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Management Matters

Posted by Dan Weiskopf, ETF Professor on Sep 28, 2022 10:30:00 AM
Dan Weiskopf, ETF Professor
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Last week, my colleague did a great job highlighting the difference between the ETF wrapper structured as a ‘33 Act rather than a ‘40 Act legal structure. We often write about markets, the Fed, and investments in this blog. We also often highlight how structure matters when differentiating between passive and active investing, and the blurry line surrounding what is referred to as “smart beta.” What we almost never speak of is the human element involved in the critical strategic decisions that CEOs are making that affect the lives of hundreds of thousands of employees and investors. In my 35-year career, I have been fortunate to have listened to and met more than my fair share of CEOs and CFOs. It is for this reason that I found the book “CEO Excellence: The Six Mindsets That Distinguish the Best Leaders from the Rest” written by Carolyn Dewar, Scott Kellar and Vikram Malhotra, helpful in creating a “playbook” of some critical questions that help answer the question: What does a CEO really do? Afterall, few consultants and portfolio managers have the access or experience, let alone the resources, that these three McKinsey & Company consultants have, so the information should be well respected and analyzed.

It is also worth pointing out a couple of key tidbits:

  1. According to the book, CEOs who rank in the top 20% deliver 2.8 times more total return to shareholders during each year of their tenure versus the average performers. They are “alpha” generators in the purest form – delivering some $10,000 of value over $1,600 by the S&P 500 during a 10-year cycle.
  2. The CEO pool that was screened for the book included 7,800 CEOs from the McKinsey & Company proprietary database, across 25 years of data. 3,500 of those CEOs were running public companies.
  3. As a firm, McKinsey & Company dedicates $700 million worth of resources towards research around consulting and analytics for CEOs, 80% of which lead Fortune 500 or Global 1000 companies.  

While the process narrows the top CEOs to a small list of only 54, data geeks will appreciate the authors’ estimation that “the economic value created by the group of 200 leaders created excess value over their peers of approximately $5 Trillion. That’s the equivalent of the annual gross domestic product of the third largest country, Japan.”[1]

What’s a CEO to do Under Current Conditions

These are unprecedented, challenging times for investors. Macro-conditions set a tone of pessimism and risk aversion. Indices such as the Long term Treasury Bond (TLT) reflect a tone of unparalleled historical conditions where liquidity is down so dramatically for both the Treasury and the S&P 500. According to my colleague Michael Gayed, never have we seen both the Treasury and the S&P500 be down together in such a dramatic fashion. What action steps is a CEO supposed to take as an investor in the business when the potential bursting of a 40-year bond bubble creates such potential dire economic conditions? Therefore, investing with the most extraordinary CEOs may be the answer today, but who is to say who those CEOs are, beyond those who consult to them?

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There will be much postering about upcoming downward revisions for S&P 500 earnings in 2023 and 2024. The point of fact is that that CEOs who are currently preparing for the challenges in 2023 and 2024 need to make hard decisions that align with the book’s 6 mindsets that the best CEOs are judged by. The book summarizes them as follows:

Mindset #1 – Direction setting – Be bold. Growing in tough times requires decisiveness in a CEO’s vision and strategy, but resources need to be harnessed, available, and properly allocated.

Mindset #2 - Alignment of cultures and people drive commitment and clarity of principles.

Mindset #3 - Mobilizing people through empowered leaders with defined outcomes and commitments.

Mindset #4 - Engage – To seek help from directors who understand the business and can add value when called upon.

Mindset #5: - Connections – Start with “why?” Great CEOs connect with stakeholders to understand their expectations and concerns and make sure to align accordingly.

Mindset #6 - Effectiveness – Do what only you can. CEOs need to prioritize the most critical issues, focus on what they need to do, and delegate any remaining tasks.

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Granted, much of this sounds like consulting advice, like “buy low and sell high.” The difference and value here is that many of the CEOs who are mentioned in the book are still in place meaning investors should carefully watch and listen to the bold steps they are taking. We would expect that most will not pull back on technology spending in a meaningful way, but almost all great CEOs will emphasize how this spending is aligned with productivity, accountability to client service, or with the overall transformation of the company’s long-term core mission. We also emphasize that many of the CEOs highlighted in the book are running global businesses, so the re-allocation of resources is an opportunity to reposition globally or re-accelerate a business that is feeling different levels of economic headwinds.

The CEO’s job is difficult, and we at the ETF Think Tank are not reversing our position and becoming stock jockey cheerleaders. We do, however, believe in active management, whether that comes in the form of portfolio adjustments as economic conditions change, thematic investing which often requires an understanding of the underlying holdings, or high conviction strategies like Davis Funds. Note that these Funds have overweighted positions with CEOs at DBS Group (DBS), JP Morgan (JPM) and Alphabet (GOOG). We would also suggest watching closely what the CEOs do, like Adobe’s CEO Shantanu Narayen, who just announced a bold move to acquire FIGMA for $20 billion. Critics may be right about the very rich price (50x times revenues), but price may matter in the absence of short term value. Clearly, this is an example of a bold move!

Bold moves can be made at all points in the economic cycles and clearly, when cost of capital is cheap, markets in the short term are more forgiving, but ultimately the goal of every CEO is to win in the long term. This point is made clear in CEO Excellence, with Netflix’s Reed Hastings’ quote during a discussion with a stakeholder back in 2002. He says, “the dream 20 years from now is to have a global entertainment distribution company that provides a unique platform for film producers and studios.” Clearly, after delivering in these past 20 years, Reed needs to be watched for his next “bold” move. CEOs who embrace innovation and transformation know how to win! They are also not likely deterred by economic cycles or fears around market conditions. The question is whether or not investors should view these cycles as an opportunity. Like CEOs, investors and career-minded people need to think long term, not just about retirement, but about how they can be positioned as winners in the end. The CEO of Cadence Design System, Lip-Ba Tan, shares the following story in the book about an investor’s advice on how to become the best stock in a portfolio. He says, “first of all you have to be mission critical to your customers, not just nice to have. Second, you have to be a category leader – number one or number two in your product lines. Third, your current total available (TAM) is only worth $10 billion. How are you going to grow to be a $150 billion platform – how will you expand into new markets?”[2]

In October, I will have the fortunate opportunity to interview one of the authors, Vikram Malhotra. Hope you will buy a copy of the book. Feel free to send questions my way to dweiskopf@torosoinv.com.

[[1] CEO Excellence, Page 6

[2] CEO Excellence, Page 6

 

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