The intangible quality of great businesses

business advice CEOs business

19 May 2017
| By Industry |
image
image
expand image

Lawrence Lam looks at why investors should start searching for companies that are founder-led.

We all know this instinctively. We always do better at something when we truly believe in it – when we truly own it.  

As Thomas J Watson Snr, former chair and chief executive of IBM, said “to be successful, you have to have your heart in the business, and your business in your heart”.

And yet for something that we all understand intuitively and has such a significant impact on investment decisions, very little attention has been paid to this in the business world until now. 

Research from Bain & Company’s 2016 study of the S&P 500 over 14 years revealed that companies where the founder remained a core member of the management team outperformed other S&P 500 companies by 3.1 times.

Another study from the Journal of Financial Quantitative Analysis showed that founder-led companies outperformed the rest of the market by 4.4 per cent per annum over a 10-year period.

These numbers only prove what we already know. Founders put their heart in their businesses. They own their businesses. In this era of fly-in fly-out CEOs with large sign-on bonuses and short-term stock options, founder-led companies are quietly outperforming their more bureaucratic cousins. They’re proving that company performance is more strongly linked to genuine ownership than we first thought. 

As the body of evidence supporting this phenomenon mounts, investment professionals and advisers are rethinking their investment strategies to capture the value produced by founder-led companies.

Why are these companies better?

And the reason why founder-companies outperform? It’s because their heart is genuinely in the business. It’s the difference between renting a house and owning a house. Sure, tenants will adequately maintain a house, but it’s not the same feeling. Owners really take care of the property like a home for the long-term, not a house they’re living in for the short-term. 

The research shows that great non-founder CEOs exist and they too perform well, but there are an even greater number of great founder-CEOs. So if you had to pick a great CEO, you’ll more likely find one in a founder-CEO.
Bain & Company calls this ‘The Founder’s Mentality’ and it’s characterised by three features:

  1. A strong sense of higher purpose over a long-term horizon;
  2. Obsession with perfecting the customer experience; and
  3. An owner’s mindset – a great sense of responsibility and bias toward speed in decisions and actions.

These are the characteristics in a leader that money can’t buy. We’ve seen many corporations pay exorbitant bonuses to executives in the hope of inducing the same founder’s passion. Instead, what often prevails is that these corporate rock stars focus on managing expectations down so they spend energy justifying why the goalposts should be wider instead of aiming to kick longer.

In contrast, founder-led companies maintain a strong customer focus, cut through the internal bureaucratic hierarchies and sustain a high level of employee loyalty and engagement. If found early, these companies become great investments.

The effective tipping point?

It is however a common perception that founders are usually seen as entrepreneurs who are great at innovating new ideas and growing small companies, but once the company grows too large, these founder-CEOs are out of their depth and they should hand over the reins to a professional non-founder-CEO. 

This perception is just not true. Research from Purdue University shows that founder-CEOs evolve with the company. They develop managerial and administrative skills as the business grows and they also continue innovating much more than others; a key reason why their companies continue to outperform (think Steve Jobs, Bill Gates, and Mark Zuckerberg). 

The study shows that founder-CEOs are more willing to engage research and development and are more effective in doing so – they get more bang for buck for their research and development spend. 

What can hinder growth isn’t so much founder involvement, but rather internal headwinds that develop as the company experiences growing pains. Bain & Company’s study found that as size increases, layers form, and leaders can become increasingly distant from their customers. Speed of decisions decline. Bureaucracy and focus on the higher purpose is lost.

But remember, the feeling of owning a home is different to the feeling of renting one. For the exceptional few, the founder breaks through these constraints. They find a way. They have an ownership mentality and they do things differently. They hire the right people and clone the same ownership mentality in them. Importantly, they maintain a leadership role and never relinquish that to others. You can hire the right people with the right skills, but you can never buy the ownership mentality.

Using this phenomenon

We intuitively know this phenomenon is true so what can we learn from this research? We no longer need to rely on our intuition to explain the intangible qualities that founder-led companies have. 

It explains why some of Australia’s best performing companies are founder-led. Great Australian examples include Nick Scali, Count Financial (since bought by CBA), Corporate Travel Management, Wotif (since bought by Expedia), and Reece. 

It would have been a profitable venture had you invested in these companies in their early stages. As investors, founder-led companies are an ideal place to begin searching for investments. All else equal, they are less risky and give you a higher likelihood of outperformance.

And whilst not every founder-led company will be successful, the odds of finding a great company are higher. That’s why investors should start, not finish, the search for great companies here. We should still focus on the merits of the business, its performance and its competitive edge. If you can tick these boxes and have an inspirational founder at the helm, you can expect returns in the multiples.

Lawrence Lam is founder and portfolio manager of Truslam Investment Management.

Read more about:

AUTHOR

Recommended for you

sub-bgsidebar subscription

Never miss the latest news and developments in wealth management industry

MARKET INSIGHTS

GG

So shareholders lose a dividend plus have seen the erosion of value. Qantas decides to clawback remuneration from Alan ...

1 month 2 weeks ago
Denise Baker

This is why I left my last position. There was no interest in giving the client quality time, it was all about bumping ...

1 month 3 weeks ago
gonski

So the Hayne Royal Commission has left us with this. What a sad day for the financial planning industry. Clearly most ...

1 month 3 weeks ago

A Sydney-based financial adviser has been banned from providing financial services in the interest of consumer protection after failing to act on conduct concerns. ...

3 days 13 hours ago

The Reserve Bank of Australia has made its latest rate call, with only two more meetings left for 2024....

2 weeks 4 days ago

Financial advisory group AZ NGA has announced a strategic partnership with a $294 billion global investment manager to support its acquisition plans....

1 week 5 days ago