysis leads me to conclude that its cheaper to rent than to buy, for the time being anyway. A core component of this conclusion is determining the investment return of real estate versus the return on stocks. Historically, housing has averaged returns of 4.8% versus stocks, which have averaged about 8% since 1975. See chart below.
With tax advantages and the help of leverage, investing in real estate does have additional advantages that isn’t reflected in the chart above, which can be great for long-term wealth, but only after considering the opportunity cost. From the lens of a 27-year old young buck such as myself, I look at the rent versus buy scenario by looking at the sunk costs. Sunk costs are just expenses that are not associated with growing your equity, like insurance, taxes, etc. An average home where I live will cost around $750,000. At that price the estimated mortgage payment would be $3,489 a month, and that’s assuming no HOA fees or maintenance costs. See cost breakdown below, provided by Zillow.
Principal payments for the first 2 years will average about $950 a month. Since this cost actually builds your equity, I subtract that out of the sunk costs, which gets us down to $2,539 a month in total sunk costs. Compared to my $1,000 monthly rent, the sunk costs associated with a mortgage is 2.5x more than renting.
Here’s another way to look at buying versus renting. The chart below is a similar comparison of my current $1,000 monthly rent versus buying a $750,000 home.
As long as I keep my rent relatively low compared to a mortgage, then renting is the much more attractive option as I can use the savings to invest in stocks which provide a higher ROI opportunity. However, I’m an opportunistic investor and if there is an opportunity to buy a house at an attractive price then I may reevaluate.
On this last note, I wanted to show you a chart which includes the excess investment returns of top investment managers, which are some of the best capital allocators in the world. The returns below are in addition to what the S&P 500 achieved, so pretty impressive outperformance.
Having a mindset of a CFO who allocates financial resources to their most efficient uses pays off in the long run. Notice how the investors who have been around for 20+ years have consistently beat the market by an average of ~5% annually. Of these top investors, the majority utilize a fundamental based approach, which is the same methodology I cover here at NINJA Capitalist. Fundamental analysis is key to understanding where the best ROI opportunities are and allocating capital to your best ideas. Luckily, you don’t have to be a CFO of a Fortune 500 company to apply a similar mindset to your own personal finances.