Global Emerging Market 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, and discusses how it is an important consideration in uncovering attractive long-term investment opportunities within global emerging markets.
While wealth generation is a goal for all businesses, some family-controlled 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 and wealth of the family. We believe that this combination helps create a long-term and risk-aware approach that is very applicable to allocating capital in emerging markets.
Exhibit 1: Market Cap-Weighted Sector Returns
Family-owned companies have outperformed since 2006
Unique Ownership Structure
The unique ownership structure of family businesses gives them a long-term orientation that traditional public firms can 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. Therefore, it is entirely rational for an executive management team to prefer to fail conventionally by following the herd and taking on too much risk, than to succeed unconventionally. For management teams whose remuneration and long-term wealth accumulation is levered to options and share awards, the risk/reward trade-off is asymmetric.
There’s a big difference between playing with “other people’s money” and the “family silver.” For many, the phrase “family business” conjures up images of a small- or mid-size company with a local focus. This does not, however, reflect the reality or powerful role that family-controlled enterprises play in the world economy today.
Family-controlled businesses are even more prevalent in emerging markets. Within Credit Suisse’s Family 1000 database, the majority of family-controlled businesses emanate from emerging markets, with “…Asia alone contributing 536 or 54% of the total.”1
BCG’s separate and unrelated research corroborates Credit Suisse’s finding: they [family-controlled companies] account for approximately 55% of large companies in India and Southeast Asia and 46% in Brazil.2
The significant presence of this type of businesses also strongly contrasts with the composition of the MSCI Emerging Markets IndexSM. State-owned enterprises (SOEs) make up a substantial proportion of the index.
By using a capitalization-weighted index, the benchmarks appear to favor scale and political influence over returns and family-controlled enterprises. Roughly a quarter of the companies in the emerging markets benchmark can be classified as SOEs – a factor that may expose passive investors to increased risks.3
Selectivity is Crucial
Not all family-owned companies practice good corporate governance. And that is why we insist that trust has to be earned over time and we do not simply make an assumption that a family owner will act in the common good. This can be tested through fundamental, bottom up research, and by asking 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 non- government environmental organizations?
These lines of inquiry help form a view of quality over and above looking at historical financial returns.
Exhibit 2: Characteristics of a Successful Family Firm
Seeking individuals with long track records of integrity and financial delivery
Profiting from Uncertainty
Another attraction of long-term owners, such as families, is their ability to make farsighted, 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 make 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.
Resilient Businesses Through Market Cycles
Seeking a long-term approach to investment and putting themselves in this position by being risk aware when it comes to the amount of debt that the business is willing and able to hold provides potential further benefits.
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, often associate debt with fragility and risk. They believe debt means having less room to maneuver if a setback occurs and that it can also lead to being beholden to a bank or bond markets during periods of cyclical economic weakness. As a 2012 Harvard Business Review study states, “family-run companies [may not consistently] earn as much money as companies with a more dispersed ownership structure. But when the economy slumps, family firms far outshine their peers.” And when this study assessed business cycles from 1997 to 2009, it found “that the average long-term financial performance was higher for family businesses than for non-family businesses in every country [they] examined.”4
We believe well-managed, family-controlled businesses are more resilient than non-family-controlled businesses because they emphasize balance sheet strength and capital preservation. Based on a Credit Suisse Research Institute Study, family-controlled businesses retain a higher percentage of earnings (i.e., lower payout ratios) and maintain more stable dividend payout ratios. Because of a higher earnings retention rate, they tend to be less reliant on external financing for capital expenditures or for supporting dividends.
Exhibit 3: Payout Ratio Comparison
Payout ratios of family-owned companies are about 13 points lower
Ensure Alignment of Interests
Emerging markets present a distinctive context in which to operate a business, with constant evolution – and sometimes revolution – in economic, political, regulatory and financial conditions. The prudence shown by family-controlled groups with focus on intergenerational wealth creation may allow them to navigate these conditions in a manner that supports long-term value creation.
Investing alongside families with good reputations that share our belief in a long-term approach to investment is, in our view, an important way to align interests as we seek to deliver “risk-aware,” superior returns for investors.
1Credit Suisse Research Institute. “The CS Family 1000.” September 2017.
2Bhalla, Orglmeister and Tong. “What makes Family Businesses in Emerging Markets So Different?” Boston Consulting Group. September 8, 2016.
3“The Dangers of Benchmark Investing in Global Emerging Market Equities” investment insight may be accessed at janushenderson.com/eme
4Kachaner, Stalk, Jr., and Bloch. “What You Can Learn from Family Business.” Harvard Business Review, November 2012.