FidelityConnects: Founder-led edge: Insights from Fidelity’s Founders Class®

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<b>Subtitles are AI Generated</b>

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Hello, and welcome to Fidelity Connects.

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I'm Pamela Ritchie. Founder-led companies have shaped many of

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today's market leaders but the real story often lies behind the

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name that everyone already knows.

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Today we are stepping beyond the Magnificent 7 to explore what truly

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sets a founder and family-led business apart, especially

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at a time when markets are debating whether we're seeing a changing of the

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guard. Joining us here today to unpack this story and

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why leadership horizon, capital discipline and culture

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can be just as important as what shows up in financial statements.

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This is Fidelity's Founders Class portfolio manager joining us live from London

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today, Thomas Williams.

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Tom, a warm welcome to you. How are you?

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Very well. Thanks, Pamela, thanks for having me.

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Delighted to have you here with us.

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I'll remind everyone joining us here that they can send questions in over the

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next half hour or so.

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This webcast is available with live French audio interpretation

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so please join us in either official language.

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Tom, let's begin with the fund itself.

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It was the brainchild of some time ago now.

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Why don't you just give us a little history lesson on why it was ever

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started in the first place, sort of the genesis story of this.

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The question is why invest in founder companies, I suppose,

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and the short answer is because we think that they exhibit a number of

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qualities that are conducive to wealth creation.

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The most powerful of those is the ability to resolve

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principal-agent conflicts which are really endemic to most

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non-founder and non-family-owned companies.

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These conflicts are actually one of the primary sources of loss to

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investors yet they're very seldom discussed.

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The interesting thing is that they're not new either.

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If you go back 250 years to Adam Smith and The Wealth

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of Nations, he described companies that, even businesses that

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had exclusive royal charters or monopolies that would

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eventually descend into folly, negligence and profusion.

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The reason was because the owners of those businesses appointed managers to

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represent them. Over time they became distanced from the capital that

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they'd contributed to the company and the managers over time meanwhile found

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cunning ways to enrich themselves at the expense of the owners.

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This isn't a problem that just resides in history.

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If you look in any business newspaper, you look at the Globe

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and Mail or the Financial Times there is probably a story or several stories

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today about restructuring which is actually a natural

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consequence, I would argue, of the five to seven year tenure of

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non-family and founder CEOs.

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You might ask how is that, how is that the case? The answer is because most

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CEOs of non-founder companies are incentivized either

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implicitly or explicitly to maximize earnings per share.

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In order to do that they do a number of things that actually minimize

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shareholder value creation over long periods of time.

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For example, you might cut sales and marketing or

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cut research and development to boost operating margins.

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You might cut capital spending to lower depreciation which is an expense

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to earnings, stretch the accounting to its limits or maybe

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even beyond lever up the company to

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conduct M&A that destroys shareholder value but it's so-called accretive

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to earnings. Then you cash in your options, you leave and the whole thing

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unravels and it's the shareholders who pay.

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Actually, with founder and family companies we see that that pattern is a lot

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less common and that really is the overarching logic for wanting to invest

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here.

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The founder themselves, him

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or herself, is obviously very passionate about the project they have

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thought up, brought to market, populated with lots of staff and

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employment and the structure around it.

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There's a natural passion there and I guess it's a more mature

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version of that, the family-led which is perhaps taken out from another

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generation, but just talk about what's attractive

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for investors about that passion being at the top of the company.

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If you're going to invest in a company you probably want it to be run by

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somebody who's passionate about the products and about growing that business.

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I think it runs deeper than that. You have this

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mitigation of agency conflict that we just talked about.

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Because the owners are managing the company and the managers own it

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it means that they have a very different time preference, effectively.

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If you are going to hand over the business to the next generation the chances

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are that you're going to make the investments that you need to make today in

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order to grow in the future.

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The curious thing is that there's a whole body of academic

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research from the '90s and the 2000s showing that founder and family companies

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have created alpha over time.

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Actually, you even had endorsement from Buffett, arguably the

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greatest investor of all time, wrote in his 2008 letter that

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their long-avowed goal is to be the so-called buyer of choice for

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companies built by families. In venture investing there's

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a lot of emphasis on founders and yet there has been relatively little scrutiny

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of these owner-managed companies in public markets.

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It's remarkable. We have a great platform here at Fidelity to

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help us figure out where these companies are and a great network of

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founders around the world to invest alongside.

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Let's come back to that time horizon which is endless if there's generations,

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in theory, or it's certainly very, very long term.

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You mentioned a lot of things that can go right

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short term but wrong longer term, for instance, with a changing of

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a guard of company management and so on.

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Just say a little bit more about that on, I mean, you could almost

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say for an investor that's looking for longer time horizons, which many of the

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investors and advisors that you're speaking to today  take

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that approach, that almost why wouldn't you invest in

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founder-led companies on some level?

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Is this going on ... do you have a lot of competitors?

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We have some competitors but I don't think that this is being done broadly.

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They tend to focus on particular geographies or particular sectors,

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technology, for instance.

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There's a fund in Japan that invests only in Japanese companies that are run by

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owner-managers. I think by and large we're one

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of the main organizations that has been trying

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to tap into the alpha here from family and founder companies.

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What better platform to do that than Fidelity which is, of course,

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a third generation family business.

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It's fascinating. We talk about the Mag 7 an awful lot,

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for lots of different reasons, but they're massive, many of them are

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founder-led, are you invested in those?

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Let's just sort of go over some of those massive eye-watering

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valuations of companies that are founder-led and are very much leading stock

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markets in the US and globally.

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Certainly. We're looking for companies that can generate high returns on

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capital and have strong balance sheets and are attractively valued

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in relation to those qualities.

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The reality is that several of the so-called Mag-7 companies do embody

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those criteria.

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Some of them don't, by the way, so we don't own all of them.

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What I would say is that we also own a lot of businesses and some

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of our largest active weights are in companies that are perhaps

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a little bit less well known and maybe a little more esoteric.

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An example of that would be Coca-Cola Consolidated

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which has arguably very little to do with artificial intelligence at

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this point which seems to have captured the zeitgeist of many of these

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conversations. Here you have the third generation of

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the Harrison family. It's a Coca-Cola bottler and they've

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done a fantastic job of creating significant value over time.

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The business started in 1902 when the current CEO's great grandfather

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secured the bottling rights, perpetual bottling right for Coca-Cola

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to distribute it in North Carolina.

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That's a really very valuable intangible asset that appears nowhere

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on its balance sheet.

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Like all bottlers Coca-Cola Consolidated buys concentrate from

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the Coca-Cola company. The Coca-Cola company is itself a

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case study of a high return on capital business.

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The intriguing thing to me is that the bottler, Coke Consolidated, actually

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makes higher returns on capital than the Coca-Cola company.

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It's been a more lucrative investment.

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It's been better investment for stockholders amongst whom the Harrison's,

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the Harrison family are the largest.

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It takes a lot of work to see their ownership because they own an unlisted

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share class. Those are exactly the sort of opportunities that we're

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focused on trying to tap into.

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That is absolutely fascinating.

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Tell us a little bit about your benchmark, which is Russell 3000, but can you

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also go around the world a bit?

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It's been quite an interesting year for international trade, the international

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trade so-called.

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Tell us about where you can invest, if you want to, geographically.

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Certainly. The strategy is benchmarked against the Russell 3000.

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We think there are around 800 companies in the Russell 3 000 that

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are family and founder owned.

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It's really a very large sandbox in which to go out and find the best

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businesses trading at the best valuations in relation to the returns

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on capital that they generate.

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We can also invest up to 20% of the firm's net asset value

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outside of the Russell 3000.

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This is something that we're

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exploiting reasonably up to the max at this point.

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The reality is that the US has a lot of founder companies and

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I think the reasons for that are largely cultural.

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There's a can-do attitude Americans have about setbacks

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whereas, perhaps, in Europe we've lost some of that buccaneering spirit along

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the way and we're a little more risk-averse and failure is a little more

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stigmatic which, by the way, may be a sort

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of leftover of the fact that in Europe up until

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not so long ago you could actually go to jail for not paying your debts.

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That happened to Charles Dickens's father for not not paying a baker.

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Whereas in the US people tend to tend to embrace risk a little more.

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Of course, it's risky to set up your own business, to be a founder

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but that said, we found a lot of great businesses outside of America

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and actually several in Canada.

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We're shareholders in Dollarama which, as you know, is a discount retailer.

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Retailing is a really tough business but the Rossi family have executed

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really well over three generations now in order to

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create a lot of value for stockholders over that time.

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That would be an example.

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That is absolutely fascinating.

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What do you do when ... it probably doesn't happen very often where the family

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itself sells. Well, I guess that happens too but what if the founder no

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longer leads the company for, I mean, even for death but also they just leave

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for various reasons.

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If everything is going well and they leave then that is probably a very strong

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signal that you should also exit your shareholding.

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Too often you then see the

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business fall apart a few months later.

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They tend to see these things coming down the track.

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The short answer is we're looking for companies where there is a founder

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on the board. Ideally, they're running the business as the CEO and

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they also own a significant economic stake in the business.

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If the first one of those changes and they do leave the company,

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it happens from time to time, then we will look to exit.

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We never want to be a full seller of any of our holdings

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but equally the whole rationale for the

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founders class is to invest alongside founders.

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If they're no longer there it doesn't make a lot of sense for us to stick

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around for the long term.

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Tell us a little bit about some of the sectors that are

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of interest to you on top of founder-led and very specific and

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idiosyncratic stories that go along with them.

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Are you swayed a little by macro events, by a cyclical

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outlook, by interest rates being lower?

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Is there anything sort of on the macro picture that at the moment

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sways you in one direction or the other?

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I think it's very hard to be consistently right with macroeconomic

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prognostications so I try not to make

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them but to a degree they are embedded in

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all of the investment decisions in the fund.

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I would observe that some sectors lend themselves better than others

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to investing alongside owner-managers like founders and

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family business owners. For example, there are relatively

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few mining companies or banks that are family owned or

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founder owned. The reason for that is because those businesses are extremely

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capital intensive and many banks tend to go bust

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every cycle or two and the equity holders get wiped out, including the founding

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family.

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Equally, as with all rules in life and all rules in investing there are

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notable exceptions.

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We're shareholders in a bank called First Citizens BancShares

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which was actually one of very few companies not to dilute stockholders by

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issuing a lot of new equity during the financial crisis.

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That's interesting.

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What they've done there under the holding family, I think it's third

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generation, is they've really prioritized having a very strong capital

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position, very strong liquidity buffers so that when competitors fail

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they can take over these competing firms under

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the FDIC's receivership process.

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Often that comes with certain guarantees.

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What they have sacrificed in short term optimization they've really

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participated in very long term durable earnings growth as a result.

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You do see these exceptions. Equally, if there's still a big

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founder stake in a company the chances are that it's probably a business that

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generates a lot of free cash flow and a lot of high returns and they haven't

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had to get diluted down over time.

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Hello, investors. We'll be back to the show in just a moment.

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DialoguesFidelity podcasts available on Apple, Spotify, YouTube, or wherever

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else you get your podcasts. Now back to today's show.

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That's really interesting because it allows for a question that sort of goes

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along with ...

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particularly probably in banking because they can be quite economically

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sensitive, understandably, and as you mentioned,

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things can be great while they're great but then they can fall off a cliff as

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well.

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Again, I guess the ballast of a founder-led company, would

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you find that often they do not as

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extraordinarily well in certain moments  but then also are able to sort of have

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a downside capture to them on some level?

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Is there something to that?

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I think that's an important point that downside capture is something

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that we've tended to score well on over time.

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When the market goes down we often don't go down as

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much as the market. We're not hedging our positions or using derivatives or

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anything like that so we will experience compression in stock

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prices when markets go down.

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I think that's really a function of the fact that these companies have much

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stronger balance sheets.

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Do they need to be a certain cap size for you to be interested?

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There are probably lots of smaller companies that

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would be founder-led and then sometimes when companies get bigger they'll

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transition out of that.

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Do you have to have ... what's the cap size that tends to be in

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the companies that you're interested in?

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I'm trying to be open-minded about all market caps.

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The reality is that it can just be very difficult to buy

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things that are extremely small.

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If you're spending weeks accumulating a shareholding that's

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one thing but equally things do change with

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companies and if I make a mistake I

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want to be able to get out within a reasonable time without completely crushing

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the stock price on the way out.

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The smallest firm that we own is probably a couple of billion dollars in

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market capitalization.

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I think that sort of level feels like an appropriate one.

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It used to be the case that the bigger you got the more difficult it was to

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generate higher returns at scale but

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what you see with firms like...

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It's not the case now.

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Yeah, it's not the case now. What you see with companies like Alphabet, which

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is a stock we own, I know we weren't going to talk about the Mag 7 but

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over time it has generated higher returns on capital

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at greater scale.

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To give you a couple of stats, I think

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in 2023 Alphabet earned

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25% on its invested capital and in 2024

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it earned 28% on invested capital, which is really a remarkable feat

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for companies of this sort of size.

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It is absolutely. That leads me, I was going to ask you if there's great

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excitement in some areas of capital markets about IPOs that

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have been waiting to come to market.

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There's lots of other stories within a private equity area.

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Some of those, do you ever buy an IPO?

18:40.452 --> 18:46.158
You take a look at private market? Do you ever enter at an early stage?

18:46.158 --> 18:50.362
We do occasionally participate in IPOs.

18:50.362 --> 18:54.633
There is an information asymmetry with an IPO where typically as

18:54.633 --> 18:59.138
a potential shareholder you're showing three years of financials, whereas

18:59.138 --> 19:03.342
I much prefer to look back over 15 or 20 years of

19:03.342 --> 19:07.846
operating history just to understand how the company in question has

19:07.846 --> 19:11.383
weathered various challenges and economic cycles.

19:11.383 --> 19:15.420
You also have to ask yourself, if somebody is trying to sell you shares then

19:15.420 --> 19:18.891
is it really the most attractive time to buy?

19:18.891 --> 19:22.361
But you don't want to get too cynical because, of course, every company started

19:22.361 --> 19:24.396
out as an IPO at some point.

19:24.396 --> 19:28.033
We try to assess them on a case by case basis.

19:28.033 --> 19:32.037
Ideally it's a company where there isn't a sell-down, where the founder

19:32.037 --> 19:33.972
or the family owners are not selling down.

19:34.006 --> 19:38.110
They actually just want to raise capital to go and grow in a new market or

19:38.110 --> 19:40.746
to bring a new opportunity to life.

19:40.746 --> 19:44.883
That would be the sweet spot, and probably a business that has a strong balance

19:44.883 --> 19:46.952
sheet as well.

19:46.952 --> 19:49.621
We have nine minutes left and you just can't escape an AI question so here it

19:49.621 --> 19:51.423
comes.

19:51.423 --> 19:55.494
You're in probably constant contact with a number of the different founder-led

19:55.494 --> 19:58.197
companies that you have in the portfolio.

19:58.197 --> 20:01.800
Some of them are producing the AI that is being sold and there's lots of

20:01.800 --> 20:05.704
discussion of circular finance and so on but what are companies perhaps that

20:05.704 --> 20:09.841
are more traditional and are using AI as tuck-ins to be more

20:09.841 --> 20:14.079
efficient, how far on the road are they at this point?

20:14.079 --> 20:17.449
They're past testing?

20:17.449 --> 20:19.384
Yes, I think so.

20:19.384 --> 20:23.922
There seems to be a popular view amongst the media that there's

20:23.922 --> 20:28.160
a bubble in AI and I would argue there's possibly a bubble in

20:28.160 --> 20:30.329
stories about bubbles in AI.

20:30.329 --> 20:34.766
It seems like every day I open the newspaper and people,

20:34.766 --> 20:38.036
or journalists at least, are talking it down.

20:38.036 --> 20:42.507
I would observe that some companies are implementing AI

20:42.507 --> 20:46.545
and making significant savings as a result of

20:46.545 --> 20:51.183
doing so. We spoke about Alphabet, Google earlier,

20:51.183 --> 20:55.954
they wouldn't be letting large numbers of employees go

20:55.954 --> 21:00.692
were it not for the fact that they can now write code using their own

21:00.692 --> 21:02.427
Gemini tools.

21:02.427 --> 21:05.731
There are clearly cost savings to be made here.

21:05.731 --> 21:10.202
I guess as a bigger picture comment, we want to participate

21:10.202 --> 21:11.870
in the march of progress.

21:11.870 --> 21:16.208
That is clearly one of the things that we're trying to capture as

21:16.208 --> 21:20.479
an investor and as investors

21:20.479 --> 21:24.516
in founder-led companies but we want to avoid permanent loss of

21:24.516 --> 21:28.587
capital as and when this cycle

21:28.587 --> 21:33.692
hits an air pocket, as it's almost certainly bound to do.

21:33.692 --> 21:37.729
If gen AI is as impactful as people think it is then really by definition we're

21:37.729 --> 21:43.302
going to see an overbuilding of the infrastructure to supply it.

21:43.302 --> 21:47.239
That's been the case with really every technological breakthrough

21:47.239 --> 21:51.143
throughout history. I think 100 years ago we had, what was it, 2000 radio

21:51.143 --> 21:54.079
manufacturers in the United States.

21:54.079 --> 21:58.350
The other key thing is, it remains to be seen whether these

21:58.350 --> 22:02.621
savings and these higher returns that AI, I think,

22:02.621 --> 22:05.991
can generate will actually just be competed away by companies through lower

22:05.991 --> 22:10.362
prices. That speaks to investing in more consolidated industries

22:10.362 --> 22:15.100
that are less likely to squander those cost savings on price wars.

22:15.100 --> 22:18.470
At the end of the day we want to be relatively balanced.

22:18.470 --> 22:22.474
I believe lots of your audience are

22:22.474 --> 22:24.776
hockey fans. Hockey's big in Canada.

22:24.776 --> 22:26.878
We don't want to play hockey with no goalkeeper.

22:26.878 --> 22:30.215
We want to have some defence as well as offence.

22:30.215 --> 22:33.885
That comes down to owning some of the companies that we talked about earlier

22:33.885 --> 22:37.856
like Coca-Cola Consolidated which should be relatively resilient in the

22:37.856 --> 22:42.661
face of any sell-off in some of these higher octane AI beneficiaries.

22:42.661 --> 22:46.765
Fantastic. So interesting. You're right, there's a bubble in the talk of

22:46.765 --> 22:48.800
bubble. That's a fascinating view.

22:48.800 --> 22:52.838
Here's a question for you coming in from your audience, how is

22:52.838 --> 22:55.507
private credit utilized by founders?

22:55.507 --> 22:58.243
Well, I mean, credit would be used, any kind of credit would be used by

22:58.243 --> 23:02.247
founders for CapEx but there is the question in there about private credit

23:02.247 --> 23:06.118
which has its own story.

23:06.118 --> 23:08.420
It certainly does.

23:08.420 --> 23:12.391
There's been a boom in private credit, as your

23:12.391 --> 23:16.328
audience will be aware of, and in large part you've seen

23:16.328 --> 23:21.299
lenders like Apollo stepping in to fill the vacuum that was left by

23:21.299 --> 23:25.737
GE shrinking its balance sheet and that really very profound restructuring.

23:25.737 --> 23:30.175
We talked about that cycle of restructuring and optimization earlier on,

23:30.175 --> 23:34.212
GE would a good example of that, went through a very painful

23:34.212 --> 23:38.383
period where a lot of the lending that it used to do,

23:38.383 --> 23:42.421
aircraft leasing, lending against or leasing

23:42.421 --> 23:46.525
of CAT scanners, a huge array of items, that

23:46.525 --> 23:51.596
has been taken up in the private credit market.

23:51.596 --> 23:55.600
Again, we're looking for companies that have strong balance sheets.

23:55.600 --> 23:58.837
Ideally, we don't want to have a lot of credit, private or otherwise, on those

23:58.837 --> 24:00.505
balance sheets.

24:00.505 --> 24:03.642
If we do, you know, people look at companies that have a lot of debt and they

24:03.642 --> 24:06.211
say, well, that company has a lot of debt but I would look at that company and

24:06.211 --> 24:09.247
say, that company has a lot debt for a reason, and that's probably because it

24:09.247 --> 24:14.052
doesn't generate a lot of free cash flow so it may not be within our

24:14.052 --> 24:15.720
universe or investible universe for that reason.

24:15.720 --> 24:19.658
Not everything is a cash flow story like the Mag 7,

24:19.658 --> 24:21.960
exactly, you have to go in there and find it.

24:21.960 --> 24:26.064
Another question, could you touch on

24:26.064 --> 24:28.166
CapEx investment in general by founders?

24:28.166 --> 24:31.903
You've done that partly there. Are there any differences to companies which are

24:31.903 --> 24:40.378
non-founders? Maybe just an approach.

24:40.378 --> 24:44.616
The obvious one is that if you were a non-founder or non-family

24:44.616 --> 24:48.720
CEO and you really wanted to gun the earnings per share

24:48.720 --> 24:52.791
of your company then you would look to shield your

24:52.791 --> 24:57.128
income statement from as many expenses as possible.

24:57.128 --> 25:01.566
One way that sometimes happens is that ordinary operating expenses get

25:01.566 --> 25:05.303
treated as CapEx and they get put on the balance sheet when perhaps they

25:05.303 --> 25:10.742
shouldn't and accounting can get quite aggressive.

25:10.742 --> 25:16.381
The thing about founder companies is that if you need to make an investment,

25:16.381 --> 25:20.452
not always but more often than not, they tend to make those investments

25:20.452 --> 25:22.621
when they're needed.

25:22.621 --> 25:26.758
The accounting can often end up being a little bit cleaner as

25:26.758 --> 25:31.696
a result. Very heavy adjustments to earnings are

25:31.696 --> 25:37.402
typically an orange flag, if not a red flag.

25:37.402 --> 25:40.438
We've experienced a lot of founder businesses, family companies over the last

25:40.438 --> 25:44.910
few years and the only time when they make adjustments to earnings

25:44.910 --> 25:49.014
they actually adjust out extraneous profits so they're

25:49.014 --> 25:52.617
lowering their adjusted earnings, whereas normally adjusted earnings are way

25:52.617 --> 25:54.986
higher than gap earnings.

25:54.986 --> 25:57.289
That's really interesting.

25:57.289 --> 25:59.524
How would you sum this up?

25:59.524 --> 26:02.260
You've been running this fund for ...

26:02.260 --> 26:07.465
is it a little over a year? You'll tell us how long, about a year or so.

26:07.465 --> 26:10.168
Tell us a little bit of what you hope to do with it going forward.

26:10.168 --> 26:13.738
It might be just exactly what you're doing right now but just give us a taste

26:13.738 --> 26:17.876
of where you hope to take this fund over the next medium horizon

26:17.876 --> 26:20.245
time.

26:20.245 --> 26:22.614
I think we're onto something here.

26:22.614 --> 26:26.818
I'm cognizant that your listeners, Pamela, have thousands

26:26.818 --> 26:30.822
of investment solutions available to them and each, no doubt,

26:30.822 --> 26:33.725
professes to do something unique.

26:33.725 --> 26:36.761
At the end of the day they must be the judge and you must be a judge.

26:36.761 --> 26:41.299
I think what we're trying to do with Founders Class in investing in

26:41.299 --> 26:45.470
owner-managed companies that resolve these principal agent conflicts

26:45.470 --> 26:49.441
really have that skin in the game and they show that tendency

26:49.441 --> 26:53.211
for people to invest their own money a lot more judiciously than they spend

26:53.211 --> 26:57.916
other people's. I think this is, hopefully,

26:57.916 --> 27:01.286
a durable source of wealth creation.

27:01.286 --> 27:05.523
We would certainly welcome anybody who agrees

27:05.523 --> 27:08.994
with us and would like to discuss it further.

27:08.994 --> 27:12.397
Fantastic. Tom Williams, live from London, thank you very much for joining us

27:12.397 --> 27:15.800
here today to talk about Founders Class.

27:15.800 --> 27:18.637
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27:18.637 --> 27:22.941
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We'll end today's show with a short disclaimer.

27:52.337 --> 27:56.174
The views and opinions expressed on this podcast are those of the participants,

27:56.174 --> 28:00.111
and do not necessarily reflect those of Fidelity Investments Canada ULC or

28:00.111 --> 28:04.115
its affiliates. This podcast is for informational purposes only, and should not

28:04.115 --> 28:06.651
be construed as investment, tax, or legal advice.

28:06.651 --> 28:08.953
It is not an offer to sell or buy.

28:08.953 --> 28:13.291
Or an endorsement, recommendation, or sponsorship of any entity or securities

28:13.291 --> 28:18.096
cited. Read a fund's prospectus before investing, funds are not guaranteed.

28:18.096 --> 28:21.666
Their values change frequently, and past performance may not be repeated.

28:21.666 --> 28:24.002
Fees, expenses, and commissions are all associated

28:24.002 --> 28:25.804
with fund investments.

28:25.804 --> 28:28.406
Thanks again. We'll see you next time.