On this episode of The Long View, Lawrence Lam, author, investor, and managing director and founder of Lumenary Investment Management, breaks down the differences in founder-led companies, what red flags to look out for, and three key pillars to assess whether founders are motivated to build their companies for the long term from his new book The Founder Effect.
Here are a few highlights from Lam’s conversation with Morningstar’s Dan Lefkovitz.
Why Motivation Matters More Than Vision
Dan Lefkovitz: What do you make of the common criticism of founders that sometimes the visionary, the entrepreneur, isn’t the right person to manage the company or to take the company to the next level?
Lawrence Lam: I’d say it’s not about whether they can make an assumption between them being a visionary and them not being able to take it to the next level. It’s not so much about that. It’s more about motivation. It’s about distinguishing the different types of motivation, the ones who want to truly build a company for a very long period of time, or the ones who are interested in flipping the company. So, I call them flippers or the builders. And for investors, you need to stay vigilant—motivations can change over time because it’s human nature, and to watch very closely what’s happening with companies.
I would argue a good recent example is Elon Musk moving into government. One could look at that as a sign that, “Hey, he’s putting his personal ambitions ahead of the companies that he’s involved in, and that motivation has changed.” No doubt that when he first joined DOGE that he would dedicate a significant effort to that and therefore take away the effort with his existing companies. The best founders can replicate their operating system, but they’re not so much of an app, they’re actually the operating system, and they design it. And that’s how they structure the organization. A lot of them have this flexibility to do things differently. They own a significant share, so they can problem-solve in a unique way.
There, of course, are red flags that you want to look for, and in particular, large equity sell-downs; that’s a red flag. And all those Palantir investors out there, keep your eyes open and stay vigilant. And then looking at that changing person versus company motivation, or one that has an org structure that is bottlenecked by the founder. All these considerations are red flags to look for. But of course, as investors, you can mitigate against that. You can rotate companies; you can trim some profits and move capital to another company. Founders are good at hyping up their business, so you don’t want anything that’s too overhyped, and maintain a deep bench of founder-led companies that you switch between. And then, of course, monitor the portfolio closely, monitor the equity movements closely.
Avoid Getting Caught Up in the Hype of a Company’s Charismatic Founder
Lefkovitz: How do you look through hype? I imagine a lot of these guys are very charismatic. How do you avoid being lured by their charisma?
Lam: They’ve started their business because of their ability to influence the market. And I outline some objective key things that investors can look for. I have a framework that’s based on three pillars that I’ve observed in a lot of successful founder-led companies and their objective. Because the question of things like motivation, cognitive biases, and alignment with investors are very subjective types of topics. But if you have some objective things to look for, you can really solve that in a scientific way.
So, I think that in terms of looking for founders that are genuinely there to build for the long term, you really want to look at not just the hype, but all the underlying facts that even an outsider can see and identify. In the book, I identify three key pillars. One is judgment and decision-making and being able to make bold decisions. The second is being aligned with investors. Their motivations are in line with what investors want over the long term. And the third thing is to be able to influence internally their staff, the organization, and therefore influence externally the media, shareholders, and customers to actually want their product. And the best of the best can do that.
How to Find Founders Who Are Motivated for the Long Term
Lefkovitz: You mentioned some metrics earlier that you look for and how you quantify these things. It would be interesting to hear a little bit more about the types of indicators that you use to assess each of these pillars of the framework.
Lam: The evolution of my process has always started with the quantitative side of things first. I’m always looking for companies that produce those continual growth in earnings, the conservative balance sheet, all those traits that we mentioned that are prevalent with founder-led companies that show up actually in the financial statements. And then once you identify those, and you may have thousands of those companies, you can very quickly see through the share register if they are founder-led quite quickly. And from the couple of thousand that you see, you narrow down quickly. I narrow down to thousands, 2,000 stocks very quickly on a global level out of, say, 40,000 to 50,000 global companies. And then next comes a qualitative analysis that any investor would do and have their own checklist and process for monitoring.
For me, what’s important is that the founder and the management team definitely need to follow the framework that I’ve written about in the book and score very highly in that. I want them to have a strong market position, and a very diversified customer base and supply base. And to really capture that essence of the founder effect to really be involved in new products and services. What I’ve seen in the past happen is some companies that I’ve invested in are fantastic companies growing, but then they’re in some old-generation businesses like producing caliper brakes for cars, producing petrochemical products, and producing fertilizers. And that can be a trap too, because then some of these companies are just content with doing what they’ve always been doing and almost a bit too stagnant. That’s why you want the new products and the new services, and trying to find the companies with that pricing power and that opportunity where they can compound and fully achieve their potential under the founder.
Find Good Businesses ‘Before an Idiot Starts Running Them’
Lefkovitz: I’m reminded of that famous Peter Lynch quote, “You should invest in a company that’s so good, even an idiot could run it because sooner or later, one will.” I think Warren Buffett has quoted it as well. So, the idea is you should look at the structural features of the company and maybe its competitive advantage. We use the economic moat framework here at Morningstar. What do you make of that, that it’s less about the people and more about these structural features of the company?
Lam: I love Peter Lynch’s quotes, especially the one about not watering the weeds and pulling out your flowers. Love that.
Lefkovitz: I don’t know that one.
Lam: For me, it’s about these businesses—get them before an idiot starts running them. Someone started that business. Someone founded that company. Get in at that time while they’re still running it, before the idiot gets in, and invest early when they’re still running it. That is the essence of The Founder Effect, and really spotting when that motivation changes, if it does, then get out and then let the idiots take over.