Management is notoriously full of paradoxes. But one of the greatest current examples goes to the heart of any organisation - or rather to its top. Chief executives, especially in the US, are being fired more frequently, and sooner into their reigns, than ever before. The departed have failed to fulfil the board's desires for enhanced performance - and have been given little time to make their marks.
These dismissals are harsh short-term judgments. The first half of the paradox is that managements are supposed to be thinking, planning and acting with long-term aims in mind. The second half of the paradox lies in this heavy reliance on one man or woman, the CEO, in an age when power and responsibility are supposed to be devolved down the line, and when management is seen as a group activity to which team work is fundamental. This isn't a pious hope: it is the actuality of managers' lives.
SYSTEMIC FAILURE
Bad results cannot stem solely from a bad CEO. There must also be serious failures of the system. True, that system and the effectiveness of its operation are among the prime responsibilities of the CEO - although very few of them show much interest in the task. The CEO is, however, certainly responsible for the main systemic actions: setting up the roles, staffing the key ones, determining relationships, and monitoring the effectiveness of performance. Yet boards rarely spend much time with CEOs on these issues, even though they are transparently crucial.
So what do boards (and the large investors whose interests they are supposed to protect) most consider? The answers are relevant to all organisations, which all have some form of governance, exercised either by an owner (collective or individual) or some statutory body. Just why did the boards of Mattel, Lucent, Newell Rubbermaid, Campbell Soup, Coca-Cola, Gillette, Procter & Gamble, Maytag and Xerox oust their CEOs after tenures ranging from a mere thirteen months to three years?
Part of the answer is that all these companies, often right up to the succession of the unfortunate victims, were universally admired successes. Coke and Gillette were two of the great Warren Buffett's star investment holdings. Rubbermaid was once America's most admired company. P&G has an immense reputation as the monarch of fast-moving consumer goods. Lucent shot to stardom after its spin-off from AT&T. The successors had extremely hard acts to follow - and in several cases had no hope of repeating the once-for-all successes that had powered their predecessors into the Hall of Corporate Fame. At Coke, for example, Roberto C.Goizueta had transformed the company's fortunes by his imposition of strict demands for return on capital and his reorganisation of the crucial relationship with the bottlers. There were no similar masterstrokes available to his hand-picked successor, Doug Ivester, who only lasted for a miserable 28 months.
THE ENCORE PROBLEM
But the Encore Problem was not that of the CEO alone. "Encore" refers to that well-known quote, "What do we do for an encore?" Xerox has been thrashing around for years, trying and failing to follow up its smashing success with xerographic copying. P&G has long badly needed to find a brand-new recipe for FMCG marketing in face of mounting evidence that the markets are changing rapidly, and that exceptionally famous brands (see Campbell Soup, later) are not enough to generate truly exceptional success.
The boards in all these cases must share the responsibility for failure. They all made the fatal mistake of leaving the Encore Problem entirely to the new CEO. Sometimes the hero will get it triumphantly right, like Coke's Goizueta or Jack Welch at General Electric. But in both these cases, the new men had a priceless advantage: the two companies were not in crisis, but were under-performing so greatly that massive uplift was possible without massive effort.
Their key contribution was to see this vast room for improvement when the board could not. The pressures on boards have mounted so heavily from one particular direction - the stock market - that the directors concerned are in the position of the farmer who killed the goose that laid the golden eggs. Boards want to gratify the stock market with a soaring share price (which also brings welcome uplift to stock options). But they take actions that undermine the only reliable foundation for share price growth. That is a strong and viable long-term strategy.
For example, there are few better ways of undermining a share price than embarking on a takeover binge. Yet boards are always voting in favour of deals that are all but guaranteed to permanently weaken the shares. The case against conventional mergers and acquisitions has been argued unanswerably by Warren Buffett, even though he himself is by far the most successful acquirer of the century.
The great man has explained the failures of other buyers in convincing manner. His own purchases have followed a simple formula. He has only looked for (and so should you) targets that are large enough to be worth the trouble. They should also fulfill six criteria:
1. They have demonstrated consistent earning power.
2. They earn good returns on equity.
3. They have little or no debt.
4. They have good management in place.
5. They are simple businesses.
6. They are available at a known price.
The sense of these stipulations is glaringly obvious. Yet most CEOs on the hunt for higher earnings (and a higher share price) through acquisition ignore several of the criteria - if not all. Rather than study past records, they look at projections of future earnings: "of little interest to us", says Buffett, who cares just as little for turning round companies in trouble. Acquirers love to believe that their brilliant management will right the acquired wrongs. Buffett can't supply management and is thus immune from this dangerous temptation.
FAILING ON PRICE
Nor (unlike so many corporate investors) will he buy high-technology or other businesses that he doesn't understand. This looked like a bad mistake when the dot.coms and other whiz-businesses were soaring, but looks like the soundest of policies today. When you buy a share at the market price, you are endorsing the valuation of the entire company. Would you really pay 160 times earnings for the pleasure of owning the whole of any company? Or huge sums for a business with no profits at all?
It's the price issue that divides Buffett from the acquiring also-rans. He is just as averse to over-paying for an entire business as for a block of shares. The failures are often so indifferent to the price that they (or rather the shareholders) will pay that they not only make the first approach, but are first to name a price. They may well raise that price, sometimes more than once, in order to secure the deal. The whole acquisition process is emotional rather than commercial, for reasons that are all too plain:
"You don't get to be the CEO of a big company by being a milquetoast. You are not devoid of animal spirits. And it gets contagious". In the 20 or so companies of which he has been a director down the years, Buffett has noted a recurrent phenomenon; "the conversation turns to acquisitions and mergers much more" when competitors are on the warpath - especially in buoyant stock market conditions. These encourage companies to pay for their purchases in shares, a practice to which Buffett is firmly opposed.
As he argues, with most deadly logic, the purchased company will probably change hands at the full intrinsic value of the business - at the very least. The purchaser's shares, however, will be valued at market, which may be much less than the intrinsic worth of the business. Buying for shares in these circumstances is a mug's game. If the acquirer is paying more in value than is being received, says Buffett sharply, "a marvellous business purchased at a fair sale price becomes a terrible buy".
Buffett's views are so well-known that Coca-Cola's recent attempt to buy Quaker Oats came as a great surprise. Buffett not only sits on the board, but he speaks for a major slice of the equity. Nor is he reluctant to pull his weight - the removal of Ivester was the result of direct intervention by Buffett and another powerful investor, Herbert Allen. The new chief, Douglas Daft, had good reason to covet Quaker: its Gatorade sports drink has a Coke-like hold over the market, and Pepsico, the arch-rival, had already made an offer. But neither of these arguments fitted Buffett's criteria: he snubbed Daft and vetoed the acquisition.
BURDEN OF PROOF
You will never, of course, be able to prove that the board was right in accepting Buffett's arguments. Maybe Daft would have made a brilliant success out of Quaker: maybe not. But the burden of proof should always lie with the people putting forward a strategic initiative. In all too many cases, the strategy wins by default. Nobody challenges the CEO, even if the strategic case is very weak.
At Campbell Soup, for example, the ousted CEO had committed himself to winning an 8% annual rise in revenues. In old-established products facing heavy competition, the target was simply beyond reach. The efforts to boost sales were self-defeating. They merely resulted in lower revenues and still larger reductions in operating profits.
At Campbell, as at Xerox, P&G, Maytag, Lucent and Rubbermaid, there was an especially curious pattern. The displaced CEOs mostly came in from outside, and were all replaced by the men who had retired in their favour. Whichever way you look at it, this is an awful failure in succession policy - and that is surely one of the prime responsibilities of the CEO, acting in close collaboration with his board. So the return of the retired heroes is especially grotesque. If they had performed excellently during their tenure, the subsequent disasters would never have happened.
The above systems collapsed because the new men were expected to work miracles. That is never how lower appointments are made - at least, not in a well-run company. The task is clearly defined, the performance criteria are agreed, and the appointee's plans for carrying out the mission are agreed and monitored. Whoever makes the appointment must also be satisfied that the task is wholly within the person's competence. In other words, the CEO should be named only after satisfying criteria that are strikingly similar to Buffett's six rules of acquisition.
SIX KEY QUESTIONS
1. Has the candidate demonstrated consistent ability to raise earning?
2. Do those earnings represent a good return on equity?
3. Has the candidate shown the ability to optimise the generation of cash?
4. Has he or she put good management in place throughout the operation?
5. Does the candidate follow the KISS philosophy; "Keep It Simple, Stupid".
6. Have the candidate's investments always generated an economic value higher than their cost?
It should always be easier to make these judgments about an insider than an outsider. Yet the percentage of American CEOs hired from outside rose from 11% to 20% between 1990 and 1999, according to Watson Wyatt. Is it a coincidence that over this decade, so says Drake Beam Morin, a third of CEOs appointed at 450 major corporations lasted no more than three years? Indee, a quarter of the companies used up three CEOs in the period. Those boards were not doing their job - and if that job is not being done well, the would-be hero at the summit must also fail.
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