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  • Writer's pictureEmily Dow

500 companies yet 505 stocks? Surely not.

The S&P 500, as described in one of my earliest posts about the 2020 stock market, is a stock index which tracks the 500 largest US companies. So, how is it that a stock index which includes 500 companies has 505 stocks? I noticed this about a year ago when looking into ETFs (Exchange Traded Funds) which track the S&P 500 such as the popular Vanguard VUSA fund. Perhaps you know why, but these 5 'lost' stocks used to annoy me like an itchy mosquito bite. The answer is actually very simple and conclusive: multiple share classes. This is when a company offers more than one 'type' - typically known as classes - of shares allowing a large portion of the voting rights to be retained by a few individuals. For example, a firm may have Class A shares which per share contain more voting power than Class B shares. Often, one class of shares will be listed on a stock exchange and the class with more voting power will be kept for founders, executives and the like. This allows the firm to protect voting powers while still raising substantial capital and fuelling growth thereby preventing stagnation caused by the founders of a firm not wanting to lose their presence. Another way to interpret this, which may reveal why there is controversy surrounding multiple class ownership, is it allows few individuals' voting powers to not be diluted even as their equity shareholding of the firm decreases.

Different firms adopt different strategies to ensure voting powers aren't uncontrollably shelled out to strangers. For example, Ford Motors trade their Class A shares with one share purchasing one voting right, however their requisite for their Class B shares, a class only accessible by the Ford family themselves, is this class will always hold 40% of the voting power despite their equity holding being less than 4%. Rather than neglect and disregard any rallied anger amongst investors at what some would say is an injustice, something which Ford has had to parry since going public in 1956, in their 2020 Annual Meeting of Shareholders, Ford states, "we believe many purchasers of Ford stock are attracted to it because of the dual-class structure". Even after 65 years of this dual-class share structure, Ford are still addressing and having to somewhat exculpate their chosen structure since they believe it is a defining trait of their model, which, having intertwined with the history of the firm, it's hard to believe otherwise.

Another approach to the structure has been taken by Warren Buffet's Berkshire Hathaway who have Class A shares purchasing one vote and Class B shares purchasing 1/10,000 of a vote. Buffet's decision to introduce this second class of shares in 1996 was to make investing into Berkshire Hathaway more accessible to independent investors looking to purchase independently rather than due to the motive of retaining voting rights. Warren Buffet is renowned for his integrity in investments and he had genuine cause for concern about the creation of unit trusts who would abuse Berkshire investors and subsequently damage the firm's reputation. It's insinuated that this was an action Buffet reluctantly executed; he was protecting his firm rather than creating access to it (something which, if the latter had been the sole aim, could have easily been achieved by a simple stock split). In 1996 The Oracle of Omaha released a statement revealing there had been numerous propositions of all-Berkshire unit trusts or investment companies. If this happened, these firms - who would hold nothing but Berkshire stock - could subsequently sell stock of their firm allowing people to indirectly purchase a 'share' of Berkshire stock. As Buffet explains in his 1997 Chairman's Letter to Shareholders, he wanted to prevent Berkshire Hathaway's association or accusation of involvement with investor abuse or taking advantage of uninformed, guileless investors. This threat requires little risk analysis: the damage would be undoubtedly irreversible if exploitation of investors had taken place. But Buffet was determined to preserve the prestige of Berkshire Hathaway's high-valued share and reputation to attract like-minded, long-term investors. His solution? To create Class B shares so purchasing stock directly was more accessible, eliminating the need for inexperienced or less wealthy investors to try and purchase stock via a unit trust and being stung with high fees along with activities likely one step away from illicit. Class A shares had a high on 1 May 2021 of $436,000 yet for Class B this figure was $289.44 (also on 1 May 2021). Obviously, there would be outrage if one Class B stock purchased one vote yet was <0.07% of the price of Class A stocks, so it's unsurprising Buffet reduced the voting rights for his second class of shares. You should be careful to not see performance as completely consistent between the two share classes. Just because they are shares of the same firm does not mean the share prices will rise and fall in exact tandem, after all, the reason for the two separate share classes is to pool the investors in Buffet's mind by wealthy and like-minded and the not-so like-minded. Thus, it is to be expected the behaviours of these investors will differ by a margin. Saying that, though, due to market arbitrage - a situation where investors would take advantage of the price difference and purchase whatever stock was 'cheaper' - the relation between Class A and Class B will never deviate by any significant value from 1:1,500. To really simplify this concept, for example, if a Class A share was £1,500 yet a Class B share was £1.10 then arbitrage would result in the purchase of Class A stock then a conversion to 1,500 Class B shares to take advantage of this price inconsistency, creating a gain of £150. Subsequently, the price would be shifted back towards the 1:1,500 ratio, as clarified by Buffet in his Memo of Comparative Rights and Relative prices of Berkshire Class A and Class B Stock last updated in 2010.

Google, too, have taken a different approach. It's no surprise the company with nap pods, pets, and amenities the rest of us thought to only be true in Sci-Fi films have decided to one up all the dual-share class firms, and have three classes instead. They have Class A, B, and C shares: for regular investors, executives/founders, and employees respectively. Class C is controversial, granting a total of zero votes, yet executives under Class B rack in 10 votes per share. Class A gets a standard one vote per share. As with Ford, along with the vast majority of company's reasoning for multiple share classes, Google have carefully engineered this structure to ensure Larry Page and Sergey Brin retain control of the direction of Google, despite their equity shareholding no longer being a majority. In an article by The Wall Street Journal, John Wilson, head of Research and Corporate Governance at Cornerstone Capital Group, an investment advisory firm, suggests this unique composition of share classes allows Google to simultaneously grow and take substantial risks investing in new and cutting edge technologies. The growth is fuelled by the capital injections from the purchase of any share class, yet the risk aspect is manoeuvred by the Class B shareholders.

These three different companies and reasons for their division of shares have hopefully crystallised the reasoning behind why a firm chooses to enforce the class structure. However, there are more categorical and universal advantages and disadvantages of the dual-class structure which we'll now investigate. A conclusion which can be confidently drawn from the vast array of diplomatic and unbiased literature is that the dual-class structure is the epitome of a double-edged sword. In a 2018 report by the CFA on the share structure, Andrew Hill from the Financial Times is quoted saying,

"The advantage of a dual-class share structure is that it protects entrepreneurial management from demands of ordinary shareholders. The disadvantage of a dual-class share structure is that it protects entrepreneurial management from demands of ordinary shareholders".

Now, in times of prosperity the impacts may not be noticed or merely omitted from business discussion, however it's during periods of turmoil where shareholders of the classes with less voting power will feel an inequity and potentially experience emotions of violation. As can be drawn from Andrew Hill's statement, the dual-class formation of a firm allows the demands of normal shareholders to be diluted and minimised. When a firm is experiencing financial difficulty, for example, and the share price is plummeting, this will impact the larger shareholders more which is likely to be the shareholders with less voting power. The executives and founders who have managed to retain control while having a reduction in equity shareholding will not be as hard-hit by a nosediving share price, therefore could enforce decisions which may not directly reflect the interests of a large portion of shareholders. This means flow of dividends, direction of the firm and trajectory, and ultimate strategic decisions are out of control of the people who own most of the business. In the same 2018 report by the CFA, they state, "Major shareholders are not incentivized to maximize the company’s potential—after all, given their low equity ownership, few benefits would accrue to them". The National Bureau for Economic Research in their report Incentives vs. Control: An Analysis of U.S. Dual-Class Companies proceed further to conclude, after exhaustive, meticulous statistical analysis that:

"The result implies that increases in inside ownership of votes, keeping the level of inside cash flow ownership constant, decreases firm value at a decreasing rate. This is consistent with an entrenchment effect of voting ownership, i.e., the more control that the insiders have, the more they can pursue strategies that are at the expense of outside shareholders."

Their research steps the investigation further, suggesting that an increase in voting rights from the 'inside', referring to founders, executives etc. actually is to the detriment of the firm's value and financial success. It's up to you whether you think this structure to be fair.

What must be accounted and considered is some firms wouldn't get to the stage of IPO if it weren't for this structure option and freedom to vary within. In 2017, 18% of all US IPOs were that of a dual-class structure. That is a substantial amount of firms who are opting for this structure, with a strong upward trend too. 'Fair' or not is rather subjective, but the facts are here to tell us all that this is a structure of increasing popularity (particularly in Tech firms, says the CFA) and shareholders may need to accept their reduced control if they want a slice of a firm. Exponents for dual-class ownership debate it's a defence mechanism against the short-termism and profit driven nature of serial investors; people who invest in many firms at a time, gaining stake and power yet have a sole interest of maximising their profits in the shortest time possible, disregarding other important factors of a firm such as culture and social responsibility. When you look from this angle, it's easy to generate sympathy for founders and executives who devote their lives to building firms for it to be sacrificed by individuals who think so linearly. The 2018 report by the CFA debates an advocation for dual-ownership to be allowing founders to fulfil their idiosyncratic ideas. Much like the rest of this argument, this has two sides. Founders should have the freedom to execute their visions for their firm, however there should be some prevention measures for potentially erratic decisions by one individual which could impact the masses. Despite the CFA providing a balanced argument, I felt throughout they were pressing against a multiple share class structure and in the executive summary state, "the CFA Institute remains firm in the belief that “one- share, one-vote” remains the fairest and most optimal market practice".

Despite it being an increasingly used structure for public firms, the reasons behind its implementation should always be considered. The structure is conducive to comforting founders that they will not lose their company to a faceless crowd, however, a shareholder often wants more than just a dividend and to strip them of their equal voting rights come with some downfalls, both internally and externally for a company.

If you have the time, I'd really recommend diving into some of the sources I listed below. All of these are comprehensive reports or letters specifically about dual-class ownership and provide an insightful peep into the world of dual-class companies and the way they are run at the highest level.

1997 Chairman's Letter, Berkshire Hathaway:

Why Warren Buffet Decided to Launch Berkshire's B Shares:

2020 Annual Meeting of Shareholders, Ford:

Council of Institutional Investors, Dual Class Companies List:

Comparative Rights and Relative prices of Berkshire Class A and Class B Stock, Berkshire Hathaway:

Google's Multi-Class Stock Structure Made Alphabet Move Unique:

Incentives vs. Control: An Analysis of U.S. Dual-Class Companies:

Dual Class Shares: The Good, The Bad, and The Ugly, The CFA:

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