Wondering How to Make Money on Stocks? The Surprising Place to Start

By Markets Fool.com

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Could this secret be the key revealing how to make money on stocks?

Every spring, I undertake the tedious chore of evaluating my family's stock positions and deciding if we need to make any changes. This year, I noticed something that -- for one reason or another -- I've completely missed before. And this one common trait accounts for the vast bulk of how we've made money on stocks.

Look at my family's top holdings below, what they've returned (they were bought at many different points), and how they're doing against the S&P 500. Do you notice a common thread?

Stock

Percent of Portfolio

Returns

Returns vs. S&P 500 (percentage points)

Baidu

14%

80%

+25

Amazon.com

13%

135%

+54

Google

9%

68%

+6

IPG Photonics

7%

106%

+44

Starbucks

7%

65%

+26

Apple

5%

159%

+71

Whole Foods

5%

43%

(17)

Facebook

4%

17%

+10

Source: Author's portfolio, as computed on Fool.com's scorecard feature. All percentages rounded to the nearest whole number. Figures accurate as of June 12, 2015.

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Perhaps you think investing in Nasdaq-listed stocks has been my family's secret to making money in stocks. While that might be true, it's not what I want to talk about today. One other clue worth mentioning: almost all of our shares of Apple were bought prior to August 2011.

Any guesses?

The thing that all eight of these companies -- which comprise 66% of my family's holdings -- have in common is this: they were all led by founder-CEOs when we bought shares.

Fifteen companies in our portfolio are actually run by founder-CEOs (many of them are very small positions). In total, these companies have an annualized return of 22.7% per year and are beating the S&P 500 by 6.2 percentage points per year.Impressive results for a portfolio that is about 8 years old.

Unfortunately, our overall returns have been pulled down quite a bit by companies that are not founder-led. The non-founder-led stocks have an annualized return of just 7.6% per year, and are underperforming the S&P 500 by 9.4 percentage points per year.

That's pretty bad.

Enough to explain how to make money in stocks?
After seeing this, I wanted to research whether this was a consistent phenomenon. Starting in early April,I went back and tried to reconstruct what the S&P 500 looked like five years earlier (in April 2010). This was an arduous task, as such information isn't particularly easy to come by.

Then, I studied how those S&P 500 stocks had performed from April 2010 to April 2015.Again, this wasn't an exact science, as some companies were acquired by others or taken private, so their returns could not be calculated. For the ease of computation, I threw these companies out. In the end, I was left with 446 companies.

Of those companies, 47 had their founder in the role of CEO or board chair, or in another C-Suite position, in 2010. This included big winners such asStarbucksand salesforce.com-- which returned 314% and 250%, respectively over this 5 year time frame.But it also included a number of losers, such asDenbury Resources, an energy company that has fallen substantially over the past year, and lost over half of its value since 2010.

But taken as a whole, the founder-led companies performed better than the others.

Founder vs. Non-Founder | Create infographics

At first blush, it might seem odd that both cohorts could outperform the overall index. There are a few reasons for this, but the most important has to do with weighting. The S&P 500 is weighted, and the results in my survey were not -- meaning a small company that grows considerably gets equal weighting in my equations, while the same is not true for the index.

As a whole, it's clear these founder-led companies did well, but it's not by a sufficiently convincing margin to say you should simply buy only founder-led companies.

I went back to check my results using the Nasdaq 100 as a second proxy -- measuring from Jan. 1, 2011, to June 1, 2015. Once again, founder-led stocks outperformed, but not by a convincing margin: 107% vs. 100%. That margin simply isn't big enough for me to say, "Founder-led companies definitely perform better."

What conclusions can we draw?
Nassim Taleb published a great book last year called Antifragile. In it, he said having "skin in the game" is important in managing risk. Without skin in the game, Taleb argued, people making important decisions don't have enough incentive to protect against downside risks.

As an investor, there's a valuable lesson here. A CEO who owns a significant portion of a company -- or whose personal wealth is entirely dependent upon the performance of his or her company -- is far more likely to take smart risks. They have "skin in the game."

Photo: Sam Beebee, via Flickr.

At the same time, a founder-CEO is also more likely to take it one step further -- as Taleb would say, they have their "soul in the game."

Not only does this mean a company will avoid stupid risks, but it will have an entrepreneurial spirit (how else did the company start?). That same spirit often thrives from disorder, with the ability to pivot focus when the market changes. This makes these companies antifragile -- something that gains from disorder.

Based on the back-testing I did with S&P 500 and the Nasdaq 100, it's clear that indiscriminately choosing founder-led companies isn't a surefire way to pick big winners. A more nuanced approach is necessary.

I suggest using a list of founder-led companies as a starting point. From there, it's important to investigate (1) your familiarity with the company, its product, and business model; (2) how much of the company is owned by insiders; (3) the strength of the company's balance sheet; and (4) the size of its opportunity going forward

Beyond these characteristics, I think it's invaluable to listen to as many interviews, and read as many books, as you can about the founder/CEO. What kind of a feel do you get after listening to him or her? Do you feel like the CEOs you study have the type of inner flexibility to help ensure long-term success? Are they open about their mistakes? Are they willing to listen to criticism?

By using this framework, I have found some huge winners. I hope this helps you find a couple of your own.

The article Wondering How to Make Money on Stocks? The Surprising Place to Start originally appeared on Fool.com.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Amazon.com, Apple, Baidu, Facebook, Google (A shares), Google (C shares), IPG Photonics, Starbucks, and Whole Foods Market. The Motley Fool recommends Amazon.com, Apple, Baidu, Facebook, Google (A shares), Google (C shares), IPG Photonics, Salesforce.com, Starbucks, and Whole Foods Market. The Motley Fool owns shares of Amazon.com, Apple, Baidu, Denbury Resources, Facebook, Google (A shares), Google (C shares), IPG Photonics, Starbucks, and Whole Foods Market. 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.