Keeping it in the family – Emerging Markets equities
Glen Finegan, Head of Global Emerging Market Equities at Janus Henderson Investors, 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 on 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 and is why we favour such groups within the context of accessing the global emerging markets investment opportunity.
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 maximising 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 US, French and German companies with sales in excess of US$1bn, 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.
The significant presence of these types of businesses within our opportunity set, and our belief in the ability of such groups to generate wealth in a risk-averse manner, helps to explain the significant presence of controlling family groups within the portfolio. In aggregate they make up over a quarter of the capital invested and account for five of the top-ten holdings as at 30 September 2017*.
These investments can be in the form of exposure to a single listed entity, such as in the case of Uni-President Enterprises, or to a number of entities under the control of a single family. This is the case with our ownership of the individually listed equities of Antofagasta, Quinenco and Compañia Cervecerias Unidas. These are all entities majority controlled by the Luksic family based in Chile.
*Source: Janus Henderson Investors
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 organisational 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 we do not simply make an assumption that a family owner will act in the common good and emphasise stewardship over greed. The case of Samsung Vice Chairman Jay Y Lee allegedly paying government officials to gain government 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.
We test this premise through our fundamental bottom-up research and we 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 organisations?
These lines of enquiry help us form a view of quality over and above looking at historical financial returns. We want to see returns that have been generated in a risk-aware manner as this fits with our absolute, rather than relative, return 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 an excellent 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 behaviour 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 also importantly tend to share our belief in a long-term approach to investment. They also put 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.
In modern corporate finance a judicious amount of debt is considered a good thing because financial leverage maximises value creation through the leverage of returns. Family-controlled firms, however, associate debt with fragility and risk. Debt means having less room to manoeuvre 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. Backing 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 and deliver ‘risk-aware’ returns for investors.
Absolute return – The total return from a portfolio, as opposed to its relative return against a benchmark. It is measured as a gain or loss, and stated as a percentage of a portfolio’s total value.
Balance sheet – A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.
Cash flow – Cash generated from a company’s trading activities taking into account expenses, which indicates if a company has had more inflows or outflows over a given period. Over the medium to long term positive net cash flow (total inflows minus outflows) is required to sustain trading and meet financial obligations.
Cyclical stocks – A cyclical company’s value or earnings tend to be strongly affected by ups and downs in the overall strength of the economy, when compared to non-cyclical companies.
Leverage – The use of debt / borrowing by a company to operate and potentially generate greater (but riskier) returns.
Listed company – A company listed on a stock exchange, which is available for investment.
Note: The stock examples are intended for illustrative purposes only and are not indicative of the historical or future performance of the strategy or the chances of success of any particular strategy. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.
Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.