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knowledge bank

Dec 13 2016
Lawrence Lam

Why founder-led companies outperform

Behavioural investing
Companies where the founder still owns a large proportion of the business and is involved in managerial decisions consistently produce 4% to 10% p.a more returns than other companies.

However not all of these companies are worth investing in, but we begin our search within these companies – it gives us confidence that we are fishing in a quality pond.

The founder-ownership phenomenon

Founder-ownership, CEO-ownership, management-ownership, inside-ownership. These are all terms used to describe a similar concept – where the people in charge of a company have a vested interest to see it succeed because they own a significant portion of it. There is no shortage of research highlighting this phenomenon – some of these have been attached below. On average, the research indicates that companies with heart outperform other companies by 4% to 10% per annum.

We like this trait a lot. So much so, that we have termed it ‘heart’. It is an intangible quality that drives a business and provides a source of self-motivation for the long term. In sporting terms, heart is what motivates an athlete to put in that extra effort during off-season, with the resultant hard work giving them significant year-on-year improvement. Athlete’s with heart train with intensity and often play at a level beyond their natural physical talents. Fame or attention does not distract them. They simply love their craft and drive themselves to constant improvement. Importantly, these athletes demonstrate objective improvement over the long term. For the NBA supporters, the player that most embodies the principle of heart in the current era is Kawhi Leonard. Kawhi has sustained statistical improvement since becoming a professional 6 years ago and is renowned for his quiet excellence. A business with demonstrated sustained improvement over the long term is a great investment.

Short term management incentive structures aim to replicate this sense of ownership in management, but often fall short. Instead, they only reinforce a short term focus and incentivise management to keep one eye on their stock option vesting dates – they do not promote long term sustainable business growth.

So why don’t we just find all of these companies and invest in them?

Given that the market knows about the founder-ownership phenomenon, why then does it continue to persist? The answer is that not all companies with heart succeed. In our view, it takes more than heart, which is why we start, not finish, our search here. It would be a risky strategy to simply invest in all companies with high insider-ownership.

It is not hard to search for companies with high founder-ownership. The practical challenge is to seek out those businesses that have heart and a competitive edge. We focus our efforts on seeking out these companies with a demonstrated objective track record of performing. Then we buy them at the right price.

Sources:

Stanford Graduate School of Business research on the behavioural changes arising from inside-ownership:

https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-quick-guide-09-equity-ownership_0.pdf

Journal of Finance article analysing 22 years of data in the US markets. This research indicates outperformance of 4% to 10% per annum.

https://www.houseoffinance.se/wp-content/uploads/2016/05/executivesummaryU.pdf