This hidden indicator seems to show stunning outperformance

In a recent Sleuth , I pointed out a few things we can look for to see if a company is well-governed. But my overall conclusion was that there’s no simple formula.

… I may have spoken too soon.

Recently, I’ve discovered that quoted companies with above-average levels of employee ownership have outperformed significantly over a long period. I thought I knew about every index under the sun, but the FTSE Employee Ownership Index (EOI) is a new one to me. The index tracks about 70 UK companies where employees own more than 3% of the shares.

The results are surprising. For instance, last year the UK All Share Index returned 20.8% including dividends. But the EOI produced a stunning 53.3% return! And 2013 wasn’t a flash in the pan. Since the end of 2002, the EOI return of 439% compares with 150% from the FTSE All Share. If we go back another ten years to 1992 when the index was started in a different guise, it’s claimed there’s a 14% per annum outperformance. This is a staggering number – given the power of compound interest, it implies that you would have earned roughly 12 times the return of the All Share over the last 21 years.

Sounds like nonsense? Well look at the Christmas results from the high street. Two of the best performers are EOI-member Next, which reported terrific results today; and John Lewis, owned by a trust on behalf of employees, is on a sustained good run too.

For growth, bring employees to the boardroom

Employee-ownership makes sense. Owner-workers are likely to contribute more in terms of ideas and effort. They should be better informed about the business and have a more complete picture of what the company is trying to do. Co-ownership needs to go deeper than employees having a few shares; they need to be fully engaged with the business. Ideally, the stocks in the EOI have adopted this culture of mutual respect.

The policy also fosters an atmosphere of shared responsibility. I’ve heard examples of workers telling absentee colleagues that they’re letting the side down. That’s bound to be a better motivator than a telling-off from management.

The EOI is not perfect though. There might well be issues about the robustness of the methodology behind it. Also the EOI’s two starting points of 1992 and 2002 are flattering since they marked significant lows in small-stock valuations. However, even if we have a healthy scepticism about the scale of these numbers, there does seem to be a seriously material effect going on.

We can explain some of it through size. The EOI is biased towards smaller companies, which have outperformed in the long term as well as in 2013. Of course, this is an effect I’m also looking to exploit in Red Hot Penny Shares! The sector bias has also helped. The EOI isn’t bogged down by big oils and banks or by ex-growth pharma and telecom majors in the way FTSE100 is. Almost half the EOI is in support services and financials with a good smattering of tech. But being in good sectors is only going to take us so far; it looks like the EOI has picked a lot of great individual stocks.

I definitely think it’s worth paying attention to employee ownership. It’s a measurable item, which sheds light on something which can be very hard to quantify – a company’s culture. The members of the EOI aren’t disclosed in full, but examples of larger companies include Next, Aberdeen Asset Management, Mitie, Admiral, Atkins and newly-floated Royal Mail. I’m going to be asking all the companies I talk to about their levels of employee ownership and engagement.

They’ve build a new fund on this idea

This interest in employee-ownership has culminated in the launch of an investment company – Capital for Colleagues. Its aim is to invest in privately-held businesses where there is a “meaningful level” of ownership amongst the workforce.

Co-ownership can take different forms. Directly through share schemes, or indirectly through employee share trusts. What’s important for CEO John Eckersley is that the scale of ownership is meaningful and open to all workers. Then there’s the important point about engagement – management have to treat their co-owners as just that, fellow shareholders in the business.

The Capital for Colleagues fund will be looking for private companies with these characteristics. As well as being a sympathetic investor, Eckersley thinks he can fill a gap in the market for funding. Traditional private equity has a limited time horizon.This doesn’t lend itself well to the employee ownership model which needs a truly long-term horizon.

Capital for Colleagues is a small £2m closed-end fund, which won’t have these constraints. It’s just listed on the ISDX market. I’ll certainly be interested in seeing if its returns emulate those breath-taking Employee Ownership Index numbers quoted above.