As some of you may know, one of the biggest influences on my investment thinking has been Prof. Aswath Damodaran.  I officially took his valuation class back in the spring of 2017 and right at the beginning we learnt some propositions about intrinsic value.  At the time, these propositions seemed trivial but as I have come to witness how narratives play out in the market, I’ve realised why he needed to include them in his presentations!  One of these propositions is the “It” proposition:

If ‘It’ does not affect expected cash flows or the riskiness of the cash flows, ‘It’ cannot affect value.

Over the years, I’ve realised that there are times when a businesses or people managing that business get labelled without numbers necessarily backing such labels.  The one that I find most troubling is the label of the “intelligent fanatic” or the “great manager”, not because I don’t believe that there are people who have superior abilities in managing businesses, but because I feel:

  • they are in much short supply than investors would have you believe.
  • there’s also a human tendency to ignore disconfirming evidence once such individuals have been thus labelled.
  • a lot of the times the label is the result of industry tailwinds rather than individual brilliance.

There’s also the small aspect of a person, who might be a great manager for one business, may not necessarily be the right person to lead another company or for that matter the same company at a different stage of its lifecycle.  That, however, is a discussion for another day.

Take a look at the historical record of two businesses which don’t directly compete with one another but are in the same industry:

 

Company A

Company B
Cumulative NPAT (FY15-FY21) ($m)

122

264
Cumulative free cash flow (FY15-FY21) ($m)

160

110
Conversion

131%

41%
Current NPAT

25.4

59.4
PE ratio (x)

27.3x

40.8x
Revenue growth (last 3 years)

18.3%

14.0%
Earnings growth (last 3 years)

21.9%

25.5%

Despite its far superior cash generating ability, Company A trades at a significant discount to Company B.  There are slight differences in growth rate with Company A growing slower at the earnings level but growing faster at the revenue line.  However, these differences don’t necessarily explain the difference in valuations.  Of course, the past is, to a certain extent, irrelevant in investing and we are more concerned with what is likely to happen in the future.  And it may very well be possible that Company B outgrows Company A in the coming years by quite a margin to justify its premium valuation.  However, taking history as a guide and current industry conditions, the probability that the growth prospects of the two companies will materially diverge in the next few years appears low.

The one difference between the two businesses though is that Company B is led by a founder who still owns a significant stake in the company whereas Company A has been professionally managed for a long time.  And the market seems to be in love with founder managers at the moment.

This might have something to do with success of companies like Alphabet, Facebook and Amazon over the last decade, with their founders adding significant value to these companies.  While there is much to like about founder led businesses, there are also cautionary tales like WeWork and Theranos.

In my view, investing in founder led businesses shouldn’t be an end in itself, rather, it should be a means to judge whether the founder’s involvement advances or hinders investment success.

I go back to the “It” proposition.  If the involvement of the founder (the “It” in this case) does not translate into higher cash flows or lower risk then, it should not have a consideration in coming to a judgment about the intrinsic value of a business.