The critical perspective investors may be missing when making investment decisions. The article below highlights a key thematic that investors often overlook: the importance of executives having Skin in the Game. In order to complete a new pedestrian bridge in the twenty-first century, there is a gamut of testing and analysis at every stage of the process. There are various regulations, architectural design evaluations, construction codes, inspections and incremental safety testing...the list goes on. The reasons for such a rigorous process are obvious - no one wants a pedestrian bridge to be at risk of failure, and, most certainly, nobody wishes to be blamed if the bridge were to collapse. What’s interesting is how the onus was incentivised historically. Nassim Taleb in his book 'Skin in the Game', offers an example: Ancient Roman engineers had to spend time every year sleeping under the bridges they designed. It is not hard to imagine their due diligence in conceiving a new bridge as their skin was (literally) in the game, and they are therefore incentivised to make the bridge as safe as possible. I bring this example to the attention of investors because it highlights a crucial concept: the oft-overlooked and incredible importance of being invested with a leader or management team with skin in the game. Family and sole-owner businesses are all around us. From cafes to web domain providers to architecture firms, there is an abundance of companies likely run and owned by the founder or a small group of people in most investors' immediate environment. I prefer to call such companies owner-operators; they own and manage the business simultaneously. These owners have a heartfelt passion for their business. They are not afraid of working outside regular office hours – they are not working for the salary. The theory behind investing alongside owner-operators is that it ensures that people who run a company also have a direct interest in running it well. When someone has a significant portion of their net worth invested in a company, they want the company to perform at a high level to generate returns for a long time. Like Charlie Munger says, “show me the incentive and I'll show you the outcome”. Having skin in the game is different from having performance-based bonuses and other types of compensation because there will be direct consequences if the value of the company's stock drops; people will actually lose money if their company does not perform. The real risk-takers are the owners, and you want to ensure the managers face the same risks as you. What’s interesting is that research shows that owner-operator companies collectively outperform the market — by a lot. One 2012 study found that owner-operator billionaires crushed stock market indices by 7% a year; the authors suggest that investors could outperform simply by investing alongside these owners. It isn’t a big mystery why. Owner-operators have their own capital at risk, which isn’t common among public companies. They move more aggressively and generate more revenue growth. Additionally, It is consistently evident that owner-operator and family ownership are naturally fitted to long-term decision-making. If anyone can resist the bait of short-termism, it would be a family. Owner-operators care about the long-term value of their business, not the share price next quarter. They care about the cash the business can generate, not the accounting earnings. They are answerable to themselves rather than to “Wall Street”, so they are willing to take non-conventional, daring actions and may require short-term pain in exchange for long-term gain. Signs for Skin in the Game when searching for investmentsFinding an owner-operator might help add conviction to a potential investment beyond evaluating its business fundamentals. Here are some simple, surface-level checks anyone could do when screening potential investments: Is the founder still involved? A founder being involved does not automatically make a company bulletproof. However, founders often view their creations as an extension of themselves. They want to create lasting, meaningful value. Do insiders have skin in the game? This information is easily found on websites or software like Morningstar and Simply Wall Street. By "insiders", this generally means board members and executives. It is good to see insiders owning a respectable amount, buying on market and having conviction in their own company. Do employees like being there? Lastly, it is positive to see if employees enjoy the company they work for. In the end, these are the people who make things happen. By using Seek and Glassdoor -- a website that compiles anonymous ratings from current and former employees --, anyone can gain a little insight into how employees feel about the business. Unfortunately, this method is not fool-proof as ratings can be gamed. Still, it should provide interesting reading and could raise a red flag if staff retention or ratings are very poor. Bottom LineThere are many, many hard-working, dedicated CEOs who do not own significant stakes in the businesses they manage. But the owner-operator starts with a massive advantage because their incentives are not to meet the short-term demands of their employer but to drive the company's long-term value. So while all owner-operators do not build outstanding businesses, many outstanding businesses were built by owner-operators. Finally, it is remarkable how many great businesses were dismissed as being “crazy” ideas early in their history. These ideas can only be brought to fruition by someone who is deeply, personally invested in its outcome. Primary examples are; Steve Jobs at Apple, Jeff Bezos at Amazon, and Warren Buffett at Berkshire Hathaway. It is tough to compete against these types of individuals, and it’s hard (if not impossible) for an unaffiliated career manager to match the same level of intensity that these founders bring to the table.
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