The Leadership Gap

Why do active, long-term investors prefer to invest in some companies over others? This simple question is important because understanding investor logic and emotions can help company leaders better position their company to gain investor confidence. Ultimately, investors make decisions based on information that they believe can improve their performance and mitigate their risk. If leaders know what investors are looking for when making investment choices, they can share better information with those targeted investors.

To answer the question about why investors invest, we interviewed about 30 senior investors and reviewed papers on the topic. From this preliminary work, we defined three broad domains of information most important to investors: (1) industry favorableness, (2) company performance, and (3) quality of leadership.

Industry favorableness refers to the characteristics of the industry, such as its growth potential, barriers to entry, competitiveness (or rivalry), social trends, customer opportunity, regulatory opportunities, and so forth. Industries may be more or less favorable (e.g., demographics favor elderly care and technological changes and are less favorable to traditional printing).

Firm performance refers to consistency of financial results as indicated by a variety of metrics (e.g., working capital, economic value added, operating margin, return on capital, and so forth). Firm performance also refers to the intangibles related to strategy, technological advantage, and organization capabilities (e.g., speed to market, degree of innovation, ability to collaborate, customer service, social responsibility, and so forth).

Quality of leadership refers to the confidence investors have in the leadership capability of the company. Investors are more likely to invest in companies with leaders who have a strong record and have proven ability to set and execute strategy, to manage current and future talent, and to develop future leaders.

Next, we determined the relative weight of each of these three domains for investor decisions. Additionally, we wanted to find out how much confidence investors have in their ability to assess each of the three domains. Thus, we designed a survey (available from the authors) to answer two relevant questions: (1) What is the relative weight of each of the three domains on investment decisions? (2) How much confidence do investors have in their ability to assess each domain?

We used a “snowball” sampling technique that identified investors who could complete the survey based on our personal contact with them, their attendance at investor conferences, individuals with whom we conducted pilot interviews on the topic, and lists of registered investors.¹ Investors were asked to complete the survey and recommend others to complete it. In total, we received 430 responses from portfolio managers, institutional investors, mutual/ hedge fund managers, private equity investors, and venture capitalists. These 430 investors averaged more than 15 years of professional investment experience.

Table 1 reports the relative importance of each domain and investors’ confidence in their ability to assess each area.

Investors consider company performance the most important domain for making investment decisions (38 percent) and also have the highest confidence in their ability to assess it (4.47). The standard deviation of 0.58 is the lowest of any domain. The written comments on company performance include the following:

• “Firm performance is the most important ingredient to a successful investment. The firm must execute to a certain level to create value for its investors.”
• “Firm performance is quantifiable and measurable [and] thus given more weight.”
• “We look at a company’s long-term history in an effort to assess its future earnings power. Understanding firm performance relative to peers is very important—an underearner is a more attractive investment than a company earning more than its peers, all else equal and assuming these are comparable businesses with no structural reason for marginal differences.”

Not surprisingly, company performance gains most investor attention because financial and strategic performance is more objectively measurable, comparable across firms, and consistent with most investor training.

Industry favorableness also matters (33 percent) to investors, and they have high and consistent confidence in their ability to track it (average score of 4.33 with a standard deviation of 0.66). Several survey comments are illustrative:

• “The better the industry structure and prospects, the higher the potential for strong, stable returns.”
• “Industry favorableness makes investing a lot easier.
  A rising tide lifts all boats—as long as the company does not make mistakes it should benefit.”
• “It is quite possible to find great investment opportunities in industries with mediocre prospects. However, it is difficult to find outstanding opportunities in industries with very poor characteristics, especially in industries with intense price competition or those in a secular decline. Nevertheless, industry characteristics can be outweighed by firm characteristics and by valuation.”
• “I want the industry to provide a tailwind.”

Although ranked lower among the three domains, quality of leadership clearly matters to investors (28.4 percent) in a consistent way (standard deviation of 14). But investors have much less confidence in their ability to assess quality of leadership (3.75) and they sense a much higher risk (standard deviation of 0.96) associated with their evaluations. Their comments reflect these findings:

• “Quality of leadership is important but I offer two observations: (1) this domain may be difficult to assess and (2) if high quality of leadership is required for an investment to succeed, then there may be other investments out there (favorable industry, performing firm) with fewer hurdles to success. There is a Warren Buffett quote along the lines of preferring to invest in businesses that even a monkey could run because at some point, one will. This is the most important factor to us. At the end of the day, it always comes down to people.”
• “We care a LOT about this. This is what drives a firm to capture opportunity. Nearly all the pathologies of leadership are easy to find if you know where to look. Too many CEOs are such great toadies (some seem to be sociopaths) that you can’t depend on just meeting them—they will charm you, and they’ll figure out what you want to hear. So, you have to get out into their operations and walk around. If you know what real leadership is and what real integrity is, you will find it or the absence of it out on the front lines where products and services are being forged and delivered to customers.”
• “Much rises and falls on leadership, so this is key, though we are always looking for ways to make companies better, and we are willing to recruit leaders to lead.”
• “Leadership is one of the most important considerations that our fund makes when considering a potential investment. If we are not comfortable with the management team, we will usually not invest until changes are made.”
• “This is a leading, non-financial indicator, yet all information systems and research services are designed to provide financial metrics. Quality of leadership, culture, and relationships with core stakeholders are critical to understand but are also difficult to gauge. We’ve spent four years trying to get better in this area.”

Clearly, leadership matters to investors but is difficult to define, measure, or track. Investors vary more on how much confidence they have in their ability to assess leadership. For example, one investor who managed a sizeable portfolio said that his firm starts with choosing to invest in a growth industry. Next, they focus on the four or five highest performing firms in their selected industry based on a set of financial criteria. Their final choice about how much to invest in each firm comes after they meet for a day with the CEO of these targeted firms. In that day, they would meet not only with the CEO but try to get outside the CEO’s comfort zone by going sailing. He felt that a lot could be learned about the CEO as a leader in this setting.

This story was consistent with our finding that company performance, industry favorableness, and leadership matter, but it also demonstrates that investors have a long way to go in determining quality of leadership. Neither comfort in sailing nor strong interpersonal skills equate to leadership success. Additionally, looking at one leader — even the CEO—does not ensure leadership depth within a firm.

Conclusions

Our preliminary study captures broad trends with clear and challenging implications. Investors tend to focus on company performance and industry favorableness and have relatively high confidence in the assessments they make in these areas, but they also pay attention to quality of leadership, despite having much less confidence in how to measure it. So, how can investors better judge quality of leadership? We propose that the investment community will be well served to develop more rigorous analytical tools to determine the quality of leadership within potential investment opportunities.

If investors had better information about the quality of leadership within a company, they would reduce their risk, increase their confidence, and make more informed decisions. Likewise, if regulators doing stress-tests on companies within an industry (e.g., financial services) could stress-test the quality of leadership as well as financial ratios (e.g., liquidity), they could make more informed decisions.