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Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.
About ten years ago, dual-class share structures were getting a lot of negative attention in Canada due to governance issues surrounding their structure. More recently, Canadian markets have seen dual-class share structures pop up in high profile names like Shopify and Cara Operations. So why the silence and why the renewed interest in these structures by companies? We think the silence comes from the fact that dual-class share companies have actually been good performers over a long time frame and that the structure allows good management teams to drive the strategic direction of a company without the distractions from parties more concerned about short-term results. Before we dig further into this issue, let's examine what a dual-class share structure is and how it impacts an investor.
Dual-class shares refer to the ownership structure of a company, where one class of shares holds some sort of voting power over the other. This is typically in the form of super voting shares that have votes worth some multiple over the single vote shares. Holders of these shares are usually a closely held group of founders, executives or family members that are able to retain control over the direction of a company. A dual-class share structure essentially renders the voice of 'the people' worthless but with many investors not having a particular insight or inside knowledge of a business and management having a lot of skin in the game, this might not be such a bad thing.
One of the primary arguments against dual-class share structures that investors will hear is that it supports nepotism and allows families and friends that may not be qualified, or care about the company, to retain control and drive the direction of the company. This nepotism can also lead to the owners being more concerned about having and retaining power than making decisions that are in the best interests of the business. Adding to this issue, if it is a family business, there is likely a great deal of tradition, legacy and pride held by the owners. While investors should want management to feel pride and attachment to the business, when family is involved it can get to a point where decisions are made that benefit the few and not the many. One could argue that a sense of hubris would overtake a management team who is more concerned about the family legacy than the shareholders. Unfortunately, as long as a dual-class share structure is in place, not much can be done to replace the management team. This is the most legitimate concern over these structures in our view and while it could be a problem; these are more often the exception opposed to the rule simply due to the fact that markets will not invest in management teams that do not act in the best interest of the shareholders. Investors will talk with their money and 'reward' these conflicted management teams with a lower share price and valuation. If there were one thing that a management group like this would react to, it would be a lower share price and in turn a significantly lower net worth for the owners in question.
The other argument against a dual-class share structure is really just a corollary to the previous point and that is the issue that the general shareholder's voice is not heard. The common shareholders are at the mercy of the group in power and just going along for the ride, whether it is for better or worse. The Canada Pension Plan is well known for its policy of only investing in companies that follow a structure of one share and one vote. Policies like this can make sense when you have the clout that the CPP has but a restriction like this may unnecessarily restrict good investment opportunities for the retail investor.
Now that we have covered two significant drawbacks to dual-class shares, what could possibly be the benefit in this structure? The first benefit is that sometimes the management team might actually know better than the common shareholders and analysts. It is not a stretch to believe that a management team that spends ten hours a day, five days a week (at least) at work knows more than a third party that is investing in a company. If this is the case and the management team does know better, then why shouldn't they have the ability to drive the direction of a company without worrying about outside parties meddling in the long-term vision of a company? This long-term point of view leads to another big defense of dual-class share structures.
The investment industry is very well known for only thinking one quarter ahead. Forget about giving a company three to five years to execute on a long-term strategy. Sometimes neutralizing the ability of capital markets to influence a company can be the best medicine. If a company misses analyst estimates, the shares are punished. If they miss multiple estimates, markets begin to look for a sacrifice to appease the 'market'. The drawback here is obvious: If a company spends a large portion of time ensuring that they are meeting expectations every three months, they have no opportunity to plan and execute on a strategy that looks out say five or even ten years. Often times hard decisions need to be made at companies and while these decisions may be at the expense of short-term results, they are usually a necessary evil to ensure long-term competitiveness. A dual-class share structure can allow a management team to ignore the short-termism often seen in financial markets. As long as they hold the majority voting power, they do not need to worry about their jobs and can make the hard and often uncomfortable short-term decisions for the benefit of the long-term sustainability of a company.
The final argument in favour of a dual-class structure that we feel is worth mentioning will resonate more with a retail investor and it is simply that investors don't vote their shares in an 'active' manner. The whole point of holding common shares (over say a dual-class share) is that the investor gets a say in how the company is run. In reality, we would think that a high majority of retail investors do one of two things with their vote. They either receive a proxy statement and throw it in the garbage or they simply vote in accordance with the recommendations provided. This differs from an institutional or activist investor that may actually want to take a material position in a company in an effort to influence the strategy or direction of a company. Most retail investors just do not have the capital (or time) to have any influence on the way a company is run. We are not saying that the individual retail investor's vote does not matter, but when most of the proxy materials are cast into the garbage or just voted as suggested, it becomes more difficult to defend the argument that having each individual investors voice heard is of the utmost importance.
Whether dual-class shares are good or bad really comes down to the management team. If the management team or owners have a lot of skin in the game and a history of building successful companies and generating returns for the shareholders, then why not join in on the ride? Should a common shareholder be able to overrule true visionaries like an Elon Musk or stellar capital allocators like Warren Buffett or Harry Singleton? Yes, these are exceptional examples but it does not mean that there are not other great managers, founders, owners etc. that should be given some semblance of trust from shareholders. This does work both ways; as for every great manager there is likely an equally poor manager. Regardless, talk is cheap; lets see what the numbers actually say about this issue.
Taking an equal weighted basket of 24 companies with a dual-class structure and comparing it to the TSX over a five and ten-year period shows material outperformance for the dual-class 'index' we created. The basket of dual-class shares had a 3.7-per-cent ten-year annualized return compared to the TSX at 1.1 per cent. The dual-class share basket also returned 4.2 per cent annualized over five years compared to the TSX at -0.9 per cent. Admittedly, even we were surprised by the outperformance of these shares over these time periods. The two main contributors for this divergence could be the concentration in the basket of 24 dual-class stocks and a lack of energy exposure. With this increased concentration, more risk is taken on and more returns should be expected but this risk does work both ways and could have just as easily led to lower returns than the TSX. The lack of energy holdings in the list of dual-class shares does help but it is not without poor performers in the form of names such as Bombardier, Torstar and AGF Management. Another reason for the outperformance could very well be that over a longer time frame, giving good management teams the ability to run a business without concerns over meeting short-term expectations may lead to long-term shareholder value creation.
Obviously past performance of these companies does not mean they will continue to outperform in the future and the analysis does not mean that investors should only hold equities with a dual-class share structure. While the basket performed well over five and ten year periods, there were still poor performers within the basket. We do believe that the material outperformance of the dual-class basket does make a very strong case for holding these types of companies in a portfolio and in the least should give pause to investors that want to paint with a broad brush and ignore all companies with this share structure.
The basket of 24 dual-class securities:
|Fairfax Financial Holdings||FFH-T|
|Jean Coutu Group||PJC.A-T|
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