Management Background and Classification

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Michael Shearn argues in "The Investment Checklist" (2011) that competitors can eventually copy successful products or business models, but the quality of management determines whether companies continue innovating and creating value.

The people at the top shape business strategy, influence growth rates, hire key personnel, and decide where to invest company resources.

The challenge is that accurately assessing management quality takes time and thorough research.

It means digging through years of articles, interviews, and industry publications to understand not just what executives have achieved, but how they think and what drives their decisions.

This post explains Shearn's approach for understanding management teams through their backgrounds and classifications. You'll learn how to categorize different types of managers, examine their career progression, and analyze compensation structures and insider transactions to understand their true motivations.

Shearn creates a classification system that places managers on a continuum from most to least knowledgeable and passionate about their business.

Managers with deep knowledge of their business and genuine passion for its success tend to make better long-term decisions. As you move along the continuum from owner-operators to hired hands, both predictability and odds of success decline…

Owner-operators (OO) represent the ideal partners for investors. These are typically company founders who built the business from scratch and view it as their life's work, creating strong alignment with shareholders.

Shearn divides owner-operators into three subcategories based on how they balance stakeholder interests:

Long-tenured managers (LT) have worked in the industry for 3-10 years but lack the founder's emotional connection to the business. They understand the industry and customers but may view their role more as a job than a calling:

Hired hands (HH) have limited experience with the company's customers and often job-hop between industries. They bring the highest execution risk because they lack both institutional knowledge and customer understanding:

The importance of this classification becomes clear through tenure statistics. According to Spencer Stuart's 2010 analysis for the Wall Street Journal:

Yet among those 28 long-serving CEOs, 25 delivered returns that beat the S&P 500 index during their tenure.

This data confirms what the continuum suggests: investors face less risk with managers who deeply understand their business and plan to stick around. Each step away from owner-operators increases uncertainty about future performance.

Shearn presents another classification system developed by Seng Hock Tan, CEO of Singapore-based investment firm Aegis Group of Companies. Tan observed that managers exhibit behaviors similar to lions and hyenas in the wild.

Lion managers think long-term and build lasting infrastructure:

Hyena managers operate opportunistically for short-term gains:

Tan used Apple and Palm to illustrate this difference.

Palm pioneered the personal digital assistant market with the Palm Pilot, reaching a $90B valuation during the tech boom. However, by 2010, Hewlett-Packard (HP) bought Palm for just $1.2B, a 98% decline.

Meanwhile, Apple grew from $5B to $220B under Steve Jobs, a classic lion manager. The difference was that Steve Jobs built the strong team, accumulated knowledge and processes, and sustainable culture needed for long-term survival.

Tan's investment team uses this animal metaphor as their first assessment tool when evaluating managers, finding it predicts whether executives will create lasting value or focus on personal enrichment.

Many investors react positively when companies hire outside CEOs, especially for struggling businesses. They believe management skills transfer easily between companies and that outsiders bring objectivity unclouded by existing culture.

In reality, these roles require completely different expertise.

Shearn cites RHR International, which found that 40-60% of executives brought in from outside leave within two years, with many departing in just months. This high failure rate stems from several fundamental problems:

Jeffrey Immelt, who served as CEO of General Electric from 2001-2017, reinforced this point through his own observations at GE.

He noted that GE's most successful divisions (such as aircraft engines) had leaders with long tenures who made key decisions based on deep business knowledge. In contrast, divisions with high management turnover, like reinsurance, consistently failed.

Outside managers can add value in specific situations:

However, even successful cost-cutters often fail at the next phase of building sustainable growth.

Shearn provides the example of Al "Chainsaw" Dunlap, who earned his nickname by aggressively cutting costs at struggling companies throughout the 1980s and 1990s.

His track record included successful turnarounds at companies like Scott Paper, where he increased market value by 155% in 20 months through massive layoffs and budget cuts.

When Dunlap joined appliance manufacturer Sunbeam in 1996, the stock jumped 60% on the announcement alone, the largest CEO-related stock gain in NYSE history at that time.

Yet his cost-cutting approach failed at Sunbeam, which needed product development and customer relationships rather than expense reduction, with the company declaring bankruptcy in 2001.

The key takeaway? Cutting costs and building businesses require fundamentally different skills:

The best outside managers take time to understand their new company before making major changes. They solicit employee opinions, learn about customer needs, and assess true organizational capabilities.

This patient approach gains employee support for eventual changes while avoiding overestimation of what the organization can achieve.

Managers who rush to implement changes without this foundation typically fail, making their companies poor investment choices.

To truly understand management, you need to map out how executives reached their current positions. This reveals far more than a standard biography.

Shearn recommends constructing detailed career timelines for the top five managers using a combination of sources. Recent proxy statements often omit early career details, so investors should review historical proxies going back 5-10 years, supplemented by news articles spanning a decade.

Such detailed chronologies help answer important questions:

Career paths also indicate potential red flags. Managers who spent most of their careers at private equity firms often emphasize short-term cost cutting over building sustainable growth, since private equity typically focuses on quick returns through financial engineering.

A manager's functional background profoundly affects their ability to lead.

Those who rise through operational roles like VP of Sales, VP of Marketing, or COO develop broad perspectives on the business and maintain regular contact with customers and employees.

In contrast, executives promoted from controller, treasurer, or CFO positions often struggle as CEOs.

The problem stems from perspective. Corporate suite executives view the business primarily through financial statements and board reports. They lack firsthand knowledge of daily operations and customer interactions. This narrow viewpoint traps them into limited thinking patterns.

Companies need CEOs who understand their core business operations, not just financial metrics. When boards promote or hire executives without operational experience, they risk losing the very capabilities that make their companies successful.

Industries where success depends heavily on management capabilities require executives with deep customer knowledge.

Restaurant chains, retail businesses, and consumer products companies especially need leaders who understand their customer base intimately.

Shearn illustrates this with Jack Stahl's move from Coca-Cola (beverage company) to Revlon (cosmetics company) in 2002.

Despite 22 years at Coca-Cola and strong operational skills, he failed at Revlon by launching confusing products and abandoning the Revlon brand name on some items. The stock declined by two-thirds during his four-year tenure.

Contrast this with Tom Folliard at CarMax (used-car retailer), who started as a senior buyer in 1993 and spent 13 years learning every aspect of the business before becoming CEO in 2006. His deep understanding of each function gave him credibility with employees and customers alike.

When evaluating management, look for leaders who have invested time understanding their particular customers rather than assuming skills transfer across industries.

Past performance provides the clearest indicator of future success, yet investors often ignore negative histories when evaluating new CEOs. Understanding previous roles reveals patterns that persist across companies.

K-Mart's bankruptcy demonstrated the importance of checking track records:

Understanding promotion rationale also matters.

Merck promoted Kenneth Frazier to CEO in 2010 primarily because he developed the legal strategy for their Vioxx painkiller lawsuits, saving hundreds of millions. His promotion rewarded legal skills over drug development expertise.

Previous company culture also shapes executive behavior predictably.

General Electric's famous "GE Way" taught managers to grow through acquisitions and implement strict cost-cutting processes. When Jim McNerney left GE for 3M in 2001, he immediately pursued both strategies, exactly as his background predicted.

These examples show why thorough background checks matter. Past failures, promotion reasons, and cultural training all influence how executives will perform in new roles.

As discussed with OO1/OO2 managers, the best compensation structures combine modest salaries relative to massive equity stakes. This ensures executives prosper only when shareholders do, aligning interests perfectly.

The proxy statement shows the relationship between cash pay and ownership percentage, indicating whether executives think like owners or employees.

Stock options represent the most common form of executive compensation, yet they create dangerous misalignments between management and shareholders. Options give executives the right to buy shares at a specific price, offering unlimited upside with zero downside risk.

The fundamental flaw lies in what options actually reward.

Broad economic expansions or industry growth can drive stock prices higher regardless of management performance. As one investor told Shearn:

Options encourage harmful short-term thinking in several ways:

To provide an example, Robert Nardelli received $30M in restricted stock awards plus $7M cash when joining Home Depot in December 2000. After earning $38M in 2006, he departed in January 2007 with $210M in severance.

During his tenure, Home Depot's stock fell from $45 to $39 per share while Nardelli enriched himself regardless of performance.

When Nardelli moved to Chrysler later that year with another lucrative package, he laid off 35,000 workers and led the company toward bankruptcy before leaving after just 21 months. In both cases, he was paid to join rather than to perform.

Even highly successful companies grant excessive options.

Larry Ellison of Oracle earned over $78M in option awards alone in 2009, despite already owning 23.4% of the company. While Oracle shareholders earned 3.5 times their investment over the prior decade, Ellison's existing stake already provided massive incentive without additional options.

The proxy statement's “Compensation Discussion and Analysis” section shows how boards structure executive pay. This disclosure helps investors distinguish between companies that reward long-term value creation versus those enriching managers at shareholder expense.

Positive compensation structures share several characteristics:

Warning signs in compensation structures include:

Several companies demonstrate how to structure compensation for sustainable value creation rather than short-term stock manipulation.

Beyond compensation structure, investors should track whether managers increase or decrease their ownership over time. The proxy statement's beneficial ownership table, read over 5-10 years, will help you understand these patterns.

The best managers continually add to their positions or at minimum retain their holdings.

For instance, Warren Buffett sold minimal shares of Berkshire Hathaway throughout his tenure.

Declining ownership sends the opposite signal. While managers often cite diversification when selling, consistent sales indicate waning confidence.

Regardless of the stated reason, a sale remains a sale. The managers most aligned with shareholders are those who tie most of their wealth to the companies they run.

Executives' stock transactions indicate their true beliefs about their company's future, stripped of corporate messaging and public relations spin. These trades require real money and carry real consequences, making them more honest indicators than any earnings call or investor presentation.

Investors can track these transactions through SEC filings:

Academic research validates the importance of tracking insider activity.

Nejat Seyhun, a finance professor at the University of Michigan, studied insider trading patterns from 1975-1995 in his book "Investment Intelligence from Insider Trading."

His findings showed that stocks insiders bought but didn't sell outperformed the market by 7.5% on average over the following 12 months. Companies with heavy insider selling underperformed by 6.1%.

However, not all insider transactions carry equal weight. The size relative to the executive's net worth matters far more than the dollar amount. A CEO purchasing $10M of stock means far more if their net worth is $100M (10%) versus $1B (1%).

Meaningful insider buying typically represents at least 15% of an executive's total ownership. Anything less might be small purchases designed to generate positive headlines rather than genuine expressions of confidence.

The strongest buy signals come when executives risk significant personal wealth to increase their ownership. These high-conviction purchases may even involve borrowing money or pledging personal assets.

Carl Kirkland, founder of home decor retailer Kirkland's, demonstrated strong conviction during the 2008 financial crisis. While most executives were selling, Kirkland purchased 3.4M additional shares for $6.8M at $1.95 per share. The 13-D filing showed he secured loans using his airplane and vacation home as collateral. The stock later climbed to over $14 per share by 2010.

The strongest buy signals share three characteristics: (1) significant personal financial risk, (2) public disclosure of reasoning, and (3) executives putting their money where their mouth is before asking shareholders to trust them.

While insider buying often signals opportunity, insider selling requires more nuanced interpretation. Executives sell stock for many legitimate reasons unrelated to company prospects. The key is identifying patterns that suggest deeper concerns.

When numerous executives cluster sells together, or when the magnitude of selling by a single executive is extreme, it warrants investigation.

Novatel Wireless demonstrated this pattern in 2007 when nine executives and directors sold more than half their holdings at $17-$20 per share. The stock fell below $10 within a year and hit $3 by December 2008.

Again, not every insider sale indicates trouble, which is why investors must understand the context and stated reasons for transactions. The notes sections of Forms 3, 4, and 5 often uncover motivations that help separate routine transactions from warning signals.

Four legitimate reasons account for most insider sales, and recognizing them prevents unnecessary panic when executives reduce their holdings:

Lastly, if there's no clear disclosure of motivations, investors should avoid drawing firm conclusions about what the sales mean. Regardless, when multiple insiders cluster sell without providing reasons, it often signals underlying concerns worth investigating further.