Photography: Peter Murphy During his decade as CEO of IBM, Sam Palmisano didn’t say a lot in public about the financial markets and their impact on his decision making. He didn’t say a lot in public, period. He’d made a conscious choice to keep a low profile, and he began breaking with that choice only toward the end of his tenure. Behind the scenes, though, Palmisano, then-CFO Mark Loughridge, and others at IBM were engaged in a sustained effort to win over Wall Street on their own terms. At its core was what Palmisano calls “the model,” a rolling multiyear road map for earnings growth and cash generation. IBM committed to increase earnings per share from $6 in 2006 to $10 in 2010, described the mix of growth and cost-cutting necessary to achieve that goal, and invited investors to judge its process along the way. It also used the metrics in the model to shape employee compensation. It took some time to put the model together. The first version was rolled out four years after Palmisano succeeded Lou Gerstner as CEO. And it was a while before the markets took notice. In early 2007, for example, CNBC’s Jim Cramer berated IBM’s board for letting Palmisano keep his job in the face of poor stock performance. Before long, though, IBM began beating the targets it had set for itself (earnings hit $10 per share a year early, in 2009), its stock went on a years-long tear, and the critics were silenced. The share price more than doubled during Palmisano’s tenure, and big dividends made investors’ gains even greater. By the simple measure of shareholder returns, the model was a huge success. Was it the right way to run a company? Palmisano thinks so. He’s not a big critic of Wall Street, just of corporate management teams that don’t deal with it intelligently. Since stepping down as IBM’s chairman, in October 2012, he has been spreading his ideas about good management by coaching CEOs, and in April 2014 he launched the Center for Global Enterprise, a nonprofit devoted to the study of the contemporary corporation. He’s also a member of Exxon Mobil’s board of directors. Palmisano recently spoke with HBR’s Justin Fox about striking a balance between running a company for the long term and keeping investors happy. HBR: After several years in charge at IBM, you launched a pretty significant change in how the company set its goals and communicated them to investors. What was the genesis of that? Palmisano: I felt that the orientation around a 90-day outlook was distorting to management practice. Not every quarter is going to be perfect. We all know that operationally, but you’re still pressured to do things that aren’t necessarily in the long-term interests of the entity in order to make your numbers. If you miss by a penny, the market knocks your stock down by 4% to 8%—for a penny, which is meaningless. Did IBM give 90-day outlooks before you took the helm? No. We gave investors annual outlooks, and we gave them earnings. You have to give them something—they’re owners. But the criticism at the time was that they couldn’t understand us. We were too complicated. You want people to have some clarity so that they will invest in you. We thought that if we could come up with something longer term that gave investors enough information to make a sound judgment, it would work for them and for us. In your first few years as CEO, the stock wasn’t going anywhere. It didn’t move. Of course, we felt that the market didn’t see all the great things we were doing. Every CEO and CFO thinks their stock is undervalued. At 100 P/E, you think you’re undervalued. That’s the nature of the people in those jobs. We met with our large holders and said, “What can we do better to articulate what we think the value of the company is?” Their feedback was, “You’re like a black box—we can’t figure you out.” So we thought about how we could give them enough transparency without getting into the quarterly drumbeat. In 2006 we told the Street that we would go from $6 to $10 in earnings per share by 2010. We then tied long-term compensation to that model. The shareholders were a little skeptical at first. They commented that it would be great if we could execute the model, but they weren’t sure we could. We executed it, and it worked for us. Many people have asked me if our model could work for other companies. It depends. It depends on the maturity of the company, the size of the company, the portfolio of the company. If you’re a small, young company and you’re driving revenue without a lot of earnings, you’ve got a completely different model. It will be rewarded for a period of time. There are guys running at 1% or zero profitability who are growing like crazy. That’s fine for a few years, but eventually somebody’s going to say, “It’s time to start making money.” And then the next demand is, “Give some of it back to me.” Is it really a different set of institutions that want to own an IBM rather than one of those smaller, younger companies? Oh, I think so. The Berkshire Hathaways, the Neuberger Bermans, the Capital Worlds are looking at a longer-term cycle for their investment returns. That’s their orientation. Clearly, there are folks out there who just trade you. They have no real interest in the company per se. Traders weren’t that interested in us. There were better places for them to go. Inviting Shareholders In It seems that you can make choices about how you communicate with markets to attract a certain kind of shareholder. We decided to treat our large shareholders with total transparency, as best we could within regulations. We would meet with them. We’d have a couple of them come in every quarter and talk with the entire senior management team. Was this Fidelity, Capital Group— Fidelity, Capital, BlackRock, T. Rowe, Wellington, Neuberger Berman—the big guys. They would each bring four or five portfolio managers. The point I would make to my team was, “Look, they own us. If an activist got involved at IBM, we’d meet with him and take him through all the stuff. So, why don’t we treat our shareholders like that?” The CFO would open the meeting, go through the year, the quarter, our cash, the balance sheet. Then the business units would come in—software, hardware, services. I’d be at the end. They could spend as much time as they wanted with the businesses. Those meetings must have gone on for hours. They’d start first thing in the morning, and the shareholders would leave whenever. Sometimes they’d leave at 2:00; sometimes they’d leave at 6:00. We’d have the conversation: “What do you think about capital allocation? Let’s talk about dividend versus share buyback. Let’s talk about acquisition strategies. Do you think we should do a big deal?” They were very good exchanges. I found them extremely valuable. These guys really have your interests at heart. They own 3% or 4% of the company, and they want you to succeed. They’re not trying to screw you up or trick you. It’s not like a sell-side analysts’ meeting, where guys are trying to write a clever report. They’re not trying to play “gotcha.” We decided to treat our large shareholders with total transparency. These guys really have your interests at heart. They’re not trying to play ‘gotcha.’ If we listened to their point of view, I found that we could be responsive in a way that fit our strategy. Basically, the shareholders were just asking us to be friendly with capital allocation. They wanted more margin expansion and cash generation than top-line growth, because they knew that if we generated cash, we’d give it back to them in the form of a share buyback or a dividend, not a crazy large acquisition that no one else could see value in. A long-running Clay Christensen complaint about financial metrics is that if you emphasize capital allocation and return on capital, you can end up focusing on efficiency and not on innovative efforts that tend to lack impressive returns at first. Is that a risk? We invested $6 billion a year in R&D. Throw in another few billion for acquisitions of technologies that we weren’t organically developing, and I’d say $10 billion, $11 billion a year. It was 10% of revenue. There aren’t a lot of companies investing 10% of revenue. At IBM, we knew we had to invest for the long term. Not everything works out. That’s why it’s called research and development. You cannot eat your seed corn in a downturn. If you do, you’re toast—look at what happened to HP. Even in the ’08 downturn, we never cut R&D; we hung in there. We hung in there after the dot-com bubble burst. I completely agree with Clay—you have to continue to invest. If you don’t, you cannot catch up. You cannot eat your seed corn in a downturn. You have to continue to invest. If you don’t, you cannot catch up. I don’t think it’s the metrics that are the problem; I think it’s the maturity of management. You can come up with a long-term orientation that the investor can measure. But you can’t be having a crappy year and just say, “I’m in it for the long haul.” Nobody’s going to buy that, right? When you have scale, you should be more efficient than your competitors. Being efficient does not mean underinvesting—it should free up money to invest. It should give you the flexibility to invest in the future, or to give your people more money, or to add marketing campaigns, or to give more money to the shareholders. But you shouldn’t say that you’re fat because you’re thinking about the long term. If you’re fat, go on a diet. When you look at your efficiency ratios, they have nothing to do with the long term, because your innovation and long-term investments are a very small portion of the SG&A [selling, general, and administrative expenses] pot—maybe 4%. Ninety-six percent is other stuff—benefits, hiring, accounting, supply chains. You can do those things better and then use the savings to generate shareholder returns or to innovate. So there isn’t necessarily a conflict between operating in a way that keeps investors reasonably happy over the medium term and doing what you need to do. You have to give them something they can measure you against that you’re comfortable with. It took us some time to figure that out. Opting Out of Earnings Calls Let’s go back to something you said before, about how you were trying to interact with long-term investors, not always with sell-side analysts. The quarterly earnings process is more or less dominated by the sell side. Did you participate in those calls? No, never. I suggest that CEOs never do that. There were two things I avoided. I didn’t do quarterly earnings calls—I did one investor meeting a year, always in the springtime, and the sell side came to that—and I didn’t spend a lot of time on television tooting my own horn. I didn’t think that was appropriate. You’re a proprietor at a point in time; you’re a steward. You’re not the founder. You’re there to protect the entity for long-term returns. We made it to a century; we want to make it to 200 years, not just to 105 years because we did something stupid when I was the CEO. About not participating in the quarterly conference calls with the sell side: It wasn’t about not being prepared. Of course we were all prepared. It was about the short-term orientation. Lou [Gerstner] never did those calls, so it was easier for me not to. I had a long conversation with Jeff [Immelt, the CEO] at GE. He said, “I can’t stop; Jack [Welch, Immelt’s predecessor] always did them.” I said, “I understand, but it sets the wrong tone.” It’s amazing how many of those calls are led by CEOs. We all talk to each other—you’re going to do them, you’re not going to do them. There’s so much pressure. But if your predecessor didn’t do them, then you don’t have to; you have a choice. If your predecessor did, it’s really hard not to. The Role of the CEO You’ve described the role of the CEO in a couple of ways. At one point you talked about the shareholders as the owners, but you’ve also said that you are the steward of the organization. We’re stewards, right. Are the shareholders the bosses? It’s not one shareholder who’s the boss. Managers and boards are responsible for looking out for the long-term interests of the entity, which should correlate with those of the shareholders. I would argue that in some cases they don’t. Having somebody with 1% or 2% ownership asking for two board seats isn’t necessarily in the long-term interests of the entity. If someone wants to hold the stock for three to five years and has 5% and wants a board seat, that’s one thing. But to have 1% and want to have three board seats and own the stock for 90 days—I don’t think that’s healthy. My point being, though, that those interests really should align if you’re managing for the long term. We never said, “We’re not going to execute in ’06, ’07, ’08.” We said, “This is where we think we’re going to go. Here’s how we’re going to invest your money. What is your point of view? Would you do it differently?” Then we’d discuss it. Did you get truly helpful answers? Well, in time. I think that at first, some of them were so shocked that they weren’t prepared to answer. The portfolio guys tend to be older; their analysts tend to be younger. The younger guys didn’t know what to do. They’d look at us like, “I can’t believe you just asked me that question. I was supposed to ask you the questions.” Financial markets have grown in importance over the past few decades. I don’t know whether investors now have more demands, but you hear more about them. Is that a problem? Have we gone too far? It depends. My answer might be a little different from other peoples’. Everybody has a negative view of activist investors, right? I did too. But I’ve thought about it a lot, and it depends on who they are and what they’re asking for. Sometimes they’re just asking you to rethink capital allocation. If management is not doing a thoughtful job of capital allocation, perhaps someone should provide some input. Now, we could argue whether [activist investor Carl] Icahn calling the guys at eBay a bunch of insiders playing inside poker is effective feedback. But there are activists who are basically just saying, “You have jillions of dollars of cash on the balance sheet. Instead of buying an asset for $8 billion, why don’t you give us some of that back?” Is that a bad argument? If I were the CEO of that company, I probably would do that. That’s what you should do if you’re not a start-up anymore. You begin with what I call act one—the first phase, the hit product, a great run. You’ve got companies in great runs right now, the Googles and the Facebooks. Good ideas, great returns, but then all of a sudden, you need an act two. Well, jeez, is act two going to propel you from $30 billion to $100 billion? That’s a little tougher. It’s the Microsoft challenge. So you have to say, “Well, I need a different view. I can still create shareholder value, but I can do it a different way. I can rethink capital allocation.” Recognize where you are on your maturity curve, as a management team, and behave accordingly. Don’t give a speech as CEO as if you just got out of Stanford and you came up with an iconic interface and you called yourself a piece of fruit. I think that’s really hard for a company the age of a Cisco or a Microsoft. That’s what they struggle with. They’re saying, “I remember the good old days, and it’s rockin’ and rollin’, baby. I’m going to find whatever it happens to be—mobility for Windows. The high-end fiber optics router for the internet of all things.” But the investor says, “Wait a minute. I expect you to be more mature now. Your company’s not young anymore.” The investor expects returns—consistent returns. These are well-managed companies with good cash flow. But there’s a gap between what the investment community thinks a company of that size and maturity should be doing and where management is. Starting with Strategy To what extent should the internal conversations of an organization relate to what’s going on in the financial markets? You’ve got to have them lined up. You need to start with the strategy. Ours was to migrate to higher-margin, higher-value businesses. To exit commoditizing stuff and get into areas we felt were generative: analytics, the cloud, big data, etcetera—a lot of software. Then we had to translate that to a financial model so that the investor could say, “That strategy works for me.” Then we had to translate the financial model into a management system, and every unit had to have a plan to execute that road map. And then we had to put a compensation system in place that reinforced that success. So it started with the strategy, and it was completely plumbed, end to end. We didn’t do it in 30 days. But we got there. If I was going to coach a CEO, I would strongly suggest starting with strategy. You have to have a strategy that’s logical—that’s based in fact, not emotion. Then how do you execute it? You can’t have a model just at the top, among the CFO, the CEO, and the strategy department. All the units of the company have to execute it. And you’ve got to set it up so that all the units don’t have to be perfect. I used to say, “I want ‘B’ performance; I don’t want ‘A’ performance. If everybody becomes a ‘B,’ we’ll hit it.” Because I couldn’t depend on 90% of the class being ‘A’s. Last, people need to understand that if they execute the model, they will be rewarded—there isn’t going to be some arm of society saying, “Don’t pay the people, because oh my god, we don’t like the fact that they made a lot of money for the shareholders.” That’s what goes on today, especially in the banks. The thing with the banks, more than with industrial companies, is that you can have a great year, but you might be digging the hole that’s going to bury you two years later. Exactly. But you can deal with it the way we did—by having long-term compensation. Exxon Mobil’s is even longer than IBM’s; it’s several years after you retire. How about that for restrictions? But it fits the company’s business. Exxon Mobil’s capital allocation process generates returns in 15 to 20 years. That means the company is making decisions for the long term. So the compensation fits the model and the strategy.

During his decade as CEO of IBM, Sam Palmisano didn’t say a lot in public about the financial markets and their impact on his decision making. He didn’t say a lot in public, period. He’d made a conscious choice to keep a low profile, and he began breaking with that choice only toward the end of his tenure.

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Reprint: R1406E
Managers and academics often lament that Wall Street&#8217;s short-term focus makes it impossible for corporations to plan for the long run. Palmisano disagrees. Yes, there are some on Wall Street, such as the sell-side analysts who dominate quarterly earnings conference calls, who can&#8217;t see more than a few months out. But CEOs shouldn&#8217;t participate in those calls anyway, he believes. They should instead focus their energies on the institutional investors who will embrace the long view if they are given ways to judge a company&#8217;s progress.
In this edited interview with one of HBR&#8217;s executive editors, Palmisano describes how IBM&#8217;s top management made significant changes to how the firm set goals and communicated them to investors. &#8220;The model,&#8221; a rolling multiyear road map for earnings growth and cash generation, included an emphasis on R&#038;D investment even during downturns, a plan for execution that involved every unit in the organization, and a shift toward long-term compensation. Transparency and open dialogues with large shareholders were also key.
The CEO is a steward, Palmisano argues, charged with protecting a company and its returns for decades to come. But that vision need not clash with success on the visible horizon; during Palmisano&#8217;s tenure, IBM&#8217;s stock price soared.

Managing Investors

Reprint: R1406E Managers and academics often lament that Wall Street’s short-term focus makes it impossible for corporations to plan for the long run. Palmisano disagrees. Yes, there are some on Wall Street, such as the sell-side analysts who dominate quarterly earnings conference calls, who can’t see more than a few months out. But CEOs shouldn’t participate in those calls anyway, he believes. They should instead focus their energies on the institutional investors who will embrace the long view if they are given ways to judge a company’s progress. In this edited interview with one of HBR’s executive editors, Palmisano describes how IBM’s top management made significant changes to how the firm set goals and communicated them to investors. “The model,” a rolling multiyear road map for earnings growth and cash generation, included an emphasis on R&D investment even during downturns, a plan for execution that involved every unit in the organization, and a shift toward long-term compensation. Transparency and open dialogues with large shareholders were also key. The CEO is a steward, Palmisano argues, charged with protecting a company and its returns for decades to come. But that vision need not clash with success on the visible horizon; during Palmisano’s tenure, IBM’s stock price soared.

Managing Investors

Summary.

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