CEO appointments: internal or external?

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The appointment of the Chief Executive Officer (CEO) and succession planning is one of the more important responsibilities of listed company boards. When a board starts the process of replacing a CEO, the company will typically announce both an internal and an external candidate search.

Commonwealth Bank and Fortescue Metals Group are currently searching for new CEOs with each company canvassing internal and external candidates. Over recent months, Blackmores and Wesfarmers have made CEO appointments from within their executive ranks, while Primary Health Care and G8 Education have opted for outsiders.

Shareholders may then wonder, is it better to appoint an internal or an external CEO?

Internal CEO appointments

Successful companies invariably have clear CEO succession plans to ensure the business is well-positioned to manage leadership transition. Based on our investing experience, boards of these companies tend to appoint ‘tried and tested’ candidates from within to ensure the business continues to employ the winning strategy and, more importantly, maintain its culture.

PWC’s latest annual study of CEO succession revealed that the rate of internal CEO appointments had reached an all-time high in Australia. The report also found that increased internal CEO appointments, coupled with better succession practices, have led the average CEO tenure rising to 5.5 years, which exceeds the global average of 5.2 years. The report’s authors found that insider CEOs not only stay in the role longer, they deliver better and more consistent shareholder returns compared with external hires.

Companies that have consistently and successfully promoted senior managers (including CEOs) from within their organisation include Macquarie Group (ASX:MQG), Wesfarmers (ASX:WES), Challenger (ASX:CGF) and Flight Centre Travel Group (ASX:FLT).

Notably, electronics retailer JB Hi-Fi (ASX:JBH) has appointed all three of its CEOs from within the company since it listed in 2003. Over that period, the company’s share price has risen from $1.55 to more than $22.60 at the time of writing.

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External CEO appointments

Outsider CEO appointments have fallen sharply since 2004 according to PWC, with internal candidates providing obvious advantages. However, external CEO appointments can provide benefits too, particularly when the company needs to be reinvigorated.

When a company is underperforming, frequently its turnaround can only be achieved by an outsider, not a manager entrenched in the business’s operations. An effective CEO, often with a new management team, can rapidly turn around the company’s fortunes delivering shareholders returns via share price growth.

When an underperforming company appoints a new CEO, we look for a strong leader and a proven performer with an articulated strategy to turnaround the company and the support of the board to effect change. When the CEO has a clear mandate from the board to ‘shake things up’ this can be a catalyst for us to take a position in the company.

Clough Limited (no longer listed on the ASX) is a prime example of an external CEO who successfully implemented a turnaround strategy. The Perth-based engineering company had floundered for many years under the leadership of various CEOs before Kevin Gallagher took the helm in 2011. The new CEO overhauled the company’s operations, reducing fixed costs and transformed the organisational culture. During his two-year tenure, the company’s share price steadily climbed from around 65 cents a share and in 2013 shareholders received $1.46 a share when South African firm Murray and Roberts Holdings acquired Clough.

In our view, the best external CEO appointees have a track record of performance in the same or a comparable industry. For example, Shaun Di Gregorio was a key person in the early success of REA Group, as it transitioned from a start-up to the largest media company in Australia as owner of online real estate advertising portal realestate.com.au. In 2010, he was appointed CEO of Malaysia-based iProperty Group that serviced the Southeast Asian property market. Shaun brought the relevant skill set, knowledge and experience to iProperty and during his four-year tenure the company’s share price rose from around 15 cents to over $3.00 a share. iProperty was subsequently taken over by REA Group in 2016 for $4.00 a share.

Alignment of interests

Whether a CEO is an internal or an external appointment, it is critical to consider how their interests are aligned with the company’s shareholders through incentive structures. Ideally, remuneration is a combination of short- and long-term incentives that focus on earnings per share (EPS) and total shareholder return (TSR). For more, see my Cuffelinks article, 5 factors to look for when assessing management.

The CEO’s interests are further aligned when they are also a major shareholder in the company. This can also ensure their long-term commitment. In our experience, CEOs with substantial ‘skin in the game’ typically have longer than average tenure and outperform other comparable businesses.

Jamie Pherous, Managing Director at Corporate Travel Management (ASX:CTD) is a substantial shareholder in the company. As founder of the business, he has led Corporate Travel Management since listing in December 2010 at $1.00 a share. The company is trading at more than $22.00 per share at the time of writing.

On balance

Considering the merits of an internal versus an external CEO appointment is highly dependent on the company, including its performance and stage of growth. In our view, companies that appoint the CEO from within the organisation on balance deliver better returns for their shareholders than companies that recruit externally. However, turnaround stories from an external appointment can provide investors with good short-term trading opportunities. When evaluating any CEO, it is critical to consider how their interests are aligned with the company’s shareholders through incentive structures and equity exposure.

 

Chris Stott is Chief Investment Officer of Wilson Asset Management. Entities managed by Wilson Asset Management own shares in PRY, CBA, GEM, FLT, MQG and WES.

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One Response to CEO appointments: internal or external?

  1. Ashley October 12, 2017 at 11:09 AM #

    Would be interesting to see if the study differentiated between hands-on business builders/proprietors (Lowy, Murdock, Harvey, Forrest, etc) and intuitionally-owned businesses where nobody actually owns it or has any real skin in the game and therefore CEOs over the past couple of decades are just a succession of outsiders – eg the big banks and miners, Telstra, oil/gas co’s, etc
    The US and Australia/Europe are in stark contrast. US companies built in the last 20-30 years dominate the world and they are almost all hands-on proprietor run businesses – Apple, Google, Facebook, Amazon, Microsoft, Berkshire, etc, etc- -where founders/insiders have their entire wealth in the game. When Apple hired an outsider Skully he nearly killed it until Jobs was brought back. On the other hand Gates handed over Microsoft to insider Ballmer and nearly had the same result – but now another insider Nadella is reviving the giant.

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