Four signs of trouble at the top

The one thing we can say for sure about BP's Deepwater Horizon rig disaster is that BP's top executives have done almost everything they can to make a bad situation worse. From CEO Tony Hayward's recent high-profile yachting trip, to chairman Carl-Henric Svanberg's "We care about the small people" gaffe, it's been an object lesson for shareholders as to why the quality of a firm's management matters. But how can you tell when a company's top team is becoming a hindrance rather than a help? Here are four signs to watch out for.

1. The celebrity CEO

If a company's boss has a higher profile than its brand, chances are the firm is heading for trouble. Shareholders reward directors for just one thing making money for them. Hot-air balloon stunts (Sir Richard Branson); anchoring TV shows (Lord Alan Sugar); and public spats with rivals (Sir Stuart Rose) are entertaining, but they rarely add much value to a brand. For example, for all the fanfare that greeted Sir Stuart's arrival at Marks & Spencer in 2004, the share price is pretty much flat over the same period the FTSE rose 22%. By contrast, few have heard of consumer products firm Reckitt Benckiser's CEO, Bart Becht. Yet having overseen a share-price rise of 450% since 1999, compared to an 11% fall for the FTSE 100, he is a real star.

2. Too big to succeed

Sir Terry Leahy's stay at Tesco's helm has been a huge success it now controls around one third of the British grocery market. But what next? With Britain effectively saturated, the company is looking overseas, and now operates in 13 markets. But while international business accounts for two thirds of floor space, it also only chips in a third of sales and 30% of profits. Tesco's US chain, Fresh and Easy, lost £165m on sales of £354m last year and a number of store openings have had to be mothballed. It's no wonder Sir Terry has announced his retirement.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

3. Growth at any price

The way to impress the stockmarket short term is to boost the share price. One way to do that, as BP's former CEO Lord Browne noted, is to take a conservative firm with lots of cash flow and turn it into an aggressive world-beater that buys the assets it needs, rather than "growing its own" organically.

Say I buy a profitable rival that made £100m in profits last year, will make £100m this year, and is expected to make £100m next year. I buy it halfway through my financial year 2010. Under acquisition accounting rules, I include none of its profits for 2009, half of its profits for this year (£50m) and all of its profits (£100m) in 2011. It's a neat trick that can make a static business look like it's growing. But while rapid acquisitions may boost short-term profits, they also create huge integration headaches that can distract directors from the job of running the core business.

4. Not sticking to your knitting

HSBC has succeeded when many banks recently failed because it knows what it does well Asian retail banking and focuses on it. The one time the bank strayed badly the $14.8bn acquisition of US subprime lender Household Finance in 2003 it got burned. It took some big losses and has been pulling out ever since. But even that purchase was relatively small (and low risk) for a bank of HSBC's size. Indeed, it rarely makes sense for a business to diversify hugely into a market it does not know when there are specialist rivals already in the space. It either overpays for one of them, buys a pup, runs the business badly, or will be bettered by more nimble competitors who enjoy a lower cost base. A smart CEO, such as HSBC's Stephen Greene, will realise that.

Be wary of picking 'tall poppies'

BP investors who looked to the firm for stable management and a steady dividend "have been side-swiped by political risk", says The Economist's Buttonwood. Such disasters can, of course, hit small firms too. But once a company attains a certain size and profile (i.e. Goldman Sachs or Microsoft) it's more likely to come under "regulatory attack", for the simple reason that governments realise that they can afford to pay. In fact, Rob Arnott of Research Affiliates reckons the "tallest poppies" (biggest firms in their sector) underperformed by 3%-4% a year between 1952 and 2007, based on a review of subsequent one, three, five and ten-year periods. This suggests that "getting exposure to a sector by choosing its largest components is... a quick route to underperformance". The FT's Phillip Coggan suggests some reasons why. It's partly down to the fact that it's easier to grow a small firm than a large one. But also, regulatory risk is much higher than it was, say, 20 or 30 years ago, due to globalisation. All this suggests that for smaller investors cheap, sector-tracking exchange-traded funds may be a better bet than cherry-picking "sector champions".