Last month, we blogged about the importance of avoiding cognitive biases in investment decisions. Such biases can also be dangerous in business leadership and are often a cause of corporate failures.
Mistakes such as herding and confirmation bias are just as prevalent among company directors as they are among investors. One of the most important ways to avoid baking these biases into corporate culture is to promote a more diverse leadership.
In our credit analysis training courses, we teach that the key question in assessing a company is ‘does it have good management?’
A tell-tale sign that it does not is a gap in leadership. Are the right voices heard at board level; do they have authority; or are they drowned out? When an important voice such as the CFO or finance director is missing, that usually indicates a problem.
For example, typical red flags appear when a company has no CFO or finance director, one with an inappropriate professional background, or gives them a lower rank. The implication is that financial management is not a key risk or success factor for the company – it is ‘just book-keeping’.
This is more common than you might think, and we see it often in the problem companies we use as case studies in our online financial courses.
It is easy to have all the right committees and management templates in your annual report, but still not give a strong independent voice to your finance function.
A good example is energy provider Abengoa. The company is under investigation for accounting fraud while trying to avoid becoming Spain’s largest-ever bankruptcy case by refinancing 9 billion euros of debt. Before it restructured its management team in response to governance concerns in 2015, Abengoa’s CFO was not on the board. Instead, the impression was of a structure in which, for years, one family was the dominant shareholder and a single family member had a lot of day-to-day control.
Another example is Vestas, the Danish wind turbine manufacturer. This is now a successful company, but before 2013, it experienced significant financial difficulties and was forced to restructure twice.
In the early Noughties, the company had very ambitious targets for global market share with little consideration of financial controls and risk management. Its board was dominated by male Danish engineers and technicians, with almost laughably similar board photos in the 2004 annual report.
This lack of diversity led to an unbalanced strategy. Given its global ambition, we might have expected at least some more varied nationalities to help Vestas deal with the cultures and frameworks of different markets, but no. Similarly it lacked attention to finance and risk, rather than engineering and got into deep water, figuratively and literally in the North Sea!
Cliques of people with the same background and experience tend to keep hiring people like them. They also tend not to know what they don’t know or how important it is. Bringing in diverse leaders can help open their eyes.
In 2021, diversity of experience and competency is more important than ever. Technology is changing the business landscape and most businesses are challenged by disruption – even without the effects of the Covid pandemic.
It has become critical to have people on your board who will challenge the status quo. Instead, boards in businesses under threat often turn inwards and become defensive. They stick to business as usual, as the world changes around them.
Dixons, for example, was the UK’s premier high street electrical retailer. In 2007, it acquired ecommerce firm Pixmania, which seemed a good move. But Pixmania’s expertise did not make it into the boardroom, but instead its CEO was left on the executive committee, with no strategic remit. Only after its restructuring did the board take on John Browett – formerly the head of Tesco Direct – to put an eCommerce champion in the CEO position.
The lack of digital expertise on boards is still a problem for many traditional brands.
The great diversity bake-off
In addition to a balance of nationalities, competencies and professional backgrounds, boards need diversity in areas such as race and gender.
They also need a strong chair to ensure robust and balanced strategic debate between these different viewpoints. For example, a board should not be dominated by a visionary CEO who tends to take big bets without much thought for risk.
We can see the value of an open mindset in the performance of companies that have gender and racial diversity among their board members. In 2018, McKinsey analysed a large global dataset that showed a significant link between diverse leadership and financial outperformance.
Companies in the top quartile for gender and ethnic or cultural diversity in executive teams were more likely to outperform on profitability. Companies in the bottom quartile for these factors were less likely to outperform on profitability.
Credit Suisse has also shown that companies with greater gender diversity on boards posted higher stock market returns; returns on equity; valuations; and pay-out ratios.
Why is this? Causative links between diversity and performance are harder to prove. But, according to the UK’s 2015 Davies Review, better gender diversity on boards is anecdotally leading to better recruitment because the talent pool is larger; and more customer focus because diversity reflects the marketplace better.
More diverse leaders may also increase employee satisfaction by reducing conflicts; improving collaboration and loyalty; and making better decisions by avoiding groupthink.
A samey mix of baking ingredients will produce a bland cake – a more varied mix will make something more fitting of a bake-off champion. Similarly, a balanced blend of distinct skills in a board is more likely to avoid a flop and instead produce market-beating results.