First published at ValueWalk.com
Public family controlled firms are always a grey area for investors. In many cases, the minority shareholders have little control over management’s decisions.
However, there is evidence to suggest that a controlling family can be a good thing, after all, their fortunes are tied to the success of the company. On the other hand, there have recently been a number of high-profile family-owned corporate collapses and management control concerns have led minority investors to question whether the returns warrant the risk.
To try and answer this question Credit Suisse Group AG (ADR) (NYSE:CS) has constructed the Credit Suisse Global Family universe of more than 900 companies with a market cap over $1bn to analyze the family business model.
The key takeaway from Credit Suisse’s report is that between 2006 and 2015 the 900 family businesses universe showed an excess return of 4.5% CAGR vs. the MSCI All Countries World Index (ACWI). The report also showed a correlation between business performance and the generation of the family running the business at the time. For example, buying alongside management, specifically, the first generation of management (the founders) generated the best return.
The difference in performance between the different generations of family management is highly noticeable. From the beginning of the study (2006) through to March 2015, with the first generation in charge, the company’s shares returned more than 110% on average. However, family firms with the fifth generation in charge during the period studied, only achieved a return of around 60% for investors.
Family firms: Conservative businesses model
For the most part, Credit Suisse’s data shows that family-controlled companies adopt a conservative businesses model. Family-owned companies operate a lower Return on Equity (ROE) business model in the more developed markets of US and Europe. Leverage is lower at US and European family businesses, the business cycle is smoother and more stable, growth is organic and family companies tend to invest less in R&D. Additionally, over the longer term, family companies have generated 2x the excess of the opportunity cost of utilizing assets or capital compared to benchmarks.
According to the data, family-owned companies trade on slightly higher EV/EBITDA and PB multiples compared to benchmarks. There is an element of ‘survivorship bias in these results’.
All the data points to the fact that family run businesses are better managed than their nonfamily counterparts. The research shows that family firms in the CS Global Family 900 universe have produced an ROE that has been on average 4.3% higher than benchmark (this includes companies Asia, Japan and EMEA. US family-owned companies have generated an average ROE 250bps below the benchmark) located in and cash flow returns on investment (CFROI) over 90% higher.
The 920 companies included in the CS Global Family 900 universe demonstrated a 47% outperformance compared to the MSCI ACWI over the nine years to the end of April 2015.
Since 1995, the universe of family owned companies showed annual sales growth of 10% compared to 7.3% for MSCI ACWI companies. Since 2006, this sales growth has averaged 8.5% for family companies’ vs. 6.2% for the benchmark. In all but two years, sales growth has been superior at family firms.
In trying to pin down a reason for the strong performance of family-run companies, Credit Suisse cites time horizon; a long-term corporate strategy. And this conclusion ties in with the variation in performance between the different generations of family that run the business.
Specifically, Credit Suisse found that over 40% of generation 1 and 4 owners said that the typical time horizon for the payback on a new investment was 5-10 years and over 50% of generation 2 and 3 owners expected new investments to pay back over 3-5 years. More than half of the business owners stated that their long-term management perspective was essential for the ongoing success of their business.
It seems that cash returns are also another important consideration for family firms. Cash flow return on investment for the 900 companies in Credit Suisse’s study has consistently been above the discount rate for the past two decades by an annual average of 320bps compared to 190bps for companies in the MSCI ACWI universe.
Credit Suisse looked at economic profit (defined as earnings in excess of the opportunity cost of using the assets or capital) generation of family-owned companies and found that the family-owned company universe has consistently delivered greater economic profit, measured as a percentage of enterprise value, over the past 20 years.
Family firms: Some risks
Unfortunately, while there may be many reasons to invest in a family run and controlled businesses, there are also several downsides. These mainly relate to corporate governance shortcomings and the inability of minorities to control or exert a good influence over owner managers. There’s also the issue of different classes of shares, most typically nonvoting shares to external shareholders. Most of the family-owned companies in France have double voting rights now.
Family firms: The investment case
There is plenty of evidence that shows family-owned business generate excess returns and are good investment opportunities for minority investors. It pays to invest alongside the company founder, i.e., in the early years of a company’s existence — the CAGR of first generation companies has been 9.0% over the past nine years.
And if you’re looking for ideas, Credit Suisse’s HOLT screens have picked out 20 top picks based on quality and momentum factors.