Obe Ejikeme, co-fund manager, Carmignac Portfolio Family Governed, explains the advantages of investors choosing family-controlled companies.
One of my favourite childhood memories is heading to the corner shop and scooping up an array of sweets from the pic ‘n’ mix into a red and white stripy paper bag. Each sweet would have a different shape, size and flavour. That was the joy of it, the variety.
Much like the sweets in a pic ‘n’ mix bag, family-run businesses come in all different shapes and sizes. There are renowned international brands such as Walmart, Samsung and Ferrari, and much smaller, less familiar names. However, investors looking to access these companies cannot simply scoop up a selection and hope for the best. Listed companies with a big family or founder stakes have had their fair share of governance issues, which elicit ethical questions because they also have external shareholders seeking to make responsible and reliable investments. Nevertheless, there are still excellent reasons to invest in family-owned firms.
Firstly, family businesses tend to have little debt compared to non-family firms. The family’s personal “skin-in-the-game” means that family businesses tend to be less leveraged. In fact, according to Carmignac's “Family 500”, Carmignac’s proprietary database, in many cases, the level of debt in family businesses is so low that they have more cash on their balance sheet than debt – a rarity for listed businesses. A family business’s profitability is also higher, with, for example, a return on equity (ROE) of 15% compared with 13% for non-family firms, according to the latest data.
Another advantage of a family business is its stability during times of crisis. During two recent major crises (2000 and 2007-2008), the profitability of family businesses was significantly less volatile than that of other companies. Although family businesses’ ROE increased from 10.8% to 13.2% between 1997 and 2012, that of non-family businesses fluctuated erratically during the same period: 13.7% between 1997 and 1999; 8% in 2000-2002; 14% from 2003 to 2007; 4.6% between 2008 and 2009; and 13.4% in 2010-2012. During times of uncertainty, consistency and stability are an investor’s best friends, and family businesses are often robust with sustained returns.
"Another advantage of a family business is its stability during times of crisis."
Yet, despite these irrefutable benefits, many investors are put off family-controlled companies. They tend to be underrepresented in ESG funds because of concerns over control and ownership, nepotism and the risk of a single minority interest taking precedence over other shareholders. Moreover, traditional ESG ratings score them low on governance, discouraging people looking to invest their savings for responsible growth.
And naturally, succession planning is another area of concern. First and second-generation family companies tend to perform well. Once they are owned by the third, fourth, and fifth generation, company performance is more variable.
But, weeding out companies with governance challenges is one of the arts of investing. There are tens of thousands of companies with family or founder holdings that generate returns and value for decades. Discernment is key to navigating the landscape of family firms.
Having an independent board is paramount. The non-executive directors must have the ability to stand up for non-family shareholders. Likewise, the executive management committee must form a professional management team with the necessary skills and experience. The company’s history of treating minority shareholders says much about what will come next. Investors need to watch how executives are rewarded, especially if they are family or related to family members. The good news is that there is increasingly more data on executive compensation, with disclosures being encouraged or mandatory. This analysis of corporate behaviour needs to extend to accounting practices, making them more transparent.
Understanding the role of geography is essential. Family businesses in the US and Europe outperform those based in places with weaker governance frameworks, yet nearly two-thirds of listed family businesses are based in emerging markets. The size of the firm also makes a difference. Large-cap family businesses do better than small-cap, whereas the opposite is true for public-owned quoted companies, at least over the long term. Who runs the company also affects the bottom line, so having that knowledge can set you apart when compiling your portfolio.
Unlike the pic ‘n’ mix of my childhood, investors cannot rely on the good old scoop method, but rather require a professional investor who can selectively hand pick companies to ensure that no nasty surprises end up in the bag.
© 2022 funds europe