Leadership Through Uncertainty

By Brian Blank

Today, so much of what is going on in our world is unprecedented. Businesses are evolving in ways seeming unimaginable just years ago, whether recovering from a pandemic, navigating remote workforces or managing labor shortages from aging demographics. As companies analyze the path forward, employees may look to the top to make sense of and navigate this uncertain environment. How can corporate leaders evaluate current circumstances, take calculated risks, outshine competitors and avoid bankruptcy?

What should businesses make of the current economic environment?

The economic environment is particularly complex, with both businesses and consumers watching the Federal Open Market Committee. The Federal Reserve’s policymaking arm is contemplating to what endpoint to raise its benchmark interest rate, as well as the pace, over the coming months and years. This fight with inflation has high stakes for the economy, which has been strong over the past year. As the Fed works to slow inflation without causing a major downturn, economic growth is also slowing.

Unfortunately, the economic deceleration has some experts believing a recession is not only likely but imminent. While the labor market is still growing rapidly, gross domestic product has slowly declined for a second consecutive quarter, which has many alarmed, as some parts of the economy slow, like housing and construction. Still, GDP appears to be growing again, and the National Bureau of Economic Research, which typically identifies recessions in retrospect, focuses on employment and income, both of which continue to grow.

Despite warnings related to high interest rates and expensive real estate loans for businesses and individuals, signs of a downturn are not present in key economic datapoints. In addition to the hot labor market, several large capital expenditures have yet to decline. For example, past recessions typically followed sharp declines in residential investment, indicating individuals spent less on new homes and improvements. However, residential investment has remained steady at an historically precedented percentage of GDP, while large expenditures like heavy truck sales continue to be strong. Coupled with the lowest unemployment rate in decades and rapid job growth, these indicators suggest a recession may still be further away.

While debate as to whether the economy is entering a recession continues, individuals and businesses are grappling with trends not seen in a generation. Elevated inflation and a slowing economy have many looking back at periods of stagflation, where the economy stops growing – stagnates – amidst inflation, searching for clues on what the future may entail.

Staring down economic challenges, companies seek to adjust to the new landscape, and firms must identify the best person to lead through uncertainty. Should businesses hire an experienced veteran or seek out the next up and coming star?

Executives adapt to economic challenges

One challenge CEOs often find themselves managing is an economic downturn, which is why in a recent study my co-author, Brandy Hadley of Appalachian State University, and I investigated how executives change their decision-making during economic downturns. When we examined how CEOs manage firms through challenging economies, we found some executives learn and develop expertise to strategically shift risks and add seven percent more value during downturns.

Amidst uncertainty, experience becomes increasingly valuable for leaders. CEOs who previously led a firm through a downturn (“Recession CEOs”), regardless of the outcome, learned from experience. In fact, CEOs at firms that have had negative experience demonstrate more learning, which results in bigger shifts in policy for the next downturn.

The secret we learn from studying Recession CEOs is that the key to their success in the next downturn does not begin when the economy deteriorates. Instead, Recession CEOs plan for challenging economic environments during expansion and growth. They use conservative financing during the boom, which provides more flexibility and less bankruptcy risk amidst the downturn. By being cautious when the economy is growing, executives ensure their businesses have more cash in critical moments. As a result, the market views the firm as less risky and is willing to lend additional capital to fuel higher growth through capital expenditures and acquisitions.

The more experience CEOs have in prior downturns, the better they perform in the next, especially after surviving severe downturns. Not surprisingly, these skills are especially valuable at firms impacted more by economic cycles. Cyclical industries that produce and sell luxury goods or specialize in travel benefit more from hiring Recession CEOs than firms in the insurance or beverage industries. Overall, recession-experienced executives add value to firms during subsequent downturns. Knowing that experience can be valuable, how should companies identify the next leader?

A game of thrones

Not all firms plan for future leadership until the need arises, but regulators and consultants urge companies to plan for CEO succession, due to the importance future CEOs have on businesses. Researching CEO succession with Brandy Hadley as well as Kristi Minnick of Bentley University and Mia Rivolta of Xavier University, we investigate the value of CEO selection methods for firms.

Research indicates companies typically hire CEOs through one of two approaches: competitions or grooming heirs. Unfortunately, competitive selections are detrimental for firm performance, even when winners are just as qualified as heirs. For example, winners of CEO competitions are 36 percent more likely to depart the firm quickly in pursuit of better opportunities. Moreover, firms led by competitively selected executives have six percent lower operating performance. While firms know the importance of identifying the right CEO, competitions induce conflict, executive turnover and inferior performance, which are costly.

Still, over 40 percent of large public companies in the S&P 1500 index continue to utilize competitive selection instead of grooming an heir. As a result, businesses must compensate and entice executive stability after identifying the best CEO to lead through challenging environments in order to avoid executives departing for greener pastures. As hiring executives becomes more challenging, rewarding innovation and developing cultures of stability become increasingly important. How can firms ensure steady leadership and motivate leaders to innovate?

Do incentives work?

Businesses are often criticized for risk-taking, but investors also desire large returns on corporate investments through sound financial decisions and innovative activities. Since calculated risks can result in higher performance for business owners and employees, incentivizing leaders to identify appropriate ventures and business risks is central to steady leadership and the success of the company. Firms can benefit from encouraging executives to invest in the research and development of new products. Unfortunately, innovation is often a slow and risky process, so executives frequently avoid these risks.

One way firms encourage innovation is by rewarding executives for successful inventions in the long run. Companies manage risk-taking by carefully designing executive compensation that appreciates when innovation increases firm value. Therefore, businesses align the incentives of owners and decision-makers by paying executives with ownership in the company, which grows with the firm.

Unfortunately, instead of designing compensation aimed at optimizing corporate decisions, firms often prefer low-cost pay. For example, when accounting regulations allowed companies to expense stock options at cost, firms awarded more stock options, which were thought to make executives increase risk taking due to the payout structure.

In research with Lee Biggerstaff and Brad Goldie of Miami University, we investigate whether firms awarding option compensation incentivize corporate innovation and resulting patents. While prior theories considered option compensation the best way to encourage innovation, our work shows company ownership through restricted stock grants effectively motivates leaders in a similar fashion.

If shareholders and executives both benefit from the endeavors, equity ownership can motivate CEOs to take the appropriate amount of risk and invest in the future of the company. Managing calculated risk-taking through equity compensation is one way that businesses can avoid being left behind by competitors or bankruptcy while navigating the economic environment and labor market challenges. If businesses select and incentivize the best executives to learn from prior experiences, they can conquer the changing financial environment, overcome economic challenges and lead through uncertainty.

Brian Blank

Dr. Brian Blank is an Assistant Professor of Finance in the MSU College of Business. He received his doctoral degree from the University of Tennessee’s Haslam College of Business, where he developed expertise researching corporate finance. He has published in journals like the Journal of Corporate Finance. He received his undergraduate education at the University of Alabama, where he also earned Master of Science degrees in Finance and Applied Statistics. Afterward, he began his career as a Consultant with Accounting, Economics & Appraisal Group, where he assisted companies facing critical challenges including fraud, bankruptcy and litigation. His projects included advising a financial institution victim of a $500 million Ponzi scheme; consulting for one of the 10 largest U.S.-based financial institutions; performing due diligence for an international healthcare acquisition and valuing a business interrupted by the costliest disaster in the history of the United States.