Those of us who favor shareholder democracy love to lament concentrated stock ownership by management because we feel it can entrench executives and make them lazy and unproductive. Thus it can lay the foundation for the tyranny of management.
But the dirty little secret is that concentrated ownership sometimes helps shareholders and our economy in a big way because it protects top managers from another tyranny: the tyranny of short-term investors.
The recent 30% pop in Facebook
(NASDAQ:FB) stock offers a great case study of this -- and a great lesson for investors on how to replicate these kinds of gains in stocks again and again, going forward. And so does the 62% move in Amazon
(NASDAQ:AMZN) stock since March 2012, and the 50% move in Google
(NASDAQ:GOOG) in the past year.
In each case, I suggested buying these stocks at those lower levels for a simple reason: At the time, investors were punishing the stocks for what seemed like the wrong reasons. They were selling because top managers were doing what they should be doing: They were investing for the future, even if this weighed a bit on earnings in the near term.
Because so many individual investors are focused on the short-term these days, their response to the shift by top managers hammered the stocks. And that alone made them a buy.
The key lesson for you as an investor: Whenever you see this happening, take the other side of the trade and buy the stock. You will most likely make a lot of money, as long as you can be a little patient. Let's look at Facebook and two other case studies for this strategy to see how it works.
At Facebook, CEO and co-founder Mark Zuckerberg controls about 57% of the voting shares of the company. This is cited as a risk by many, since theoretically, it gives Zuckerberg the power to be indifferent to shareholders. But it also gives Zuckerberg the power to look beyond the demands of short-term investors and spend money to make the company even stronger over the medium term.
Last April, for example, I wrote that Facebook was down over 20% from its January highs, trading below $25, in part because investors were disappointed in first-quarter earnings. They also hated cautionary language that implied that continued investment might weigh on earnings growth.
"We're doing what we think will build the best service and business over the long term," explained Zuckerberg in the conference call at the time. That seemed to make sense to me because it meant more money for servers and data centers to keep Facebook users happy. And more importantly, it meant more code writers to try to figure out how to make advertising work on Facebook pages, particularly on mobile phones.
The pay-off came in the second quarter. That seemed seemed too soon at first, but in fact, Facebook has been investing heavily in itself for a while. The upshot: Mobile ad revenue jumped to 41% of total revenue in the second quarter, compared to about 30% in the first quarter. And overall ad revenue advanced 61% to $1.6 billion. The stock went up over 30% in an instant to trade above $34, providing nice profits for anyone who bought below $25 in April or May.
"I think we're really starting to see the upside of some of the investments that we've been making," said Zuckerberg in the most recent conference call. No kidding. I think if you keep holding this stock, you will make much more over the next few years, because of the continued focus at this company on long-term reinvestment.
Amazon CEO Jeff Bezos has put tens of millions of dollars of his own money toward the prototype of a "forever clock" -- designed to last 10,000 years -- now being constructed within a remote Texas mountain. This is all you need to know to understand what Bezos thinks about long-term thinking.
But here's another clue: Over the years, he's regularly sacrificed earnings a bit in order to redeploy money into infrastructure like servers and data centers to keep customers happy and grow market share, and to develop new products and services like the Kindle and streaming video services. Bezos owns about 20% of Amazon shares, which probably helps him take the heat from short-term investors. Along the way, the sell-offs they've created in this stock -- like the decline to $192 in March 2012 -- have been great opportunities to get exposure to Amazon.
They won't be the last openings for buying because both Bezos' commitment to long-term thinking and the short-term thinking of so many investors won't be going away anytime soon. But Bezos' thinking has obviously paid off; the company just announced 22% sales growth, which helped push the stock over $310.
One of the knocks on Google when I suggested it under $600 back in May 2012, now at $885, was that it had "lost its focus" because it was using cash flow to invest in things like self-driving cars, computerized glasses, and green energy research -- all of which seem pretty distant from its core business of search.
This is part of the company's "healthy disregard for the impossible" ethos, which is something the company can get away with in part because of the concentrated ownership by management. Cofounders Larry Page and Sergey Brin and executive chairman Eric Schmidt together own about two-thirds of the voting rights in this company.
But projects that seem off topic at first at this company often go on to make a lot of sense -- like the Android operating system and the Chrome browser. Both are now major platforms for devices and the accumulation of knowledge about Web users, which are key to Google's advertising success. "With hindsight, Android and Chrome were no brainers. At the time, they were big bets," said Page in the most recent conference call.
Of course, not all companies with concentrated management ownership make for great bets. This capital structure can still make managers complacent and lazy. Judging by the common factors in the three case studies above, I'd offer the following checklist on what to look for in order to separate the good from the bad.
Are the founders still in charge?
If so, you probably still have managers with the original passion and fire that inspired them to create the company in the first place. That kind of drive doesn't necessarily get killed by success. Studies show that companies run by founders outperform.
Has revenue growth been strong?
Short-term investors tend to focus on the bottom line, which gets hit by investments for the long term. But to check the health of a company and judge management's track record, look at the top line. At each of these three companies, revenue growth has been impressive, which should have been a clue that managers probably knew what they were doing when deploying cash into long-term investments.
Are the shareholder activists on their case?
You don't see activists like Carl Icahn going after companies just because they are sacrificing earnings a bit for the long term, as long as sales growth and product development looks solid.
Do they have a plausible explanation for their investment plan?
With each of these companies, all you had to do was listen to the conference call to hear managers make plausible cases for their investment strategies. They do so patiently, as long as you are willing to take the time to listen.
Ok, so maybe it's not 100% clear how Google's "Project Loon," a plan launched in June to provide balloon-powered Internet access to remote areas, will help with search. But given management's track record, don't count it out as a potential winner for Google shareholders.
Editor's Note: Michael Brush is the editor of the stock newsletter Brush Up on Stocks.