Launch of global and Australian investment strategies
Financial market developments in recent times have been captive to growing concerns around short termism; the tendency for firms to focus on the short-run implications of their decisions (eg. meeting earnings guidance) at the expense of longer run growth prospects associated with brand or reputational damage for instance. Short-termism also manifests in board behaviour, where boards increasingly assess CEOs on the basis of short-run performance. In some cases, this may be desirable. But the secular trend towards shorter CEO tenures we believe, reflects greater impatience of board directors which contributes to CEOs adopting shorter time horizons, detrimental to shareholder value over the longer run.
In light of findings of misconduct from the Royal Commission into financial services, there is an evolving re-assessment about the structure - in terms of size and composition - of senior executives’ remuneration in financial services organisations, and how these can be re-aligned to encourage bankers to think beyond the short-term. What had largely been status quo for over a decade - cash salary (one third), short-term incentives made up of largely internally generated and non-transparent hurdles (one-third), and long term incentives based on total shareholder return and/or a combination of EPS growth (excluding non-recurring items) and ROE hurdles (one-third) - is now in flux.
The Coalition Government recently introduced the Banking Executive Accountability Regime (BEAR), the stated purpose of which is to offer bankers clear incentives to take account of the longer term effects of their decisions. It does so by effectively enforcing a lift in the vesting period of senior bankers’ pay of up to four years. For the CEO of a major bank for instance, they can choose to have 60% of their variable pay deferred or 40% of their total pay. This part of their pay is at risk if their actions do not meet community standards.
The emperor with no clothes?
In response to these developments, much of the cottage industry around Environmental, Social & Governance investing (ESG) will need to re-assess the criteria by which they evaluate financial services firms and other listed companies more broadly, particularly under the Social and Governance categories. If the key stakeholders in this industry - asset owners, institutional investors, proxy advisers and ESG data vendors - do not adapt, then expect the state directed solutions to address market failures through more intervention and regulation. Heightened product market competition acts as a powerful incentive for firms to focus on the long-term consequences for their decisions, but some key industries in Australia remain highly concentrated with low levels of market contestability.
The dark side of diversification
In The Modern Corporation and Private Property, the pioneering work from the 1930s, Adolf Berle and Gardiner Means foreshadowed much of the current crisis in capitalism. They argued that securities markets had facilitated the rapid growth of the modern corporation, particularly those that were able to capitalise on economies of scale. But with that, came the emergence of diffuse ownership. This was thought to undermine the very basis of capitalism because shareholders had little incentive to monitor the behaviour and performance of senior management. With shareholders having little skin in the game, Berle and Means drew attention to the the dark side of diversification; that the separation of management and ownership of corporate assets gave rise to potential conflicts of interest. The agency costs of listed firms and how they are managed (or mismanaged) still resonates almost a century later.
The growing institutionalisation of stock markets in recent decades may well have exacerbated the dark side of diversification due to the free rider problem. Lucian Bebchuk, Alma Cohen, and Scott Hirst (The agency problems of institutional investors, Journal of Economic Perspectives) suggest that institutional investors face little incentive to expend resources to engage in monitoring of the boards or management of companies they are shareholders in because the benefits of such monitoring is shared across the entire shareholder base. The base fees they collect are not significant enough to justify the financial resources associated with monitoring programs or campaigns.
From a global perspective, there has been much debate around the observation that for a given level of profitability, firms are less inclined to go public, preferring to remain privately owned for longer periods, particularly in the United States. This largely reflects a number of developments: what are considered to be onerous listing requirements, the growing assets that private equity and venture capital can marshal from limited partners - notably sovereign wealth funds and public pension funds - and the desire for start-ups to retain the flexibility of having patient capital as their key source of funding.
Founder companies - The best of public and private markets
Against the backdrop of growing scepticism around short-termism, we are launching two investment strategies that invest exclusively in founder stocks. We believe that these firms offer the key benefits of public ownership - transparency and liquidity - and private ownership - patient capital, concentrated ownership and a strong alignment of incentives amongst the key stakeholders. Of course, there can be pitfalls associated with founder companies, notably management entrenchment, where it is difficult for the board to remove an under-performing founder-CEO for instance. Further, the founder - subject to the size of her ownership stake - may have scope to make decisions that are detrimental to minority shareholders.
A focus on focused founders
Our selection process is designed to identify founder companies where there is a strong alignment of interests with minority shareholders. To that end, we search for founders or controlling family members who are poorly diversified, both financially and personally. We also prefer founders because they tend to be focused on growing their business rather than eyeing off opportunities to jump ship to other firms. Given that much of the value proposition and skill set that founders offer are unique to the company they founded, they are unlikely to be active in the market for managerial talent, unlike many professionally hired CEOs.
The key criteria for a stock to become a candidate for selection are an ongoing and active involvement in the company, and skin in the game. The founder(s) of the company or a steward - someone who was at the company around the time of its inception or listing and has been instrumental in its success - must still have an active involvement in the company as either CEO, Chair, board director or as senior executive. An example of a steward would have been Mr Brian McNamee, who steered CSL though its ASX listing in 1994 and remained CEO for over two decades. If the founder has stepped away from an active role in running or monitoring the company, we still consider a company where the founder’s heir or family members are still actively involved in running the firm as executives or monitoring the firm as board directors.
A company’s culture of ownership is measured by the ownership stake of the founder(s), steward or founders’ family members (as long as they have an active involvement). The heirs of Sam Walton, founder of Walmart, each have substantial but passive ownership stakes in the listed US retailer, which is therefore not considered as a candidate for our global investment strategy.
Skin in the game counts
We concede that some founders are motivated by more than the size of their ownership stake; they may view the company they founded as one of their key legacies. Nonetheless, their skin in the game we believe represents the best proxy for a company’s culture of ownership and the alignment of interests between the founder, senior management, board of directors and minority shareholders. Some founder companies are still regarded poorly in terms of conventional governance metrics, relating to concerns surrounding board independence and the fact that some founders occupy the dual roles of Chair and CEO. Our investment strategies are not designed to be the antithesis of ESG investing. But we believe that conventional governance metrics are less pertinent for founder companies because governance mechanisms are designed to address the agency conflict in listed firms. Yet, as discussed, agency costs are already low for founder stocks where there is no clear separation between the ownership and management of corporate assets.
To our knowledge, the Australian and global strategies we have developed and are offering to clients are the first products of their kind to invest exclusively in founder and/or family controlled companies.
For the Australian strategy, we identify over 125 founder companies from the All Ordinaries index. In addition to their active involvement and ownership stakes, drawing on the academic literature, we consider other factors that have a demonstrated ability to forecast stock returns, including cash based operating profitability, earnings quality, valuation, stock liquidity and the firm’s track record in building organisation capital as a source of sustainable competitive advantage. We make adjustments to financial accounts to reflect the fact that investments in organisational capital are typically not recorded on the balance sheets.
These filters are used to narrow down the universe to a portfolio of 40 to 60 names. There are 46 stocks in the portfolio at present. The table below reports the largest five positions in the portfolio and their weights: Fortescue Metals, Mineral Resources, Link Administration, Cromwell Property and Northern Star. The chart below that depicts the sector exposures; the three largest exposures are in financials, mining and REITs.
For the global strategy, we identify over 300 founder companies from 3,000 stocks listed in Developed Markets: the United States, Canada, Europe and the United Kingdom. As per the Australian strategy, we utilise a variety of filters to narrow the universe down to a portfolio of between 40 and 60 stocks. At present, the global portfolio comprises 50 stocks. The table below reports the five largest positions and their portfolio weights: Burelle, Sports Direct International, Saputo, United Internet and Fedex. The charts below depict the country and sector exposures. Founder stocks listed in the United States account for 70% of the overall portfolio, while the largest sector exposures include software & computer services, general retailers and healthcare/biotech. We look forward to keeping you apprised of the strategy’s performance on a quarterly basis.