Understanding Management Compensation

We look at the importance of understanding how company management is compensated. At a very basic level, we believe that incentives matter. Presumably, executives want to maximize their compensation, so any time you are thinking of investing in a company, you should want to know what incentives those executives are responding to, because that will tell you what kinds of actions they are likely to take. (February 21, 2023)

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Transcript

Speaker 1: 0:02

Hello, and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Welcome back, everyone, to another episode of Actively Speaking. Today we're gonna be talking about management compensation, how, how managers get paid. It might seem like a sort of esoteric subject, but we actually think it's, it's quite important when you're looking at a company. This podcast is actually the third stage of a , uh, of a multimedia blitz we've been doing on the topic. There was a piece in the Epic quarterly newsletter that David Cino and I wrote, and then , uh, I spoke about the topic on the most recent quarterly webinar, and today David is joining me. So welcome David. Thanks Steve. And David is , uh, as a reminder of the lead portfolio manager on our , uh, capital reinvestment strategies , uh, global US non-US , uh, on which I serve as a co-portfolio manager. And when , when we look at companies for the Capri portfolios , uh, management compensation is, is a key part of our research process. Now, why is that? Well, basically, you know , at its heart, it's, we believe that incentives matter. If you , uh, look at how somebody gets paid, it's, it's a good insight into what sort of behavior you can expect from that person. But you might think, well, you know , this is, this is pretty simple. I mean, you know, how, how complicated can this be? Incentives should just be there to make sure that management does a good job , uh, which is true, but the devil's in the details as the cliche goes. And, and the question is, what constitutes a good job by management? What is it you're trying to incentivize? And the truth is that there are many different kinds of incentive plans out there when you look at different companies. They don't always incentivize the same kind of behavior. So in our minds, this question of what constitutes a good job by management has to do with not surprisingly earning good returns on capital. That's what the, the Capri strategies are all about. But, but many companies go about it differently. They think that, for example, you , you want to incentivize management to maximize or , or , you know , grow the profits, for example. Well, you know , as we, as we never tire of pointing out, you can grow profits without really creating value for the shareholders because the money you have to spend to generate profit growth is not free. There's a cost of capital, and sometimes you can grow the profits, but that growth might represent a poor return on the capital that you had to invest to get it. So simply saying to management grow the profits, it doesn't necessarily mean that they're gonna make wise capital allocation decisions. And in fact, you , you may be incentivizing them to just go out and, and make acquisitions regardless of whether they represent good returns on investment, because they will grow the , the , uh, you know , the revenue. But most likely, and , and as managements love to talk about when they make acquisitions, it's quote accretive to earnings, you know, in , in year one or two, which again, doesn't mean it was a good idea. If I go out and spend a billion dollars and I generate 20 million in additional profit, that's accretive to earnings, but it's a 2% return on investment, which is quite poor. So what we thought we would do , uh, on the podcast today is go into a little more detail on some company examples that we didn't have space to do or time in the newsletter piece, or time to do in the webinar. And so that's what David is, is joining me to talk about. So David , um, tell me about some good or , uh, some things you've seen at companies you've looked at , uh, incentive plans that , that you think made a lot of sense.

Speaker 2: 3:29

Sure. Thanks Steve. Not surprisingly, the answer to that question starts with return on invested capital. It really is a mindset that companies must have and company management teams must have that the money is not theirs . Yes, it may seem like yes, they , they have control of it, they can influence , uh, how that that money is allocated to , to different projects or different constituencies. However, it's , it's not their money. It's the shareholders' money. And, and the goal of management , uh, the mindset of management, in other words, should be to hold that capital, dear, use it wisely and parsimoniously because it really is not, it's, it belongs to the shareholders and they owe it to the shareholders to earn a high return or the highest return on that capital or give it back since the shareholder might be able to return a , it might , might be able to earn a higher return on their own. In terms of specific plans that I've seen , um, there are three companies that we own in our portfolio that, that stand out in this regard, that if you read their annual report, it's quite clear they value returns. They value not just growth for growth's sake, but actually in effect charge their management teams for use of that capital and expect the management teams to earn a premium to the cost of that capital. So in the case of First Rand , for example, first Rand is the largest privately owned bank in South Africa, consistently one of the highest earning banks , uh, in the world as measured by return on equity, which is how banks measure their profitability and , and their returns on capital. Uh, not surprisingly, their management teams are incentivized to generate high returns on capital. Each line of business, depending on their relative level of risk or characteristics of that business , is charged a cost of capital. In the case of first ran on average, that that average is around 14% over time . So if you're a management , uh, manager and you want to earn a bonus that year or want to earn a a bonus over a multi-year time period, you need to generate a return while in excess of 14%. In other words, create economic value or economic value added, which is a close cousin of , uh, return on invested capital, which we talk about. Another , uh, management team that, that pays a lot of attention to this is Atlas Copco. Atlas Copco is an industrial conglomerate based out of Sweden, whether it's an internal project or an acquisition. Atlas Copco uses , um, an 8% weighted average cost of capital to measure its its management team's success or , or lack thereof. Uh, 80% of their long-term incentive comp what a management earns for , uh, other than the , the annual bonus that they earn is tied to generating a spread or , or economic value added over that 8% cost of capital. Now, Atlas Capco has been a , uh, fairly , uh, frequent acquirer of other businesses, however, infrequently that those acquisitions are large, they make a number of small acquisitions, which they can talk, take the technology, take the distribution, take cost out, and earn a high return on capital. Very few public market transactions for Atlas Copco public market market , uh, transactions are expected to pay a premium to that company's shareholders, which often erodes the , uh, the e economic value that is created by that acquisition. A last company I wanna mention today, Steve, is Constellation Software. Uh, Canadian software conglomerate owns , uh, hundreds of small software companies in verticals as the disparate , as golf course management and, and gym management, court docket management, not the sexiest software businesses in the world. However, they are often the , the number one or number two in each silo in which they participate. There is not much they admit, there is not really a lot of synergy between all these businesses, but all of these businesses, when they acquire them, held to the same standard and that is earning a return on invested capital , uh, well in excess of their cost of capital, they used to use a 30% threshold for transactions. Uh , as they've gotten larger and the transactions have gotten larger , uh, they've lowered that to we think , um, 20% or 25%. However, when, when their cost of capital is measured in the high single digits , uh, they still earn a very, a very high spread. So management teams , uh, the management teams of each of those businesses are not just incentivized to grow revenue. Yes, we want in the strategy, our companies to grow revenue, but they are also incentivized to grow , uh, return on a vested capital. They don't tell us what that level is, but over time, the company , uh, as I mentioned, has generated well over 30% returns on capital. So we can guess that management teams are incentivized to do that. One , one positive part of , of the, of the scheme, which I'd like to mention, 75% of what they take home from their annual cash bonus, they're required to put back into the stock with a multi-year lockup. So I , I think the common denominator of all of these schemes is , um, management teams that are incentivized to align their interest with ours, that is grow the wealth of the business through earning high returns, reinvesting in the business, and not really growth for growth's sake.

Speaker 1: 8:22

Yeah, I , I , I'm just gonna mention , um, a couple of things on , on a related topic of , you know, we , we like to see that these sorts of schemes that that reward basically , uh, managements for any good returns on the capital, you might think, well, well how about ROE ? Surely that's just as good. And , and the , the , the key distinction of course, between return on equity and return on invested capital is that the invested capital includes the debt. And if you just focus on return on equity , uh, management could actually kind of engage in financial engineering to sort of game the ROE by, you know , you go out and you borrow some money, you use it to buy back stock, you've reduced the , the outstanding equity base, even if the, the profitability of the business doesn't change. You've raised the ROE simply because there's less e in the denominator, but you haven't actually improved the business in any way. And, and in fact, you've probably made the business riskier because it now carries more debt. So that's, that's something to be wary of on , uh, on ROE. And then a , another one, another metric that pops up a lot, which, which in general is not bad, is, you know, total shareholder return. Because you might think, well, you know, that certainly aligns management's interest with me, the shareholder. I wanna see maximum shareholder return too. Uh , and, and so should managers. But , um, the , the , the one problem with that, that I would point out is that management doesn't always agree with us on what it is that will generate good shareholder return. So like they might think that, hey, if I can just get the ROE up another three points, that'll boost the stock. So, so they may have sort of crazy notions, or at least crazy to us about what it takes to generate good return on stock . They may think that if they just go out and make an acquisition that grows the earnings, even if it's a poor return on capital, that will boost the stock price. So , uh, I think the important thing is, you know, when, when you have managements that are focused on ROIC , that that ultimately is, that that's what grows the value of business earning a return on the capital that's greater than the cost of the capital. That's literally how you grow the value of the business. So another question for you, David. You know, does it ever make sense, and we, we just went through an interesting experience over the last few years with COVID . Does it ever make sense to sort of move the goalposts in the middle of the game, as they might say? So, you know, 2020 was a , a crazy year for many companies. You had sat around at the end of 2019 with the board at the management , uh, the compensation committee and the board may have come up with some targets for management to meet , uh, whatever the metrics were in 2020. And then covid comes along and businesses are forced to shut down. And, and obviously it became very, very hard to meet those targets. Now you could say, well, that's too bad. That's, that's the way the world goes sometimes. And certainly the the workers, you're not , not the senior management, the regular day-to-day workers didn't necessarily get to reset their , uh, their incentives , uh, because of covid. Why should management be any different? Just , uh, did , did you see any of , did you see that happening? Were , were there companies that , that tried to reset incentives in the middle of 2020? And what was your reaction to that?

Speaker 2: 11:19

Well, we did have a, a , a , uh, two companies that that come to mind. Uh , which , which I won't name, but philosophically I'm against moving the goalposts. Um, I think that not to diminish the impact of, of covid by any means, but the world is inherently a , uh, a volatile and uncertain place. Management teams should be held to the same standard as , as , as you mentioned, as, as the entire employee base who may not benefit from the sort of measurement to , uh, to , to performance. It is fair to say that top talent is rare and commands a premium in the market. Uh , so perhaps some allowance can be made for retaining important managers, but I wouldn't, I wouldn't take that to the extreme. As I mentioned, it's rare to have a talented and skilled capital allocator in charge of a business, and I don't think that the , the goalpost should be moved. You want to avoid a scenario where in terms of the , from the manager's perspective, it's heads , eye win tails, you lose like their employees, like their companies, like their shareholders. There , there is no, they're not entitled to earn , uh, a , a , a premium return or any scenario. So I would just say that , uh, philosophically, I , I strongly disagree with the notion of moving the goalpost because of covid.

Speaker 1: 12:36

Okay. Yeah, I mean, the point that we raised in the, in the piece in the newsletter , uh, and , and you alluded to it, is there , there is this , um, sort of the , the deeper philosophical issue is what is it you're rewarding management for? And if it's for some sort of rare skill they have, and if there's a competitive marketplace for that skill out there as you allude to you could, I think somebody could make an argument that , uh, you know, there are some circumstances where if , if there were things that were beyond management's control, they, they have a rare skill that we still want to reward them for through no fault of their own, they were unable to meet the incentives. We might wanna change the incentives in the middle of the year still. I mean, it should be, even in a situation like that, you don't wanna change the incentives to ones that they can easily beat. I mean, the point is you can still change the incentives. It could , it could make sense to change the incentives, but do it in a way where they still have to, you know, reach something where they have to achieve something just maybe less than you thought they had to achieve at the start of the year because of some unforeseen circumstances. Famous, you know, cases in, in over the last 20 years where like tech companies would issue all these options to employees as part of the compensation, then the stock went down. They would just, you know , res strike all the options at lower prices, which that now that seems, you know, kind of ridiculous. I would say that's not a good example of, of , uh, moving the old posts in the middle.

Speaker 2: 13:51

Now Steve, you mentioned a couple things there. One on one was management control two was, was stock comp, and I'll , I'll address those separately. So the only thing that's purely within management's control is allocating capital. They cannot control the stock price from a pure standpoint. Uh , this terminology comes, comes often , comes up often in , in baseball, for example, right? There are only three pure outcomes where, where the pitcher controls what happens, there's a strikeout, a walk and, and a home run. Right? Management really only controls how they allocate capital and uh , that's why we tend to frown upon these sort of relative TSR or total shareholder returns or absolute total shareholder returns. Since so much is out of management's control, we much prefer that the metrics I alluded to earlier, 'cause you really want to influence managers behavior and , uh, influencing the short term stock price may lead to bad behavior. Uh, on the , on the subject of stock comp, it's interesting because a lot of companies today, particularly in in the tech space, you think, well, what , what is my free cash flow ? Epic talks about free cash flow , a lot, free cash flow is cash flow from operations less CapEx. Well, what is , uh, what is underneath cash flow from operations? Well, it's your net income, your working capital and sort of non-cash expenses such as depreciation and amortization. And you guessed it , stock-based compensation, which in , in the case of some businesses can be quite large up to, to 15 or 20% of revenue. Uh , since it is stock comp, it is , um, is a non-cash charge. You're not paying out cash, you're awarding stock, but that stock has a value that has stock, has a cost, which is taken away from the shareholders of the business. So if you're only focusing on free cash flow , not adjusting for stock-based comp , uh, that is sort of an incomplete picture. 'cause oftentimes what managers will do, they'll go out and buy that stock back in the open market that they're awarding to employees and to management teams. What I'm trying to get at is it skews the free cash flow calculation and investors should adjust accordingly since oftentimes , uh, what what should be subtracted from the , from the key free cash flow metric is not, and it should be. And that would be the , the expense for buying back the stock to avoid dilution of common shareholders. Okay .

Speaker 1: 16:02

You know, you mentioned in that, in that your comments just now , uh, working capital. And I know in the past when we talked about Atlas Copco, which is one of the companies you mentioned before as an example, that that came up , uh, as part of their incentive scheme. Can , can you go into detail on that?

Speaker 2: 16:16

Sure. So working capital is simply , uh, the , the value of your current assets on your balance sheet, less the value of your current liabilities. In our in practice, what investors tend to focus on are accounts receivable plus inventories, minus accounts payable. Now, there , there's some strange consequences as , as far as how a company manages its working capital, working capital at , at its core is it , the name implies it's it's capital that's tied up in the business. So if you're building inventory that you're not selling or, or you're building it fa at a faster rate than you are selling, then that is an , that is a deliberate investment. You are taking shareholders' capital and investing it in your inventory. Similarly with accounts receivable, now there is somewhat of a mismatch , uh, in, in terms of the financial accounting. You could book a sale in a given year, but give the, give the client attractive terms such that they don't have to pay the bills , uh, maybe two or three months out. So that could be a way, it can be a way not always of perhaps manipulating earnings if you're building up that accounts receivable too rapidly. So in the case I mentioned Atlas Copco scheme earlier , uh, management , uh, as part of their incentive scheme, they are incentives to generate returns in excess of their cost of capital, but they're also in incentivized to maintain working capital or reduce working capital as a percentage of sales, which is a metric that most investors use to , to measure sort of the , the working capital intensity of a business holding that capital. Dear , again, incentivizes management teams a against bad behavior, such as perhaps inflating earnings at year end or building up inventory , uh, which could be a sign that , that maybe something is, is off in the business. Now, during the pandemic, we had an interesting example , uh, Texas Instruments, which is one company that, that we've owned for some time that , uh, is very, very transparent, more transparent than most in terms of their , their capital allocation policy. In fact, they held an annual call to give you investors an overview of their planned capital allocation for that year. And in 2020 they made a choice. If you recall, demand was plummeting around the world and supply chains were lengthening and , and there were a number of bottlenecks around the world. And what they decided, well, we're gonna take shareholders capital and invest it in inventory so that we have it on hand when we come out of , uh, this pandemic dip. So when customers need that product, we'll be ready and maybe our competitors won't. So working capital is , is a deliberate choice on the part of, of management teams, and it , it can be a , a real virtue of any business. Costco, for example, carries a neutral to , to a negative networking capital balance. What does that mean? Their payables balance, their receivables and inventory. There is no shareholders' capital tied up in, in on the asset side of , uh, the balance sheet. All of their long-term capital is tied up in long-term assets such as buildings and distribution centers and so forth. So working capital maybe is a , is an under appreciated, under reported aspect of, of capital allocation, which we certainly pay attention to and we like to see embedded in management compensation schemes.

Speaker 1: 19:25

Okay, well hopefully , uh, this has given our listeners a feel for how this subject is not as simple as it seems on the surface. Um, so David, thanks for joining me and fleshing that out.

Speaker 2: 19:35

My pleasure, Steve, and

Speaker 1: 19:37

Work for another episode of Actively Speaking, hopefully soon. Thanks. Remember to subscribe to actively speaking on Apple Podcast, Spotify or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.

Speaker 3: 20:01

The information contained in this podcast is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed the information is accurate as of the date submitted, but is subject to change any performance information referenced represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this presentation are forward-looking statements and are based on epic's research, analysis and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur and the actual results may be materially different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they're profitable or not, they're being provided as a means of illustrating our investment thesis. Each security discussed has been selected solely for this purpose and has not been selected on the basis of performance or any performance related criteria. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable. The securities discussed herein do not represent an entire portfolio and in the aggregate may only represent a small percentage of a client's holdings. Client's portfolios are actively managed and securities discussed in this podcast may or may not be held in such portfolios at any given time. A .