Owner-Operators & Shareholder Value Creation
“Never, ever, think about something else when you should be thinking about the power of incentives.” – Charlie Munger
During our due diligence process on new investment ideas, we spend time looking at the structure of management compensation. We especially like to see significant insider ownership. That being said, we don’t go out of our way to target companies where the insiders are outsized owners.
But our portfolio is full of these “owner-operators”.
The list below was put together by @HarvestInvestor in December. It shows the 47 members of the S&P 500 where insiders own more than 5% of the company. Of this list, our current portfolio holds Oracle, L Brands, Alphabet, Cerner, Charles Schwab, Paychex, and Discovery Communications. This is an amazing overlap given that our core portfolio owns 20-25 securities. It means our holdings have insiders with 5%+ ownership stakes at 3.4x the frequency that you would expect to find by chance.
Adding to that list, our holding Luxotica is majority owned by the founding CEO and retired founder Phil Knight owns more than 15% of Nike in a combination of share classes and entities. Interestingly, MasterCard is 10% owned by the MasterCard Foundation. And while Broadridge’s CEO Rich Daly no longer owns a large stake in the company, he founded the proxy business that he sold to ADP back in 1989 before it was spun back out as a separate company in 2007. Likewise, First Republic’s Jim Herbert owns 1.9% of the company, but he founded the business himself in 1985 before selling the business to Merrill Lynch at the peak of the housing bubble and then buying it back with the backing of private equity partners in the depths of the financial crisis.
So what’s going on here? If we aren’t actively seeking out companies where the founder and/or management has a large stake in the business, how did we end up with so many of them in our portfolio?
As the Charlie Munger quote leading this post suggests, a big part of the explanation is the incentives of owner-operators often lead to them building the sort of companies we look to invest in. Owner-operators of companies care about the long-term value of their business, not the price of the stock next quarter. They care about the cash the business can generate, not the accounting earnings. They are answerable to themselves rather than to “The Street” and so they are willing to take actions that are non-conventional, daring and may require short-term pain in exchange for long-term gain. Its remarkable how many great businesses were dismissed as being “crazy” ideas early in their history. These ideas can only be brought to fruition by someone who is deeply, personally invested in its outcome.
But it isn’t only financial incentives. Owner-operators have often committed their entire life to their company. They remember the days they scrapped together $500 to start the business (Nike), they worked long nights in their dorm room while their friends were out partying (Alphabet), they decided to do the unthinkable and slash prices when all of their peers where raising prices, giving birth to a new business model (Charles Schwab). Their incentives transcend money because their company is their life. It is their reason for being. It is the first thing they think about in the morning and the last thing they think about at night because they are obsessed with an idea. They are what Charlie Munger has called “intelligent fanatics”.
What’s interesting is that most of the businesses in the world are small businesses that are run by owner-operators. But as a company grows, it generally needs to raise capital with the founding owner selling off pieces of the business. Once a company has gone public, the management team in place is usually “rented” by the shareholders to manage the company. There are many, many hard working dedicated CEOs who do not own big stakes in the businesses they manage. But the owner-operator starts off with a huge advantage because their incentives are not to meet the short-term demands of their employer but to drive the long-term value of the company.
So while all owner-operators do not build outstanding businesses, many outstanding businesses were built by owner-operators. Our portfolio is full of founder and owner-managed companies not because we target companies with this sort of management structure, but because we seek out outstanding companies that create shareholder value.
If you’re interested in learning more about owner-operated business, a firm called Horizon Kinetics has built an index of these companies and put together research on how they’ve performed over time. You can learn more about the index, their methodology for how they define owner-operators, and the long-term performance history of owner-operated firms vs the market here. (Note: we point to the Horizon Kinetics index as a resource to learn about owner-operated businesses, not as an investment recommendation).
Ensemble Capital’s clients own shares of Alphabet (GOOGL), Broadridge Financial (BR), Cerner (CERN), Charles Schwab & Co (SCHW), Discovery Communications (DISCA), First Republic (FRC), L Brands (LB), MasterCard (MA), Nike (NKE), Oracle (ORCL), Paychex (PAYX), and TransDigm (TDG).
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