U.S. small-cap stocks are typically young start-ups in the early, rapid-growth stage of their existence. That’s what makes them so exciting to own – and profit from. Such exciting small-cap investments are often managed by their visionary, entrepreneurial founders, who started the company based on passion for an idea — not “professional managers” who hop from one mega-corporation to the next. If you are interested in a short cut for determining which CEOs are most likely to exhibit the “honest and competent management” criterion that qualifies their companies for Roadrunner Stock consideration, focusing on founder CEOs is the short cut.

Founder CEOs are entrepreneurs who passionately want to create a business, not just collect a paycheck. They are often compensated mostly with stock, not borrowed cash, which aligns their financial interests with the average shareholder and makes these companies much more shareholder-friendly than the bloated behemoths in the S&P 500.  Small-cap investors rarely have to worry about paying for corporate jets, extravagant management retreats or obscene golden parachutes.

Nowhere else besides the small-cap universe will you find so many fresh “disruptive” ideas or such hungry management. These “owner/operators” are obsessed with success and improving the world, which make the best long-term investments.

Of course, there are exceptions. Take, for example, the recent ouster of Groupon (Nasdaq: GRPN) founder and CEO Andrew Mason. But study after study has found that stocks of companies run by founder CEOs, on average, outperform the average stock:

• 2007 Study:

“Founder-CEO firms differ systematically from successor-CEO firms. Founder-CEO led firms not only have a higher firm valuation than non-founder-CEO firms, but also a higher stock market performance. Furthermore, they undertake more acquisitions in their core business, and invest more in R&D and capital expenditures.

The larger investment expenditures of founder-CEO firms do not correspond to an overinvestment by founder-CEO, but that they are used to undertake positive NPV projects. Therefore, one possible explanation of the higher valuation of founder-CEO firms is that during the 1990s, founder-CEOs successfully embraced an expanded investment opportunity set.

An equal-weighted (value-weighted) investment strategy that invested in founder-CEO firms from 1993-2002 would have earned an abnormal return of 8.3% (10.7%) annually in excess of what could have been achieved by a passive investment.

• 2006 Study:

“26 FORTUNE 500 companies boast founder-CEOs. The stocks of these 26 companies returned an average of 18.5 percent annually from year-end 1995 through 2005, which is seven percentage points better than the FORTUNE 500’s average return over the same period.

Their profit growth has been superior, too, increasing at an average rate of 19.6 percent a year from 1995 to 2005, vs. 11.7 percent for the FORTUNE 500.

• 2008 Study:

“Founders tend to be less responsive to performance incentives and generally more entrenched. At the same time, founders’ led firms are more valuable, supporting our predictions. This suggests that for founders, regulation of compensation may not be very effective.”

• 2010 Study:

“Founding CEOs consistently beat the professional CEOs on a broad range of metrics ranging from capital efficiency (amount of funding raised), time to exit, exit valuations, and return on investment.”

In November 2009, Fortune Magazine named Apple’s Steve Jobs (a founder CEO) the CEO of the decade. Interestingly, of the six serious runner-up CEOs (six others were either not CEOs or were infamous CEOs like Bernie Madoff and Enron’s Jeffrey Skilling), all six were company founders. In an earlier 2006 article, Fortune Magazine interviewed founder CEOs James Sinegal of Costco Wholesale (Nasdaq: COST) and Richard Kinder of Kinder Morgan (NYSE: KMI) to demonstrate the winning ways of founder CEOs. Costco’s Sinegal demonstrated love for his company and is more interested in long-term success than the short-term variant:

“It would be truly devastating to me if this company ever failed,” says Sinegal. So he doesn’t let near-term cost pressures divert him from what he thinks is good business.

Richard Kinder also demonstrated passion through his shareholder-friendly commitment to cost control:

Kinder, who co-founded Kinder Morgan in 1997, has no patience for the costly executive perks that are so common in corporate America. Kinder Morgan doesn’t have corporate jets (its executives all fly coach). It doesn’t pay for sports tickets (never mind luxury boxes). And there are no special retirement or benefit packages for senior officers (their base salaries are all capped at $200,000).

The preference for founder CEOs is not limited to academic researchers and magazine editors, but includes actual investors like venture capital firm Andreessen Horowitz, which evaluates CEOs for a living. In an April 2010 blog post by name-partner Ben Horowitz, we are treated to the firm’s reasons for why it favors founder CEOs over professional outsiders. Three main reasons:

• Comprehensive knowledge
• Moral authority
• Total commitment to the long term

While Mr. Horowitz conceded that professional managers were often better equipped to maximize the profit-making potential of an existing innovative product, they typically have no clue how to create innovative products themselves. Creativity is the rarer and less-easily taught skill:

Professional CEOs are effective at maximizing, but not finding, product cycles. Conversely, founding CEOs are excellent at finding, but not maximizing, product cycles.

Our experience shows—and the data supports—that teaching a founding CEO how to maximize the product cycle is easier than teaching the professional CEO how to find the new product cycle.

A similar conclusion was reached by a business strategist for a commercial bank, who dealt with small-company CEOs all the time. He favored focusing marketing efforts on founder CEOs because they possessed the following qualities of success:

• Relentless persistence
• Long-termed thinking and personal investment
• Tenacity
• Brilliant innovation
• Key customer retention
• Employee loyalty
• Passion (most important)

Two of the most well-known current-day examples founder CEOs are Jeff Bezos of Amazon.com (Nasdaq: AMZN) and Mark Zuckerberg of Facebook (Nasdaq: FB).  Zuckerberg made waves last year when Facebook filed a registration statement in preparation for its May 2012 IPO. On pages 67-70, Zuckerberg wrote a letter to potential shareholders that was shockingly unconventional:

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take.

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something.

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits. By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

This philosophy screams “long term” value building and is the opposite of the short-term profit maximization practiced by most professional managers. Former Internet analyst Henry Blodget wrote at the time that he wished most, if not all, U.S. companies would employ a similar philosophy when making business decisions.

More recently, Jeff Bezos of Amazon.com wrote a shareholder letter with similar long-term sentiments that downplayed short-term profit maximization. In fact, Bezos quotes legendary value investor Ben Graham!:

Our heavy investments in Prime, AWS, Kindle, digital media, and customer experience in general strike some as too generous, shareholder indifferent, or even at odds with being a for-profit company. “Amazon, as far as I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers,” writes one outside observer. But I don’t think so. I think long-term thinking squares the circle. Proactively delighting customers earns trust, which earns more business from those customers, even in new business arenas. Take a long-term view, and the interests of customers and shareholders align.

As I write this, our recent stock performance has been positive, but we constantly remind ourselves of an important point – as I frequently quote famed investor Benjamin Graham in our employee all-hands meetings – “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed, and we’re always working to build a heavier company.

Once again, Henry Blodget praised the long-term thinking exhibited by a founder CEO – in this case, Bezos. Even Warren Buffett has nice things to say about Bezos, stating in a February 2013 interview (timestamp 3:10 to 3:48) that Bezos “will never stop” innovating and focuses (as he should) on long-term value creation “5-10 years from now,” not next quarter’s earnings report.

Despite earning minimal short-term profits, Amazon.com has been a fabulous long-term investment, returning shareholders more than 17,600% (38.7% annualized) since its May 1997 IPO. In contrast, Facebook has been a bust so far as a public company, losing shareholders 31% in the past year. Long term, I am confident that Facebook shareholders will do just fine given founder CEO Zuckerberg’s long-term value-creation focus.

Are there any other public companies out there with founder CEOs that may follow Amazon.com’s path to greatness? Using my trusty Bloomberg terminal, I searched for small and mid-cap stocks with founder CEOs. There are plenty, so I just highlight a sampling of 30 such stocks below:

30 Small/Mid Caps with Founder CEOs

Source: Bloomberg

Around the Roadrunner Portfolios

Buckle (NYSE: BKE) posted flat March same-store-sales, but — as usual — beat overly-pessimistic analyst expectations. Fortunately, the company may experience higher sales in the second half of 2013 if Piper Jaffray’s latest survey of teen spending trends is accurate. According to the survey:

Two-thirds of respondents view the economy as consistent to improving, and just over half signaled an intent to spend “more” on key categories of interest, particularly fashion and status brand merchandise.

The pause in spending may be temporary, approximately 53% of upper-income teens plan to spend more on fashion apparel in the coming periods.

Diamond Hill (Nasdaq: DHIL) hosted a conference call with its portfolio managers on April 17^th. It was great to hear that most of the company’s mutual funds outperformed their benchmarks during the first quarter. Even better, the portfolio managers spent a good deal of time explaining their investment strategy and what stocks look good now. As I wrote in What is a Roadrunner Stock? Part 2: Honest and Competent Management, one sign of a shareholder-friendly company is frequent and informative communications with shareholders.

HMS Holdings (Nasdaq: HMSY) sold off on April 19^th in sympathy with a revenue warning from PRGX Global (Nasdaq: PRGX), to whom HMS subcontracts about 15% of its Medicare recovery audit contractor (RAC) work. I believe this sell-off is an overreaction for a few reasons:

• PRGX subcontracts involve only 2-3% of HMS’ total revenue
• Medicare RAC revenues constitute only 10% of PRGX’s total revenue, so the company’s revenue warning must involve PGRX company-specific problems unrelated to the Medicare RAC program.
• PGRX is vulnerable to a part of Medicare RAC that is being drastically changed (subcontractors are being eliminated), whereas HMS’ status as a Medicare regional audit contractor is unaffected.
• HMS has already baked some Medicare RAC disruption into its 2013 guidance.

For all of these mitigating reasons, analysts at Wells Fargo Securities continue to give HMS Holdings the top “outperform” rating, stating that “we believe these shares are compelling given the Medicaid expansion in 2014-15 and significant RAC potential.”

Western Refining (NYSE: WNR) announced a new $200 million share repurchase plan to supplement the $200 million share repurchase announced in July 2012 that has almost been used up. According to Zacks:

We believe the new buyback plan not only highlights the oil refiner’s commitment to create value for shareholders but also underlines the confidence in its cash generating abilities.

The company also finalized the refinancing of its shorter-term, high-cost debt with longer-term, lower-cost debt. The refinancing is very good news that strengthens the corporate balance sheet and, by reducing interest expense, will increase earnings. The crack spread between gasoline and crude oil appears to have stabilized at a level one energy analyst characterizes as “a value area that reflects where the fundamentals really are.”