Philadelphia Reflections

The musings of a physician who has served the community for over six decades

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Investing, Philadelphia Style
Land ownership once was the only practical form of savings, until banking matured in the mid-19th century. Philadelphia took an early lead in what is now called investment and still defines a certain style of it.

Who Watches the Watchmen?

The Latin phrase Quis custodies custodies warns that it's pretty hard to find hired agents you can completely trust. Investing for your retirement, you must be careful to avoid excessive transaction fees to pay your agents and minimize taxes to pay your government to watch your agents, who in turn watch the companies they invest in. Those companies are managed by hired experts, who are selected and overseen by a board of directors. The agents hired by the investors are charged with overseeing this process.

Gradually, the world is coming to accept John Bogle's idea of a market index fund as the best most people can do. Index funds don't even try to tell a good one from a bad one; they just buy them all in proportion to their size (successful companies grow, unsuccessful companies shrivel). Investing in the whole market,an index fund doesn't do much trading, seldom buying or selling. Therefore, it has minimum costs, minimum taxes. As a by-product, it has maximum diversification, hence maximum safety. Low costs and high safety don't automatically give the best performance, except that somehow they do. The Index Fund idea just relentlessly outperforms the vast majority of investment advisers, in both up-markets and down-markets. Investment advisers just hate index funds, bad-mouthing them constantly. But if you buy anything else, you had better have a very good reason to do so. The performance of an index is called beta; outperforming the index is called alpha. The sad truth is that most experts have a negativee alpha.

Well, it's just possible that a second Philadelphia-born idea can do the seemingly impossible task of showing a small but consistently positive alpha. The Pitcairn Foundation was created for his family by John Pitcairn, one of the world's all-time champion investors. About fifteen years ago, the Johnny Appleseed spirit caused the Foundation to open up its investment approach to non-family members; they created a public mutual fund company based on the collective ideas and experiences of the Foundation. John Pitcairn bought the Pittsburgh Plate Glass Company, nurtured it to success as PPG Industries, and then eventually sold it, based on the observation that almost no firms, family owned or otherwise, survive more than seventy-five years. Companies should be bought with the intention to sell them, even though they are managed expertly throughout their existence.

The Pitcairn Foundation observed that continuing dominance by a founding family almost always proved beneficial for the running of the company by hired expert managers. Notice that, while nepotism was often a bad thing in the managers, it could be a useful thing in governance. If you go too far with this idea, of course, you may get into the stifling arrogance of family control in European and Oriental firms. Founding family control keeps the managers from over-paying themselves or worse still, under-working themselves. But outside investors better watch these founding families; if you allow the inevitable minority of worthless family members to pilfer the company, you get the same thing at a different level of control, where it is even harder to fire them. There's a good idea here, but it needs a little extra.

After a great deal of intense scholarly work, it was observed that there are about six hundred major American corporations available for public participation where the founding family maintains control. Even this select group comes in two types. About a quarter of them have no "outside" directors other than the family, and the performance of these companies is about 15% worse than the index, suggesting the dominance of playboy directors. In the remaining group, family members only constituted about half of the outside directors. Now, that group of companies regularly perform 15% better than the index. Guess which type you ought to buy as an investor.

So, now we have the Constellation Pitcairn Family Heritage Fund, open to the public as a no-load mutual fund. Its portfolio consists of fifty-five of those six hundred families dominated companies (with a market capitalization of at least $200 million each), selected by the Pitcairn Financial company, entirely owned by the Pitcairn family. As long as it continues to outperform the index by 150 basis points, you can be fairly confident that the principle of family domination will endure, up and down the line. But not exclusively; somewhere it must be mixed with professional management. The family owns the fund manager, which is run by professionals, who watch the governance of the portfolio components, which are run by professional managers, overseen by founding family members on the corporate board -- themselves overseen by an equal number of non-family independent board members. It's like a Calder mobile, which by the way, is still another Philadelphia idea.

If you are looking to get rich fast, this isn't much of an idea. But since the Family Heritage Fund has consistently outperformed the index by 1.5%, it looks as though the advantage of selecting better corporate governance in the portfolio distinctly outweighs the disadvantage of reduced diversification. Maybe that's all it proves, but most of us poor saps don't even know that much.

Originally published: Friday, June 23, 2006; most-recently modified: Friday, May 24, 2019