Download PDF - Why "skin in the game" may mean "out of the index"

Aligned Investors
Why “skin in the game”
may mean “out of the index”
Are you underweighted in companies with owner-operator CEOs?
Indexes are often described as a way to “own the market,” and,
These float adjustments solve the liquidity problem, but they
for the most part, that is true. Companies are weighted by their
also cause an index investor’s portfolio to no longer mirror the
respective market capitalizations, so larger companies receive
broader economy quite as well. Gaps are created.
greater position sizes, and the end result is a portfolio that
reflects the broader economy.
Take Wal-Mart, for example:
With one main exception that is not very well known. Most
• The Walton family continues to own roughly half the company.
market indexes, such as the S&P 500, are float-adjusted, meaning
• So Wal-Mart’s weight in most market indexes is reduced by
about one half from what it would be based on its market
capitalization.
the portion of a company’s shares that is not readily available for
trading in the open market is adjusted out of the index.
The inadvertent result: companies that are led by owneroperators who have “skin in the game” are underweight
in the index. This means an investor’s portfolio could be
overweight in companies with cash-paid CEOs – those with
• Similar to this example with Wal-Mart, index investors
also own less of other well-known companies like Amazon,
Alphabet, Facebook, Berkshire Hathaway, and Nike.
good people, but perhaps not as good for shareholder value.
• The founders or founding families of each of these companies
continue to own a large stake.
This happens because index providers want to ensure there
And that last part is important. Most companies that have
are plenty of shares available for their clients to purchase.
their index weights reduced by float adjustments are led by
owner-operators. It is commonly the founder or founding
Did you know?
It was not always
this way. Before index
For example:
family that continues to own the large stake. This can be a
If a large company (say, Apple) was
The Owner-Operator Advantage.
90% owned by insiders that rarely trade
their shares, then it would be difficult for
investing became
each index client to buy enough shares
increasingly popular,
to build the required substantial position
liquidity was not a
(say, 3%). There would be too much
problem and the
money forced to buy a finite number
S&P 500 was not
of shares, sending Apple’s price up in
float-adjusted.
the process.
great benefit to companies, as we describe in our white paper
Even if you are skeptical that owner-operators outperform over
time, it is at least worth knowing that a passive strategy
underweights these companies – and pairing a passive strategy
with a complementary active strategy that emphasizes owneroperators might be worth considering.
Gaps created could mean opportunities for investors
This change was
made in 2005, to
However, because indexes are float-
accommodate the
adjusted, Apple’s weight in this scenario
greater amount
would be reduced from 3% to 0.30%.
of assets tracking
Index investors would be able to buy
indexes.
fewer shares to achieve the required
Float
adjustment
Weight based
on market cap
weight, and the liquidity problem
would be significantly reduced.
Actual index
weight
For illustrative
purposes only.
Is the U.S. large-cap market truly efficient?
One reason indexes have gained in popularity – and therefore
The table below provides a closer look at whether or not that
need to be float-adjusted – is that it has become common
has been the case. As a reference point, over the 12 months
wisdom to say that the U.S. large-cap market is efficient.
ending 30 June 2016, the high point for the S&P 500 was 18%
As the argument goes, there is just too much attention on
greater than its low point.
these companies for mispricing to occur; too many sell-
So what if we just looked at the 10 largest companies by
side analysts, too much media coverage. It is a persuasive
market cap? Maybe their high/low differences would be a little
narrative, but is there data to back it up?
higher, since we’re giving up the diversification benefits, but
If it is true that the U.S. large-cap market is efficient,
certainly not much higher. These are the most well-known
the prices of these companies should not move around that
companies in the world after all. Actually, when looking at the
much over shorter periods. Rather, it would be expected that
numbers in the table, we can see that the average high/low
their prices would remain close to their true long-term value.
difference was 50%!
S&P 500 10 largest companies by market cap
1 July 2015 - 30 June 2016
Low price
High price
% change
Apple Inc.
89.47
132.97
49%
Alphabet
515.18
789.87
53%
Microsoft
39.72
56.85
43%
Exxon Mobil
66.55
93.83
41%
Berkshire Hathaway
123.55
148.03
20%
Amazon.com
425.57
731.50
72%
Johnson & Johnson
81.79
121.41
48%
Facebook
72.00
121.08
68%
General Electric
19.37
32.05
65%
AT&T
30.97
43.42
40%
-
-
50%
Average
Source: FactSet
Surely, there were developments and changes in the market
This does not mean that active management is easy, but
environment for all 10 of these businesses, but did anything
these inefficiencies should give investors reason to pause
happen over the last year to change the long-term intrinsic
before jumping to the conclusion that successful active
value of these companies by 50%?
management in the U.S. large-cap market is impossible.
Almost certainly the answer is no. These types of dramatic
price movements suggest there is not much basis for
assuming large companies are always perfectly priced.
The same forces that have always driven prices away from
intrinsic value – the emotions of greed and fear – are still
present today and continue to create opportunities if you
know where to look.
In summary
Companies with owner-operators
This could mean that you are
Consider active management that
that have “skin in the game” are
missing out on owning your fair
emphasizes owner-operators as a
likely to be underweighted
share of some of the best-led
complementary strategy to pair
in indexes.
companies in the market.
with passive investing.
About Aligned Investors
Aligned Investors is an investment boutique within Principal Global Investors* that utilizes a completely fundamental,
bottom-up approach. The name Aligned Investors highlights the group’s conviction in the power of aligned incentives.
This is emphasized in the investment process through a distinctive preference for owner-operators. Led by Bill Nolin
since 1999, the team manages MidCap Equity and Blue Chip Equity strategies.
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*Principal Global Investors is the asset management arm of the Principal Financial Group.
Aligned Investors is a specialist equity investment group within Principal Global Investors.
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