How To Invest When The CEO Has Got To Go

David Sterman's picture

Monday, December 22, 2014 - 1:30pm

by David Sterman

It's not easy being a CEO. Their days are filled with back-to-back meetings as they try to keep track of the many small details that comprise a company's daily operations. Still, it's an incredibly well-paying job, and they are expected to perform at peak levels.

So it's a bit unconscionable when a CEO overlooks clear problems. In September, shareholders of Hertz Global Holdings, Inc. (NYSE: HTZ) learned that the rental car firm was letting its vehicles rack up too many miles before being replaced, which led to lost business with key corporate accounts. They soon demanded CEO Mark Frissora's resignation.

Luckily, activist investors helped locate a new CEO, and the damage will likely be repaired in 2015.

In another instance, the board of directors waited far too long to replace a clearly unsuccessful leader. Dov Charney, the controversial head of American Apparel, Inc. (NYSE: APP), almost drove his company into bankruptcy, as I noted in 2011, yet the board waited until 2014 to get around to replacing him.

American Apparel is one of many firms that suffered from what is known as a "pocket board," whereby by all of the company's directors have very cozy -- and unquestioning -- relationships with the CEO.

That's one of the first things that activist investors such as Carl Icahn like to focus on. As he started building a position in Hertz, he lobbied the board to add a pair of his own hand-picked candidates. That's one of the best ways to ensure that the board is no longer (uniformly) in the CEO's pocket.

In many situations, you can sense that a CEO may deserve to be let go by simply looking at the stock chart. When a stock loses the support of key investors and CEO's fail to take quick action to improve operations, the board understands that the only way to restore shareholder trust is to find a replacement for the CEO.

When the board at Francesca's Holdings Corp. (Nasdaq: FRAN), a women's apparel retailer, decided to replace the CEO on December 5 with a more seasoned industry veteran shares had an immediate relief rally.

In a similar vein, shares of Monster Worldwide, Inc. (NYSE: MWW) have staged an impressive 24% rebound in the six weeks since the board made a change in the corner office.

Of course simply buying stocks that you think will benefit from an eventual CEO change is a foolhardy way to invest. As long as that CEO remains on the job, the stock price could keep falling.

Yet in instances such as Monster and Francesca's, investors may have wondered if they have missed the boat. If you look at the multi-year stock charts of such firms, then you'll often notice that a seemingly dramatic short-term rebound has still left shares trading at a steep discount to previous peaks.

The real key is what new management will do to revitalize operations. You'll be hearing about turnaround plans at Francesca's, Monster and Hertz, for example, when Q4 results are released.

Even if the new vision sounds compelling, investors may not quickly bid up shares. Though a decision by Bon-Ton Stores, Inc. (Nasdaq: BONT) to bring in a new CEO in August 2014 has been seen as the right move for the struggling department store operator, thanks to her extensive industry experience, shares have actually drifted lower since then.

Yet Bon-Ton is now a remarkably inexpensive retailer, by a whole host of metrics. If the new CEO has even a moderate impact on operating performance, then Bon-Ton could deliver robust upside in 2015.

Risks To Consider: New CEOs often find that some operational challenges are well beyond their control. Cutting overhead, for example, is a tried-and-true tactic of new CEOs, but that doesn't bring back loyal customers that have drifted away.

Action To Take --> Monster Worldwide, Bon-Ton and Hertz should all be on your radar. These are precisely the kinds of companies that have room to improve operations. At a minimum, these companies now have boards that are paying much closer attention to management performance, and/or have the attention of activist investors. That sets the stage for a path to unlocked shareholder value, often through a sale of the company.

The next time you read about a CEO being replaced, you should move quickly to assess what kind of turnaround strategy might be pursued, and how the stock's current valuations compare to the peer group. That helps you assess if a turnaround is feasible and what kind of upside remains. But don't dawdle. Many institutional investors will get a chance to sit down with new management within a matter of weeks, and as they regain confidence in the company, shares will have already started to appreciate.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.