When shares of Stryker Corp. fell 19.3 percent, to $46.24, in July after the orthopedic medical-device maker reported slowing sales growth, portfolio managers David Larrabee and Eric Feder decided to add to their position. In their judgment, Stryker’s sales slump would be temporary because the Kalamazoo, Michigan, company was well managed and perfectly positioned to benefit as aging populations around the world boost demand for its orthopedic implants. Another major factor behind their confidence in the company: The Stryker clan is a big shareholder.
Is that a good thing?
For Larrabee and Feder it is. They co-manage the $83.3 million Constellation Pitcairn Family Heritage Fund, which invests exclusively in companies that boast significant family ownership (which the co-managers define as firms with a minimum of 10 percent of outstanding common stock owned by the founding family). In the case of Stryker, the family retains about 28 percent of the outstanding shares; Rhonda Stryker, a granddaughter of the founder, is on the board of directors and was once president of the company, which makes prostheses, implant systems, powered surgical instruments and endoscopic products.
Some investors associate family ownership with inadequate corporate governance, less-than-top-notch management and decision making complicated by such extraneous factors as a need to maintain high dividend payments. But the Constellation portfolio managers are convinced that family stakes go hand in hand with strong stock performance. “We believe the presence of the founding family -- in the form of a management position, a seat on the board of directors or a controlling equity interest -- contributes to high growth rates and superior rates of return,” says Larrabee. He contends that the presence of family members helps to foster a long-term perspective and ensure that management interests are aligned with shareholders’.
This has clearly been true of Stryker. Constellation first bought the stock back in 1996, when it was selling for $6.20. It recently traded at $47.
“Family owners tend to know their businesses very well and be very passionate about them,” says T. Brook Parker, a partner at Boston-based Lineage Capital, a private equity fund that invests in family-controlled businesses.
Those investors who focus on family-owned companies in the U.S. are confining themselves to a relatively small patch of turf. Only 600 of the companies with market values greater than $200 million in the Wilshire 5000 index of U.S. stocks are family controlled. About 23 percent of publicly traded U.K. companies are family owned. In continental Europe it’s a different story. Companies whose founding families control at least 20 percent of the voting rights account for approximately 65 percent of listed stocks in France and Germany and roughly 60 percent in Italy, according to Mara Faccio, assistant professor of management at Vanderbilt University’s Owen Graduate School of Management. Among Europe’s most high-profile family-controlled giants are BMW Group, L’Oréal Group and Roche Holding.
Certainly, Larrabee and Feder have found some good values in the family-friendly crowd. Over the three years ended December 31, the fund generated an average annual return of 5.78 percent, versus 3.53 percent for the Standard & Poor’s 500 index and 5.48 percent for the Wilshire 5000, the fund’s benchmark. Larrabee and Feder use the same approach in picking stocks for the $42.7 million in private accounts they run for Pitcairn Financial Group, a firm founded in 1923 to manage the wealth of John Pitcairn, a co-founder of Pittsburgh Plate Glass Co., the forerunner of PPG Industries. For the ten years ended December 31, the strategy returned an annualized 13.04 percent, compared with the S&P 500’s 12.05 percent and the Wilshire 5000’s 11.92 percent.
Larrabee and Feder begin their stock selection process by narrowing the list of family-controlled U.S. companies with a market capitalization of at least $200 million. Taking a bottom-up approach, they look for companies selling at reasonable valuations, such as historically low price-to-earnings, price-to-book-value and price-to-cash-flow ratios. They also look for well-differentiated products or services, historically high reinvestment rates and superior growth prospects. “We try to identify the factors that will allow the company to maintain its innovative edge, high profit margins and above-average growth,” explains Larrabee.
Before Pitcairn first implemented its Family Heritage strategy back in 1989, it studied 20 years of historical return data for the 132 family-controlled companies then included in the S&P 500. The analysis concluded that family-controlled businesses returned on average about 135 basis points per year more than the index. “It confirmed our suspicions that family-controlled firms outperform,” Larrabee says.
More recent Pitcairn analysis indicates that family-controlled companies plow cash back into the business at a higher rate than do nonfamily companies. The 600 family-controlled businesses in Pitcairn’s universe reinvested between 75 and 80 percent of their 2003 earnings, while the average Wilshire 5000 company retained only about 60 percent.
David Reeb, associate professor of finance at Temple University’s Fox School of Business and Management, and Ronald Anderson, associate professor of finance at the Kogod School of Business at American University, studied the relationship between founding-family control and corporate performance in S&P 500 companies from 1992 to 1999. They concluded that family businesses perform better and are more valuable than non-family-controlled companies -- at least to a point. “Our findings indicate that the optimal level of family control is 30 percent,” Anderson explains. “After that the benefits begin to decline.”
Of course, not all experts agree that family ownership adds value.
Finance professors Belen Villalonga, of Harvard Business School, and Raphael Amit, of the Wharton School of the University of Pennsylvania, studied the performance of U.S. Fortune 500 corporations between 1994 and 2000. They concluded that family ownership creates value only when the founder serves as the CEO or chairman. Villalonga and Amit also found that control mechanisms, including dual share classes, pyramids and voting agreements, reduce the founder’s premium.
Larrabee and Feder are especially bullish on Troy, Michiganbased Flagstar Bancorp, a leading mortgage lender whose founding family owns one third of the outstanding stock. Thomas Hammond, who created the bank in 1987, is chairman of the board, and his son Marc is president and CEO. The Constellation Pitcairn Family Heritage fund bought the stock in August 2001 at about $8.25 a share. “Flagstar is one of the largest mortgage originators in the country,” Feder says. “Its return on equity is the highest of any bank or thrift in the U.S. in the past five years.” Like its rivals, Flagstar has benefited from tremendous growth in its mortgage business, driven by low interest rates. The stock, which was trading at $22.60 in late December, is taking a breather -- it was up just 5.5 percent for the year ended December 31 -- as rising interest rates cause mortgage refinancings to decrease. “We still like the company and consider it a core holding,” Feder says, noting that the stock also boasts a 4.5 percent dividend yield.
Lance Helfert, president of Ventura, Californiabased West Coast Asset Management, is another investor with an affinity for family control. “We like companies with high levels of insider ownership and good managements that have been in place for a long time,” he says. “These criteria often lead us to family-controlled firms.”
West Coast Asset Management runs about $300 million for high-net-worth individuals. The firm tends to maintain highly concentrated stock portfolios. Of its current 14 equity holdings, five have a high level of family control. West Coast’s family-controlled holdings include Arden Group, ATP Oil & Gas Corp. and Berkshire Hathaway, a holding company run and 37.2 percent owned by Warren Buffett -- which itself owns a large number of family-managed businesses, including Borsheim’s Fine Jewelry, Fechheimer Brothers Co. and Nebraska Furniture Mart.
Helfert purchased Arden Group in 2002, when it was selling at between $55 and $60 a share. The stock was trading at roughly $102 in late December. Arden owns Gelson’s, a chain of 17 upscale grocery stores in Southern California. By offering superior customer service and high-quality products, the stores are able to charge premium prices, resulting in gross margins at least 50 percent higher than the industry average. Arden’s chairman, president and chief executive officer, Bernard Briskin, owns about half of the outstanding common stock and has headed the company for more than 25 years.
Arden recently announced a special class-A stock dividend of $20 a share and a special class-B dividend of $18 a share. “The company made a very conservative and prudent decision to return the excess cash to shareholders,” says Helfert. “The decision is in keeping with Briskin’s long-term record of making decisions in the best interest of shareholders.”
