Overvalued: Why Jack Welch Isn't God

A recent issue of Publishers Weekly featured a two-page advertising spread touting "the year's most eagerly anticipated book." The promised $1 million marketing onslaught apparently will include national TV and radio spots, appearances on CNBC and the Today show, and "transit advertising" in New York, Washington, D.C., and Boston.

In other words, get ready to know Jack. The book's title, subject, and nominal author is, of course, Jack Welch, the departing chairman and chief executive officer of General Electric (which owns CNBC and the Today show) and easily the most lionized corporate hero alive. Warner Books famously agreed to pay Welch $7.1 million — nearly a record for nonfiction — to tell his story; the book will likely have to be a million-seller just to break even.

It's hard to imagine what Jack, due out in September, will add to the already voluminous body of work describing Welch and his management techniques. Among the at least ten titles in this oeuvre are such classics as Get Better or Get Beaten!: 31 Leadership Secrets from GE's Jack Welch; Control Your Destiny or Someone Else Will: Lessons in Mastering Change — From the Principles Jack Welch Is Using to Revolutionize GE; Jack Welch and the GE Way; Business the Jack Welch Way; and the just-published update Get Better or Get Beaten!: 29 Leadership Secrets from GE's Jack Welch. (Apparently two of the original secrets didn't pan out.) Welch's hagiographers have declared him "the Vince Lombardi of business," "a heroic form of CEO," "the world's greatest business leader," "the manager of the century," and "CEO of the century." You'd almost think Welch was single-handedly responsible for the growth of the entire global economy. Oh, wait, he's been credited with that as well: "As the most widely admired, studied, and imitated CEO of his time," argued Fortune, "Welch has enriched not only GE's shareholders but also the shareholders of companies around the globe. His total economic impact is impossible to calculate but must be a staggering multiple of his GE performance."

Welch's critics (when they can be found) typically point to the massive layoffs he has overseen at GE or to allegations that GE plants have polluted the Hudson River. (Thomas F. O'Boyle's muckraking book At Any Cost is probably the most comprehensive anti-Welch brief to date.) But these and related attacks, whatever their merit, are largely beside the point as far as Welch's boosters are concerned. As long as GE isn't overwhelmed by some massive scandal (think Firestone) or federal lawsuit (think Microsoft), Welch will ultimately be judged by his impact on GE's bottom line.

And that impact looks impressive. In 1980, the year before Welch became CEO, GE recorded revenues of roughly $26.8 billion; in 2000 they were nearly $130 billion. When Welch took over, the stock market judged the company to be worth about $14 billion. Today its market capitalization is roughly $490 billion, making it the most valuable company in the world.

But there's a difference between being a good CEO — which Welch has been — and being the undisputed all-time champion of corporate leadership. Or, to put it another way, think of Jack Welch as a stock. If the most sensible way to gauge the current value of a stock is the famous price-to-earnings (P/E) ratio — that is, the ratio of a stock's market cost to the company's actual or expected profits — then consider Welch's reputation as "price" and his achievement as "earnings." A stock can be overvalued, sometimes wildly so, even if its earnings look solid. In bottom-line terms, Welch's achievements are solid. But his reputation? As a multiple of what he has actually accomplished, it's gotten far too pricey to buy.

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What lessons could Jack contain that would justify its $7.1 million advance? Well, one key piece of advice that Welch might offer — but probably won't — is that the best way to look like a great manager is to work for a great company. CEOs are often depicted as almost single-handedly responsible for the good fortunes of their companies. (This is a notion CEOs embrace when crafting or defending their compensation packages; Welch himself has benefited from this reasoning, to the tune of an estimated $93.1 million in 1999 and $122.5 million last year.) So it was Lou Gerstner who turned around IBM, Lee Iacocca who saved Chrysler, and Jack Welch who "revived" GE. But sometimes the truth is just the reverse. Although most observers discuss GE as the house that Jack built, it's more true to say that GE is the house that built Jack.

John Francis Welch (i.e., Jack) took the reins at GE in 1981, following a long, exhaustive, and competitive succession process overseen by his predecessor, Reg Jones. But, contrary to the notion that Welch inherited a moribund company, things were going pretty well already. Over the course of Jones's stint at the top, which began in 1972, revenue had grown at an average annual rate of 12 percent, and earnings had grown at 16 percent. The spin offered by Robert Slater, author of The New GE: How Jack Welch Revived an American Institution (as well as three other Welch volumes), is that Welch "did not want to wait until General Electric was in trouble.... To keep those figures from declining, Welch knew he had to push the company to become more competitive." Janet Lowe, author of Jack Welch Speaks and the recent biography Welch: An American Icon, echoes this line: "The challenge for Welch was to spot trouble before it occurred, to take preventative measures, and to make the most of GE's tremendous momentum."

Fine. And in fact GE has averaged a solid 12 percent annual earnings growth throughout Welch's time at the top, and about 15 percent over the last eight years. But if no trouble had yet "occurred" when he took over, and GE already boasted "tremendous momentum," why credit Welch with a revival rather than with maintaining a past record of excellence? The truth is that while CEO biographers need a larger-than-life hero, GE did not. Indeed, as James C. Collins and Jerry I. Porras explain in their celebrated and insightful 1994 book Built to Last, the firm has enjoyed success under a series of innovative chief executives stretching back to the early 1900s.

Early in the twentieth century GE started what's been called the first major industrial research lab in the United States. Its top managers in the '20s and '30s pioneered "enlightened management" ideas, such as paid vacations for most workers, that helped attract and retain top talent, and they shrewdly moved the company into home appliances. "Few corporations are more progressive or better managed," observed Forbes in 1929. In the '50s GE was again a pioneer, this time in decentralizing its management structure to encourage divisional independence and growth, paving the way for new business units organized around, for instance, plastics. Its CEO in the '50s, Ralph Cordiner, founded the company's well-known corporate university in Croton-on-Hudson, New York, which has been described as the first private facility designed to codify and teach management skills. In the '60s the company experimented with new industries once again, and, while some of these experiments floundered, others — plastics, airplane engines, and especially the decision to let its credit division branch out into other financial services — laid the foundation for the industrial conglomerate that GE is today. When Welch took over after the recession- and inflation-plagued '70s, Jones was a celebrated figure whose tenure had left GE, in the words of Welch biographer Lowe, "one of the strongest [companies] in America" in financial terms; its debt rating was triple-A.

How strong has GE been under Welch? One popular benchmark is return on equity (ROE) — earnings as a percentage of shareholder equity — which measures how efficiently management has used shareholders' capital to create profits. Last year the median figure for profits as a percentage of shareholder equity among Fortune 500 companies was 14.6 percent. According to GE, its average annual ROE under Welch has been 25.8 percent, which is exceptional. But it's not unique, even for GE. In Built to Last, Collins and Porras compile pre-tax ROE figures for seven "chief executive eras" at GE; they find that Welch ranked fifth. (Using an updated number provided by GE that includes the exceptional boom years since that book was published, he places third.) Collins and Porras do not suggest Welch has done a bad job — they go out of their way to note their respect "for his remarkable track record" and "immense achievements." Their point is that they "respect GE even more for its remarkable track record of continuity in top management excellence over the course of a hundred years."

Indeed, despite the marketing of Welch as a "self-made man," a "rebel," and a "revolutionary," he's actually a company man who rose up through the ranks and then continued many of the traditions of his predecessors. In keeping with GE custom, Welch became CEO after spending his entire career at the company. He joined in 1960; by the time The Graduate was encouraging America to laugh at the idea of a future in plastics, he had taken charge of GE's plastics business department. He was part of Jones's inner circle of top managers during most of Jones's tenure. However you want to characterize the changes and decisions Welch made during his 20 years at the top of GE, they stemmed from his background as a consummate insider. And among the many things Welch has not changed at GE is the institutional habit of promoting from within: His successor, Jeffrey R. Immelt, is also homegrown.

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But Immelt won't be able to benefit from the second lesson Jack might offer those wishing to emulate Welch's career: Become a CEO in the early '80s. In an era when stock performance has become (for better or for worse) the one true measure of corporate success, it's useful to have begun your tenure as CEO just before the greatest bull-market run of all time.

This run has been driven not just by increased earnings but by a huge change in how much investors are willing to pay for those earnings. In 1981, S&P 500 stocks traded, on average, at nine times earnings, according to Thomson Financial/ First Call. Today, the average is nearly 25 times earnings (way above the historic figure of about 15 times earnings). To be sure, GE shares trade well above this, at 38 times earnings (more on this below). But there's simply no denying that Welch — unlike, say, Jones — ran GE during a period when the winds of investor sentiment blew mightily at the backs of share prices, and that much of his eye-popping share-return performance is attributable to a general sea change in what investors are willing to pay for stocks. (Consider this: GE’s P/E is currently 51% above the average. If, in a less generous market, that average dropped to its historic norm of 15, and GE held onto its premium, the company’s shares would fall from about $50 to about $29 a share. If the average P/E were 9, and again GE kept its premium, its share price would be $18 — or 64% below its recent price.)

Of course, that doesn't change the fact that today GE is the most valuable corporation in the world, measured by stock market capitalization. This, if we can get down to brass tacks, is the core fact of Welch mania: He did better by his shareholders than anyone.

Except that's not true. Yes, the rise of GE shares during Welch's tenure has been awesome. But turn again to this year's Fortune 500. Where does GE rank in annual rate of return to investors over the past decade? Fifty-fifth. A great performance, to be sure, but not in a class by itself. Elsewhere in its 500 issue, Fortune notes that, over 17 years, shares of Colgate-Palmolive have decisively outperformed those of GE. (The 17-year time horizon is pegged to the tenure of Colgate-Palmolive's CEO, Reuben Mark, who avoids the press and is not, needless to say, being offered seven-figure book deals.)

But then, there are many yardsticks by which to gauge a company's performance, and raw stock market gains may not be the best. (As noted above, the monumental gains made by stocks in general — the S&P 500 is up roughly 2,000 percent since 1981 — distort direct comparisons between stock performances in the last couple of decades and those of pre-'80s CEO tenures.) Built to Last employs a better measure of corporate success: It measures the performance of an individual company's stock relative to the market during the same period. The easiest way to express this is as a simple ratio: Collins has calculated that, from 1981 to 1995, shares of Welch's GE stock stomped the broader market by a factor of 2.4 to 1. Surely that astonishing run of success is close to unique — something pulled off by only a few similarly celebrated corporate chiefs.

In fact, no. In his forthcoming book, Good to Great, Collins finds eleven companies that beat this benchmark. Earlier this year, he wrote about the former CEO of one such firm, Kimberly-Clark, in Harvard Business Review. From 1971 to 1991, that company's stock outperformed the market by a ratio of 4.1 to 1 under the leadership of one Darwin E. Smith. "And yet few people — even ardent students of business history — have heard of Darwin Smith," Collins wrote in HBR.

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So why is Welch routinely described as the greatest corporate leader of his generation, if not of the century? Part of the answer is that, during Welch's career, America's relationship with business leaders has changed. For starters, business in general, filtered through coverage of the stock market on networks like CNBC, receives much more public attention than it did in 1980. Add to this the rise of technology companies, from Microsoft to Apple to Dell, that appeared to come from nowhere on the strength of visionary individuals whose entrepreneurial achievements were inspiring in a way few political figures could match. Looking to make business accessible in an age of economic boom and innovation, the press frequently told business stories through the prism of individuals — Iacocca, Bill Gates, Steve Jobs, Welch. In his day, Reg Jones was also lauded by his peers as the nation's most admired and influential CEO. It's just that the wider public wasn't that interested in such things back then.

But there's another explanation as well. Welch has given Wall Street what it wants. And, in the '80s and '90s, what it wanted above all else were companies that delivered results predictably, with no surprises, quarter by quarter. As noted above, GE trades at a distinct and impressive premium to the P/E of other companies. This is something Welch achieved. When he took over, GE was trading at a P/E of eight, roughly in line with the broader market. Typically, a company's P/E shrinks as its revenues and earnings increase; investors get less and less generous in what they're willing to pay for earnings, for the logical reason that percentage gains in earnings growth get tougher to replicate as the numbers get bigger. Nevertheless, GE under Welch has done the opposite: The market is apparently a far greater believer in GE's growth potential now than it was in 1981. That's a neat trick when you consider that today's earnings dwarf those of two decades ago.

One reason the markets may have rewarded Welch's GE with such a generous multiple is that the company has mastered the quarterly earnings ritual with almost eerie efficiency. "Wall Street loves the more than 100 quarters" — it's now 103 — "of uninterrupted growth in net income that have occurred under Mr. Welch," The New York Times summarized late last year. This isn't strictly accurate, since that string began in 1975, six years before Welch took over. Still, it's an incredible feat to roll out orderly growth from continuing operations on a quarterly basis for that long, through a wide variety of short-term economic twists and turns.

Incredible may be right. As the Welch era winds down, some critics have suggested that the methods by which GE produces its vaunted quarterly growth numbers may be less than pristine. A persuasive story by Jon Birger in the November 2000 issue of Money magazine argued that the company uses "a number of confusing but apparently legal gimmicks to achieve its vaunted consistency." (GE responded by sending a note to its stock analysts labeling Money's article "an unprecedented collection of nonsense.") Fortune (arguably Welch's biggest booster) followed up on March 19 with a story called "Accounting in Wonderland." Each wrestled in the thicket of restructuring charges, onetime special gains, and sales and acquisitions.

Observers are particularly suspicious of GE's record of using unique gains and restructuring charges to offset each other without disrupting that quarterly earnings flow. Most recently, charges associated with shutting down the Montgomery Ward chain, which was owned by GE Capital, were offset by a onetime gain from the sale of the last of the firm's stake in PaineWebber. Had these events occurred further apart, they would have ultimately balanced out the same way, but they could have created either a dip in earnings growth or a spike that would have been hard to top the next earnings season. And it does seem curious that GE's many onetime gains, acquisitions, and special charges invariably and smoothly balance each other every three months.

Then there's the company's pension plan. As noted in a 1999 column by Alan Abelson in Barron's, echoed in Money, GE's pension plan has been fully funded for years; it is invested in stocks and fixed-income securities, and when gains in the fund outpace the amount the company must pay, the difference falls into its reported income. This amount has grown at a faster clip than overall earnings in the last few years, and in 2000 it totaled $1.74 billion, or about 13.7 percent of net. (GE has lately stopped using the phrase "total pension plan income" to describe this figure, instead labeling it "cost reduction from pension" in its latest annual report; but it's the same thing.) The point is that this number has nothing to do with GE's actual businesses, but it helps the company meet its aggressive revenue-growth targets each quarter.

Of course, corporate accounting can get extremely creative without running afoul of the law — or even running afoul of good business practices — and no one has suggested that whatever gimmickry may be going on masks a flawed business. The danger is in letting the short-term mania to "make the quarter" undermine the balance sheet's long-term health. There's no evidence that it has so far, but such things take a long time to play out.

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Chances are that GE will remain healthy under Immelt — again, because it is a business with executive talent both deep and wide. What's less clear is whether the intangible optimism, tied to Welch's mystique, that has helped inflate the growth of GE stock can hold out. It will take years, for instance, to figure out whether Welch's last act, the mega-acquisition of Honeywell, will play out as planned. If the integration process hits a speed bump — if, God forbid, something interferes with that quarterly earnings streak — that good-vibrations optimism could disappear.

Although the rockiness of the market has left GE shares essentially flat over the past 18 months, they are still generously priced. If this generosity deteriorates even mildly — say GE's growth slows a bit — it will severely affect GE shares. Suppose the stock's P/E enjoyed merely a 10 percent premium over the market's current (historically high) average. That would knock about 29 percent off GE's current share price — or wipe out a whopping $142 billion of the company's overall value. Such are the perils of a stock priced to reflect a belief in managerial perfection. Even now, GE shares are about 19 percent off their 52-week high, not because of weaker earnings, but because investors aren't willing to pay as much for those earnings as they used to. If Welch picked the perfect time to take control of a company whose success would be measured by shareholder value, Immelt may have picked the worst.

On the cover of Jack, Welch wears a friendly grin, a cream-colored sweater, and the look of a man who figures his record speaks for itself. He is ready to talk from the gut, to explain his success, to share his secrets. Some of them, anyway.

A very similar version of this story appeared in the June 11, 2001, issue of The New Republic.