Karan Phadke is portfolio manager of Mawer Global Small Cap Fund.
In investing, there’s a critical factor that often receives less attention than financial metrics and market trends: the alignment of management teams with the long-term interests of the company and its shareholders.
There is a tendency for executives running a business to have incentives at odds with the owners and shareholders. In most instances, that takes the form of too much focus on individual compensation and unchecked careerism, with no (or not enough) skin in the game to encourage a more vested interest in the long-term profitability of the business.
When such misalignment occurs, in the case of companies, it’s often the owners that suffer from the hidden costs – usually in the form of suboptimal decisions (sometimes also known as agency costs). In our experience at Mawer Investment Management, the potential for such principal-agent disconnect can be more acutely observed in the small cap investing space, where management decisions tend to take on more immediate and obvious effects.
The reverse, however, is also true: If a small cap company has capable, aligned and effective capital allocators at the helm with significant skin in the game (”engaged owners” or “owner-operators,” as we like to call them), that can create a powerful, resilient combination over the long term – and attractive potential investment upside.
Protecting the downside
Management with more skin in the game tend to plan in decades instead of quarters, and frequently have healthy paranoia over potential risks. This long-term perspective can be a game changer for investors, as it often results in strategies and decisions that reduce downside even in the face of economic turbulence.
Consider the case of Technogym, a company that manufactures high-end equipment for gyms, hotels and luxury consumers. It was founded by a visionary entrepreneur who started making gym machines in his garage; he continues to run the business today.
One key feature of having an actively engaged founder is their consistent investment in evolving the product line. They allocate a material portion of their sales to research and development (about five per cent), which has led to continuous improvements in functionality and the integration of digital tools and connectivity.
Furthermore, Technogym adopted a slow and steady approach to building their brand globally across various channels, including commercial and consumer. This patience and focus on risk management through diversification paid off during the COVID-19 crisis.
While many competitors experienced boom and bust, Technogym was able to benefit from increased home equipment demand early in the pandemic and offset the pandemic recovery slump in consumer orders with the return of commercial customers as gyms reopened. The result was much more stable performance through cycle than the typical peer.
This exemplifies how management who have something to lose are incentivized to build more resilient and diversified businesses that can thrive in various market conditions, without having to predict where the next macroeconomic shock will come from.
Capturing the upside
It’s not just about protecting the downside, though. Engaged owners can help steer companies to outperformance, too, as is the case with market research firm Ipsos. Its founder sits on the board and provides clear stewardship, allowing the management team to make difficult decisions such as investing more in talent even if it might hurt short-term financial results.
At the same time, the company does not overspend, prioritizing profitable growth over rapid expansion at any cost. This approach encourages slow and steady improvement in the bottom line that is safer in the long run, rather than running at maximum speed like the many venture-capital-backed firms of yesteryear.
Additionally, the company is able to foster a culture of entrepreneurialism by ensuring people get promoted on merit (the chief executive officer is an internal hire who worked his way through the ranks), and decentralizing the organizational structure such that local managers get autonomy and reward based on their own efforts.
These real-world examples demonstrate how alignment plays a critical role in shaping the decisions people and firms make. When the right incentives are combined with a track record of execution, the odds of outperformance can be greatly improved.
Just as clients look at fees and the quality of the people when selecting an investment fund, so, too, should investors look at the fees (agency cost) and people running the businesses that client capital ultimately flows into.