Outside 1-1-3

Hodges Insights

"In the investment business, you go to school every day, but never graduate." - Don Hodges

Betting on the Jockeys! An Active Manager's Perspective on Corporate Leadership

by Eric Marshall, CFA, on January 5, 2023

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.

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.

Hodges Insights

The Hodges Insights Blog is designed to keep our clients educated and abreast of certain major news headlines. We aim to help investors separate the news from the noise by providing our perspective. 

Subscribe to Hodges Insights