Episode 7 | Management in GWII's BMPB Framework

In Episode 7 of "Market News with Rodney Lake," Rodney Lake, Director of the GW Investment Institute, discusses the critical alignment of management incentives with shareholder interests. He uses Tesla’s unique performance-based pay package as an example to highlight the importance of evaluating compensation packages through proxy statements. Professor Lake advocates for a mix of metrics like market cap, revenue, and profit margins to assess true company value, cautioning against sole reliance on earnings per share metrics due to potential manipulation. He underscores the significance of operational efficiency, a key factor that demands the audience's attention and focus. He also stresses the importance of employee satisfaction and long-term growth strategies, drawing on successful examples like Apple and Visa. Tune in to learn more!

Transcript

Thank you for joining market news with Rodney Lake. This is a regular show of the GW Investment Institute where we discuss timely market topics. I'm Rodney Lake I serve as vice dean for undergraduate programs at George Washington University School of Business. Let's get started. Welcome back to Market News with Rodney Lake. This is episode seven. I'm your host, Rodney Lake.

Let's get into it. Today we're back to the bump that is the investment framework for the GW Investment Institute. We covered business before today. We're going to cover management. So how do we think about management for our analysts that are fundamental in us? At the GW Investment Institute, we're trying to give them the tools to evaluate what makes a good management team.

Well, that can be very challenging. How do you decide if this management team is doing a good job versus that management team? Well, we're going to give you some tools to think about that and hopefully that helps you improve as an analyst. Just as a reminder, the five the four components that we use for the Jib Investment Institute framework are business management, price valuation and balance sheet 25% each.

And then we give them a score of 1 to 10, ten being the best. And again today the focus is on management. So when we talk about management we think well these are the people running the company. So how do we know if they're actually doing a good job. Maybe they put out news releases you know saying that they're doing a great job.

Well of course they might say that because they're running the company, they're getting paid to do so. So maybe they're a little bit biased. So how do we understand, whether that's believable, whether they're actually doing a good job? Well, that's what we try to do in our classes, and we try to give our students the tools to do that.

So when we talk about management, we've created an acronym to help to help people, and specifically our students. And that is capital. so capital capital. And so I'll go through each one. The first one is on capital allocation. that is the c a part of that. And that is the top job of a management team.

So when you talk about capital allocation for a company, what are you talking about. Well where are they taking let's say the retained earnings and putting it. Are they paying dividends. Are they buying back shares. Are they paying down that or are they growing the company. If they're growing the company, are they doing organic growth, through R&D efforts, new products and services that they built in-house?

Or are they doing, you know, purchases of other companies, mergers and acquisitions, M&A? You know, it doesn't necessarily mean that one is better than the other. Some companies are much better at organic growth. some companies have succeeded with M&A. It depends. But it's really up to you as the analyst to try to understand what is driving, that, let's say specifically on the growth, is it organic?

Is it M&A? Is it a combination of both? And is management doing a good job of this? Because if you overpay for something for example, anybody can go out and buy companies. Right. So if you take this retained earnings for your company and you overpay for this company, another company, well certainly you can grow sales. and so that's a metric, possibly that you look at as the top line.

But if you grow sales at the expense of profit margin, meaning you acquire these companies, but the margins are lower because you acquired a company that has a higher cost structure. You didn't get any what are called synergies out of this business? meaning essentially cutting costs. Well, that's probably a poor acquisition. And you should really be thinking about, you know, was that a one off, from the management team or do they have a consistent pattern of buying things, overpaying, not integrating them well, and really diluting the profit margin of the company over time.

So it does take some work to dive in and understand from one acquisition to the next how the company is doing what's called a creative meaning. did it help the company? So did the company actually grow the top line and the bottom line, did they increase profitability? Well, that'd be a fantastic acquisition. If they can do that, and they would actually then deliver on those promises made, other ways.

Again, to give back capital, to shareholders would be through dividends. And so what's the dividend policy? Are they growing it companies like Procter Gamble, for example, or are known as these sort of Dividend aristocrats. And so they've been, paying dividends for a long time. and they've been increasing those in a certain shareholder base. That's what they want.

So when you're looking at the capital allocation, what is the dividend policy, for the company, is it responsible what you don't want? If you're looking for growth, for example, as a company that pays out a lot of dividends, at the expense of trying to grow the company, because that's the capital that they could have used to either buy other companies or invest in new products or services.

and the R&D is really trying to figure out, okay, well, what's next for the company. And if they've done all that and then there's money left over, then they should send that money back as dividends, or they should buy shares back or they should pay down debt. Those are the only four things you can really do on the capital allocation side is growth.

And that's through organic and mergers and acquisitions. That's paying down debt, that's buying back shares and paying dividends. But that's all you can do. So as an analyst, those categories you need to think about what's the capital allocation. And that's really the top job of management because they're in charge of this company that you're invested in and they're in charge of those resources.

They're going to decide what's the future of the company, the money, the company is making, it needs to be either delivered back to the shareholders or it needs to be invested and grow the company. So you, as an analyst, need to decide how am I going to figure this out? Well, you got to look at their track record.

Have they been, let's say if they're doing a lot of M&A, what's the track record for the M&A? Are they doing these big acquisitions that don't ever seem to pay off, or are they doing small tuck in acquisitions? So a company, that, you know, to contrast two companies, one that does big ones and one that really does small ones, you can look at a company like Apple who really does tuck in acquisitions for the most part, and Microsoft, which is willing to do bigger acquisitions like LinkedIn.

so, those are just two examples. But I'm using those as examples because many people know those companies. And we also happen to own shares in both of those companies. Also, disclaimer we're not promoting any specific company here. on the podcast, but it's, you know, up to you to think about these companies. And I'm trying to give examples that are relatable.

And then most people would know. But in those two cases, it doesn't mean that Apple is better than Microsoft or Microsoft is better than Apple in the capital allocation game. It means they have a different strategy and you as an analyst have to decide, okay, are they executing on that strategy? So far, Microsoft has been very good at that.

The they invested in open AI as one of the more recent examples. Seems like it's working so far. Time will tell how that flows through into their products. Copilot would be an example of that. So they're really investing, for growing the company and trying to come up with new products and services. They did that through a 49% stake in OpenAI.

I well, you know, is that working? Is it paying dividends as far as the growth of the company? Not not the actual dividends? That's for you to decide. And you really need to start looking at the track record for the management team. So you got to look at the management team. What are the things that they've done with the capital and start thinking about, do you think that they actually have done a good job?

Do you think they're doing a poor job? the next piece, in the component here in our capital, framework here, is preparation. so you're looking for a team, a management team, that consistently is preparing the company for challenging times. Challenging times will come. We don't necessarily know when, but they will come in, the market will sell off.

and the economy might be bad. And so is the management team really living on the edge or, for example, do they have a rock solid balance sheet? and they're really prepared for a difficult time such that during that difficult time, they actually pick up market share from the weaker competitors that maybe either go out of business or a really struggle to survive.

And so you're looking for a management team that's ultra prepared. How can you how can you know that? Well, one of the things I already mentioned is on the balance sheet. This is where the balance sheet is very interrelated to the management component, because the management team is is the group along with the board. That really sets the policy on how much debt the company should have.

And so the management team is running that. So if they have a really weak balance sheet, meaning they have a lot of debt and maybe it's a lot variable, that's that could be a challenge, right. If difficult times come and interest rates go up on them, their, their payments, you know, could be very challenging to make.

That puts a company into potential bankruptcy, and insolvency. So you as an analyst need to be thinking about that. Is this company prepared balance sheet would be the first go to do they have a clean balance sheet. And if they do, if they have net cash, that's fantastic. That helps you sleep at night. if they have debt, one of the metrics that you can look at is the time interest earned or the interest covered ratio, which is Ebit over interest, earnings before interest and tax over interest.

So that's just something for you to think about. If it's a really low number, that's a problem. If it's a really high number, again that helps you sleep at night, meaning that they have 50 times as an example, to cover their interest payments, you're in good shape. If it's three, that's a problem. And it's different for different industries.

And and we can talk about that in future episodes. But you do not want to be in a position to have a weak balance sheet, and not be prepared for difficult times as an investor, if you're investing for the long term at the investment, it's who we are. We know that we're going to have to invest through the cycles we started nearly 20 years ago.

And so we went through the great financial crisis, certainly went through Covid. there's been other challenging periods, throughout that time. But we know we don't specifically know what's going to happen. We didn't certainly know what's going to happen in the great financial crisis. We didn't, predict Covid. but there are stresses that will come whatever the next one happens to be.

Are you prepared as a management team for that and as an analyst can you understand? Is this management team doing a good job to prepare for something difficult? We don't necessarily know what that is, and a good proxy for that is having a very strong balance sheet. And when you read the annual letters, if you listen to the conference calls, you should be listening in for what sort of redundancies, what resiliency is the company putting in, to not just having cash on hand, but resiliency in the business?

Are they prepared for outages? So if they supply cloud services, you know, what's the uptime for those cloud services? Well, look at that in evaluate. How prepared are they, for these eventualities that that come with, you know, having challenges over time? Do they do a good job of preparing and being prepared so you can give them a score for that?

The next one in the capital here is I, which is incentives. So you can look in the proxy statement and you can get the compensation for the named executive officers. And you should be looking for metrics that help promote alignment with you, a minority shareholder, if you just hold a few shares, in the management team. So for gigantic companies like Apple and Nvidia and Microsoft, it's not likely, for example, that Tim Cook is going to take our calls, although he did commencement a few years ago for GW.

Thank you, Tim Cook. not likely to. Tim Cook's going to say, hey, GW Investment Institute, what do you all think about the new iPhone? What do you all think about these services, our AirPods, you know, doing a good job. Should we make changes? That's not going to happen. Right. So you have to understand from a distance, what incentives are in place.

And do you think that they're actually doing a good job against those incentives. So what's the pay and is it aligned with you as shareholders or is the management team getting rich at your expense? Are they really just taking your money and moving it into theirs personally? You don't want that. You want in alignment with shareholders. You want to make sure that you and the management team are aligned so they only really get paid if they grow the value for the company.

One extreme example of this is it's very topical and in the news was the Tesla pay package. that was very much aligned. And I would say virtually no other CEOs would take that type of compensation, which was zero, cash in all incentive compensation that had to vest over time. If you would like to understand how that works, I would use that as a good example to understand.

And most CEOs, and I'm not sure if I know of any other CEO that would take that type of compensation package. Now it's in the courts and it's being litigated now, but that alignment is something you're looking for. The CEO in this case, you know, I Musk only got paid if he actually grew the value of the company over time.

And then he couldn't sell his shares either. So that's something you're looking forward to. What are the restrictions on those if they do get shares, are there restrictions. Can they sell them right away? Well, if they generate value in the short term and they can sell them right away, maybe they can cash out. and they they've only done projects that are short term.

So you're looking for metrics, in that compensation package that you can find in the proxy statement that the board sets for their CEO, their CFO, their CEO. And you're looking for metrics that help drive the value of the business. And so one metric that we talk about in class, if you only use, for example, earnings per share, one of the dangers of using only earnings per share is that the management team can manipulate that metric.

How can they do that? Well, they can buy shares back to manipulate the outstanding share count so that it looks like, well, they've actually been growing earnings per share, but they've been doing that really at your expense of the shareholder expense because they're taking retained earnings and they're saying we're going to buy shares back. and even if, the valuation is super high right now and it's not a really great time to do that, well, we'll get paid if earnings per share metric looks better for us.

So not that you can't use that as a sub metric, but you certainly want to have metrics that are aligned with shareholders. Are they growing? The overall value of the company over time? Is the market cap for the company growing over time? is the revenue is the profit margin the gross margin. So some of the things you want to have in there are these operational metrics.

And the tighter, you have those on those operational metrics and the longer time periods, the more rigorous it is, for you, as a shareholder to understand, okay, this is aligned with me as a shareholder, and I am very interested in these companies that are that are have their incentives aligned. people work to their interests.

That's Ben Franklin. And so you really have to work on that. That's in the proxy statement. And it takes some time to understand. And it's certainly not rocket science. You can get it online. You look at the proxy statement, they're required to file this with the SEC. And so you start to understand the difference between what are good metrics.

What are solid metrics. you certainly want metrics that are operationally focused not time focused wise, time focused, not a go to well, you don't want to give somebody a bunch of money just for sticking around, right? Just for lasting longer than anybody else. You want them to be growing the company's value as a shareholder. That's how you're going to get paid when they grow earnings overall when they grow the value of the company. So they're growing revenue, not not at the expense of profit margin, but they're growing profit margin and revenue. So top line and bottom line, if they're doing that generally they're doing an excellent job. And if they do that over an extended period of time, that's also a very good thing.

That aligns with long term investors like Gus at the GW Investment Institute. So you want to make sure you have that. All right. Next component here is the TI. And that's the track record. we talked a little bit about this, at the front end here when we talked about capital allocation. So you want to look at the track record for the company, for mergers and acquisitions and capital allocation, overall.

But just in general, how are they treating shareholders? How do they interact with shareholders? are they efficient with the capital that they have versus on the allocation side, but also just in general, are they running the business efficiently? So asset turnover, we talked about it in a prior episode on Return on Equity. Are they is asset turnover good.

Are the operational metrics for the business in the top you know, tier of their industry. And so what's their track record for running the company. What are some of those metrics associated with that. Well one would be okay. What's the asset turnover and how do they compare to other competitors in their industry. Do they have a good track record of consistently running efficient business, or is it stopping, you know, for example, does the profit margin change the year to 

dramatically. That's an extreme example that typically doesn't happen. But if it does, that's something where maybe they don't have a really good track record of actually running this business. And if something happens and it moves all over the place, you should really understand that sometimes it can be good. They're doubling down on some investment. So it's going to it's going to change the profit margin.

but you really have to take time to understand what's the track record for them running the company. Do they are they aligned with shareholders and are they shareholder friendly? Right. Are they trying to help people understand what the company does and how they do it, and to make themselves a good investor in the company? they're they're proving, their track record by doing all these things efficiently.

Like, again, proxy would be asset turnover. So making sure, you do that. So you also want to have alignment. And we talked about that in the incentives. you want you want to be alignment not just with the pay package, but you want alignment between the management, and the people helping build this business in the team.

there are different ways to find this. Glassdoor would be an example of that. Where is it a good place to work? because it's very difficult to run a company if, the management team is saying one thing, but really, they don't have any, staff that sticks around very long, right? Their team turns over a lot.

So the alignment is not just with you. in the named executive officers, you want this self-similarity alignment between you, the named executive officers, and the team. Costco talks about this. The number one is, you know, the people they take care of, care of are the people working at the company. And so if those people do a great job and you take care of them, they're going to take care of the customer.

So you want that alignment. You want to make sure that everybody is aligned, not just you and the management team, but you, the management team and the people helping execute on this business. Are they taking care of those people? And again, there are different ways, to find that out. Costco, you can go look and it's on their web page that they think it is a paramount concern for them and make sure they they take care of their team members because intern, if they do that, their team members will take care of their customers.

And people are very loyal to Costco and they keep coming back. And then the lastly here is for the acronym capital is long term. And I mentioned this already a few times. Is this management team is this business set up for the long term. So we're talking about the management team. Are they focused on the long term.

If there's a lot of turnover at the management team that's already one sign where you really need to think about, maybe this is not a good company to get involved with right now. If it's a turnaround and you think the new team is going to do a good job, that's something else. But if they turn over their CEO's and their CFOs and their chief operating officer all the time, they're not running this business for the long term.

And that's another problem, possibly with the board of, that's running the company. so that's something to think about. But you really want companies that are set up for the long term, because that's how you can compound capital. You compound capital over a long period of time. Some of the best returns, for example, for the investments to have come over years, Apple being, the biggest example where we've held it for almost 20 years and it's done over 100 times for the investment Institute, but also a company like visa that we bought near the IPO.

Our students, our students identify that. And that's done like a 17 times return so that those are fantastic returns. Those are extreme, returns. But we're very proud of those things. But we've just held those companies over the long term. And those companies have been focused on growing value over the long term. That's how you're going to make money.

Typically, you're going to make a lot of money over an extended period of time. If you've been, you know, focused on, for example, Nvidia and we talked about in the prior episode, yes, they've gone up a lot, in the short term because of the focus on AI. But the people who are building in Nvidia have been building it for decades now, and they've been at it and they've been now they're extracting some of the economics that they've built.

But it has been a long time coming. And for a shareholder, you want to be focused on the long term. And is this management team focused on the long term? Are they not just focused on the next quarter, the next year or the next two years? They're really thinking about what's the company going to look like next quarter for sure next year.

But now three years and five years and ten years, where are we going and how are we going to get there? If you can find management teams that are focused on that and meet all of these other criteria, the capital that we went over, then you're likely going to find some good investments. Now, you don't always know and it doesn't always work out.

But this is something that can help you think about that. So use this acronym to your advantage capital. And I encourage all of you, to become an analyst if you're not already. If you are, I encourage you to use these tools to make yourself a better analyst. Again, not an investment advice. You got to do your own work but thank you. That's a wrap for episode seven. We'll be back on episode eight. See you soon. Thank you.

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