• Large organisations tend towards unaccountability
  • Large firms are held largely by passive investors
  • Smaller firms are more responsive to shareholder pressure

Do you ever doubt whether the government is acting in your best interests?

Do you wonder if they occasionally or perhaps even frequently act in a self- rather than public-serving manner?

You’re not alone. According to various polls, public trust in public institutions is at an all-time low in many countries. This includes the UK.

Lack of trust in government is hardly something new. Indeed, mistrust of government, or at least healthy scepticism, has been around for a long time. This even includes so-called democracies. Socrates was sentenced to death by a “democratic” Athens for public criticism of government policies, including the devastating Peloponnesian War.

In democracies, at least, the voters have the ability to change the guards from time to time. That said, there seems at some times little difference between the mainstream party on the “right” and the mainstream one on the “left”. “Meet the new boss, same as the old boss!” as The Who sang all those years ago.

But when voters change their vote, yet things don’t change, voters learn a lesson of sorts: that perhaps the system itself is the problem.

This can take one into dangerous territory. If democracy isn’t working, do you really want to try something else? As Churchill famously said, “Democracy is the worst form of government, save for all the others.”

There is an important subtlety to consider here, however. “Democracy” is a blanket term for a wide variety of governance models around the world. Some democracies are clearly less accountable to their voters than others. Some have huge problems with corruption. Some are direct democracies, some republics. Some have large public bureaucracies, some small.

To lump them all into the same basket is perhaps to miss some of the key features that result in some democracies functioning well, and others less so. All democracies are not created equal, even if their citizens supposedly are.

One thing I will note here is that, other factors equal, small democracies have a better track record at growing their citizens’ wealth and defending their freedoms than large ones. Think Switzerland in Europe, Singapore in Asia, Uruguay in South America. Then contrast these countries with their larger neighbours. There is a pattern. Could it be that citizens find it easier to maintain effective, democratic control over smaller rather than larger democracies?

Now, let’s pivot to another governance model, that of the public corporation. A public corporation is one that is open to investment from outsiders. It has a board of directors, elected either directly or by delegated proxy vote of the shareholders. One share is worth one vote.

If the corporation is performing poorly, and the board refuses to change the executive management team, there is a chance that the shareholders will vote to oust one or more members of the board. The new board will be expected to make substantial changes to the management team, which will have a mandate to modify the company’s growth strategy or perhaps restructure it entirely.

Or so the thinking goes. Most shareholders, as it happens, are not particularly activist in their orientation. They might be largely passive, for example, investment funds more interested in basic asset gathering and administration than on outperformance.

Index-tracking funds are a prominent case in point. All they do is invest in order to track popular benchmark indices, without any regard for which corporations they believe are well managed, or rather less so.

Indeed, given the exponential growth of the passive fund management industry in recent decades, one could make the case that only a small portion of investors in large public corporations have any activist inclination whatsoever.

While a handful of shareholders might want to force a change of some sort, and vote accordingly, if they’re not able to get a majority, then nothing need change. The board and management team will remain in place. The interests of these shareholders, and of management, are poorly aligned.

At some point, a chronically poorly managed company will end up trading at a distressed valuation and probably become a takeover target by a more successful competitor or a private equity firm. But much damage to shareholder value will have already been done by that point.

If you were an investor in such a firm, say as a contrarian value play, you’d be sorely disappointed that things hadn’t turned around more quickly. You might have joined with other activist investors to try and force changes, to no avail.

Now imagine something slightly different. Let’s say that there is a public company which, for whatever reason, has been performing poorly. The board has yet to replace the members of the management team.

Unlike the company described above, which was large and included in prominent indices owned passively by large institutional investors, this company is too small to be owned passively. Most investors don’t even know about it. Those who are invested do so only actively, believing that the company, for whatever reason, trades at an attractive valuation.

Now let’s say that a few prominent shareholders start to lose patience with the management team, then with the board. Before the next proxy meeting, they get organised and prepared. And they make a persuasive case to other shareholders that it is time to act. It is time to vote out the board and bring one in that will install a management team with a mandate to turn things around.

The vote is held. The activists win. The old board is replaced with the new. Same for the management team. A full corporate turnaround becomes possible.

No, there is no guarantee of success, but the new management team has a clear mandate and clear accountability. Chances are they’ll only receive attractive compensation, including bonuses, if they deliver on specific, board-agreed targets. Interests, as it were, are well-aligned.

Now, which contrarian value investment do you think is more attractive: the large-cap firm owned largely passively by institutional investors? Or the smaller company owned largely by activist shareholders who are only involved because they think their presence makes a difference?

If you think (and invest) as I do, you definitely prefer the latter.

So does my colleague Sam Volkering. Sam has zero patience for passive investing. He is always seeking out new opportunities. And he is well aware of the importance of a strong management team to the success of any small business.

While Sam occasionally invests in large companies, he does so because of the story. But when it comes to small caps, Sam well knows that passive investors are nowhere to be found. It is active investors like him who are involved. And if things aren’t going well, they’re going to take action.

No, that’s no guarantee of success. But it is a guarantee of accountability, which correlates with success in all areas of life, public and private. And yes, this includes accountability in government too.

If you’d like to learn more about Sam’s approach to active, small-cap investing, you can do so here.

Until next time,

John Butler
Investment Director, Fortune & Freedom