Crunching the numbers on owner -managed stocks
My love affair with owner-managed businesses began back in the mid-1990s when I was in my 20s, and naturally as one imagines at that age, an investing genius. Surely sensing my potential, my bosses allocated me a ‘small-cap’ company to cut my teeth on as an analyst (read: limit any potential damage to portfolios). The trading liquidity of the company was low, and it did not get a lot of airtime among the bigger, sexier companies. I took a good look at the company, reading all the (hard copy!) annual reports, and got a sense for the underlying quality of the business.
The company – Reece Limited (ASX:REH) – was outwardly pretty boring – a plumbing wholesaler that was majority-owned by the Wilson family, a family that had no interest in spruiking the stock to pump up the share price. This put them at odds with 90% of other companies on the bourse, and pretty much all my experience of management teams thus far.
Over a few years, we slowly but surely accumulated enough stock in Reece to make it a meaningful holding in the portfolio. The results had been impressive, with the company growing profits at a meaningful clip and the share price following. So, expectations were high leading into another half-year result when I excitedly printed the results out – sales were up meaningfully! Double digit! … but net profit was down … meaningfully!
To better understand my consternation, perhaps a slight detour on how the market operates and concentrates on short-term performance. There … that is the detour.
In my experience, the market was (still is!) ONLY interested in the right here and now, and it wants profit growth NOW and the promise today of more of the same into the future with no detours taken along the way.
The reward? A nice upward path for the share price. In my experience as an analyst to that point, this is what companies strove for each half year and they would move hell and high water to achieve it, egged on by market participants (buy and sell sides). The poster child at the time was US-listed General Electric with the lauded Jack Welch as CEO. It turns out the remarkable quarter-over-quarter profit growth that GE produced was an illusion, but that is another story.
So, I frantically looked at this profit result from Reece with a growing sense of sickness in my stomach – costs were way higher than the previous period, in my mind destroying a beautiful sales result. The ‘market’ in its short-term wisdom declared this a poor result and reacted accordingly. The stock fell.
Now as I have mentioned, Reece was majority-owned by the Wilson family, with ownership of over 70% of the shares on issue. The family did not communicate much with the market, nor frankly did it seem to care what a bunch of financial analysts thought about how the company was run, rightly so as we’ll see below. However, in my infinite wisdom I was determined to tell CEO Alan Wilson what was what, and didn’t he understand the purpose of producing half-yearly profit growth numbers? Hadn’t he heard of operating leverage?
So, with more patience and politeness than I deserved, Wilson heard me out and further explained the strategy that was already laid out briefly in the result commentary (had I bothered to read it). Where I saw a cost blow-out, he saw great opportunities for investment to grow – simply, rolling out the Reece store network in more locations around Australia, taking market share, and becoming ubiquitous within plumbing and bathroom. I hung up the call having learnt a valuable lesson.
Now I had dutifully read the Warren Buffett letters and paid lip service to buying ‘pieces of companies’ not ‘lottery tickets,’ but in the cut and thrust of everyday markets, I too had absorbed the focus on the short term.
The penny dropped that Wilson was investing now for future growth, and that the opportunity could be massive.
Now around that time in the late 1990s, Reece was actually half the size of the big player in the market – Tradelink (owned by the mini-conglomerate Crane Group). The chart below shows that Reece was half Tradelink’s size in terms of sales and profits.
Fast forward more than 20 years and Wilson’s strategy has played out perfectly. From a relatively unknown company based in Victoria, the Reece name has become synonymous with plumbing and bathrooms nationwide. The chart below shows the result – sales in Australia/New Zealand up 8x and profits up 22x. Amazing results and all without raising any equity (until its expansion into the US in 2018) or meaningful debt. In fact, the company acquired property sites for a lot of its best-located stores along the way. Meanwhile, you can see what happened to Tradelink – 23 lost years where sales went nowhere, and profits backwards – overseen by numerous management teams and a new corporate owner (Fletcher Building ASX:FBU)).
Which now brings us to the lesson in all this. Standing in 1998, armed only with sales and profits of Reece versus Tradelink, traditional business theory would usually predict Tradelink would go on to dominate, given it had a larger store base and hence larger sales base to generate economies-of-scale benefits, etc. Yet we see that an owner-managed business can meaningfully outperform a competitor. Why might this be the case?
Firstly, it’s worth defining how we think of owner-managed businesses. We break our definition into two groups:
- High ownership, high control: By this we mean an owner/founder who retains a shareholding of more than 20% of the shares on issue and manages the business. Companies such as Reece, Fortescue (Andrew Forrest), Seven Group (Stokes family) and Harvey Norman (Gerry Harvey) fit this definition.
- Low ownership, high control: This group is a bit more nuanced. For example, despite owning only about 14% of News Corp, the Murdoch family is unanimously considered ‘owner-managers’ of the company (helped by the family’s higher ownership of the voting shares). Other examples include the Lowy family formerly at Westfield (less than 15% ownership) before its merger with Unibail-Rodamco, ARB Corp (4WD accessories) run by Roger Brown and his brother (less than 10% ownership), and even ResMed (sleep apnoea devices), co-founded by Chairman Peter Farrell and now managed by his son – Mick – despite the Farrells owning less than 5% of the company.
So why can companies that fit these definitions do so well? We believe it comes down to three fairly obvious factors:
- A strong focus on the core
- Long-term planning
- Resilience, leading to optionality (typically underpinned by conservative debt structures).
Using Reece as an example and running the company through the three factors:
With a continuous management team implementing the above, the results can be powerful. Reece has had two CEOs in 50 years – Wilson and now his son Peter – while, as mentioned, Tradelink has had at least five different senior management teams over the past 20 years. The result of this continuity for owner-managed companies is that the ‘culture’ that is developed over time can be an amazingly powerful weapon in a company’s success.
Owner-managed – The numbers re-crunched
We have been keen on this owner-managed theme for some time and indeed in the Airlie Australian Share Fund a third of our holdings are owner-managed companies. We first put together an owner-managed index in 2018 that backed up our view that owner-managed companies overall outperformed over the long term, because of the reasons listed above. At the time, we noted the limitations of our exercise:
- Had we captured all the owner-managed companies out there?
- Was survivorship bias distorting our data? (ABC Learning anyone?)
- What about when the owner-manager sold down or stepped back? (Computershare, Primary Healthcare)
“Owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period.”
We have pored over the data set and re-crunched the numbers (with the help of Macquarie Equities) to test the limitations listed above. We have included all owner-managed businesses up until the point at which the owners stepped back. Some simple conclusions have been drawn (and the numbers are shown in the table below):
- As a collective group, large and small cap, owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period: 10 years, 15 years, and the full history of our test over 22 years (since 2000).
- This outperformance includes notable blow-ups ABC Learning, Babcock & Brown et al associated with the GFC meltdown.
- Small-cap owner-managed companies are the place to be – over the years think ARB Corporation, Mineral Resources, and Premier Investments. Companies that have compounded at more than 20% p.a. for years. More recently (past five years) companies such as AfterPay have made the owner-managed universe.
We have further refined the notional index by applying Airlie’s investment filters that favour financial strength, business quality and management capability. We believe that not all owner-managers are created equal. We feel some look after minority shareholders better than others and/or their businesses fail our quality test. As mentioned, ABC Learning and Babcock & Brown were two high-profile situations where shareholders lost all their money. Both companies failed Airlie’s test on financial strength.
Further, we have excluded some business models (notably the buy-now-pay-later space) where we feel there is a question mark around sustainable profits. Note that the exclusion of AfterPay penalises our notional index performance.
So, taking our investment process filters and looking 10 years over the performance of owner‑managed businesses versus the broad market:
So, 10 years ago $10,000 invested in Airlie’s notional owner-managed index (purple line) is worth $60,000 while $10,000 invested in the market is worth about $30,000. Of the 70 owner-managed companies that make up this notional index, the strong performers include:
- Fortescue (ASX:FMG)
- ResMed (ASX:RMD)
- Goodman Group (ASX:GMG)
- Mineral Resources (ASX:MIN), and
- Northern Star (ASX:NST)
To be clear, we have not owned all of these companies in our funds over the years. Although it is pretty evident to us now that our performance would have been enhanced if we had! The poorer performers include: Monadelphous, Nufarm, Freedom Foods, and Oroton. We have not held any of those companies in the fund.
The small-cap effect is evident when we split our notional index into two market cap groupings. So, the bigger companies (purple) versus the smaller ones (green):
The conclusion we draw is that the owner-managed model is immensely powerful in a small company, where the success factors of owner-managers can be leveraged into truly remarkable results. Examples in our fund include ARB Corporation, Premier Investments, Nick Scali, PWR Holdings and of, course, Reece. So going back to years ago when I was allocated Reece to analyse, the market capitalisation was less than $250 million.
With a market cap of nearly $9 billion today, Reece remains the poster child for the power of backing the right owner.
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Matt entered investment management in 1993 and has over 20 years industry experience. Since joining Airlie in July 2016 he has managed Australian share strategies for institutional clients. Prior to that, he was Head of Equities at Perpetual.