“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact” – Warren Buffett.
In recent years, the role of the Chief Executive has become increasingly high profile. They are widely recognised (at least in the media) and feted as veritable supermen, taking a firm by the scruff of the neck and leading them to greater glory. They are interviewed by business media with a reverence that borders on awe and they wield a great deal of influence on governments – the near-universal belief in their judgment on the part of MPs, for example, may help to explain why the latter are (mostly) against Brexit. A “loss of confidence” is often a precursor to an economic slowdown (and job cuts), which may also justify parliamentarians’ attentiveness.
It was not always thus – according to a study from Stanford Business School, (page 5), executive pay was stable around $1 million per annum for the period from 1936 up to the late 1970s but then soared thereafter, largely as a result of share options, etc. to average around $9.2 million as of 2005; according to a CNBC article, as of 2018, the average pay level has risen to $15.6 million! It is the same story in the UK, with Executives earning 133 times that of the average worker. There is now an enormous “equality gap” between the titans of industry and their staff, which is beginning to fuel resentment. This manifests itself in demands from Democrats in the US (and elsewhere) for new curbs on both pay and share buybacks, which we discussed a month ago, which tends to escalate when news of scandals and dubious sales practices emerge (primarily involving financial companies it seems).
But what if this “cult of the CEO” is baloney? Does it matter which business school they went to and whether they got an MBA? Does the track record of the individual provide any indication of future performance at another firm (for shareholders, as opposed to themselves)? Do they actually have a role in corporate performance (as measured by the share price?).
Two students (as they were then) set out to answer these questions and got some (not massively surprising ) answers. (The full article is here). Contrary to popular belief, there was no significant statistical association between the “quality” of the MBA programme attended by the approximate 8,500 CEO’s studied and the subsequent share price returns of the firms they ran; 25% of the executives had above-average performance (again, measured by share price returns) over two successive 3-year periods, which is what one might expect purely from chance. The data suggests the same for those executives that ran multiple companies – the previous performance of a CEO had no effect on the performance at a new firm, the results of which held, regardless of which industry the new man was working in.
Thus, the idea of a Corporate “Superman” is a myth; but it is a powerful one, particularly if a share price falls, and shareholders are looking for someone to blame (or lionise if the opposite occurs). Of course, if the top man at a firm cannot significantly influence the share price (and this analysis would argue that they cannot), why should investors (and the compensation committees of boards) be so keen to tie the two together? As Nassim Taleb might say, they are being “fooled by randomness“.
In business, as in other areas of life, it is all a matter of context – an avowed “cost cutter” will not flourish in a high growth firm whilst a visionary may find it hard to deal with the nitty-gritty of turning a poorly performing company around. The question that few seem to ask is whether the potential executive temperamentally suited to the task at hand, or is he/she a square peg in a round hole? Unfortunately, none of the metrics described above answer this question.
All this of course applies equally to Active Management. Measuring a share price by recent performance or the “quality” of the management provides no basis for durable returns for the investor; having gone to the “correct” school, or the right university predicts nothing about the ability of the fund manager to generate performance, most of which is out of their control. (It is out of the power of fund managers but they still trumpet their successes as if happenstance played no part in the process). The other similarity is that in neither case can one be sure of their longevity – both executives (and fund managers) have an unfortunate habit of leaving their jobs abruptly! Investors are not blameless either – they tend to switch funds (or “fire” their fund manager) at the slightest sign of underperformance, even if it has little to do with the manager’s strategy. In fact, investment errors of this type permeate right down the investment process, all the way to the individual investor…
[This phenomenon exists in other areas of our society too – (mostly completely unqualified) boards of directors of football clubs hire and fire their managers with depressing frequency – sometimes they get lucky, but in most cases, they conform to type].
All of which helps to explain why we see no real value on the whole “meeting with management” process, or in trying to pick stocks. The link between Executive “success” and that of the company that they run is tenuous (at best). Active fund managers spend large amounts of their time trying to identify “good” management teams, (as they do with “good” stocks), but the role of luck in both arenas is consistently overlooked (or downplayed). Both Jeffrey Immelt, who ran General Electric (prior to its share price collapse) and Neil Woodford for example have seen major revisions in the perception of their status in recent years, but is it possible that they were just lucky in the first place? Nobody can overcome the negative external effects of an economic slowdown (or a market that veers away from one’s investment style), so it is hard to see why they should get the credit if it goes their way either. But the number of Active Managers still out there suggests that for many, this idea is a hard one to let go of.