They must eat their own cooking
Investors should educate themselves about dual-class shares. In this post I’ll look at what they are and the pro’s and con’s from an investor’s point of view.
What are dual-class shares?
Some companies have two or even more classes of common stock. This structure gives certain shareholders voting control of the company unequal to the amount of equity they hold in the company. An example would be one class of shares that carries one vote per share and another that carries ten votes per share. Well known examples today would be Facebook, Alphabet, and Alibaba which each have dual-class-shares.
The structure is typically used by company founders who want tap the stock market for equity financing but who are reluctant to give up control of their company.
Arguments pro and con
The main argument in favour of dual-class shares is that they allow the founder to pursue their long term vision for the company without having to worry about Wall Street’s preoccupation with short term results. The main argument against is that they allow families and insiders to maintain control of a company without adequate accountability to all the rest of the shareholders who have the largest equity stake in the company.
An article in the Harvard Business review in 2018 noted that “One-fifth of companies that listed on U.S. stock exchanges in 2017 had dual-class shares.” It surveys the arguments about whether dual-class shares should be banned. See here.
Some investors hate them
The most vocal opponents of dual-class shares are institutional investors. In the U.S. the charge is led by the the Council of Institutional Investors. In a recent article in Canada the head of a very large institutional investor wrote an opinion piece titled: “Dual-class share structures always end in tears”. The article railed that the rule should be ‘one share, one vote’. Since institutions hold the most shares, they should have the most votes. I have little sympathy with this view, as I will explain.
The other group pressing the abolition of dual-class shares are the so-called “activist” hedge funds. Their raison d’etre is to push and shove boards and management of companies to do things to quickly boost share prices. I have little in common with activist shareholders.
In Canada, most dual-class companies have a “coattail” provision in their by-laws that ensures that in the event of a take-over at a premium all shareholder classes benefit equally. As I understand it, this provision is rare in the U.S.
Why I like dual-class shares
In a speech given on July 20, 1982 at a Financial Analysts Workshop, John Templeton noted that in the long run, shares of companies in which management owns a large stake generally will out-perform the others.
When you look at the list of companies that don’t have dual-class shares, all too many of them have boards or management without ‘a large stake’. In fact many mature companies are run by an old boys club.
It is distressing how often it seems the board of directors are simply ‘yes’ men effectively appointed by management. These ‘yes’ men attend a few meetings and receive a variety of fees, options and share units and in turn have to approve the compensation package of the management who appointed them. It is cronyism in action.
Stephen Jarislowsky (for 40 years the dean of Canadian money managers) writes: “The function of a board is to look after shareholders’ interests by assuring that a company has a sound executive and operates effectively and ethically so as to produce the best long-term results. The board must look after every shareholder even-handedly, and each director, no matter what group may have installed him, should also look after all shareholders alike, big or small. But I have served on boards where the shareholder was rarely mentioned. The board, made up mainly of friends (cronies) of management, was normally there to do no more than rubber stamp the decisions of management, and the participation of many of the directors was pretty negligible.” (Jarislowsky, The Investment Zoo: Taming the Bulls and Bears. 2005) p62.
It’s not that dual-class share companies are magically good. It’s that institutions often own companies where the board and management together own less than one percent of the outstanding common shares. These companies are rife with agency problems.
One key reason to check alignment of interest is that management compensation is generally a one way bet. We are forever told that a major component of compensation is long term incentives. This is baloney. If the company does well over the long haul, management scores big time. If the company fails, management lose nothing. All those deferred share units and options may become worthless if the company flounders but, they never had any value on day one in any event. What I like to see is a CEO with a very large holding of common shares that can lose value just like mine if the company does poorly. This will discourage management from using company capital to plunge into some big investment with hopes of a big score.
In 1776, Adam Smith wrote in the Wealth of Nations about joint stock companies:’
“The directors of such companies…being the managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
Alignment of interest
As for Berkshire Hathaway, Buffett says: “In line with Berkshire’s owner orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.” (Buffett, 1998, p.30)
In the cohort of dual-class companies I can find companies where the directors have the major portion of their net worth invested in the company.
Each situation is different
One should not blindly tally up the shareholding of management. For example, the chairman of the board may be the founder of the company. He may have stepped back from running the company and chosen a successor who is steadily building up his shareholding. In this case there is probably a suitable alignment of interests.
A slightly different case is next generation companies where the children of a founder control or have a major shareholding and serve on the board. These companies seldom fit the bill. They may be managed in an institutional fashion to serve the interests of the children of the founder.
One last thought
MSCI analysis shows unequal voting stocks outperformed the market over the period from November 2007 to August 2017. I’m not sure how much weight I would put on these statistics. It is possible that the study is distorted by FAANG and other tech stocks. This is shown in the following chart. The article can be read here.
Multiply voting shares require careful thought. Many investors shy away from these companies as they feel they may be managed to serve the interests of the controlling shareholder. The writer has never been especially bothered by multiple voting shares. But each situation needs to be examined on its own merits.
Institutional investors and activist investors have their own axe to grind. I have good luck finding the kind of companies I like to invest in amongst the ranks of those with dual-class shares. As for one share, one vote, I have the ultimate voting power with my small shareholding in any company. I can vote with my feet.
Other posts on finding great companies to invest in
To did more deeply into choosing common stocks check out the Motherlode Part 6: The Hallmarks of Superb Businesses
That part contains the following chapters:
31. General Approach to Choosing Common Stocks
32. Sectors and Company Attributes to Avoid
33. Thoughts about the Different Sectors and Groupings
34. Bottom Up and Various Qualities
35. Capital Structure, Strength and Economic Performance
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