These Stocks Treat You Like Second-Class Shareholders

Nobody likes being treated like a second-class citizen, but investors often ignore this negative attribute in their stocks. Many companies have multi-class stock structures in place that block shareholders from having significant say; these types of stocks can make rotten investments on several different levels.

A matter of integrity?
Dual-class stock structures have long been associated with news media companies, which could make sense when arguing in favor of tight management control of business. The desire for creating such structures to maintain "editorial integrity" seems valid when people start imagining profit-crazed shareholders influencing front pages and skewing top stories of news operations.

In reality, modern news media isn't always lauded for integrity or being particularly unbiased, and removing shareholders from the equation hasn't protected the programming from the profit motive.

Consider News Corp. (NAS: NWS) , which owns The Wall Street Journal and Fox News, among other media properties, or The New York Times (NYS: NYT) . These companies both have dual-class structures giving management control, and whatever the American public may believe about these news outlets' businesses, biases, or journalistic quality, they both involve very powerful managements with a ironclad grip on control. (That didn't stop The New York Times' outside shareholders from at least trying to stage a revolt several years ago, withholding their votes for directors at the company to indicate displeasure with the Sulzberger family's tight rein over the company.)

When Google (NAS: GOOG) went public, it brought the multi-class structure practice into the Internet world. Since then, the policy has increased and magnified. Facebook (NAS: FB) has a dual-class structure, giving Mark Zuckerberg a boatload of power. Zynga (NAS: ZNGA) took the proverbial cake with its triple-class structure, which is an even worse affront to shareholders. CEO Mark Pincus owns all the Class C shares.

Not to be outdone, Google upped its own ante by announcing plans to issue a third class of stock, giving Google's founders even more control than they already had.

How does it feel to be a second- or even third-class citizen, investors? Not very good. The votes on your proxy ballot mean next to nothing, especially since management's shares under multi-class structures often include at least 10 votes per share compared to your single vote per share.

Ruined returns
Sadly enough, many investors may feel the sting of insult added to injury when it comes to this policy. The practice certainly doesn't guarantee better returns, and in some cases it may be a much worse investment decision than investing in companies with a single, more democratic class of stock.

A recent report from IRRC Institute in conjunction with Institutional Shareholder Services showed that over a 10-year period, non-controlled companies' stocks outperformed those with multiple-class ownership structures.

According to the report, the average 10-year shareholder return for controlled companies with more than one class of shares was 7.52%. Interestingly, non-controlled companies boasted a return of 9.76%, and controlled companies with a single class of stock -- where management controls most of the stock but outside shareholders own the same class of stock with parity in voting power -- boasted an average decade return of 14.26%.

The report raised other red flags associated with controlled companies with multiple classes of stock. These companies tended to have more related party transactions (disclosures of such transactions are usually pretty interesting stories that smack of, say, nepotism, favoritism, and shades of conflict of interest) and more material weaknesses in controls, as well as heightened share price volatility.

The IRRC report is interesting because another piece of conventional wisdom tended to bolster the argument for multi-class ownership structures: that such structures allow management to invest for long-term shareholder value instead of myopically focusing on the short term. It turns out that's simply not the case. In fact, the report found that the opposite was true in terms of shareholder returns; multiple-share companies underperformed for every time period tracked except for the shortest, one-year time frame.

The ABCs of anachronism
New-school social media companies that have adopted this policy in droves have been bothersome here lately. It's not just anecdotal evidence provided by the multi-class structures at social media companies like Facebook and Zynga. The IRRC report revealed that over the last 10 years, the number of controlled companies in the S&P 1500 has grown 31% to 114.

Why would a new generation of public companies -- so reliant on the democratization of information and touting the ability to empower so many -- run their businesses so that shareholders provide capital yet basically receive no voting power? Taking all stakeholders seriously -- including shareholders -- is a sign of good management.

A multiple-class ownership structure may not be a 100% guarantee of a poor investment, but obviously it can reduce the chances that a stock will be a good one for the long haul.

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Alyce Lomax has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and Google and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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