Visiting Warren Buffett in Omaha a few years ago, my students and I got a rare glimpse into his method for selecting managers. When asked about his process, Buffett explained it simply: He takes them to lunch, and if they seem motivated by money alone, he doesn’t hire them.
For Buffett, with his extraordinary knack for judging character, this might be straightforward. But what about the rest of us? How can we evaluate CEOs effectively?
Key Roles of a CEO: Operator and Capital Allocator
CEOs have two critical roles: operator and capital allocator.
Characteristics of Effective Operators
Evaluating a CEO as an operator involves both quantitative and qualitative assessments.
Quantitative Analysis:
Examine the company’s financial ratios over time and compare them to peers. Key ratios include:
Asset Turnover
Operating Margin
Return on Equity (ROE)
Return on Assets (ROA)
Return on Invested Capital (ROIC)
Working Capital Ratio
Superior ratios compared to competitors indicate a proficient operator.
Qualitative Analysis:
Focus on the manager’s character. According to Charlie Munger, former vice-chairman of Berkshire Hathaway, young managers need discipline and integrity. Integrity means being truthful and consistent. Managers who mislead or act inconsistently, like those at Enron, fail this test.
Red Flags in CEO Behavior
Certain behaviors can indicate potential problems with a CEO:
Misleading Reports: Do they produce reports that misrepresent the company’s performance?
Recurring Non-Recurring Charges: Do they frequently incur supposedly one-time charges?
Inaccurate Projections: Check if their forecasts match actual performance. For example, former GE CEO Jeff Immelt’s projections often missed the mark.
Incentive Structures: Are their salaries and bonuses reasonable or excessively large? Do they show signs of an extravagant lifestyle?
Complex Corporate Structures: Have they created unnecessarily complex organizational or ownership structures? Are they active in unrelated mergers and acquisitions?
Evaluating the CEO’s Understanding of the Business
A CEO must thoroughly understand their business. Examine their background, experience, and education. This is crucial, especially in commodity businesses where a lack of understanding can lead to bankruptcy. For instance, Denis Durcotte’s deep knowledge saved Algoma Steel from bankruptcy.
In businesses with high entry barriers, an unqualified CEO might diminish the company’s value but won’t destroy it. Consider Carly Fiorina’s tenure at Hewlett-Packard or Dave Calhoun’s at Boeing. Both had backgrounds misaligned with their companies’ needs, unlike Steve Jobs, whose profound understanding of Apple was pivotal to its success.
The CEO as a Capital Allocator
A CEO’s ability to allocate capital effectively is as important as their operational skills. They must invest the company’s cash in opportunities that maximize value—whether through acquisitions, share buybacks, dividends, or reinvestment.
Traits of Good Capital Allocators
Effective capital allocators make decisions that create value. They buy back shares at low price-earnings (P/E) ratios and avoid overpaying for acquisitions. Research shows that superior capital allocators’ stocks outperform their peers by 33% over three years.
Moreover, these CEOs attract patient, focused shareholders with long holding periods and concentrated portfolios, as noted by corporate governance expert Lawrence Cunningham. Good CEOs draw quality investors, exemplified by Berkshire Hathaway and Fairfax Financial.
Conclusion: Identifying a Good CEO
Exceptional CEOs are both efficient operators and diligent capital allocators. They consistently create and seek value, attracting the best investors and driving long-term success.
By carefully evaluating both the quantitative and qualitative aspects of a CEO’s performance, investors can make informed decisions and identify leaders who will drive their companies to success.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario. He is the author of the recent book, “Value Investing: From Theory to Practice.”
Reference: How to determine if a stock investment has a CEO right for the job
