Charting the CEO 100 Index

Company Stock Price Rank I

1998

CEO Performance Index Rank II Companies and Industry III

Five CEOs became 5-time members of the CEO 100 Index this year, something that has never occurred before. Of the five, three (Clear Channel Communications's Lowry Mays, Maxim Integrated Products's John Gifford, and Tellabs's Michael Birck) accomplished the feat for a remarkable five years in a row. Thomas Golisano of Paychex had repeated on the list in 1993-1996 for four years in a row before missing last year.

Impressively, our fifth CEO is also the holder of this year's top ranking on the CEO Performance Ranking, a measure of how well the company has performed adjusted for its size. As we go to press, news reports indicate that this CEO will step down in May 1998 but will remain with the company as chairman. This all-star of all-star CEOs is, of course, Andrew Grove of Intel Corporation, Time's Man of the Year for 1997. Grove has served as CEO for 11 years.

Coincidentally, last year's number one in the CEO Performance Ranking, Joseph Costello of Cadence Design Systems, also left his firm last fall to join the well-financed Knowledge Universe, a young educational software company, where he serves as vice chairman. At 43, he wanted a new challenge, "to make a quantum-leap impact on the education process." Cadence continues to prosper.

In March 1998, Kim Edwards, CEO of Iomega for 4 years and this year's number one in the CEO 100 Index, resigned following two quarters of disappointing earnings as excess inventories build. David Dunn, Iomega's chairman noted, "Under his leadership, Iomega grew from $141 million in annual sales to over $1.7 billion in 1997. Kim transformed a static, relatively small company with mature products that was suffering losses, into a dynamic growth company."

These events focused attention on the differences between those CEOs who stay at the top for a long time and those who only appear once. A complicated combination of characteristics seem to be at work for those who repeat:

• Start small (only Intel of the 5-time repeaters was a reasonably large company the year before the performance that led the CEOs to make the CEO 100 Index);

• Pick a market or markets that will grow rapidly for a decade or more, or allow for rapid growth through substantial market share gains;

• Grow revenues rapidly in the market you have picked (only Paychex grew less than 8 fold in the last decade);

• Consistently expand profit margins as a percentage of sales (each company more than doubled this key ratio, and had good margins to start with);

• Increase shareholder's equity on the balance sheet faster than revenues;

• Create these outstanding performance results in a consistent manner (with a seldom a down year in earnings from the prior year);

• Become a public company in 1988 or earlier;

• Have a CEO who is a founder of the company and young enough to be able to serve for much longer than the 4-6 years that is typical of most CEOs.

Another way to think about this is as the performance of a company that is providing goods or services for which there is a rapidly-growing demand, with superior performance for customers that frequently permits premium pricing, efficiency in operations that brings costs down while the company grows so that profit margins can expand, which is able to innovate through several cycles of expansion by providing newer products and services that build logically on its past success, and which takes no risks that backfired in a large enough way to derail progress.

Candidates to join this exclusive group in the future include Doctor Crants (Corrections Corporation of America), Michael Dell (Dell Computer), David Duffield (PeopleSoft), Charles McCall (HBO & Company), Harold Messmer (Robert Half International), Charles Schwab (Charles Schwab Corporation), and Charles Wang (Computer Associates).

When we look just at the five consecutive repeaters, the importance of the CEO Performance Index becomes apparent. With the exception of Lowry Mays last year, each of the 3 CEOs has ranked no lower than 36th on our list at any time in the past 3 years. The median rank was 16 of the nine overall ranks measured in the last 3 years. Of the nine performance measures we used this year, in only one area (ending ROE) did the 3 companies' average rank fall in the lower half. This is also a picture of remarkably balanced performance.

What qualities does such a CEO probably display? The founder's perspective is probably important, because that means that the CEO is more likely to understand why the company has been successful and what will be needed in the future to sustain that success. Thus, we should have a clearer future vision, that is well-connected to the reality of the company's situation.

These CEOs are probably able to bring a high level of knowledge and expertise to understanding the company's issues. Many CEOs make little effort to understand the important details on which their company's success is based. For example, a typical CEO approach is to shunt all customer complaints to lower-level personnel for resolution, without using this information to personally learn how the company is performing. These CEOs show signs of having detailed knowledge of the marketplace, new trends, new technologies, competitors, and large shareholders. They can then draw on this knowledge to produce superior strategies and be sure that key operational objectives are set and met.

Now that our 5-time repeaters are becoming larger companies, they will have the interesting challenges associated with finding more ways to grow profitably than have brought them to their current place at the top. For Intel by comparison, this challenge until recently was to primarily to narrow the company's focus into high-end microprocessors. Now, it appears that Intel will also have to spread out to serve low-end customers and earn a leading position for microprocessors not used in personal computers.

A further challenge seems to be found in changes in the economy that are reflected in the shifting mix of companies on our list. About one-third are involved in high technology businesses, less than we have seen in the past. Also, within high technology people involved with storage devices, personal computer, and semiconductors in the past have faced roller-coaster rides in performance. As problems in Asia increased over the last year, high technology companies were among the first to feel the effects on their businesses.

With the drop in interest rates in the last few years and low inflation, we have many more financial institutions on the list. Because information and drilling technology have combined to vastly reduce the break-even level on new oil or gas wells, those involved with petroleum drilling have joined the list in large numbers, too.

On the other hand, a longer-term challenge for such a CEO is to create a management process that ensures that superior company performance will continue under the CEO's successor. We will begin to get a sense of that at Intel in the next few years as the company has its first nonfounder CEO (who joined when the company was six years old), but the other 5-time repeaters have that test further ahead of them.

The contrast with the one-time appearing companies and CEOs is clearest when looking at a company like Advanced Semiconductor Materials (number one in stock-price growth two years ago). Although the company does have the same CEO, the stock price is now lower than two years ago. Sales and earnings are also lower through the third quarter of 1997. The company is now shifting its focus to outsource its manufacturing, and took two large charges in 1997 related to this discontinuance and a settlement of litigation with Applied Materials. Turmoil in Asian semiconductor manufacturing is expected to put future pressure on the company's results.

A similar picture arises when we look at Chesapeake Energy, last year's leader in stock-price growth. The company also operates under the same CEO. The stock is down by more than 70% in 1997 from the end of 1996, and earnings dropped substantially in fiscal 1997 (ending June 1997). Since then Chesapeake has been making acquisitions to help grow the company. Revenues continue to grow rapidly as a result. Petroleum prices, of course, have dropped quite a lot in the last year or so.

Time will tell if these shifts will reignite high performance and stock price growth.

Donald W. Mitchell is chairman and chief executive of Mitchell and Company, a financial and management benchmarking and consulting firm in Waltham, Massachusetts, focusing on how to make successful, rapid improvements in organizational performance. He is a coauthor of The 2,000 Percent Solution: Free Your Organization from "Stalled" Thinking to Achieve Exponential Success, due to be published in January 1999. Additional research and analysis for this article were conducted by Mitchell and Company's Joan Henson, Kim Loomis, and Sarah Christopher. For more information, please contact Mitchell and Compnay.

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The CEO 100 Investment Guide

Since 1992, the CEO 100 has cumulatively outperformed the benchmark S&P 500 Composite Index. Based on the market at the end of each month that the list was published in Chief Executive, the first six lists, cumulatively, are up 156.2%; the S&P 500 rose 141.6% during the 12 months following publication and results through the end of 1997 for the latest year. Last year's list, unfortunately, has not been holding up as well; when we took the CEO 100 pulse on December 31, 1997, the Î94-'96 list was, in fact, trailing the S&P 500, something that happened the prior year, as well.

Two years ago, we looked at how to select stocks that will outperform the S&P 500 from among those stocks that had been members of the CEO 100 for two years or more. We suggested taking a look at Applied Materials, Broderbund Software, Computer Associates, Linear Technology, LSI Logic, Oracle Systems and 3Com. This strategy led to an average growth of 20.0% compared to the S&P 500 at 26.8%. The big loser was Broderbund Software (down 67.7%) while the big winner was Applied Materials at 75.2%.

Taking the same strategy last year, the stocks to buy were 3Com (again), Corrections Corporation of America, Global Marine, Oxford Health Plans, and PeopleSoft. This time that combination did even worse through December 1997, falling 8.8% while the S&P 500 grew by 14.4%. The problem mostly related to a 77.9% drop at Oxford Health Plans (which discovered that through a massive computer mix-up it did not know what its costs were, had mispriced its services and had not been billing subscribers) and 3Com (following the merger with U.S. Robotics). If one were to have narrowed that list with a revised process and buy from both lists, Corrections Corporation of America, Oxford Health Plans, and PeopleSoft would have remained. Through December 31, 1997, these three stocks fell an average of 8.3% due to Oxford Health Plans.

The lesson here seems to be that further investigation is needed to be sure that the company is not experiencing or about to experience any adverse changes just before being selected. In addition to the screening we have done in the past, we have tried to also check for that factor this year.

For the current year, selective purchases could be considered in America Online, PairGain Technologies, PeopleSoft, and Vitesse Semiconductor. The risk on America Online relates to the operating problems experienced in the past or a slowdown in online use by personal computer owners. PairGain has seen some price pressure on its products and delayed orders from Baby Bells. PeopleSoft could be hurt if corporate budgets are overly diverted to Year 2000 software fixes. Vitesse is in the middle of starting up a major new plant. Be cautious with the market so high now. Also, these are all high technology stocks, which could be hurt if market psychology shifts due to problems in Asia.

Running the Numbers

To produce the latest CEO 100 list of companies that delivered superior stock-price gains over the prior three-year period -- 1995 to 1997 -- we accessed the Value line database of more than 6,500 public companies traded in the United States and narrowed it down to the 100 fastest growing stocks that:

• Had the same CEO in place from January 1, 1995, until December 31, 1997;

• Were public from 1993 to 1997;

• Had a market value of public common stock that exceeded $850 million at the end of 1996.

These last two measures are a revision of our prior methodology, to better reflect the population of companies that have been public more than three years and the growing size of public company valuations since we began the index.

The CEO 100 has outperformed the S&P 500 in 3 of 5 years where we have final numbers (and trails slightly part way through the 6th year), so you should think of the list's potential for providing superior returns as part of a several year-long investing strategy. To date, the Index has exceeded the track record of more than 90 percent of professionally managed portfolios since we began publishing the list in 1992, despite our not using debt leverage or derivatives to boost the return.

The return in 1996-97 was the worst of our brief history, with the S&P 500 climbing 26.8 percent while the CEO 100 trailed at 11.8 percent. A major reason for this difference is that the S&P 500 is a weighted index (the larger your market capitalization, the larger your weighting in the index on a pro rata basis). The CEO 100 is an unweighted index (which means that you are assumed to hold the same dollar value of stocks in each company at the beginning of the year). As a Bull market climbs higher, the fastest gains normally become concentrated in the largest capitalization stocks. We would expect this trend to continue in the coming year, unless there is a large stock-market correction occurring in May 1999.

The CEO Performance Index, introduced two years ago, adjusts for size differentials among companies to better measure the CEO relative to the scale of opportunity to grow or perform. The size scale adjustments were done by regressions of logarithms of performance variable growth or the ending variable itself versus size dimensioned to that variable across all 100 companies. A large company would rank higher for its business performance than would a smaller company with the same business performance. All CEOs on the list, from financial companies and otherwise, were ranked by an average of their ranks on five measures: growth in book value per share, earnings per share, equity market capitalization, and return on common equity; and the ending level of return on equity. For non-financial firms, four additional measures were added: growth in cash flow per share, net margin, and revenues per share; and the ending level of net margin.

The rank differential is just that: the difference between the CEO 100 position and the CEO Performance rank. Companies with a positive differential have demonstrated faster stock-price growth than business progress, compared with their CEO 100 peers; companies with a negative differential show better business progress than stock-price growth.

© 1998 Mitchell and Company

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