Why Leadership Matters

I'll admit it: I'm a statistics junkie. I memorized the stats on the back of my baseball cards as a kid, and I know the quickest way from Fairfax, Va., to Silver Spring, Md., at rush hour because I timed and tracked the various routes. Numbers don't lie. Unfortunately for my early investing career, numbers don't tell the whole truth, either.

Numerical shortcomings
When I started as a do-it-yourself investor, I was infatuated with the great metrics used for screening and evaluating small-cap stocks: owner earnings, enterprise value divided by owner earnings, inventory percentage increase divided by sales percentage increase ... I loved them all. Because of this infatuation, I was a victim of selective reading and was burned by chasing numbers without rounding out the picture. I focused too deeply on my comfort zone.

In hindsight, it's now obvious that I was completely missing one essential key to long-term success: quality leadership. True leadership sets the vision for the organization and then outlines the strategy for accomplishing that vision, and the difference that leaders can make in performance can be staggering. From April 1993 to March 2002, the annualized return on IBM (NYSE:IBM) was 27.2%. Compare that with 11.2% for the S&P 500, 11.4% from Hewlett-Packard (NYSE:HPQ), and an ugly 1.1% from Unisys (NYSE:UIS) -- the company formed by the merger of two IBM competitors, Burroughs and Sperry. It's no coincidence that outsized performance occurred during Lou Gerstner's tenure as IBM CEO.

So what should we look for when separating leaders from mere managers?

Leadership with a capital L
Look up manage in the dictionary, and one of the definitions is "to continue to get along; carry on." This doesn't engender the kind of confidence I'm looking for in a great long-term investment. For example, Motley Fool Hidden Gems Watch List laggard Goody'sFamily Clothing (NASDAQ:GDYS) is competently managed, but there doesn't appear to be any leadership. The company drifts along quarter after quarter: Growth is not sustained; margins won't increase.

Leadership brings compelling vision and meaningful direction to bring that vision to fruition. Middleby chairman and CEO Selim Bassoul completely and successfully refocused his company from a general kitchen manufacturer to a leader in commercial ovens. Since he took over the company, the stock is up almost 70% per year for investors.

FARO Technologies CEO Simon Raab is another leader with a vision for his company. On the recent Strategic Outlook and Guidance conference call, he stated a clear five-year plan to deliver market-beating success for shareholders. Despite FARO's recent volatility, this company is on track to maintain its accelerating growth.

Quality leadership is recognizable ... but I had to learn to look.

Been there, done that
Many top-notch leaders have a history of success. Just as with stocks, the best predictor of future performance is past performance. Management at TransActTechnologies (NASDAQ:TACT) lacks a sterling pedigree and, in the face of slow growth, beamed with excessive optimism. The stock has been stagnant for almost 10 years.

Contrast the performance of TransAct with Alderwoods. Alderwoods' leadership has vast experience navigating complex turnarounds -- and it shows. They've done it before, and they're doing it again with Alderwoods -- up almost 125% since being recommended in Hidden Gems.

It's a given that investors need to carefully check balance sheets and income statements before throwing hard-earned dollars into common stock. You should also do the same on a company's personnel. Here's a quick litmus test for your toolbox: (1) Where did executives and board members learn their craft? (2) How did their previous companies perform?

Above all
Honesty and integrity are the two most important factors in judging leadership. Without honesty and integrity, all other qualitative and quantitative metrics are useless. Dishonest leadership can nullify the most meticulous quantitative analysis in a nanosecond. I should have been suspicious when New Frontier Media (NASDAQ:NOOF) kept generating cash hand-over-fist while insiders blithely granted and exercised stock options. The projections were too sweet to bother scrutinizing such nonsense -- until the stock shed nearly 50% of its value in a four-month span.

Another tarnished stock of mine, Precis (NASDAQ:PCIS), repeated the same story quarter after quarter -- the familiar "We're spending money now, but the payoff is right around the corner!" -- without ever hitting the target. That kind of management leads a stock nowhere but down.

Follow the leaders
Now that I've decided that leadership matters, the statistics junkie in me wants to know just how much. So let's compare the performance of the aforementioned leaders and managers:

Foolish bottom line
When all I had was the hammer of statistics in my stock-picking arsenal, a lot of companies looked like nails. With a new appreciation for the difference between management and leadership, I have a new tool to help build my portfolio into a big winner.

This lesson in the intangible importance of leadership was preached to me by Fool co-founder Tom Gardner. Every month, his Hidden Gems newsletter service pores over the quantitative and the qualitative of the more than 3,000 small-cap stocks on the U.S. exchanges. It's been successful, too -- Hidden Gems recommendations are up 33% on average, versus S&P 500 returns of just 11%. If you'd like to learn more tools for your investing arsenal, or if you'd just like two thoroughly researched stock picks a month, sample Hidden Gems for 30 days -- for free. You'll have full access to everything we've ever published, with no obligation to subscribe. Click here to learn more.

It's not enough to put money on management. You have to find the leaders.

Marty Kaufman owns shares of Middleby, FARO Technologies, Alderwoods, and New Frontiers Media. Middleby, FARO Technologies, Alderwoods, and TransAct are past Hidden Gems recommendations. The Motley Fool has adisclosure policy.