April 5, 2021
Betting on the Jockeys! An Active Manager's Perspective on Corporate Leadership

Whether it’s George Washington leading the Continental Army across the Delaware in 1776 or the quarterback of your favorite football team on any given Sunday, it is obvious that leadership is a key element to the success of any organized effort. Investing is no exception. Over the long term, most successful equity investments require trustworthy leadership. This paper seeks to highlight for investors the importance that quality management, sound corporate governance, and good directors should play in individual stock selection.

“Good managements are like cats; they always land on their feet.” – Bill Simms

Why Management Matters

Unfortunately, public companies are not 737 aircrafts on autopilot that investors can passively purchase airfare on and expect to arrive safely at their final destination without giving much thought to the underlying skill level of one pilot over another. Instead, the overwhelming competitive forces of capitalism do not lend themselves to running any business on autopilot. Therefore, the skill and abilities of senior management to create shareholder value should always be a consideration in individual stock selection.

Over the long run, investors are most often rewarded when the underlying business is able to generate returns above its cost of capital, and then compound those returns through prudent reinvestment in capital projects or returning gains to shareholders in the form of dividends or stock repurchases. Most often, we find that successful companies are driven by management teams that are laser-focused on generating consistent returns above the company’s cost of capital. Such returns are measured by comparing a firm’s return on invested capital (ROIC) with its blended cost of capital (weighted average cost of debt, equity, preferred stock, leases, etc.). While making business decisions on the premise of generating positive returns relative to a firm’s cost of capital may sound overly simplistic, in reality, there are a multitude of business variables, as well as both foreseen and unforeseen risks that require the navigation of a skillful management. As a result, successful management teams are typically those that avoid the distractions of organizational politics and overcome personal egos in an effort to stay focused on long-term shareholder returns at every decision point.

At the helm of a company’s management team is the ever so important role of the Chief Executive Officer (CEO).  This role can be compared to a jockey in the Kentucky Derby. Although a good jockey does not guarantee that a given thoroughbred horse will win the race, no horse has ever won the Derby without the direction of a highly skilled jockey. Much like a jockey, critical attributes of a good CEO include the ability to quickly adapt to prevailing conditions and confidently make crucial decisions.

The role of a CEO often involves wearing multiple hats within the organization. This especially rings true among smaller companies, where the CEO may be involved in product development, marketing, operational processes, and overseeing a multitude of administrative responsibilities. While the authority associated with these duties is often delegated within an efficient organization, the responsibility can’t be delegated and always resides with the senior leadership. Although the role of CEO may vary across different industries and companies, we have observed five critical functions of a CEO that investors should consider when evaluating the effectiveness of senior management.

Five Critical Functions of a CEO

1. Strategy/Vision – The CEO must provide the company with a clear strategy or Without this element, the organization and its associates will not have purpose or motivation.
2. Business Model – A CEO needs to develop a well-thought-out business model to execute the company’s strategy to generate its required return on invested capital.
3. Resource Allocation – This is probably the most important and encompasses both the allocation for financial capital, as well as human talent with the An effective CEO must hire the right people and recognize talent, as well as acquire the proper resources to deploy the business model.
4. Communication – The CEO plays a vital role in helping the organization overcome obstacles though effective The most critical ingredient in any collaborative effort is communication, and senior leadership must be the conductor of this effort.
5. Set the Culture – The essence of corporate culture begins with the A sound corporate culture is to a company what carbon is to steel. It is essentially the character of the institution. A CEO with poor character or who takes self-serving actions is not likely to establish a corporate culture conducive to serving the needs of its customers, rewarding the valuable contributions of its employees, or creating value for shareholders. Establishing an effective corporate culture is predicated on the CEO’s message, the consistency of that message, and the ability to demonstrate this message to his team. 

When evaluating the competency and character of management, each of these five critical functions should be considered by investors. Over many years of studying public companies, we have found that if a CEO is deficient in any of these critical functions it diminishes the likelihood of creating value for shareholders. For example, if a CEO has a clear vision for the organization and a sound business plan to execute its strategy but is ineffective in the area of communication or selecting the proper talent, the business model may still flounder. Furthermore, if a CEO fails to establish an appropriate corporate culture, the organization may find itself run aground due to a lack of ethical standards.

Skin in the Game

As shareholders, we want management to run public companies like an owner would operate a small business. In essence, owners act like owners. It is unrealistic to expect the CEO or any member of corporate management to act like an owner without having their own skin in the game. For this reason, we believe it is important for the senior management team of a public company to own a meaningful amount of common stock relative to their net worth. In contrast to stock that is indirectly held through option grants or bonus plans, it is especially relevant when management invests their own personal capital in open market purchases of a company’s stock. While there are no hard and fast rules for how much stock management should own, it is often reassuring to investors when insider holdings amount to 5-10% of a company’s outstanding shares. Of course, the relevance of this amount as a percentage may vary dramatically depending on the size of a company’s market capitalization. Depending on the growth phase of the company, it is reasonable for insider ownership to be less in a larger, more mature public company. In contrast, a prudent investor should expect an entrepreneurial management team of a small growth company to have a greater degree of equity ownership. The bottom line is simply that insider ownership in a public company demonstrates a commitment to the business, promotes financial stewardship, and aligns management with the shareholders.

Corporate Governance

Franklin D. Roosevelt once said, “Rules are not necessarily sacred, principles are.” In the early 2000s, we saw a number of infamous scandals including Enron, Tyco, and Worldcom, followed by the worst financial crisis in 80 years. Such painful losses for the investing public helped put corporate governance policies in the headlines. As a result, there has been growing debate by regulators, academics, corporate consultants, rating agencies, and the business community at large over what policies should be promoted through new laws and regulations. In 2002, the Sarbanes-Oxley Act was enacted in an attempt to enhance the accountability of senior management of publicly traded companies. While the spirit of Sarbanes-Oxley demonstrated good intentions, the benefits to the investing public from this legislation are questionable. What is certain is that Sarbanes-Oxley increased administrative and legal costs that are a disproportionately larger burden to smaller companies and ultimately reduce earnings, as well as weakens the global competitiveness of many U.S. firms. This is also one reason why some companies have avoided going public in recent years or waited until they reach a larger size to endure the costs of regulatory burdens. As investors, we have little confidence in the role of any government mandate to enforce good corporate governance and business ethics. Instead, we suggest shareholders should hold individual fiduciaries responsible. In the following discussion, we will explore several key issues that investors should consider when evaluating corporate governance.

“Rules are not necessarily sacred, principles are.”  - Franklin D. Roosevelt

Enterprise Structure:

In evaluating a company’s corporate governance, investors should review the framework of corporate policies from a bottom-up perspective. Many of these are statutes that can be found in a company’s periodic SEC filing or articles of incorporation. Evaluating other policies may require in-depth due diligence that can be completed by interviewing management or industry participants firsthand. Such framework covers a wide variety of business practices and internal controls to include the following:

• Code of Conduct
• Accounting Methodologies
• Employment Contracts
• Pension Policies
• Legal Concerns
• Health & Safety Controls
• Contingency/ Succession Planning
• Shareholder Rights Policies
• Investor Relations Efforts
• Shareholder Voting Policies

Management Compensation:

One of the most obvious elements of corporate governance that investors should review is compensation packages. Just as markets are the most efficient when prices are set by supply and demand, management compensation should also be set by the ability to create value for shareholders. Therefore, we do not believe compensation should be limited by salary caps or government regulation. We believe it is best for upside to be unlimited to a reasonable degree and for compensation to be ultimately tied to performance. Measuring performance should be aligned with long-term directives to generate sustainable shareholder returns. Such measures might include linking management compensation to a company’s net income, free cash flow generation, or the returns on invested capital. The definition of “long-term” varies across industries due to the cyclical nature and unique operating characteristics of certain businesses, but in general, we suggest investors consider long-term as a range from three to five years. Consequently, the medium CEO tenure for most Fortune 500 companies amounted to five years in 2017 according to data published by the Harvard Law School Forum on Corporate Governance and Financial Regulation. For this reason, we believe it is also important for investors to put the tenure and track record of building shareholder value in context to overall compensation.

It is especially important for performance not to be measured on the basis of short-term fluctuations in the stock price or quarterly financial performance. In the latter part of the 1990s, investors found this out the hard way as the senior management teams of many high-tech companies were routinely incentivized through exorbitant stock option programs. Many of these stock option plans ultimately diluted shareholders by increasing the number of shares outstanding and penalized long-term investors by incentivizing management to focus on short-term results, use aggressive accounting, and hype a company’s prospects in efforts to realize gains from exercising stock options. Conversely, shareholders might be better served if a portion of management’s performance bonuses are paid in the form of common stock that is acquired through open market purchases. In recent years, we have seen a growing trend in the use of generous stock compensation plans for many Corporations that are viewed as having above-average growth potential, but little in the way of profits. Most of these are specialized high tech or social media companies in Silicon Valley where today it is not that unusual to see fast-growing companies with stock compensation equal to 50- 100% or more of after-tax profits. Many of these stock grants are then liquidated in short order by management as if they are part of cash compensation. It is also not unusual for companies with generous stock compensation plans to report supplemental financial performance on an adjusted Pro-forma basis to exclude the expenses related to such stock grants.

To quote the legendary football coach Bill Parcels, “You are what your track record says you are.” Not everyone liked Bill Parcels, but he won, and that made him a legend in the NFL. At the end of the day, we believe management compensation should be tied to their track record of creating shareholder value instead of the relative pay of peer executives at similar size companies.

Principles of the Boardroom

When evaluating the investment merits of a public company, prudent due diligence should include a review of a company’s board members, which are ultimately your advocate as an investor. However, directors sometimes forget that they do not work for management, debt holders, creditors, industry trade organizations, or labor unions, but solely exist to look after the interest of the shareholders that they represent. Unfortunately, far too many board members view their board seats as a gravy train, in which retired executives or military Generals collect sizable board fees in exchange for a token quarterly meeting and round of golf with management. Below we have identified a few variables that investors should consider when evaluating the fiduciary role of a public company’s board of directors.

1. Independence: Outside board members should be free from conflicts of interest or any personal ties to management that might prohibit a director from acting When outside directors are independent in their relationship to management, studies show that it tends to have a positive impact on corporate governance and stock prices (Shivdasani, et al. 2002). Although it may be best for the majority of a board to be comprised of independent outside directors, it can also be beneficial for more than one internal director to be a member of management. By having multiple executives on the board, outside directors are not solely dependent on just the CEO or a single insider as the conduit of information. Although it is not a common practice, the Chief Financial Officer (CFO) of the company is often a logical candidate for the board.
   
   
2. Relative Experience: Required board experience and skills may vary dramatically across different organizations and However, directors should bring relative expertise and experience, as well as the ability to offer advice and guidance to management. In most cases, the best intellectual perspectives and fresh ideas come from individuals who have experience in running a business.
   
   
3. Reasonable Compensation: Board compensation should be competitive based on that of a public company’s peers, taking into consideration the size, complexity, and required time commitments of the directors. Compensation should also be highly transparent and void of any hidden perks such as access to the corporate jet or expensive country club memberships.
   
   
4. Ownership: A reasonable guide is for a director’s ownership to equate to at least 4-5X their annual board It may be overly pragmatic, but we reiterate that the best way to have someone act like an owner is for them to be an owner.
   
   
5. Diversity: It is often the case that a heterogeneous mix of directors is key to a board’s overall While this factor may vary across unique circumstances, it is beneficial for directors to hold different backgrounds in areas such as industry knowledge, financial expertise, accounting proficiency, and operational oversight. It is not realistic for every board member to be an expert in every one of these aspects, but a combination of such experts can be complementary in providing the board with a balanced perspective.

Conclusion

While good management alone does not ensure a successful investment, it is important for investors to incorporate the quality and character of management into their investment rationale for an individual stock. As with any organized effort, effective leadership is often the difference between success and failure. Furthermore, we advocate that insider ownership, good fiduciaries, and adequate corporate governance policies are important elements that protect shareholder interests and create long-term shareholder value.