Steve Blieberg (00:03):
Hello, and welcome to Actively Speaking. I'm your host, Steve Blieberg. Join us each episode, as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Steve Blieberg (00:15):
Well, welcome back to another episode of Actively Speaking. We're pleased today, we have a special guest. Uh, our guest today is Greg Milano, who is the founder and CEO of Fortuna Advisors, a strategy consulting firm. Welcome, Greg.
Greg Milano (00:29):
Thank you for having me, Steve.
Steve Blieberg (00:31):
And uh, as, as we go along, I think listeners will understand why we felt this was such a great opportunity to have Greg on our program. Uh, we have s- we have a lot of, uh, common views about the importance of capital allocation, how companies should go about doing it. So, so Greg, let's start off. Tell us first, uh, what is Fortuna Advisors?
Greg Milano (00:48):
Sure, thank you. Um, so Fortuna Advisors is a small strategy consulting firm that is focused on helping companies create long-term value. Uh, and the, the, the focus that we have starts with setting more aspirational goals for high levels of achievement and then better methods of capital allocation, better measure- methods of operating decision making, performance measures that track TSR much better than traditional measures, and ultimately really enhance and set up compensation that simulates ownership. Ultimately, we like to think that our clients embrace an ownership culture and start to think and act more like long-time committed owners.
Steve Blieberg (01:26):
And TSR, of course, is total shareholder return, just for, for anybody who's not familiar with that acronym. So, a- as I, as I said, you can see why, uh, we thought it would be good to have Greg on. Uh, Epic shares a very intense interest in how companies go about allocating capital. It's a big part of our investment philosophy. And we tend to focus on the importance of, the measure we like to look at is return on invested capital. And we always talk about how if companies, basically there's five things we talk about that companies can do with their cashflow. Broadly speaking, they fall into two buckets. One is ... and they're pretty intuitive. You the, you reinvest it in the business or you return it to the owners of the business. And w- we always say that in making that decision, companies should be focused on what sort of return on invested capital they would earn if they do reinvest the money in the business, and if they can't earn more than their cost of capital, they should give the cashflow back to the shareholders.
Steve Blieberg (02:15):
But Greg, I believe you use a different metric, and you've come up with something you call residual cash earnings. Tell us what that is and why you think it, it matters so much.
Greg Milano (02:23):
Sure, Steve. That, the residual cash earnings measure is an evolved version of economic profit. Economic profit is, is sort of like return on capital, but it's the dollars of excess profit at a minimum [inaudible 00:02:36] or a minimum quest to capital, but in dollars, not in percentages. So we care about the quality and the quantity of activity, the amount of investment that's been put into place. Residual cash earnings, uh, as I say, is an evolved version of economic profit because it's cash-based. We don't measure profit. We measure what we call gross cash earnings, which for many companies is sort of like an after-tax EBIDTA. And then we calculate a capital charge to subtract from those gross cash earnings. And that capital charge is based not on net investment, but on gross investment. Because we don't charge depreciation. We don't depreciate the assets, and actually our, our measure tracks total shareholder return much better than traditional economic profit or EBA in every industry.
Greg Milano (03:17):
So, it's, it's a measure that aligns better with share price performance. And so using it as a guide for decision making and, and resource allocation, you know, leads to much better outcomes.
Steve Blieberg (03:28):
So, when, when you talk about that, at Open, we talk about, you know, ROI seems out of whack, or you're talking about residual cash earnings. This all sounds like common sense, you know. This is what people would jokingly refer to as, "Finance 101." And anybody who went to business school or studied for a CFA, you know, knows that, that companies are only supposed to do things that earn a positive return on capital versus their cost to capital, or generate a positive NPB. So, you know, why don't all companies do this? What drives their decision making around capital allocation, if not this?
Greg Milano (03:57):
I think everyone that I meet inside of companies, certainly those with a finance background, understand the principles that, that we both believe in of net present value and returns of open cost to capital, but there are many other influences on them that lead them astray. They listen a lot to investors. And although there are very smart investors out there, like your organization, there are also very many short-term focused investors that don't really care what the share price is a year or three years from now. They care what it is next week. You know, their, their, uh, advice to companies is often driven by more of, you know, what's gonna get the best pop when something is announced rather than what's really gonna be good for the long-term of the company.
Greg Milano (04:37):
Uh, and then on top of that, you have an entire, you know, industry of, uh, brokerage analysts talking about consensus earnings per share to the point where, you know, they very often will do something that might help short-term earnings per share, but it's not good for the long-term value that they create. Um, and those external pressures wind up driving them away from, you know, what you refer to as common sense.
Greg Milano (04:59):
The last thing though that's wor- important to mention is some of the problem starts inside the company. Inside the company, there's this measurement of profit and revenue numbers against internally contrived budgets and plans. And the whole process of measuring people against their plan winds them, um, up encouraging them to be very, very short-term. Next year doesn't matter. There'll be a new plan next year. Whatever I can do this year to hit or beat my plan is gonna put more money in my pocket. And even the, the, people with the best of intentions very often get pulled in the, in the direction of doing things, especially at the end of a quarter or at the end of the year, try and get a couple of more upticks in the EPS number. Uh, and in doing so, they often sacrifice, you know, things that are good for the longterm.
Steve Blieberg (05:43):
So, so then what is the catalyst that leads a company to come to you and say, you know, "Gee, tell us how we could be doing things better"?
Greg Milano (05:50):
The ideal company situation is one where the management believes in the kinds of principles that we believe in, but they've been pulled in other directions and they suddenly decide they want to put their foot down, and, and kind of do what they know is right deep down. And the catalyst that makes them actually suddenly feel that way can be a bad reaction of the market that's something that they did. It can be fear of an activist coming in. Uh, it can be, you know, a, a share price decline, uh, in, in, in the wake of something they thought was good for the stock, but actually turns out that h- you know, lead to a bad reaction. And there are a wide variety of different catalysts.
Greg Milano (06:27):
And actually one is often a new management team. New management comes in and they often take a, a fresh look at things and then want a framework that's better than what the prior management had put in place. And often they're less encumbered by trying to protect their reputation, and so they're willingness to try something new and to pursue what seems to be a better path is, is a little bit higher.
Steve Blieberg (06:46):
Okay. Let's, let's dive a little deeper into some of the principles of capital allocation. In particular, uh, I want to focus for a minute on going back to what I said before about the, the two buckets of what companies can do with their cash. And one of them is return it to the shareholders, and one of the vehicles they can do, uh, uh, to do that is a share buy back. Obviously there's a cash dividend. You could pay a cash dividend, but in, in recent decades because of, uh, some regulatory changes, it became attractive to some companies, uh, and their investors instead to return the capital through share buy backs because that way, you know, if you get a dividend, you have, you have to recognize the income. Some investors might not want the income, and so companies, by offering to buy back shares, put it, the decision sort of in the hands of the shareholders. If you want to sell some stock, it's a chance to get back some of your capital. If you don't, you don't have to.
Steve Blieberg (07:33):
This is a topic I know is, uh, near and dear to your heart, buy backs, because they, they've come in for a lot of criticism for, people believe that management's abused them to manipulate the share price. Sometimes it's connected to incentive plans. And you, you have written, uh, on this subject of, of buy backs. So, tell us how you think about buy backs.
Greg Milano (07:50):
Let me tell you how my interest in buy backs really, really got started. Uh, I had worked in an investment bank, and about 10 years ago, after I founded Fortuna, I was sitting with a CFO. And he asked me what I thought about buy backs. And I told him all the reasons, like what you just said about distributing capital they couldn't use and giving it, uh, giving investors a choice as to whether or not they want to, you know, receive the capital and, you know, the preference that often the lower tax investors will participate in a buy back and the higher tax investors won't, so the total amount of tax that gets paid is lower than with a dividend, and so forth.
Greg Milano (08:23):
And he looked at me and he said, "So does that mean the companies that do more buy backs will have better share price performance in any given industry?" And I said, "Well, I think so." And then I went back and tried to prove that, and cut the data as many different ways as I possibly could, and, and couldn't prove it. I wound up publishing an article titled, Are Buy Backs the Best We Can Do. Uh, a little later that year, I developed a metric called buy back ROI, to measure the return to investors in the manner that they can compare to the returns they earned on capital expenditures, acquisitions, and so forth. And the buy back ROI is, is calculated using the amount you spend on the buy backs, the avoided dividends, and the ending price at the end of a period. And so there's a, an annualized IRR that comes out of that, and, and that's basically the buy back ROI, the return to the remaining shareholders due to the timing.
Greg Milano (09:12):
Unfortunately, many companies had worse buy back ROI than their share price performance. And when we looked at, uh, closely, we found it was because very often companies buy back a lot more stock when it's high and a lot less when it's low. And of course it's not supposed to work that way. You want to buy low and sell high, but they, they were doing the exact opposite. And, and that mitigated the effectiveness of the buy back program. They were buying back fewer shares than they could have. And so, I realized early on that buy backs can be good, but they're often not because of pro- poor timing and, and poor execution.
Greg Milano (09:43):
And so, you know, our approach is to give people objective value-based, uh, and trend-based signals to guide them on when it's a good time to do buy backs and when it's not, so that they can, you know, over time buy back a lot more shares than they might, might otherwise buy in.
Greg Milano (09:58):
Uh, the last thing I'll say on this, which is important, is it would all be much easier if managements could just do a, a one time dividend if they, you know, want to distribute money one time without committing to ongoing dividends. And the problem with that, or the obstacle to that that we found pretty early on is that when you do that, there's often a permanent take down in the share price if you distribute a bunch of money, you know, through a one time dividend. And that winds up punishing the management, right. If they've got stock options and there's suddenly a down tick in the share price, uh, you know, that's, that's not good for them. The beauty of the, of the one time dividend is you're treating all investors the same way.
Greg Milano (10:36):
When you're doing buy backs, you know, when you're buying, buying back high, you're kind of punishing the remaining shareholders to the benefit of the- those that sell out, and when you buy back low, you're kind of punishing the selling shareholders to the benefit of those that remain. The dividend just treats everybody the same way. So, you know, we've done a lot of work on this. We've developed services around trying to help companies time their buy backs better. But overall, we find that on average, companies are actually pretty bad at, at timing their buy backs.
Steve Blieberg (11:02):
Okay. So it's not that you're really, you're not really challenging the premise of buy backs as a capital allocation tool. It's more you think they could do a better job on the timing. Because our perspective at Epic would be, okay, I'm, I'm a company management. We're evaluating our prospective reinvestment options. We've invested in all the projects that we think have a positive NPV. We still have some cash. Gee, what do we do with it? And we should give it back to the shareholders. So, you're saying a buy back is, in that circumstance, certainly a viable option for management, but they should simply, rather than just going ahead and doing it regardless of where the share price is at the moment, you're saying there are things they can do to try to time it better.
Greg Milano (11:40):
Right. I mean at a minium, they can go into a, a, a constant buying back the same amount every month or every week, so they get dollar cost averaging. So when we time the buy back, more shares when it's cheap, less shares when it's expensive. And that's the first step in the direction. The vast majority of the companies in our, in our five year studies we publish every year, uh, do worse than that in terms of their buy back timing. But, you know, there are ways to actually time it better. The obstacle that they face is, is oftentimes this external pressure when they build up cash on their balance sheet. And, you know, when you're, when you're generating a lot of cash, that's when you tend to be building cash, and that's also tends to be when your share price is high.
Greg Milano (12:17):
So, if every time you have some surplus cash you go and buy back stock, you're probably gonna time it badly. You're gonna tend to buy back a lot when it's high and not much when it's low, because when it's dipping, that's usually when you're not generating cash, right. I mean, that's the, that's the reality of the world. And so having some patience and some signals to be able to time it better, a, a few years ago, Warren Buffet had a simple one. Whenever his stock went below a certain market to book ratio, he was gonna go in the market and start buying back stock. Uh, most companies need something maybe a little more sophisticated than that, but that kind of an approach is really what we're talking about, is to try and buy us the buy backs to where when the price is low, and to be patient when the price is high.
Greg Milano (12:55):
The market is volatile. At some point, it's gonna be low again, you know, for at least a period of time. Taking advantage of those buying opportunities is no different than it is for a shareholder wanting to buy on dips as well.
Greg Milano (13:06):
Steve, if I could ask you a question. In the Epic core model, which I, I read some descriptions of, of the way you calculate returns and so forth. One of the things you do, which is similar to what we do, is you capitalize on the expenses and treat them as an investment instead of as an expense. Uh, again, we encourage our, our clients to do the same thing. I'm curious, from your perspective, well what is the advantage of treating R and D as an investment, even though the accounting treats it as an expense?
Steve Blieberg (13:34):
Well, it's, it's really to put firms in different kinds of industries on a more equal footing when we are looking at them and comparing them across industries, because, you know, the nature of some businesses, if you're, if you're in a, uh, just to make it simple, I mean, if, I mean even manufacturing businesses, obviously you still need to spend on R and D, but less so, say than, I don't know, maybe a, a bio tech company where, you know, it's not about building gigantic factories to turn out huge, you know, gigantic, uh, steels of things. It's just coming up with the ideas, uh, and experimenting to come up with new drugs.
Steve Blieberg (14:07):
But accounting sort of treats those different, those businesses differently. If you were to look at the accounting treatment of those two industries, and the bio tech company is spending all this money in R and D, it's not building any factories, so it doesn't get to capitalize that factory and, and depreciate it slowly over time. All the money is going out the door today on the R and D, but that really is, uh, effectively the same as what the manufacturing is doing when it builds a factory. It's committing capital to something that is going to generate revenue over the long-term. Uh, and actually in, in accounting, there, there is that, you know, matching principle that's supposed to match up revenues and expenses in time based on when they occur. And that's the whole reason you capitalize a factory. Even though you pay for it all upfront, well this factory's gonna generate revenue for years and years and years, so you capitalize the expense, and then you depreciate it over those years and years and years to match up the expense with the revenue generated by that expense.
Steve Blieberg (15:01):
So, R and D to us is no different than that. It's, it's the equivalent of building a factory for certain kinds of industries, like software or, or pharmaceuticals, where again, it's not about building factories. It's about doing research. But that research is gonna pay off for many, many years. And so to us, it's, uh, as I say, a way of putting companies on an equal footing, uh, across different industries.
Greg Milano (15:22):
So, uh, just to take this a step further if I could. So if there were two companies out there, so similar size, similar financials, similar market cap, maybe a little difference in their business, but basically similar, you know, financial story, and one of them suddenly announced they were gonna be spending $50 million on a, a new factory, you know, all PPE and, and so forth, and the other was gonna spend suddenly a, a new investment of $50 million in R and D and puts on a new program that they, you know, had to, an equally strong, you know, PR story about how great it was gonna be for the business, uh, you'd essentially look at those two the same way. Is that right?
Steve Blieberg (16:00):
Yeah, yeah. Ultimately, you know, our approach is, uh, we're focused on how businesses generate cash, uh, you know, not, not how they generate accounting earnings. It's how they generate cash, and to us that is ... The whole point of doing it that way is that one of the things about certain accounting treatment is it kind of ignores the time value of money, which is, uh, you know, I always think back to me very first day in business school, and introductory finance class. The professor went up to the board and he wrote two words on the board. It was time and uncertainty. And he said, "Finance is the study of how do you value uncertain cashflows over time." Which is a great definition and, uh, it's something I keep in mind every day because, you know, there, there is a difference between what an accountant would tell you, uh, again for the expense of either building a factory or spending the money on R and D, versus what the actual pattern of the cash distribution, uh, uh, the cash going out and cash coming in.
Steve Blieberg (16:52):
Ultimately, that's what matters to the value of business. The timing matters. A dollar a year from now is not the same as a dollar today, so we care more about how much cash is going out today and how much is that expenditure of cash going to generate in future revenue and when. And then you, you know, so you're basically just trying to figure out what do the cashflows look like over time in and out, and what's the present value of that cashflow stream. So yeah, that's what it is to us. We still care about, you know, even though the spending on R and D, obviously it's, if you capitalize it, it's not an expense, so it doesn't impact this year's earnings, other than the fact that there's some depreciation going on, or amortization going on right away. But we care more about just what is the pattern of the cashflow stream.
Steve Blieberg (17:31):
And by looking at it that way, by recognizing that in essence what you can say is what we're recognize that R and D, even though it's a lot of cash out the door today, it's gonna generate a lot of cash in the future in the same way that spending money on a factory is gonna generate cash in the future. So, we just want to look at them all the same way.
Greg Milano (17:47):
That's great. Uh, again, very much the same way that we look at things. And, and one additional point on this, which I think from our perspective is really important, because we want measures that encourage good investment in the business, but also hold people accountable for producing good returns on those investments. And when you expense R and D, it's like they can forget about it after the year after they spend it, because it's just an expense and that's it. But in our framework, uh, and yours, because it endures, you know, if you invest a bunch of money in R and D and it doesn't work, doesn't pay off, but you're gonna be facing, you know, a bunch of capital in future years, and in your case, you know, amortization that you can't get out from under, and it's gonna actually drive your performance down.
Greg Milano (18:25):
So from our perspective, what we like about it is, you know, before somebody in a business unit of a company asks corporate, hey, can I spend $50 million more on R and D, you know, they know that they're gonna be accountable to that for along time, and if it doesn't work out, you know, their measure are gonna go down. If they're measures are gonna go down, they're gonna get paid less money. And so before they ever try to convince corporate that they have a good plan, they're gonna spend a lot of time convincing themselves they believe in it, because they can't just forget about it after a year. Really impa- important behavioral impact.
Greg Milano (18:51):
So, how much does this, does Epic focus on incentives, l- executive incentive compensation when you're thinking about, uh, whether or not you should be invested in a company?
Steve Blieberg (19:02):
Uh, well it's actually, it's pretty important to us. We definitely, you know, we, we don't just look at things like the, the 10K and stuff. We look at the proxy every year to see what the long-term incentive plan consists of for management because we definitely want to see, or we prefer to see, and obviously you can't find it in every case, but we prefer to see management incentivized to basically generate a good return on the capital that is being entrusted to them. We don't like seeing incentives say, like, well just hit a particular earnings per share target, or grow sales by a certain amount, or achieve a certain market share in your business, because it's possible to do all of those things in a way that is destructive of shareholder value. I mean, you know, you can go out and make an acquisition to bolt on the earnings, to hit your earnings per share target, but it could be that that acquisition earns a very poor return on the investment.
Steve Blieberg (19:50):
You could cut price to gain market share and, and eat into your margin and lower your returns on capital there. There's all sorts of, you know, perverse incentives that could be created with the wrong targets. So yes, we want, uh, like you said at the beginning, you know, to create a, an ownership culture amongst management. That's what we look for. We want to see managers who are incentivized to behave like owners so that their interest align with ours as outside owners. That's what we look for.
Greg Milano (20:16):
That's really great. I think that not every investor looks so carefully at incentives and I think they, they really should. We spent a lot of time and effort with our clients trying to improve the quality of their incentive compensation. We find a number of problems in, in what typically happens, and unfortunately, uh, when they turn to their, you know, compensation advisors, very often the compensation advisors just tell them what everybody else in their industry is doing. And so there's this perpetuation of, you know, what we would consider to be pretty bad practices in many companies. But the, the problem we think starts with, as I said before, measuring performance against a plan or a budget leads you to plan for mediocrity.
Greg Milano (20:58):
You know, if you're gonna be paid based on performing versus your plan, you're gonna try to get away with the lowest profit plan, the lowest return on invested capital plan, the lowest, uh, whatever the measure is plan that you can get away with, that you can negotiate, because whatever you wind up doing, you make more money if the target is low. And, and so there's this huge incentive to plan for mediocrity. Uh, and so the first thing that we try to do is to separate incentives from the plan, so that the planning process can be free to plan, right. The way that if they see some upside, they have an incentive to go for it. If the CEO turns to a business unit with ideas for improvement, the business unit welcomes them, instead of saying, "Oh, I don't want to put those in my plan."
Greg Milano (21:38):
But in order to separate the plan, the incentives from the plan, you need to have a measure that pretty much always, when it goes up it's good and when it goes down it's bad. That was really, that's really the benefit of, of our residual cash earnings, or RCE metric, is it's so comprehensive, revenue growth, margin improvement on a cash basis, asset productivity. Whatever you can do to drive sort of, you know, success in the company is captures in RCE, and whatever the company invests during this year, if they cover the cost of capital in that investment, their RCE stays flat. And if they beat the cost of capital in that investment, their RCE goes up. And when we time their incentives to measuring RCE against last year, we're actually really simulating ownership really well.
Greg Milano (22:22):
And for, you know, most companies, maybe excluding unprofitable early stage bio techs and, and such, for most companies, it winds up leading to incentives that correlate much better with total shareholder return than what, you know, companies already, uh, you know, have implemented in, you know, through whatever incentive processes that they have. So, separating the plan from, or separating the incentives from the plan by having a complete measure so we can just measure it against last year, we find, you know, works really well. And again, going back to my comment about R and D earlier, whenever somebody invests in the business, if it doesn't cover the cost of capital, the RCE goes down, they get paid less money.
Greg Milano (22:58):
You know, I'm not marketing to the board. I'm not marketing to senior management to approve my project. I have to convince myself because if I don't cover that cost of capital, some of the value I destroy is my own. And that's how we really c- you know, try to make the whole ownership culture really come to life, you know, inside the company. And we, we found that when we try to implement our sort of value-based framework without incentives, we get probably half the impact than we do when we also include the incentives, because it really focuses the mind of the people, rather than it just being one more thing they need to measure. Uh, and, and so incentives to us are, are incredibly important in achieving that ownership culture.
Steve Blieberg (23:36):
Okay. Well that was, uh, very fascinating. It's, it's always great to talk to somebody who, who thinks so much like you, but I think we're at risk of this turning into a mutual admiration society. But, but speaking of incentives, we'll have to come up with incentives to, to have you back again. This has been a, a great conversation. So, once again, my guest has been Greg Milano, the CEO and founder of Fortuna Advisors. Greg, thanks very much for joining me.
Greg Milano (23:59):
Oh, thank you very much for having me. This has been a, a very enjoyable conversation, Steve.
Steve Blieberg (24:03):
Thanks. And uh, to our listeners out there, if, uh, if you like this podcast, please, uh, give us a, a good review on wherever, whatever platform you're getting the podcast on, and we'll be back again soon with another episode. Thanks.
Speaker 3 (24:16):
Remember to subscribe to Actively speaking on Apply Podcast, Spotify, or Google Play. You can find all of our previous episodes and additional content on our website, www.EIPNY.com.
Speaker 4 (24:32):
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 contained in this podcast is accurate as of the date submitted, but is subject to change. Any performance information referenced in this podcast represents past performance and is not indicative of future returns. Any projects, targets or estimates in this podcast 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 materially be different.
Speaker 4 (25:20):
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 are profitable or not, they are being provided as a means of illustrating our investment thesis. 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.
