Dual-class shares –good or bad for investors?

Superb companies

They must eat their own cooking

This is a revised version of a post first published October 30, 2021. I was stimulated to write this revision when I was reading the annual report of a company I’ve owned shares in for some ten years. The controlling family holds 95% of voting rights and I hold none. I’ve done well. See >>>Revision below.

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.

Coattail provisions

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.

>>>Revision: For fun, I thought I would ask Google’s AI mode, which uses the Gemini model, the question: What are the pros and cons for investors of non-voting shares in public companies? The AI response gave nine bullet points that didn’t contain the key insights of my October 30, 2021 post.

Let me review the nine Google AI mode points. On the plus side: 1. Lower purchase price. AI suggests non-voting shares can be purchased at a very slight discount to voting share. 2. Higher dividend yields. AI suggests some companies have a slightly higher dividend for non-voting shares. 3. Long term vision. AI suggests founders or controlling shareholders can pursue long term goals without hindrance. 4.Participation rights. AI suggests that under circumstances that might adversely affect non-voting shareholders rights, they may have opportunity to vote.

On the negative side: 5. Zero influence. 6. Management entrenchment. 7. Lower liquidity. 8. Takeover discount. This is the situation where controlling shareholders can sell in a takeover at a premium. But, in Canada at least many companies have coattail provisions to equalize this. 9. Reduced oversight

My main reason

There is no reason for me to repeat what is written below. Suffice it to say that dual class shares almost always lead to a good alignment of interest between the non-voting shareholders and the controlling shareholders. For me this is the critical feature. In many ways I prefer non-voting shares or limited-voting shares.

Let me give the example of CCL.B TSX – CCL Industries Inc., whose annual report I have just finished reading.                                                              

CCL is the world’s largest converter of pressure sensitive and specialty extruded film materials; the world’s largest supplier of labels; a leading creator and producer of RF and RFID tech for inventory accuracy; and a leading producer of surface engineered films. It employs more than 26,000 people operating over 214 production facilities in 42 countries with corporate offices in Toronto, Canada. The founding family controls the company with 95% of voting shares. Two family members are on the board but are not officers. Between them their shares are worth over $2B CAD. The current President and CEO is not a family member. He has steered the company through solid growth over the last two decades and holds almost $100 CAD million of non-voting (yes, non-voting) common shares and units. Market cap $13.7B CAD. Most board members are less than 60 years of age and three are women. I have held the shares for about ten years.

What I like is that the controlling family and the President and CEO have major skins in the game. As for voting, I can easily vote with my feet if I feel the company is losing its way.

What I hate about many companies without controlling shareholders is that a coterie of the old boys’ network is ‘appointed’ to the board by the president. They owe the president for their cushy remunerative role and happily approve stupendous pay packages for the president regardless of how the company is doing.

Here’s how CCL.B has been doing the last ten years. I am happily remaining a shareholder. I might add that the shares may be overpriced at present. Buy them at your peril.

End Revision<<<

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.

Conclusion

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.

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Other posts on finding great companies to invest in

How to identify great companies to invest in – Part l

How to identify great companies to invest in – Part ll

How to identify great companies to invest in – Part lll

How to identify companies that make lots of money for shareholders

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