Young & Invested: Can this strategy pick better stocks?
How one attribute might lead to company outperformance.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 32
I have something to confess.
Regular readers of this column know that I’m an avid proponent of ETFs. My key holdings comprise of broad market equity ETFs split across Aussie and developed international markets.
I’ve previously written about my disdain for individual holdings and the transition to an ETF based portfolio. In short, the choice was due to my poor behavioural tendencies in volatile markets, a lack of investing edge and therefore, an inability to consistently outperform the market. The odds are stacked against most investors. Spending time trying to pick the winners just isn’t a game I wish to play anymore.
But here is my confession: I currently hold shares in one company. I’m not going to mention its name to avoid a shameless plug or derail the focus of this article.
My investment thesis was based on a solid understanding of the business, its market position, as well as the role it would play in my portfolio. As a bonus, leveraging Morningstar’s equity research material allowed me to invest with a significant margin of safety. Admittedly, this was an incredibly time consuming process that I probably won’t undertake again. Thus, it takes its place as the only individual holding in my portfolio.
Zooming out for the larger picture, broad-based ETFs form the core component of my portfolio, whilst I consider my individual holding as somewhat of a satellite exposure. The returns from my core holdings are the definition of accepting the average (or the market) and I am largely okay with this outcome. However, many young people don’t like the implication of being an ‘average’ investor and look elsewhere to generate excess returns. I don’t think this is entirely irrational, though it can encourage performance chasing.
It’s well documented that only a handful of companies generate significant returns whilst majority fall into the abyss. This success ratio is the main implication of building a portfolio of individual equity holdings. But that’s not to say funds don’t come with their own set of issues.
There are several strategies that claim they can consistently pick winners. From factor exposure to concentrated bets on thematics, deep value plays – the list goes on. Given I often discuss fund strategy, this week I figured I’d tilt my focus to companies and one of the attributes that may lead to success – the strong presence of a founder.
Although I didn’t set out to gain exposure to ‘the founder effect’, my only individual holding coincidentally exhibits this attribute. Intentional or not, it’s a lens worth exploring, especially in a market where it seems durable advantages are increasingly rare.
Why the fascination?
Founder-led companies can be loosely defined as businesses where the founder retains a significant stake and holds an executive position with the ability to influence long term strategy.
Conviction on such companies isn’t entirely new. A 2010 study suggested that entrepreneur-led companies derived superior returns when evaluating publicly traded US companies over a decade. This was further reinforced by research from Bain & Co that found S&P 500 companies where the founder remained deeply involved saw performance 3x better than the rest over the examined period (1990 to 2014).
It appears similar outcomes might ring true domestically. Australian fund manager, Blackwattle Investment Partners’, built a founder index (equal-weight portfolio of 50 ASX founder-led companies) which outperformed the ASX 300 by 18% a year in the decade to October 2024.
But what explains the superior performance? Blackwattle attributes this to an emphasis on long-term thinking, higher investment in innovation, risk tolerance, strategic decision-making and alignment.Given these qualities are difficult to quantify, they pose a challenge to traditional valuation approaches.
The founder effect
We all love a founder story. I often scroll past countless LinkedIn posts of self-proclaimed ‘visionaries’ and ‘disruptors’ leading the charge on media engagement.
Morningstar’s US team recently interviewed Lawrence Lam, managing director and founder of Lumenary Investment Management, as well as author of The Founder Effect. The book provides a clear framework for evaluating management teams by highlighting the traits that make great founders successful.
Lam outlines three ‘pillars’ of success that he has observed in successful founder-led companies. He intends these to be a framework for investors to objectively assess management teams.
- Judgement and decision making: The ability to make bold, high stakes calls that institutional owners may shy away from. Think Zukerberg rejecting Yahoo’s $1 billion offer in 2006 or Lego’s pivot from near bankruptcy. Decisions that might defy conventional wisdom.
- Alignment with investors: Ensuring the interests of the executives align with shareholders, given their significant equity stakes and view of the business as an extension of themselves. This can alleviate the pitfalls of bureaucracy that can plague other firms.
- Influence: The ability to shape internal culture and external perceptions. This pillar captures the intangible value of leadership. NVIDIA’s Jensen Huang is a great example of a founder who builds narratives far beyond the balance sheet.
Lam believes that understanding these three pillars is essential to separate the founders who flip companies from the ones who build dynasties.
Where to start
Founder-led investing isn’t a free-for-all situation. A large element still relies on making tactical allocations.
So how do we find quality found-led companies in a vast market? Lam chooses to look at the quantitative element first. He screens for companies with consistent earnings growth and conservative balance sheets. These financial traits often signal operational discipline and long term thinking, features Lam believes are prevalent in founder-led companies. From there he narrows this list down to determine the extent of founder involvement through share registers.
Finally comes the qualitative framework he discusses in his book. The key is determining whether the company has a strong market position, diversified customer and supply base, and a founder who is engaged in developing new products and services.
Notably, Lam warns that not all founder-led companies are created equal. Some operate in legacy industries – petrochemical products for example – and consequently whilst being financially sound, lack the dynamism needed to compound value over time.
One thing I can take away from this is that investors who wish to utilise this strategy have a considerable amount of due diligence ahead of them. Identifying founder-led companies with strong fundamentals is only the beginning. Whilst Lam’s strategy is one of many, he underscores the importance of a dynamic approach that understandably demands continuous evaluation.
Risks and red flags
But it isn’t all roses in the garden of founder led companies.
Most recently, two prominent ASX founders – Chris Ellison of Mineral Resources and Richard White’s WiseTech Global has been under fire after scrutiny over questionable personal dealings and flimsy corporate governance structures.
Many founders begin as passionate visionaries but may morph into flippers or become distracted by personal ambitions. Lam cites red flags like equity sell-downs, especially large ones, which may signal changing priorities and motivations.
Building on this this, excessive involvement in unrelated ventures may also be undesirable. He uses Elon Musk’s recent political ascent as an example, with investors reacting poorly to both his publicised personal convictions and diversion of focus away from Tesla as potential reasons to dump the stock (down 13% YTD).
Lam states that founders should have influence but not be the ‘main’ person in the company. Therefore, organisational structures that are bottlenecked by the founder aren’t ideal. Reliance on a single individual can create issues such as succession risk, limit scalability and stifle innovation.
Furthermore, unchecked power can lead to some of the problems we’ve seen on the ASX recently. Allegations of misconduct and the consequent handling of it like what we’ve seen at WiseTech, has arguably damaged investor confidence.
Lam suggests that investors may mitigate these risks by rotating companies when red flags emerge. Trimming profits and moving capital before the narrative catches up with the market is key.
Of course, diversification is also key, not just to build a basket of uncorrelated assets, but also to avoid overexposure to a single founder. The onus is on the investor to monitor equity movements, organisational changes or external engagements then determine whether they are worth taking action.
Concluding thoughts
I find myself with unintended satellite exposure to a prominent founder-led business. Its status wasn’t part of my original conviction, but it’s interesting to observe the effects it has had thus far.
However, like any strategy, this is not a silver bullet.
Investing in a handful of founder-led companies and crossing your fingers that they outperform is not the point that Lam (or anyone else with this conviction) is trying to make. As young investors we are often drawn to shiny things, be that innovation, megatrends or charismatic founders. But this strategy demands more than just enthusiasm, it requires several assertions that must hold true.
First, you must select the right founders and companies. As Lam states, this might be a mix between the qualitative and the quantitative. Second, you need a deep understanding of the founder’s motivation and how it evolves overtime. This requires constantly vigilance. Thirdly, you must have the stomach to adapt when red flags emerge, sometimes against broader market conviction.
Perhaps you hold a founder-led company in your portfolio or are looking for a new strategy for success. Ultimately, I’d say this approach should be reserved for those willing to do the work. It’s more than just being an Elon Musk loyalist – it’s about understanding motivations and consequent impact. Something that isn’t just difficult, but also elusive and ever changing.
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On the topic of great books, my colleagues Mark LaMonica and Shani Jayamanne have co-authored their own - Invest Your Way, which serves as a guide to successful investing with actionable insights and practical applications.
You can pre-order a copy on Amazon or at Booktopia today.
