US INVESTMENTS: Follow the founder-owner

After a formidable year in 2012, the United States stock market is likely to be a popular focus for investors in coming months. Some say it pays to invest in small caps, particularly those owned by their founders. George Mitton reports.

The S&P 500 rose more than 16% last year and has continued its good performance into 2013, rising more than 5% in January.

The returns for the popular US stock market index left many other asset classes lagging. Eurekahedge, a provider of data on alternative investments, says its index of hedge funds rose a mere 6% during 2012.

But is the S&P 500, Standard & Poor’s venerable index of the top 500 publicly traded American stocks, the best way to access the US stock market?

The Russell 2000, an index of small cap stocks that together account for 10% of US stock market capitalisation, is a popular way to gain exposure to small companies. The Russell 2000 produced almost exactly the same return as the S&P 500 in 2012, but its ten-year average return is better at nearly 10%.

“The best long-term average has been the Russell 2000 over the past ten or 20 years,” says Russell Cleveland, who manages the RENN Universal Growth Trust. “You make more money in smaller, growing companies than in the Dow or the S&P 500.”

There is a simple rationale behind investing in small companies: growth potential. The large caps in the top 500 are established entities with all the baggage that brings – large payrolls, large fixed costs in terms of production capacity, machinery and office space. Though many of these companies succeed in pleasing their shareholders by increasing earnings over time, they rarely demonstrate the kind of explosive growth that gets investors’ mouths watering.

There is little hope, with a large cap, of buying shares at $3 (€2.2) in 1997 and the price rising to $600 in 2012, as happened to Apple – though the technology company’s share price has since fallen.

Investment literature abounds with examples of spectacular small cap growth. If you had bought ten stocks in Walmart when the company went public in 1970 your investment would now be worth about $1.5 million. Of course, it is no easy challenge to identify the future winners. The hope is that an index such as the Russell 2000 will capture the performance of the few stocks that succeed.

Cleveland has a theory that claims partly to explain why small cap stocks often outperform larger ones. His view is that companies that are substantially owned and controlled by their founders perform better than other companies.

Some large companies fit this description, such as Warren Buffett’s Berkshire Hathaway, or Oracle, whose chief executive Larry Ellison owns a large stake. But the founder-owner is more closely associated with small companies.

Cleveland is particularly keen on internet companies, which “can grow rapidly with very little capital” though, he says, he is also invested in medical technology firms.

But why should founder-owned companies perform better than firms with professional and, in many cases, highly-paid chief executives?

Cleveland says founder-owned companies are more conservative, less likely to take on debt and better at planning for the long term.

Whereas professional managers tend to focus on producing good results on a quarterly basis, founder-owners plan years ahead. And, of course, the interests of founder owners are neatly aligned with those of shareholders – not always the case with high-flying chief executive officers.

“If you’re an owner, you treat things differently from a professional manager,” he says. “I’m not saying there aren’t good professional managers. I’m just saying if you’re in investing and you want to get the best returns, you want people allied with your interest.

“Warren Buffett’s salary is only $100,000, but he’s the second wealthiest man in America. He makes all his money on the stock.”

Cleveland’s company has created an index of companies that are founder-owned. The index’s biggest constituents include Amazon, whose founder Jeff Bezos owns about a fifth of the company, and Nike, in which founder Phil Knight holds a large share.

Had the index been around for the past ten years, its performance would have been impressive, says Cleveland. For the ten years up to January 11, cumulative back-dated returns for the index were 228%.

©2013 funds europe



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