8 tips to spot star management

A former colleague once suggested I should think of BRW magazine, which I then edited, more like a sport publication. That is, having a regular parade of “star CEOs” on the cover and a track of winners and losers in business. Some might call this the “cult of the CEO”.

Right or wrong, the market puts a premium on business personalities, even though their influence on company valuations is rarely as clear cut as it seems.

Over the years, I’ve seen the market gush about CEOs whose success, in truth, was built on the efforts of their predecessor. And slaughter CEOs who appeared to struggle based on company performance, yet were cleaning up the mess of former management.

In the sharemarket, choosing the right boat is always more important than choosing the person rowing it. That is, focus on choosing a high-quality company with a sustainable competitive advantage, preferably when it trades below fair value. Then focus on the people pulling the oars: the executive team and the board that oversee them.

The caveat, of course, is company size. Many junior miners promote around their management. The team’s previous exploration success is the main drawcard (often, the only one). Assessing management and the board is critical when deciding to invest.

That’s not as much the case with BHP Billiton (BHP). Granted, a strong management team and board are critical for BHP and all large companies. But BHP’s tier-one mining assets, balance sheet, management depth and succession planning make it less reliant on an individual.

Still, management matters to market valuations. Blackmores’ (BKL) shares fell 4.4% in June when CEO Christine Holgate announced her resignation to lead Australian Post. Her departure wiped about $70 million off the vitamin-maker’s valuation, but it has since recovered those losses.

Many fund managers watch CEO gestures and actions closely. Some even send their staff to body-language interpretation sessions, so they can interpret CEO expressions in this heightened era of continuous disclosure. Pity the poor CEO who winks when announcing a profit because of dust in his or her eye, and the share-price tanks as investors misinterpret the gesture.

Giant US fund managers even use sophisticated algorithms to interpret CEO statements and language. Computers pore over every word in company announcements to determine if CEOs are bullish or bearish, or if sentiment in language is changing.

Assessing management is far harder for retail investors. For starters, small investors do not have the same access to management as fund managers. The closest most retail investors come to management is at highly staged Annual General Meetings, where attendances continue to fall.

Still, it’s possible for retail investors to form a view on management if you know what to look for. Here are eight tips to spot star management and avoid the duds:

1. Start with the board

Too many investors obsess about management and overlook the board, whose main job is to choose, monitor and incentivise the right CEO. A strong board, in theory, should appoint the best-possible CEO for the job and help the executive team maximise performance.

Do not fall for the glossy write-ups of directors in annual reports. Every director looks like a star in those puff pieces. Board independence is also no guarantee; plenty of academic research shows boards that are less independent often govern higher-performing companies. Too much independence on the board can dent performance and shareholder returns.

The best guide is the remuneration report. If the CEO is excessively paid relative to industry peers and performance, chances are that management has “captured” the board. Directors are cheerleaders for the CEO and afraid to stand up to him or her. Inevitably, they persevere with an underperforming CEO for too long and not act as shareholder agents.

2. Focus on the numbers

Trying to assess the CEO’s personality and gestures is pointless, particularly in larger companies that often stage-manage executive appearances and comments. Far better to let the numbers speak for themselves about CEO performance.

The key one is return on equity (ROE). Top-performing CEOs have a knack of ensuring their organisation delivers high (above 15 per cent) and rising ROE over long periods. In doing so, they work each dollar of shareholder funds harder each year.

3. Capital raisings

The capital structure provides vital clues when assessing CEOs. The best ones find ways to fund growth internally through surplus cash flow and minimise debt and equity issuance. They ensure any extra capital raised underpins higher ROE.

The worst CEOs raise debt or issue shares to buy assets, so that they run a larger company. Sadly, the only reliable predictor of the size of executive pay is company size; the bigger the organisation, the more the CEO is paid. Beware empire builders or those that issue shares like confetti and dilute shareholders.

4. Internal or external

Smart companies ensure there is a pool of skilled candidates who can step into the CEO role. They groom them over many years and benchmark them against external talent when filling the top job. Other companies are forced to hire external CEOs (outsiders) to run the business.

There’s no concrete rule, but academic research suggests external CEOs perform better in turnaround situations. The new CEO tends to make faster decisions because he or she is less beholden to previous strategies and company personalities than insiders. But external CEOs are riskier and can produce more erratic performance.

Insider CEOs tend to do better when the company is performing smoothly and the outgoing boss hands the reins to a successor who knows the business back to front. The market likes smooth succession events and new CEOs they know. There’s been a trend towards internally appointed CEOs in Australia since the 2008-09 Global Financial Crisis.

5. Executive turnover

Good CEOs have a knack of developing star talent who eventually leave the company to run other companies. No shame in that. It’s a sign of a strong company and organisation culture when its alumni are leading businesses across industry.

However, warning signs should flash if there are too many executive departures, particularly when those leaving do not move to higher jobs elsewhere.

The best judges of the CEO are executives who work with him or her every day. When the chief financial officer and company secretary start to leave for no reason, it could be a sign that the executive team is losing confidence in, or cannot work with, the CEO.

Of course, the CEO could be managing out underperformers, but high executive turnover is rarely good.

6. Alignment

The alignment of CEO interests with those of shareholders comes in many forms. A good board will ensure the CEO’s pay has an appropriate mix of cash, short-term incentives (annual bonuses) and long-term incentives (options or share grants).  The goal: to ensure the CEO’s performance is linked to organisational gains and shareholder returns.

Other CEOs, particularly founders, have high stock ownership. I always like management teams that are strongly invested in the business with their own “hurt’’ money, not only through shares or options that the board grants them.

Even better is when the CEO’s stake in the company represents the bulk of his or her assets, not a token amount that matters little if it falls a few per cent.

For example, Blackmores chairman Marcus Blackmore still owns about a quarter of the business. Nothing drives CEO performance harder, or ensures it is more aligned with shareholders, than a founder on the board who effectively gives management the keys to his or her fortune and demands high performance.

7. Tenure

Again, there’s no concrete rule. Some longstanding CEOs do an excellent job, remain as hungry as ever and develop greater intuition each year in the job. Others get jaded and burn out the longer they stay in the job, or lose motivation.

The average CEO tenure in Australia is 5.5 years, a 2016 PwC study found. Tenure is rising because of improved corporate governance and succession planning.

Every company and CEO is different, but tenure above seven years requires extra consideration. The demands of the CEO role are so intense these days that long stints are hard to maintain. Like high-performance athletes, most CEOs struggle to maintain peak performance over long periods.

8. Communication

It’s a mistake to read too much into a CEO’s communication style. Over the years, I’ve seen nerdy CEOs who are terrible presenters, yet brilliant managers. Some charismatic CEOs have been awful performers because they did not know the detail, were strategically inept or could not manage. I always worry when CEOs are not across the numbers in presentations.

Focus on the company’s communication style. Is the company as open and available to shareholders as possible? Do the CEO and the board treat shareholders with respect at the AGM? Is the CEO, particularly of a smaller company, attending roadshows and working hard to promote the company? Does he or she regularly meet the investment community?

In my experience, companies that have transparent, respectful communication with shareholders tend to treat them as equal partners. The board acts as an agent of shareholders and the CEO works in the best interests of investors, not only their own.

It’s no good being a star CEO if too many of the gains go to the executive team and board, and shareholders are treated liked second-class citizens.