General Electric - Bad Management Strategy or Bad Luck

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It is very important to understand a company’s management strategy and management’s ability to create wealth for its shareholders. By using The Applied Finance Group’s (AFG’s) Management Quality score you have the ability to grade management’s ability to make wealth creating decisions and eliminate wealth destroying firms from your list of constituents. AFG’s Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses when they are not even profitable (generating negative Economic Margin or negative EM, which is AFG’s way of understanding a firm’s economic profitability). When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit and concentrate on the parts of their company that have been creating wealth. Instead, the corporation needs to fix the broken parts of its business first by divesting losers and work on improving profitability to earn the right to expand. The best strategy AFG or an investor likes to see is a very profitable business (generating positive EMs) that grows its assets to maximize its profitability.

In the examples below we analyze GE’s Management Quality under the control of Jack Welch from 1980-2001 and under Jeffrey Immelt’s reign as CEO from 2001-2009.

Welch, once the youngest CEO in GE’s history, is highly regarded for his innovative management strategies, leadership style, and a good understanding of how to create shareholder value. From 1980 to 2001, Welch was able to grow GE’s revenues from just over $26 billion a year to $130 billion and took GE’s stock price from around $1.25 a share to nearly $50 a share. Welch streamlined GE and made it a more competitive company in the market through his dedication to identifying and improving ways of adding value to its shareholders as well as numerous successful acquisitions. During the 1990s, Welch transformed GE from a simple manufacturing company to one of the world’s largest conglomerate. He even acquired the NBC network, and turned it into a success. Welch’s compensation/termination policy added to the internal competiveness of its management teams who knew if they ended up in the bottom 10% of performance of managers they would no longer be working for GE and only those in the top 20% received bonuses and stock options.

Jeffrey Immelt on the other hand has not been able to achieve the same success as Welch in his time as CEO so far. To be fair, Immelt took over GE at an unfavorable time, just days before the 9/11 terrorist attacks, which cost GE’s insurance arm over $600 million. Along with 9/11 Immelt also had to deal with last year’s financial crisis and the prolonged economic recession in developed nations, which dealt a huge blow to GE Capital and GE’s Industrial business. Under Immelt the company lost two/thirds of its stock’s value, missed earnings estimates for the first time and has continued to miss, and lost its place as the largest company (by Market Cap) in the U.S. to Exxon Mobil. GE’s stock price has gone from $39/share when he took over to less than $12/share, underperforming the Dow Jones Industrial by nearly 60% (price return). Despite the above-mentioned environment Immelt had to deal with, it is not encouraging as an investor to see Economic Margins evaporate away while other businesses have adapted and been able to change their misfortunes. It is yet to be determined if Immelt can recover but it is certain he has yet to prove his ability to create shareholder value.

Below is a graphic representation of the value of GE’s stock under Welch vs. Immelt. This highlights the importance of strong leadership to increase the value for shareholders’ investments. By understanding a company’s true economic profitability (EM) and relating that to a company’s growth strategy will give investors a much clearer picture of whether a company is likely to create or destroy wealth in the future. As you can see in the chart below GE's Economic Margins have been closely correlated with the subsequent performance of their stocks price. Welch was able to grow GE's EM's from 2 to 12 in his tenure and Immelt has taken that EM level and diminished it to an expected negative EM in 2009.

GE's stock performance under Welch vs. Immelt

Source: www.economicmargin.com
*returns on this chart do not reflect total return (excludes dividends)

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Management Competence Factors
• Have there been any changes in the executive management team?
• Has the company had any significant write-offs or poor earnings quality?
• Has the company recently made any significant acquisitions and, if so, what are the strategic implications and costs?
• How is the company spending any excess cash?
• What did we learn from the company’s most recent earnings call and what was the tone of analyst questions?

Management Quality Score Insights:
• Measures a company’s EM+1 and LFY Asset Growth.
• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.
• Un-bias quantitative way to analyze a company
• Holds management teams accountable for unprofitable growth

Related article: Why P/E's don't tell the whole story.