Warren Buffett has always emphasized that great businesses start with great management. But what exactly makes a management team exceptional? Is it innovation, leadership, or aggressive expansion? While these traits can be valuable, Buffett takes a different approach—he focuses on how management thinks and makes decisions, especially when it comes to capital allocation.

For Buffett, the best managers exhibit three key traits:

1. They make rational decisions – particularly when it comes to allocating capital.
2. They are honest and transparent – openly communicating successes and failures with shareholders.
3. They resist the corporate herd mentality – avoiding reckless expansion and short-term trends.

In this article, we’ll explore how Buffett evaluates management, why smart capital allocation matters, and how investors can use his principles to assess whether a company is truly being run in the best interests of its shareholders.

Rational Decision Makers

Buffett sees capital allocation as managements most important responsibility since, over time, it directly shapes shareholder value. When a company is growing quickly and at high rates of return this is a simple decision. Just keeping pumping money into the core business. But when the growth rate slows, and return on investment declines where should management direct cash flows?

Management has three options for allocating their excess cash.

1. They can retain it
2. They can use it to acquire other businesses or projects
3. They can distribute it to shareholders.

If a company can reinvest extra cash at a return on equity higher than its cost of capital, it should retain and reinvest its earnings. That’s the logical choice as it will create value for shareholders. But holding onto earnings to invest at a return lower than the cost of capital is simply irrational as it will destroy shareholder value.

Rational allocation of capital

Return on equity > Cost of capital = Retain and reinvest

Return on equity < than cost of capital = do something else.

Sometimes management can be irrational, continuing to retain and reinvest cash flows when the returns are not satisfactory. Why would they do this? Managers who keep reinvesting despite low returns often believe the situation is temporary. They’re confident that with the right strategies and leadership, they can turn things around and boost profitability. Often, they are wrong. Buffett prefers management who can see reason.

What if the company has returns on equity lower than their cost of capital? Then the company has two choices

1. Acquire other businesses
2. or distribute cashflows to shareholders.

Acquisitions generate buzz, grabbing headlines and media attention, but Buffett is usually sceptical. First, they often come at an overvalued price. Second, acquiring unrelated businesses can be a distraction or the company will get into businesses they have no idea how to run. If a company does acquire, Buffett prefers it to be within its core industry. If the company runs hotels, they should acquire other hotel businesses, they shouldn’t acquire fast foods restaurants or fashion labels.

Key Questions to Ask:

• Is the company actively making acquisitions?
• Are the acquisitions within the same industry, or are they unrelated diversifications?

Now we get to Buffett’s preferred method of allocating capital when reinvestment is unsatisfactory. Returning capital to shareholders. This can be done in two ways

1. Paying dividends
2. Buying back shares

Dividends return cash to shareholders giving them the opportunity to reinvest the cash elsewhere at a higher return.

But Buffett prefers buybacks for two reasons. If a company’s stock is trading below its intrinsic value, repurchasing shares is a highly effective use of capital. For example, if a stock is priced at $50 but its intrinsic value is $100, each $1 spent on buybacks effectively acquires $2 of value. This benefits the remaining shareholders by increasing their ownership stake in a company that is worth more than its market price suggests.

Beyond financial benefits, buybacks also send a strong message to the market. When executives actively repurchase shares, they demonstrate a commitment to shareholder value rather than pursuing unnecessary expansion or empire-building. This reassures investors that management is focused on maximizing long-term returns rather than chasing growth for its own sake. As a result, disciplined buybacks can attract more investors looking for well-managed companies that prioritize increasing shareholder wealth.

Summary

• The allocation of capital is managements most important job.
• Management has three main ways to allocate capital:

1. 1. Retain and reinvest
2. 2. Acquire other businesses
3. 3. Distribute to shareholders

• If return on equity is greater than the cost of capital, then management should retain and reinvest
• If return on equity is less than the cost of capital than they should look for acquisitions that can earn a higher return or distribute capital to shareholders.
• Acquisitions should be into companies within the companies’ field.
• Management can distribute capital to shareholders in two ways:

1. Pay dividends
2. Buy back shares