EM Equities: Keeping it in the Family
Glen Finegan, Head of Global Emerging Market Equities, believes that family ties make for a formidable force in both business and investing.
While wealth generation is a goal for all businesses, some family firms appear to place an equal emphasis on the goal of longevity. Each successive generation attempts to pass the baton to the next and maintain the good name of the family. We believe that this combination helps create a long-term and risk-aware approach to allocating capital.
Unique Ownership Structure
The unique ownership structure of family businesses gives them a long-term orientation that traditional public firms often lack. The cautious chief executive who balances both risk and reward will be fortunate to remain long at the head of a listed company. Since bonuses and share prices are often related, together they call for maintaining a certain head of steam in terms of business performance. Any diversion from maximizing profits on a consistent quarterly basis is likely to lead to dismissal. It therefore makes it an entirely rational decision for an executive management team to prefer to fail conventionally by following the herd and taking on too much risk, than never fail at all.
To many, the phrase “family business” denotes a small or mid-sized company with a local focus. This does not, however, reflect the powerful role that family-controlled enterprises play in the world economy today. Not only do they include corporations such as Walmart, Heineken, Tata Group, and Porsche, but they account for more than 30% of U.S., French and German companies with sales in excess of $1 billion, according to analysis from Boston Consulting Group (BCG).
Family-controlled businesses are more prevalent in emerging markets. BCG research indicates they account for approximately 55% of large companies in India and Southeast Asia and 46% in Brazil. These companies may present an ability to generate wealth in a risk-averse manner, whether in the form of exposure to a single listed entity, or to a number of entities under the control of a single family.
Selectivity is Crucial
Often the more complex a conglomerate’s corporate structure, the greater the potential for misalignment between controlling-family interests and those of shareholders. Equally, having a simple organizational structure is not a guarantee for sensible alignment. At the heart of the issue for minority investors is whether there is an alignment between voting rights and access to cash flows and financial returns.
Trust has to be earned and investors cannot simply make an assumption that a family owner will act for the common good and emphasize stewardship over greed. The case of Samsung Vice Chairman Jay Y. Lee allegedly paying government officials to gain support for a merger of Samsung C&T and Cheil Industries speaks to the fact that not all family-founded firms create strong governance structures that protect minority shareholders.
To help test this premise, investors may ask questions such as:
- How has the family treated its minority shareholders in the past?
- What businesses do the family own outside the listed entity and are there conflicts of interest?
- Are there good-quality independent board members providing oversight?
- Does the family conduct government-related business and if so how does it win contracts or licenses?
- How is the family regarded by non-financial stakeholders such as local communities and environmental non-governmental organizations?
These lines of inquiry form a view of quality over and above looking at historical financial returns, allowing for a risk-aware approach to what are more risky markets, often with weak rule of law.
Profiting from Uncertainty
Another attraction of long-term owners, such as families, is their ability to take far-sighted, sometimes contrarian decisions, that a professional management team more focused on short-term results and stock market pressure might not.
A chief executive with a reduced time horizon can take decisions that are influenced by the short-term and often pro-cyclical moves of the stock market, which can hurt the long-term value of a business. This is particularly the case in commodity and cyclical sectors of the market.
An example of longer-term thinking comes from family-controlled Chilean miner Antofagasta, which is controlled by the Luksic Group and announced in July 2015 the acquisition of a copper asset from a financially distressed seller. In contrast to many of its peers, Antofagasta had maintained a strong balance sheet throughout the last decade and was able to act while other miners, facing pressure from a weakening copper price and highly levered balance sheets, were forced to dispose of high-quality assets. This counter-cyclical behavior by Antofagasta is exactly how we believe mining companies should act, but it requires a management team able to resist short-term market pressure, which in this case the family provides.
Resilient Businesses Through Market Cycles
These types of controlling groups importantly tend to believe in a long-term approach to investment by being risk aware when it comes to the amount of debt that the business is willing and able to hold.
In modern corporate finance, a judicious amount of debt is considered a good thing because financial leverage maximizes value creation through the leverage of returns. Family-controlled firms, however, associate debt with fragility and risk. Debt means having less room to maneuver if a setback occurs and can also lead to being beholden to a bank or bond markets during periods of cyclical economic weakness.
Ensure Alignment of Interests
Emerging markets present a distinctive context in which to operate a business, with constant evolution in economic, political, regulatory and financial conditions. The prudence shown by family-controlled groups can allow them to navigate these conditions in a manner that supports long-term value creation.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.