It's not how much you own. It's how you use it
With a fierce commitment to legacy comes a natural resistance to giving up control. A big positive of founder-led companies we previously discussed was their tendency to be stingy with equity: any dilution will affect them most. This often promotes capital discipline, however an obsession with maintaining control can lead to question marks among prospective investors.
Take Mark Zuckerberg as an example: he holds less than 1% of Facebook's publicly traded Class A shares, yet owns 81.7% of their Class Bs. This grants him voting power of 52.9%, making him virtually immovable. A similar story can be seen in Rupert Murdoch's News Corp - In fact 11.9% of the Russell 3000 utilise a dual-share structure.
Concerns around ownership dominance led to the S&P500 refusing to admit companies with dual structures to the index. But is this a worthwhile concern? In the second wire of this collection into founder-led companies, I asked our fundies to discuss the risks that investors must keep in mind when considering these companies. I reached out to the following fund managers to hear their insights:
- Maroun Younes - Fidelity Global Future Leaders Fund
- Shaun Weick - Wilson Asset Management
- Emma Fisher - Airlie Funds Management
- Andrew McAuley - Credit Suisse
Understand how managers use their control
Emma Fisher - Airlie Funds Management
The main risks are those associated with poor corporate governance. In many situations, if the founders retain enough ownership, investors are minorities and can be treated as such. This can lead to adverse outcomes, particularly around capital allocation. Signs of empire building, in particular, need to be monitored.
Clues we look for include outsized voting rights, which allow founders to exert control over a business that is disproportionate to their actual shareholding (à la News Corp), and nepotistic management appointments. However, even this latter one isn’t always a red flag- we’d point to Reece and Resmed as two examples where a founder CEO has passed the CEO role on to their offspring with good results.
It’s important to scrutinise how capital is being allocated by founders with a large degree of control. Are bets concentrated within the core business, or is the founder using the public company balance sheet in lieu of their own personal one?
For example, at times minority investors in Harvey Norman have seen value destroyed via non-core investments such as dairy farms and mining camps that led to severe losses. It does appear that Harvey Norman has “got the message”: since the last of these investments was written off in 2018, the share price is up over 60%.
Talkin' bout your generation
We believe that family-owned companies may provide better “through cycle” returns because their main shareholders (founder or family) have to adopt a long-term focus given that their capital is effectively locked in. As the company matures, ownership is likely to transfer from the original founders to their relatives, typically their children and grandchildren.
This broader group of individuals, while related to the founders, might not have the same affiliation with the company, implying that the “family alpha” factor might decline over time. We have calculated the relative share price returns for our family-owned companies when grouping them by age in order to assess whether a generational impact is visible.
Our calculations suggest that younger family-owned companies (those in the first two generations) do tend to generate stronger share-price returns.
While our data does not support the view that the third generation destroys wealth, it does support the relative view about the impact of the various generations. The first generation represents the wealth creators, the second generation represents the wealth inheritors, while the third generation and beyond is often seen as potential “wealth destroyers.”
While our data does not support the view that the third generation destroys wealth, it does support the relative view about the impact of the various generations.
One interesting statistic is that we have calculated relative share price returns for our companies when grouping them by holding and conclude that the data suggests that a smaller holding typically coincides with a stronger outperformance.
Family-owned companies with a family or founder stake of less than 30% generated the best performance, whereas those with a 60% or higher stake offered the lowest outperformance.
Keep an eye on governance and liquidity
Maroun Younes - Fidelity Global Future Leaders Fund
There are a couple of risks that investors need to be mindful of that a more magnified with founder-led companies.
The first centres around the level of control possessed by the founder (or family). As outsiders, minority shareholders can usually have their say on matters through shareholder voting mechanisms. However, if the founder or family have enough control, it can be hard for outside shareholders to have their say and effect change. This isn’t always inherently bad - as demonstrated, founders are often making decisions with the best long-term interests of the business in mind.
In the odd instance however where they may not be, often the governance protections available for outside shareholders are a lot more limited. The founder is often calling the shots and you need to be comfortable in taking a passive role and ‘go along for the ride’.
Secondly, often the founders own such a large stake in the listed entity that they can significantly reduce the liquidity of the stock, thereby discouraging some potential institutional shareholders. This lack of liquidity could be magnified in times of market stress where market participants are looking to reduce their risk exposure and begin to sell their holdings. The lack of liquidity in the individual listed security compounds on top of the drop in general liquidity witnessed during corrections, possibly exacerbating share price movements.
Credit Suisse's research revealed (also references above) that founder stakes of up to 30% perform relatively the best amongst founder-led businesses, whilst those with stakes over 60% perform relatively worst. Whether this is due to liquidity concerns or perceived level of control, we don’t quite know.
Growth at a reasonable rate
Shaun Weick - Wilson Asset Management
Whilst in isolation we believe the positives of investing in founder-led companies outweigh the negatives, there are some red flags we believe investors should be mindful of.
The level of power or influence that a founder-led CEO has within the company is an important consideration, as if this becomes overbearing it has often proved to be detrimental to the organisation, stifling alternative thinking and innovation and leading to poor capital allocation decisions.
A “growth at all costs” or empire-building mentality that lacks strategic focus and suggests a potential pivot is another red flag we look for when investing in founder-led companies. This may signal that something is wrong within the core business, particularly if stepping out into new areas whereby the CEO has less experience.
A big characteristic of founder-led companies is the scale of control held by a single body. While this can be cause for concern, our fundies believe that it is more important to understand what managers are doing with that control. Looking beyond the numbers and seeing their development over time or across generations is imperative when considering whether this ownership is a risk.
Join me and our guests in the other parts of this collection, where we explore the benefits of founder-led companies, prominent sectors they feature rise and our experts' tips for the next founder-led behemoths.
I will also be publishing a Fund Manager Q&A with Lawrence Lam from Lumenary Investment Management, whose investment strategy revolves around the idea of finding companies that are founder-led.
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If you enjoyed this wire, please click like and comment below what you think about companies where the majority of power rests with the founder. Would you be comfortable with an individual holding 52.9% of votes?
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