1/

Get a cup of coffee.

In this thread, I'll walk you through the basics of Capital Allocation.

The better we understand how capital moves in and out of a business, the better we can predict the business's future cash flows and its stock's long-term performance.

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Businesses generate *cash* through their operations.

For example, Apple generates cash by selling iPhones.

Starbucks generates cash by selling coffee.

Google generates cash by selling ads.

IBM generates cash by doing things I don't understand.

Etc.

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Capital Allocation is the step that comes *after* generating all this cash.

That is, once the cash is available, what does the CEO *do* with it?

What projects does he invest in? What acquisitions does he make? Does he return any cash back to shareholders? Etc.

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Capital Allocation can make a tremendous difference to a company and its shareholders.

For example, at Berkshire Hathaway, Buffett took the cash generated by textiles and allocated it towards operations that produced much higher returns. Like insurance and candy.

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This transformed Berkshire Hathaway from a lowly bunch of textile mills to the super successful giant diversified conglomerate that it is today.

Along the way, long term shareholders reaped rich rewards.

That's *good* Capital Allocation.

1/

Get a cup of coffee.

In this thread, I'll walk you through the various connections between asset prices, interest rates, and inflation.

As an investor, it's useful to have a mental picture of how these pieces affect -- and are affected by -- one another.

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Suppose we have an investment opportunity.

This could be buying a stock, a bond, a private business, etc.

Let's say this opportunity will return $1M in cash to us after 1 year.

And not just that. This $1M will grow at 10% per year for the next 9 years, and 3% thereafter.

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This is a classic "cash flow model" that finance-y folk use all the time.

We have a business that promises to grow quickly for a while (in this case, at 10% per year for the next 10 years or so).

But after that, growth slows to a "terminal" crawl (3% per year).

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If we decide to buy this business, our "cash flows" from it will look like this over time:

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The question is: how much should we pay for this business?

Well, that depends on what kind of return we hope to get from buying it.

If we want a high return, we can't pay very much.

The lower the return we're willing to tolerate, the more we can pay.