Family businesses: outperformance through capital allocation

From building a new manufacturing facility overseas to acquiring a rival, strategic investment decisions taken today can impact the company, and its shareholders, for years to come. 

At times, shareholders may find company executives are pursuing objectives that are odds with their own. A risky but headline-grabbing hostile takeover, for example, may boost a CEO’s profile or power. But this could spell trouble for the company in the future if it fails to achieve the expected value.

Such debacles are rare for listed companies that have founding
families as shareholders. And this represents an attractive feature for investors who invest alongside them.

Owner managers prioritise projects and investments that create long-term value for the company and typically do so while maintaining strong balance sheets. The financial health and sustainability of the company comes before short-term profits.

Research has shown that this differentiated approach can
create sustainable competitive advantages for family run and founder led businesses.

And this ultimately translates into better returns for investors. For example, one study has shown that listed companies controlled by their founders performed almost twice as well as the annualised performance of the broader market.¹

By adding owner-managed companies to a diversified equity
portfolio, investors can achieve a more favourable risk adjusted return.

Overcoming the agency problem

In running a business, it's often the case that one party makes decisions for another.

In listed firms, it becomes problematic when decisions made by
company managers do not serve the interests of shareholders, which end up yielding adverse results.

One way to resolve this issue, typically known as the principal-agent problem, is to create contracts or incentive structures that will encourage managers – the agent – to act in the best interest of the principal – shareholders.

This is not easy.

There are many different stakeholder interests to balance and most “long-term” executive incentive programmes last just three years while the median tenure of an S&P CEO is less than five years.²

Owner-managed businesses, by definition, don’t fall into this trap.

For them, the principal and agent are the same people. Owner-managers interests are always aligned with those of shareholders.

In our experience, founder led firms are typically run according to four main principles – all of which allow the management to take a
long-term vision when deploying capital.

These are:

Entrepreneurship. A founder is an entrepreneur by definition, fostering a culture of innovation and agile decision making. The best family companies have shown that they can retain this entrepreneurial spirit through the generations.

Stewardship. Owners are tasked with protecting a legacy; they see as their duty to secure the company’s long-term health and sustainability. The reputation of the founder or family is closely tied to that of the company.

Discipline. Prioritising health and sustainability of the company is often associated with financial prudence, maintaining an operational margin of safety and allowing the ability to be agile when opportunities arise.

Reinvestment. Putting profits back into the business, at high rates of return, prioritises long-term economic value creation over payouts.

High quality and enduring businesses

We have identified a number of companies that adhere to these principles. It is an investment universe of high quality, resilient businesses that have demonstrated the ability to thrive through many market cycles.

Take Rollins, a leading pest control provider founded in 1948 by brothers John and Wayne Rollins. In a highly fragmented market, the company has developed proprietary technology and used strategic acquisitions to become the industry leader in North America. Rollins’ family culture and decentralised management style encourage employees to develop their own local franchises, fostering a sense of ownership in the company.

This approach has allowed the company to enjoy average sales growth twice as much as its closest peer, a cash flow return on investment consistently more than 10 per cent above that peer and a steadily expanding margin profile.³

As a result, the share price has outperformed by seven times over twenty years.

Improving health and financial outcomes

Investments in infrastructure is a typical type of capital spending though it can take years to pay off. But for those with a long-term approach, it can be a source of competitive advantage that can deliver stable returns.

That is particularly true for hospitals. A new hospital wing with advanced equipment and sophisticated information systems raises standards of care and wellbeing for patients, which should also improve the financial outcome for its shareholders.

The Frist family clearly understand this. The founding family and controlling shareholders of HCA Healthcare, the largest hospital owner and operator in the US, have long prioritised value-creating reinvestment in the business in their capital allocation decisions.

Over the last 10 years, HCA has generated cash flow of USD70 billion, half of which has gone back into the business through capital expenditures, including new hospitals, and the business has generated over 20 per cent return on that capital employed. The rest was returned to shareholders through buybacks, which halved the share count since 2011 in a clear demonstration of sound investment discipline.

This combination has driven HCA shares to outperform both
its closest peer and the S&P index by around 1400 per cent since 2011 on a total return basis.⁴

Skin in the game

Successful family or founder led firms prioritise long-term strategic value creation, rather than short-term gains, when allocating capital.

The alignment of interests of owners and managers helps create attractive and enduring return for themselves, and their investors.