Exploring the Founder Myth

 EXPLORING THE FOUNDER MYTH

Investing is a complex business, and many try and simplify a message to get a point across. The ability to convey complex subjects succinctly and simply is a rare skill and worth a lot in the industry. With it usually comes a compromise of the subject matter and often a misunderstanding. These messages operate at the helicopter level and don’t deal with the nuance and detail so critical in the art of investing, imo. For example, take the word “value” investing. What does that mean to the average punter? I would answer so many things that it is almost meaningless to use. This blurb explores the much-used founder myth as a way to investing nirvana. All my own opinions and comments, so beware-could be wrong.

The theory is built on the premise that investing alongside founders is a low-risk way to invest in the share market and will deliver much outperformance. Some statistics are often forwarded to support that theory, but I have seen statistics that show the theory in a favourable light and a less favourable light. I am wary of statistics that could be skewed by outliers. For example, anything with PME in its base universe is going to skew returns in the Australian context, I would think. Eg companies formed in Richmond Vic, outperform, the stats clearly show it. Lol.

Over the long term, which is what I am interested in here, within the vast majority of cases, a company adds value by increasing assets while maintaining a high ROI (or any other measure with returns above its cost of capital). That about includes everything, can it grow assets and maintain high returns, that’s what you want. We may add competent and honest management, but in my mind, that will ultimately be reflected in returns, but is a useful future indicator.

My first investing experience was the 1980’s, during that tumultuous time of massive deregulation of the markets, a new breed of manager arose, the entrepreneur. These were founder operators, skilled in the new-fangled corporate finance, able to understand wealth creation, unlike the moribund management of the 1970s. they cleaned out the old managers. They were extremely highly regarded in the industry and the markets. Names like Holmes a Court, Spalvins, Brierley, Skase, Elliott plus a large number of smaller imitators. (ok I admit “Bondy” was never really considered special). The ASX even created an “Entrepreneurs” index, and at its peak, five of the top ten companies on the ASX by market cap were entrepreneurs.  The point I'm making here was that they were heralded, had skin in the game, considered the forefront of the new era, were founders….and they all came a huge cropper. Is this cherry picking? Maybe, but it's a big cherry. What went wrong? simply, the above definition of adding real value was not met; the asset accumulation, built off excessive debt, was not value creating; it was, in the end, paper shuffling and the much-anticipated fruits were never really produced. Blindly following founders, which many did in the 1980’S, can be caught out big time.

When we examine the above definition of adding long term value it gives us clues why a founder model may be a safe guard but not always. If we agree adding value is running assets well to optimise returns and add assets above the cost of capital, what is it the givers founders an advantage over professional managers. In terms of the knowledge required to operate a business better in day to day operations, maybe the founder knows the business well enough to know a good deal from a poor one, how expensive it is to run a line, fill capacity and the million other details to run a business. To know what matters and what doesn’t. that is true, but what about the next generation of family owner of the businesses, that skill may not be hereditary. Secondly, there are outside managers who have also managed and know businesses exceptionally well, and they can be hired and, if appropriately incentivised, can pretty much replicate the owner/operator. Operational excellence is a possible differentiator, but probably marginalises over time.

That leaves capital allocation and a possible differentiator. Does a founder add more value than a professional manager when it comes to acquisitions? We can narrow that definition to large acquisitions as bolt-ons, I think, are more difficult to measure, do less damage and maybe some good. We are talking about large transitional acquisitions here. The benefit here, imo, is in the negative stance, ie founders adds value by being much more cautious when it comes to transformative acquisitions than professional management. What does that mean? Professional managers are incentivised to operate large operations, they enhance their salary and prestige. The founder usually doesn’t care about that, they have too much wealth in the base business and probably expect to hand that over to the next generation.

As a complete aside, I would be very weary of ‘skin in the game” when it comes to insider transactions. Being that although a founder may own 30% of the company, he may “own” 100% of the other side of a transaction. Numerous non-arm 's-length transactions, are of course , a red flag, even for founders.

Back to transformational acquisitions. These can be specifically targeted as the case for any differential in performance, imo. They are large, so they change shareholder wealth by a significant amount, and there are incentives to enact these that are not aligned with shareholders. Does this favour the founder model? Perhaps. However, does it mean that all large transformational acquisitions should be intensely scrutinised? absolutely. Of course, no management team is going to come out and say we just blew up a huge amount of shareholder wealth, they will have an attractive, seducing presentation justifying their actions. Shareholders should be aware that this is a pivotal moment in the company's history and may repeat every 5 years or so, yes, I'm looking at you, old BHP (they have many friends).

Am I convinced of the founder model? That is first-order thinking; it is easy and sits well. the real issue, imo, is the proper allocation of capital over time. By doing less or nothing, the founder comes out ahead. Winning by default is always an interesting proposition because it highlights the real issue at hand. Scrutinise every deal, remember the stats, deals outside the area of expertise, so a new market is risky, followed by offshore acquisitions in an area of expertise and then the less risky smaller bolt-ons in your established position. The offshore acquisition into a new industry—yikes, very low hit rate. There are guidelines not guaranteed to work.

Therefore, I like founders as long as they bat within the crease. Pick off the occasional boundary. Dancing down the wicket stretches the friendship.

 

That’s my spiel