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Family-size returns, without the drama
The Adelphia mess gave a bad name to family-owned companies, but their returns are often the best around. Here's how you can find the good ones.
By Michael Brush
Throughout the headline-grabbing scandal that drove shares of Adelphia Communications into the dirt, smart alecks quipped that the Rigas family treated the cable company they ran like their own personal piggy bank.
The analogy is fitting -- and not only because two family members so far have been convicted of fraud for diverting funds from Adelphia Communications (ADELQ, news, msgs) . After all, personal piggy bank conjures up images of a cozy domestic setting where family members dont have to answer to outsiders about how they spend their money.
And if weve learned anything from the Adelphia disaster (which cost me personally as a shareholder), weve learned thats how family companies work. You simply cant trust them. The kinsfolk will do whatever they please, and damn the public shareholder. Right?
Actually, that would be about the worst lesson you could take away from the Adelphia disaster. The truth is -- despite Adelphia -- family-run companies are some of the best places to invest.
Banking on family
For proof, consider the research of Temple Universitys David Reeb, a finance professor whose niche is putting family-run companies under the microscope. The bottom line: Whether your yardstick is some accounting measure like return on assets or good, old stock-price performance, family-run companies outperform the rest by anywhere from 6% to 13%. On average -- across all measures -- they beat other companies by 10%.
They are so much better; every firm should be a family firm, says Reeb, whose conclusions were based on studies of family-run companies in the S&P 500 ($INX) he conducted with American University's Ronald Anderson.
Outside the walls of academia, you find the same conclusions, even if the differences are a bit less dramatic. Theres actually a mutual fund run on the principal that all in the family is best. Its called the Pitcairn Family Heritage Fund (PTFMX), managed by Eric Feder and Dave Larrabee out of Jenkintown, Pa.
As of June 30, the fund had three-year annualized returns of 1.58%, compared with a decline in the S&P 500 of 0.65%. Over the past two decades (the fund has been out for only a little over three years), the strategy used in private accounts has outperformed in all kinds of markets, says Feder. (Pitcairn Family Heritage Fund has a $5 million minimum now, but it will be open to accounts with a minimum of $2,500 soon.)
3 family-run companies
If youre from Pennsylvania, you may know that the Pitcairn family founded Pittsburgh Plate Glass, now known as PPG Industries (PPG, news, msgs). The impressive performance of that company -- shares are up about 1,900% in the past three decades -- helps explain why the Pitcairn Family Heritage fund exists today.
The Pitcairn family felt their ownership and influence within PPG Industries as major shareholders and board members helped foster the long-term growth, says Feder. So the family wanted to manage some of its own money in the same way by finding conscientious, family-run businesses to invest in. We call it the family effect in a company, he says.
Three companies that are big holdings of the Pitcairn Family Heritage fund, which Feder and Larrabee think will see payoffs from the family effect for some time to come, are Flagstar Bancorp (FBC, news, msgs), Stryker (SYK, news, msgs) and William Wrigley Jr. (WWY, news, msgs).
Flagstar is a $10-billion-asset thrift based in Troy, Mich., thats controlled by the Hammond family. (They own more than 30% of the shares.) Family members hold key positions, including chairman and chief executive. This is just an outstanding company, says Larrabee. They have one of the highest returns on equity among banks in the past five years. The company seems to be very focused on the share price and returning value to shareholders.
Flagstar is down 28% from highs earlier year, as investors exit financial stocks on fears that higher interest rates will slow mortgage banking. Larrabee thinks the declines in Flagstar are unwarranted. "Flagstar gets lumped in with the mortgage banking group, and it is not given credit for its consumer banking business," he says. Flagstar has a fast-growing consumer banking group that represents 58% of its business, Larrabee points out. Deposits have grown 14% year to date.
Kalamazoo, Mich.-based Stryker makes surgical and hospital supplies. Controlled by the Stryker family, the company has a history of reinvesting cash flow to stay a leader in its field. Chicago-based Wrigley, where the family has 60% of the shares outstanding, has a dominant market share, strong and consistent growth, and no long-term debt. Right now, their focus is growing internationally, and they are plowing money back in to do this, says Larrabee.
Why family companies do better
Exactly why does this family effect occur? After all, its natural to think a lot of families might just take advantage of their position in a company and use the shop as their own private ATM. Analysts cite the following reasons why this isn't so:- Families have a stake. In most companies, owners, or shareholders, are isolated from management. So management is free to do what it wants, Reeb says. And often they dont care much about shareholders. Not so with family companies. Because they own such a big chunk of stock, they actually have the power to stop the managers if they dont like what they do, Reeb says.
- Families focus on the long term. Family-run companies tend to get less hung up on meeting quarterly targets, says Walter Salmon, a professor emeritus at the Harvard Business School. Instead, they focus on the long term. This means they tend to reinvest cash to improve the business, rather than squander it.
- Family-run companies have better financial strength. They typically have stronger balance sheets, which may help explain why they normally pay lower rates to borrow money.
- Family companies have lower turnover. A stronger corporate culture and better workplace environment means good employees tend to stay around.
Separating the good from the bad
But not all family-run companies work so well. Reeb estimates that 65% to 75% of family-run companies do really well, but about a third end up in the tank. How do you tell the difference?
The best-case scenario, according to Reeb's research, is when family members have a strong presence on the board but there are enough independent directors to offset the family influence. (Independent directors are those who dont have financial ties with the company.)
"You want the family around, because family members monitor the managers, says Reeb. However, you need someone around to monitor the family."
In practice, this means if family members have two or three board seats, you want two or three independent directors, as well. In contrast, a nine-member board that had three family members and six insiders -- people who work for the company -- would be a potential problem.
Family-run companies with a solid presence of independent directors on the board include: Magazine publisher McGraw-Hill (MHP, news, msgs), appliance maker Maytag (MYG, news, msgs) and athletic-gear maker Reebok International (RBK, news, msgs), Reeb says. Two family-run companies Reeb says you should be cautious about because they have few independent board members are: Dillard's (DDS, news, msgs), the Little Rock, Ark., department-store chain, and Marriott International (MAR, news, msgs), the lodging giant.
5 red flags to watch for
Ric Marshall, an analyst at the Corporate Library in Portland, Maine, doesnt think its enough simply to look for independent boards at family-run companies to separate the good from the bad. (The Corporate Library is a private company that analyses corporate-governance issues for investors.) Adelphia had an independent board, and it didnt do them any good, says Marshall.
Instead, Marshall looks for five red flags that suggest a strong family presence could lead to trouble for the common shareholder. No single red flag is a problem by itself, says Marshall. But several of them together suggest family members might put their interests above those of the common shareholder.
Adelphia, for example, had all five of his red flags:- Red flags No. 1 and No. 2: Class A and Class B shares. Marshall looks for multiple classes of stock (usually called A shares and B shares) and special voting rights granted to family members. The more complicated it is, the worse it is, without question, says Marshall. Example: Charter Communications (CHTR, news, msgs), the St. Louis-based cable company. Charter Chairman Paul Allen has the power to select eight of the nine board members. (Allen is also a co-founder of Microsoft, which publishes MSN Money.)
- Red flag No. 3: Complex ownership structures. Marshall is cautious about layers of ownership inside a corporation that set up a confusing and complex ownership structure, like multiple trusts or general partnerships. Marshall cites Forest City Enterprises (FCE.A, news, msgs), the big property management company, and cosmetics giant Estee Lauder (EL, news, msgs) as good examples. Estee Lauder has four or five pages of footnotes just describing the family trusts, says Marshall. And you shouldnt have to have your own lawyer just to invest in a company."
- Red flag No. 4: Related-party transactions. Marshall gives low corporate-governance ratings to family-run companies that do a lot of related-party transactions. Thats when a company does business with companies in which relatives of board members or managers have an interest. UMB Financial (UMBF, news, msgs), a Kansas City, Mo.-headquartered banking company, has a long list of these, one reason Marshall gives the company a low grade for corporate governance.
- Red flag No. 5: Special change-of-control provisions. At Estee Lauder, family members have the right to make an offer and block a sale if another family member wants to privately sell shares to an outsider. Estee Lauder points out that this provision has never been used, and that family members regularly sell stock without any restrictions in the public market -- where anyone can buy enough shares to gain influence in the company.
Marshall says Charter Communications and Forest City Enterprises carry Red flags 1, 2 and 3. UMB Financial carries Red flag 4 for related party transactions, and Estee Lauder carries all five. Charter Communications and Forest City declined to comment on Marshalls assessment. An Estee Lauder spokesperson said that its founding family has a solid track record of increasing net sales for over 50 years. Also, growth in its share price, sales and earnings have been among the best in the industry for the past two years, thanks to the premium the company puts on rewarding shareholders. UMB Financial chairman and chief executive J. Mariner Kemper responds that in every related party transaction the deals benefited the company. People hired were well-qualified, and contracts were put out to public bid and done at fair market value.
So what are some examples of family-run companies that come up squeaky clean? The best are the ones that have a clear and easy-to-understand corporate structure, says Marshall. Family-run companies that fall into this group include: Hub Group (HUBG, news, msgs), the freight company; Value Line (VALU, news, msgs), the stock research firm; Heartland Express (HTLD, news, msgs), the trucking company, and Cintas (CTAS, news, msgs), which supplies uniforms and cleaning supplies to business.
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