Think Small, Think Great

The one that got away.

That old fisherman's cliche also sums up one of the great pains of stock market investing. We've all noticed a company that early in its life had great prospects and a bright future. We kinda knew it then, but never invested in it. We absolutely know it now, but it's too late to get in on that growth story.

To spark a nostalgic memory, let me ask: Do you remember the first time you picked up a Gillette razor to smooth your face or legs (whichever the case may be)? Maybe you recall your first pack of Johnson & Johnson cotton swabs? Or perhaps you recollect your maiden visit to Wal-Mart? The answer to all of these questions is probably a resounding "no" -- however, I'd be willing to bet that you've been a regular customer of these businesses ever since.

So what did these companies have in common all those years ago? For starters, they were significantly smaller than they are today. They had quality business models and manageable debt, and no doubt there were numerous Wall Street professionals shouting "buy!" I would also expect that each business had great long-term managers with stakes in the success of their business.

Is that everything? Well, not for me. I want to know how to spot and buy these types of companies when they are even smaller, before the Wall Street analysts commenced their daily commentaries. So is there anything else I can look for in a company positioned for greatness?

Actually, yes.

Level 5 leadership
In 1996, renowned management researcher Jim Collins and his research team took on a mammoth task. They sought out companies that had underperformed the S&P 500 for at least 15 years, and then, at a point in time aligning with a new CEO, went through a transition to subsequently outperform the stock market three times over for the next 15 years. Out of 1,435 Fortune 500 companies they studied, only 11 achieved and sustained greatness. What did all of these 11 companies have in common? Each had a "Level 5" leader at the helm.

According to Collins, a Level 5 leader displays -- with dedication bordering on the religious -- the paradoxical combination of deep personal humility and intense professional will. Such managers will settle for nothing less than an enduring great company, and they are intolerant of mediocrity and stoic in their resolve to do whatever it takes to produce great results. They will set up superb successors for even more greatness in future generations, and at all times will demonstrate a compelling modesty, shunning public attention.

Take, for example, Darwin Smith, CEO at paper products maker Kimberly-Clark from 1971 to 1991. In the 20-year period prior to Smith's arrival, Kimberly-Clark's returns to investors had fallen 36% behind the S&P 500. Over the following 20 years, Smith refined the company's core business while being shy, self-conscious, and attention-shunning. In order to build strength within the company, he redefined its goals, increased the geographical diversification of Kimberly-Clark's facilities, and unremittingly reviewed the company's leadership team. Those who met Smith's metrics were promoted; those who did not were removed.

Smith introduced Kimberly-Clark employees to the Educational Opportunities Plan, which provides continuing education to all workers, and the Health Management Program, which improves mental and physical health. R&D funds were poured into consumer products under Smith's leadership, which catapulted Huggies to rank as the No. 1 diaper brand in the country. Despite Wall Street skepticism, an outstanding turnabout ensued, generating returns that hammered the S&P 500.

How do I find such a captain?
The most effective way to get into the mind and makeup of a business chief is to listen closely to what he or she says about the organization's success and failures. Who gets credit for the wins? Who is blamed for disappointments? Is the CEO fiercely aligned with shareholder interests? These answers are critical in detecting Level 5 leadership qualities.

One way to winnow down the list of CEO candidates worthy of further investigation is to screen for insider ownership. At a time when the average CEO tenure has dropped to less than five years, managers that own a significant stake (10% or more) in the company they run are more likely to align themselves with shareholders. Some current small caps that meet this criterion are:

Another way to uncover Level 5 leaders is to get to know them. While that sounds like it would be impossible, with a library of CEO interviews that grows every month, Motley Fool Hidden Gems subscribers are no strangers to the traits of great and not-so-great chief executives. Fool co-founder Tom Gardner also knows a Level 5 leader when he finds one, and so far has found traits of humility and fierce resolve in Middleby's Selim Bassoul.

Bassoul's credentials come through loud and clear in his words: "I look first at the integrity and ethics of management. ... I like companies like ours where there is not a distinction between the insider and the outsider." Resolve, resolve, resolve.

These leaders will see their companies through years of market-beating returns because of their humble determination.

As Jim Collins puts it in "The Misguided Mix-Up of Celebrity and Leadership" (available via his outstanding website):

Our problem is not a shortage of Level 5 leaders. They exist all around us. Like the drawing of two faces that transforms itself into a vase, depending on how you look at the picture, Level 5 leadership jumps out at us as soon as we change how we look at the world and alter our assumptions about how it best works.

No, our problem lies in the fact that our culture has fallen in love with the idea of the celebrity CEO. Charismatic egotists who swoop in to save companies grace the covers of major magazines because they are much more interesting to read and write about than people like Darwin Smith.

Collins' lesson is something all investors should absorb.

Great and small
Quality of leadership differentiates good companies from outstanding companies and is becoming more important to the Hidden Gems team, whose full-time work is to identify superior small caps. Not every manager will have such traits, of course, but when you detect them, you may have found someone born to lead.

By taking a stake in small-cap companies that have great business models and financial health, coupled with chief executives who show signs of Level 5 leadership, I believe that in years to come I won't lament the one that got away -- because I'll have caught it long before the Street came looking.

To see which small caps Fool co-founder Tom Gardner and his Hidden Gems team are uncovering each month, try the service out free for 30 days. You'll have access to a library of more than 60 recommendations, CEO interviews, and thousands of like-minded subscribers who can help you keep tabs on your favorite firms. Click here for the details.

This article was originally published on Nov. 22, 2005. It has been updated.

Emmet Savage is moderately modest and has shown fierce resolve from time to time. He owns shares of Middleby but no other companies mentioned in this article. The Motley Fool has a disclosure policy.