Family Values: Are the Stocks of Family-Controlled Firms Good Investments?
Nearly a decade ago, Adelphia Communications founder and CEO John Rigas, along with his son Timothy, were convicted of conspiracy, bank fraud, and securities fraud for looting the family-controlled cable company. The Rigas family, which had held majority voting control of Adelphia, had treated the firm as their personal ATM, financing a Gatsbyesque lifestyle at the expense of the company’s minority shareholders. Adelphia was forced into bankruptcy and its shareholders were wiped out.
And while the story of Adelphia remains a cautionary tale of the risk that comes with investing in family-owned firms, evidence suggests that it’s also the exception rather than the norm. Most studies of the impact of family ownership indicate that, on balance, family control is a good thing for stockholders. And Warren Buffett agrees, saying, “Family-owned businesses share our long-term orientation, belief in hard work, and a no-nonsense approach and respect for a strong corporate culture.”
In the US, the stocks of Amazon.com (AMZN), Microsoft (MSFT), and Wal-Mart Stores (WMT), have delivered spectacular returns since their founding, and they remain under varying levels of control by their founding families. Long-term shareholders of European family-controlled firms like L’Oreal Group (LRLCY) and Novartis AG (NVS), and Asian electronics giant Samsung (SMSN), have been similarly rewarded. Drawing on the research findings related to family control from academia as well as my own experience as a manager of a mutual fund dedicated to investing in family-controlled firms, I can identify some common attributes, good and bad, of family-controlled firms.
What Constitutes Family Control?
When it comes to publicly held firms, there is no standard definition of a family-controlled company. Family control — which can come in the form of stockholdings, board representation, or management positions — equates to the degree of influence a family is able to exert over the strategic direction and management of a company. Board seats and management positions are obviously more tenuous claims to power than equity ownership, which often comes in the form of a special class of shares with super voting rights. In “How Do Family Ownership, Control, and Management Affect Firm Value?” Belén Villalonga and Raphael Amit define a family-controlled company as one in which the founder or a related family member is an officer, director, or owns more than 5% of the firm’s equity. In “Founding Family Ownership and Firm Performance: Evidence from the S&P 500,” David Reeb and Ronald Anderson consider fractional ownership and board representation as their primary indicators of control. In their study, Reeb and Anderson considered over 35% of the S&P 500 constituent firms to be family-controlled. Family control among publicly-held firms is even more prevalent in Europe and Asia.
The Benefits of Family Influence
Warren Buffett was right: Family-controlled firms tend to be more patient and less beholden to hitting their quarterly earnings numbers than companies without a strong family influence. This also makes them less apt to succumb to accounting gimmickry and worse, the example of Adelphia notwithstanding. This relative financial conservatism extends to the balance sheet, as family-controlled firms have also been found to carry comparatively little debt. And, perhaps surprisingly, dividend payout ratios are smaller among family-controlled companies. Low employee turnover, which leads to higher productivity and a stronger corporate culture, is another hallmark of family-controlled firms. The end result seems to be better financial returns, which don’t go unrecognized by investors. According to an extensive study conducted by Pitcairn Financial Group in the 1980s, the stocks of family-owned firms within the S&P 500 Index annually returned approximately 135 basis points more than the broad market over a 20-year period.
Too Much of a Good Thing?
Reeb and Anderson’s research confirmed that family control enhanced firm performance, as measured by both Tobin’s q and return on assets. They attributed this outperformance to those firms in which a family member served as the CEO. They also found that the outperformance was not uniform across all levels of family ownership. Firm performance increases until families own about one-third of the firm’s outstanding equity, beyond which performance begins to decline. Reeb and Anderson posit that beyond this threshold “the potential for entrenchment and poor performance is greatest.”
Villalonga and Amit also used Tobin’s q as their measure of value, and found that family ownership adds value only when combined with certain types of family management and control. Family management adds value as long as the founder is CEO of the company, or its board chairman with an outsider as CEO. Family control in excess of ownership, often in the form of a special share class, reduces shareholder value, though minority shareholders still benefit. Importantly, Villalonga and Amit found that investors were worse off in family-controlled firms led a descendant CEO.
Despite the prospect for attractive relative returns, family control clearly needs to be held in check, and this hasn’t always been the case, particularly in Asia. In “Independent Non-Executive Directors: A Search for True Independence in Asia,” authors Lee Kha Loon, CFA and Angela Pica, CFA, assert that relatively weak regulatory oversight and lax corporate governance practices have disadvantaged minority shareholders of family-controlled firms in Asia. And in “Dividends and Expropriation,” authors Mara Faccio, Larry H.P. Lang, and Leslie Young maintain that family ownership in East Asia has hurt company performance for similar reasons.
Beware Common Pitfalls
There can be drawbacks to family control and chief among these is what Reeb and Anderson charitably call “opportunism” on the part of the controlling family. Excessive compensation, self-dealing, and related party transactions are examples of such exploitative behavior. Reeb and Anderson suggest that agency issues, including expropriation by controlling families, can be mitigated by a strong and independent board of directors.
Nepotism, either real or perceived, is another common pitfall of family-controlled firms. There may be no bigger killer of company morale (or investor interest) than the meteoric rise of an employee whose sole qualification is a common last name.
While investing in the shares of family-controlled firms is not without risks, the evidence does suggest that 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 firms are more inclined to have a long-term perspective, conservative financial management, and a strong corporate culture, all attractive attributes conducive to long-term share outperformance.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.