Think about all the steps involved in building a pedestrian bridge today. There are codes, architectural designs, the actual building of the bridge, inspections and testing...the list goes on. And for good reason: we want our bridges to work. No one wants to be on a bridge the moment it gives out.
So how did civilizations long ago build bridges without all the tools we have today? In his book Skin in the Game, Nassim Taleb offers an example: in Roman times, engineers had to spend some time every year sleeping under the bridges they drew up. If their own skin was in the game, they'd be incentivized to make it as safe as possible.
I use this example for beginning investors because it brings a crucial concept into focus: the oft-overlooked and incredible importance of "skin in the game."
What is skin in the game?
Put simply: you have skin in the game when you stand to benefit or lose something substantial based on a decision you make. The exact definitions of "something" and "substantial" are up for debate.
Here's another way Taleb describes the phenomenon: he'd rather fly on a plane where the pilot is in the cockpit as opposed to one that is being flown remotely via drone. Why? Because the pilot in the cockpit has just as much incentive as the passengers to land safely. Of course, that doesn't mean all drone pilots would automatically be reckless -- but they could walk away from a "crash" with their life intact.
How I apply skin in the game in picking investments
In my own investing framework, "skin in the game" is one of three broad areas I evaluate (here are the other two). I've devised a simple (and perhaps shallow) way of doing that. I check:
- Is the founder still involved? A founder being involved does not automatically make a company bulletproof. But founders often view their creation as an outgrowth of themselves. They want to create lasting, meaningful value.
- Do insiders have skin in the game? You can check this by going to the Securities and Exchange Commission's database, typing in a ticker, and looking for the DEF 14A: the company's proxy. If you search the document for "beneficial," (as in, "beneficial ownership") you'll see how much of the stock insiders own. I prefer companies where insiders own at least 8% of shares outstanding. At the bottom of the statement, it will tell you how much of the stock is owned by insiders. And by "insiders", this generally means board members and executives.
- Do employees like being there? Lastly, I like to see if employees enjoy the company they work at. In the end, these are the people who make things happen. By using Glassdoor.com -- a website that compiles anonymous ratings from current and former employees -- I can review their analysis. This is not fool-proof. Glassdoor ratings can be gamed. But the more time you spend looking at them, the more comfortable you feel discerning real concerns/praise versus noise. In general, I like investing in companies that are rated 4.0 or higher.
At the end of the day, skin in the game is not a panacea. But I believe it is useful as a screener for making wise investment decisions. While checking out the business fundamentals and evaluating a company's moat are undoubtedly more important, skin in the game can help you whittle your "stocks to buy" list down to the very best options.