Investing in family companies
“Founding families, kept in check by an independent board, tend to exert a positive influence on companies, particularly when the founder remains actively involved in setting strategic direction. Family-controlled groups are more inclined to have a long-term perspective, a strong corporate culture, and conservative financial management, all attributes conducive to long-term share outperformance.” FT 1/12/13
“When we looked across business cycles from 1997 to 2009, we found that the average long-term financial performance was higher for family businesses than for non-family businesses in every country we examined.” Harvard Business Review
Why family companies tend to outperform
“A CEO of a family-controlled firm may have financial incentives similar to those of chief executives of nonfamily firms, but the familial obligation he or she feels will lead to very different strategic choices. Executives of family businesses often invest with a 10- or 20-year horizon, concentrating on what they can do now to benefit the next generation. They also tend to manage their downside more than their upside, in contrast with most CEOs, who try to make their mark through outperformance.” Harvard Business Review
In our opinion, there are some clear reasons why family companies tend to outperform over the long term:
Family companies view each dollar as their own and are thus focused on controlling costs throughout the economic cycle.
“We do not spend more than we earn.” Harvard Business Review CEO interview
The same applies to CapEx budgets; family companies tend to be focused on return on investment and thus generate higher than average returns on investment over the long term
Family companies tend to like cash and dislike debt. By taking a very long term view on their business and thinking about future generations’ wealth, these management teams tend to be financially conservative which generally serves shareholders well over the long term. It is very common to see family companies carry net cash surpluses on their balance sheets.
Family companies tend to prioritise organic growth over acquisitive growth which reduces the risk of large value-destructive acquisitions.
“We don’t like big acquisitions—they represent too much integration risk, you may get the timing wrong and invest just before a downturn, and more importantly, you may alter the culture and fabric of the corporation.” Harvard Business Review CEO interview
Family companies think about long term, through the cycle returns which means they are often involved in defensive, diversified business models, and are thus less exposed to economic fluctuations.
Family companies tend to look after their staff and thus retain them far better than competitors over the long term. By treating their employees like individuals rather than numbers, family companies offer significant non-monetary benefits for employees. It is common to see family companies invest significantly in their employees through training which highlights to employees that they are highly valued members of the team.
“Interestingly, family businesses generally don’t rely on financial incentives to increase retention. Instead, they focus on creating a culture of commitment and purpose, avoiding layoffs during downturns, promoting from within, and investing in people.” Harvard Business Review
Family companies tend to have good track records of international expansion. This is consistent with their preference for long-term, organic growth; they are happy to start small in new markets and to gradually build new geographic revenues step by step. This is a very different approach to the large value-destructive acquisitions often attempted by non-family management teams.
The challenges of investing in family companies
Being a minority shareholder in a family run company is however not without its challenges:
- The founding family often exerts strong inter-generational management control. For example, Westfield Corporation, 55 years after it was founded by Frank Lowy, continues to be led by Frank’s sons, Steven and Peter. Rightly or wrongly there can be a perception of nepotism in family companies - that family members are in these management positions due to their surname rather than their ability.
- Family companies are often also associated with a large number of related party transactions – whether that be the leasing of properties owned by family members, supply/purchase agreements with other family companies, and/or consultancy agreements with certain family members. There can be a perception that the controlling family is favoured in these transactions at the expense of non-family shareholders.
A strong board with genuinely independent directors is important to ensure that the position of minority shareholders is appropriately considered. The combination of a strong independent board and an experienced, driven family management team can represent a powerful investment proposition.
An example within DMX Capital Partners
We recently wrote about SDI (ASX: SDI) in our emerging global leader series, and this is a great example of a family company which is well placed to outperform by virtue of ticking many of the above-mentioned family company attributes:
The company had been run by its founder Jeffrey Cheetham for some 40 years, while his daughter Samantha Cheetham has been working as the Sales and Marketing Director in recent years. Jeffrey retired on 30th June 2016 with Samantha taking over the CEO role. This multi-year succession plan and CEO training path is common amongst family businesses and often makes for a smooth transition between the family ranks.
“SDI commenced operations in Jeffrey Cheetham’s garage, producing amalgam fillings and selling the products direct to dentists. By 1975, the company had operations in New Zealand, United States, and Greece.” DMX SDI Emerging Leader report.
- The Cheetham family have a 43% stake in the business.
- SDI has a very strong balance sheet with almost no debt (3% gearing) and fully owns its large manufacturing facility in Melbourne.
- SDI is cautious when it comes to making acquisitions and has a track record of focusing on organic growth. There have been no large equity raisings or share issues that would otherwise dilute the holding of the Cheetham family.
- SDI is involved in a relatively defensive market, dental products, where margins are high and costs are well controlled.
- SDI has a strong track record of international expansion and in our opinion is an emerging global leader in its market.
SDI is a well run, growing family-run company with strong fundamentals and attractive valuation metrics. However its seven-person board is very much controlled by Cheetham family members and directors that are close to the company and/or family. Our view is that there is an opportunity for SDI to become an even more compelling investment through the appointment of strong, independent directors.
CONCLUSION: Investing in family companies aligns with our strategy of investing in long term overachieving companies which are largely unknown in the broader market. There are compelling reasons why family companies tend to outperform and we expect to see similar outperformance on average looking forward
For more details see our recent emerging leader article covering SDI: (VIEW LINK)
Article contributed by DMX Asset Management: (VIEW LINK)
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