Google’s 2 Share Classes Benefit All

Companies do better when founders control the lion's share of corporate voting power.

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ETF specialist
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Reviewed by: Boris Valentinov
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Edited by: Boris Valentinov

Companies do better when founders control the lion's share of corporate voting power.

Google's act of issuing a new class of nonvoting C-shares and thus preserving the founders' control of the company has generated a lot of heated arguments.

One thing is clear—this isn't an isolated incident. To the contrary, it's emerging as a trend among even the largest publicly traded companies. So much so that the S&P indexing committee is changing its methodology to accommodate these developments.

My colleague Paul Britt wrote an excellent blog on the subject of Google's new share class, lamenting that it had created what he cleverly called the "S&P 501 Index," as Google now has two share classes that are part of the benchmark.

I agree with Paul's points on corporate governance and shareholder representation in general that one share-one vote is a compelling ideal. But I also believe there are compelling reasons why founders who still run their companies should retain control of them for as long as possible.

To start with, let's take a look at the historical data. In 2004, there were 27 Fortune 500 companies that had a founder at the helm of the company who also had significant ownership control. The table below shows their market value in 2004, and again 10 years later.

Market Value in $MM
Company Name1/01/20041/01/2014
Amazon21,105182,540
Apple7,858504,771
Berkley (W.R.)2,9175,860
Berkshire Hathaway129,451292,396
Capital One Financial14,15344,170
CarMax3,20510,501
Cardinal Health16,0233,520
Charles Schwab16,06233,520
Chesapeake Energy2,94018,051
Costco17,02452,336
Countrywide Financial13,9654,335
EchoStar Comm6,47626,450
FedEx20,14144,889
Genworth Financial13,2187,676
Kinder Morgan9,19135,315
Liberty Media9,17018,677
L-3 Communications4,9719,471
Limited Brands9,31617,954
News Corp47,91190,188
Oracle69,161172,071
Performance Food Group1,6571,250
Sanmina-SCI6,5181,407
Sonic Automotive9401,290
Sun Microsystems14,6025,700
Toll Brothers2,9056,559
Triad Hospitals23,72531,381
Whole Foods Market4,05021,521
Return
Cap-Weighted Portfolio509,1111,663,091327%
S&P 500 Index1,1121,663,091166%

Source: Bloomberg

Notice that Google isn't included because it had just gone public and it was not a Fortune 500 company yet. But as an additional point of reference: Its shares have risen more than tenfold from its initial public offering price in 2004.

You'll also notice that there were a few bad apples in there—most importantly Countrywide Financial, whose founder Angelo Mozilo defrauded investors. The company was acquired by Bank of America in 2008.

Other companies that spiraled down and were ultimately acquired were Sun Microsystems (bought by Oracle) and Performance Foods (bought by a consortium led by BlackRock). I've used the purchase price that shareholders received as a final valuation in all three cases.

Despite some individual failures, the group of owner-controlled firms as a whole did quite well. If you had invested in a cap-weighted portfolio of these companies, you would have tripled your money over the period—beating the S&P 500 Index by a factor of 2.

What economic rational might lie behind this amazing outperformance?

 

First, let's admit there are a lot of outside influences that can interfere with the optimal way to run a company and with the ability to create long-term shareholder value.

There are activist investors who gain influence by accumulating positions in a stock. They usually end up pressuring companies to embark on strategies that elevate the stock price—often just temporarily—without much regard for long-term consequences.

They make all kinds of demands that benefit just shareholders who aren't in it for the long haul, leaving long-term shareholders holding a depleted bag. Among those unwise demands are:

  • Buybacks, even if the current stock price is above the estimated intrinsic value of the business
  • Dividend payments, even if those payouts need to be funded with borrowed money
  • Spinoffs of crown-jewel divisions, even if those businesses are essential to the future of the company.

Again, all these benefit shareholders who are exiting—activist investors included—but hurt the ones that stay behind.

Yet it's not just activist investors who are short-sighted.

The U.S. stock market as a whole has become more and more short-term-focused, and chief executive officers are now routinely held accountable on a quarterly basis for reaching and exceeding preset targets. To keep their jobs, they have to please Wall Street by maximizing profits now at the expense of investing in the future of their companies.

Contrast this with founders/CEOs who are more secure in their positions and can afford to take a long-term visionary approach to running their businesses. They're better able to provide leadership and make decisions that might be unpopular at a given moment but that will end up benefiting their companies over the long haul.

In an ideal world, that's exactly what all shareholders would want anyway. But sadly, that's not the case at all. The average holding period for a stock in the U.S. stock market today is less than five months.

Of course, the flip side of this independence is that shareholders need to trust the CEO's intentions, as they would lack the ability to discipline CEOs directly. How can they be sure that the people running the company have their best interests at heart?

Aligning the actions of a company's management with the interest of the owners—something called the "agency problem" in economics—is a thorny issue for large widely held corporations. Nowadays, the most common solution to this problem is to grant senior executives, especially the CEO, huge amounts of stock options.

What a flawed way to measure and reward management's performance!

Since options have no downside and unlimited upside, they tempt CEOs to manipulate earnings and execute strategies that temporarily inflate the stock to take advantage of those option grants. They present a strong incentive for taking short-term risks that might lead to a quick burst in earnings but that can lead to ignoring meaningful longer-term investment opportunities.

In the case of founders/CEOs, the "agency problem" is made much easier by the fact they already are a large if not the largest shareholder. Their interests are naturally in sync with the rest of the owners.

My colleague Paul Britt aptly compares this arrangement to a limited partnership, such as a private equity fund, where "the general partner runs things and the silent partners hop on for the ride."

The main reason silent partners are willing to give up control is that general partners put up a sizable chunk of their own capital, and so general partners stand to lose or gain depending on the fund's performance.

It's why smart institutional investors don't often invest in a hedge fund unless the hot shots running it keep most of their net worth in the fund.

The simple truth is this: Knowing that the people running the show have their own money on the line provides more peace of mind than the ability to micromanage.

Yes, it is an old-fashioned way of doing business, and it's not always possible in the context of a large publicly traded company. But when the situation exists, we should embrace it instead of fretting that shareholders' voices are being suppressed.

Let's face it—voting power is so dispersed these days that most individual votes don't even get exercised. Sure, some large fund issuers like Vanguard and BlackRock do a decent job consolidating and voting on behalf of their owners, but even they don't have the resources to analyze and keep on top of all the companies they hold. And when they do, it's usually just rubber-stamping.

In the end, the ultimate power shareholders have lies with their willingness to be an owner and with how much they would pay for the privilege. They can and do vote with their wallets. The message they send in the process is likely to be a powerful one for the founder/CEO whose fortune is still invested in the company.

So, here's to Google continuing to make oodles of money for all its owners, despite its being a dictatorship at the top.

I'm even looking forward to future ETFs that screen for companies run and controlled by their founders and then build a portfolio around that simple idea.


Contact Boris Valentinov at [email protected].

 

Boris Valentinov is an ETF specialist at etf.com. He focuses on equity, currency and European-domiciled ETFs. Boris' previous experience includes a number of positions at various businesses within GE Capital. There, he analyzed corporate financial statements, evaluated market opportunities and developed business strategies in support of M&A activities and other investment decisions. Boris holds a B.A. in economics from Hamilton College, an M.S. in financial analysis from the University of San Francisco, and is a 2015 Level III candidate in the CFA program.