Where to find and how to invest in founder-managed firms

published 2 May 2019

945_MW_P28_Analysis — Reed Hastings has overseen a 28-fold increase in Netflix's shares since its flotation

Companies that are set up and then run by the same person for a long time tend to be lucrative investments. Dr Mike Tubbs explains why, how to find them, and which ones to buy now.

Amazon, Berkshire Hathaway, Dyson, Facebook, Netflix and Virgin Group all have one thing in common. They are market leaders that have been managed by their founders since their inception. But not all founders have the ability to lead their companies and grow them into global giants. That's because founders capable of long-term success not only need an excellent initial business concept or product idea, but also the talent and foresight to grow the company and bring in the high-quality staff capable of managing a large operation.

When it goes right, however, it bodes very well for investors. Surveys have shown that founder-managed firms outperform on shareholder returns. For example, a study by Bain & Company in 2014 showed that founder-managed companies in America's S&P 500 delivered nearly three times the total shareholder returns of other companies over the period 1990-2014. Credit Suisse, taking a global view, found that founder-owned or family-owned firms generated higher margins and outperformed other companies by more than a factor of two from 2006 to 2018.

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A brief look at some founder-managed success stories shows what compelling investments they can be. Amazon was founded by Jeff Bezos in his garage in 1994 and floated in 1997 at a share price of $1.96. The share price has risen to $2,000, turning an initial investment of $5,000 into $5m in 21 years. Warren Buffett's listed investment company, Berkshire Hathaway, started out as a failing textile company. Buffett took it over in 1964 when the share price was $19; it reached $335,600 in October 2018, giving early shareholders a gain of more than 17,600 times.

Netflix was set up in 1997 by Reed Hastings, renting physical DVDs over the internet. Its initial public offering (IPO) took place in 2002 and it launched its streaming service in 2007. By 2017 Netflix's total number of US subscribers equalled the sum of all cable company subscribers. Reed Hastings remains CEO. The share price rose by a factor of 28 from the IPO in 2002 to a peak of $418 in 2018. Finally, Abcam was founded in 1998 by Jonathan Milner, a biotech researcher at Cambridge, who decided to do something about the poor quality of antibodies (proteins used to diagnose diseases) by founding Abcam. Abcam became "the Amazon of antibodies", a supplier of a wide range of top-quality antibodies through a global website backed up by excellent customer service. The shares have jumped by a factor of 36 in 14 years.

Successful founder-managed companies behave differently from most others. The major difference is their long-term focus. They emphasise organic growth (rather than growing by taking over other firms), while another hallmark is higher research and development (R&D) intensity (R&D as a percentage of sales). They tend to plough earnings back into the business rather than return it to shareholders in the form of dividends and share buybacks. They tend to have little or no debt. Their long-term focus is evident in the ever-expanding product ranges of Amazon and Abcam and in Netflix's massive investments in proprietary content to attract more subscribers. Warren Buffett of Berkshire Hathaway is famous for investing in companies that have competitive "moats" advantages underpinning high margins that are difficult for competitors to erode.

The other key factor is the big stake founders normally have in their businesses. Their own personal wealth is in it, grows with it, and is at risk should it falter. Investors are comfortable knowing their interests are closely aligned with those of the founder-manager. Where the founder-manager controls more than 50% of the equity, City investors cannot demand that money be diverted from long-term growth to increase short-term profits, dividends and buybacks. A good example is high-precision measuring equipment maker Renishaw, where founder and executive chairman Sir David McMurtry and his co-founder control slightly more than 50% of the shares. And Renishaw invests in R&D nearly three times the percentage of sales of the average company in its sector.

Sometimes founders are frauds. Investors should check carefully to ensure there are no indications of dodgy dealings in their past. A recent example is Telit, the internet-of-things (IoT) company, set up by Oozi Cats, who had been its boss since 2000. In 2017 it became clear that Oozi Cats was, in fact, Uzi Katz who had been indicted by a Boston court over wire fraud, but had left the US before the court hearing. Telit's shares crashed from 372p in April 2017 to 113p in August. The opposite situation occurs when a founder leaves, the company declines but is reinvigorated by the founder's return Steve Jobs and Apple is the classic example.

This suggests two general investment approaches. The first is to track successful profitable private companies likely to move to an IPO in the next year or so and to invest soon after the IPO. This approach is riskier than the second option of selecting profitable listed founder-managed companies that are leaders (or close to being leaders) in their niches and where there is plenty of room for growth. Room for growth means either that the market is growing fast, or that there are good reasons why the company will increase market share, or preferably both. I suggest investors consider the following eight examples of successful founder-managed companies in six different sectors. Their annualised returns over the last ten years range from 20% to 37%, and there should be plenty of scope for further gains.

Amazon (Nasdaq: AMZN) stands out as the largest with 2018 sales of $233bn, up from $89bn in 2014. That's incredibly fast growth for one of the largest companies in the world. Amazon is estimated to have around 50% of the US e-commerce market. Amazon's growth is driven by expansion of the online market at the expense of the high street, its entry into further retail sectors, and its increasing online market share. A much smaller example is Abcam (Aim: ABC) with 2018 turnover of £233m. It believes it can double its scale between 2016 and 2023 as its market and its share of the market expands.

Another larger example is Salesforce.com (NYSE: CRM), a software company with sales of $13bn. It pioneered software-as-a-service (updating other firms' software online rather than selling them discs) and is top of its sector, known as customer relationship management. In 2017 it increased its market share by more percentage points than the rest of the top 20 customer relationship management vendors combined.

Precision-instruments manufacturer Renishaw (LSE: RSW) is a global leader in metrology with a long record of growth. Earnings-per-share (EPS) more than doubled from 2014 to 2018. Renishaw's chairman David McMurtry bought Renishaw with 3i in 1995, currently has a 33% shareholding (the largest), and steered the company through to list on Aim in 2005. He is therefore the effective founder of the current listed company.

Highly qualified (BSc PhD CPhys FInstP MIoD) expert in R&D management, business improvement and investment analysis, Dr Mike Tubbs worked for decades on the 'inside' of corporate giants such as Xerox, Battelle and Lucas. Working in the research and development departments, he learnt what became the key to his investing; knowledge which gave him a unique perspective on the stock markets.

Dr Tubbs went on to create the R&D Scorecard which was presented annually to the Department of Trade & Industry and the European Commission. It was a guide for European businesses on how to improve prospects using correctly applied research and development. He has been a contributor to MoneyWeek for many years, with a particular focus on R&D-driven growth companies.