The advantages of owner-managed businesses

Management’s core focus, long-term thinking and conservative approach can pay off for investors.

The advantages of owner-managed businesses

September 2018

Reece is Australia’s largest supplier of bathroom and plumbing equipment. Over the past 49 years, the family in control of the ASX-listed company that earned A$2.4 billion in revenue in fiscal 2017 has steadily reinvested profits to create a network of about 450 branches in Australia and New Zealand.

Investors were thus surprised in May when Peter Wilson, CEO and son of Chairman and former CEO Alan Wilson, announced Reece’s first major acquisition; a swoop on US-based plumbing company Morsco, which overnight resulted in Reece growing by a third in terms of revenue. To finance this deal, Reece conducted its first-ever equity raising. Melbourne-based Reece successfully raised A$560 million in equity capital to add to the A$1.14 billion of borrowings to buy a company that has a presence in 16 US states.

Peter Wilson told The Australian Financial Review  that Reece had studied the US plumbing market for about a decade before pouncing on Morsco. His father, who gained control of Reece in 1969, judges Morsco to be as well placed for long-term steady growth as was Reece five decades ago.[1] “He’s as excited with this as he was in 1969,” Peter said of his dad.[2]   

What corporate memory! At a time when many CEOs barely last five years in the top job, Reece is under the control of the Wilson family members who combine over 80 years of history with the company. Such is one advantage of owner-managed companies.

There are more, especially in a world where a common criticism of CEOs is they focus too much on the short term. Such allegations can’t be made as easily against family-owned and family-managed businesses, as Reece’s patience before its US foray highlights.

Studies show that such listed companies reward their long-term (non-family) investors because they instil a core focus, a stability and an approach that is geared towards the long term. When constructing portfolios, Airlie gravitates towards companies with owner-management profiles because these companies provide a portfolio with a long-term stability; what we call a “backbone”.

That’s not to say family-owned businesses aren’t ever flawed. Some family-owned companies are under the control of managers who make strategic decisions that take the company far from their core focus; retailer Harvey Norman’s recent loss-making diversion into dairy farming is one such decision. Other problems may include key man risk (e.g. Rupert Murdoch at News), succession planning (Berkshire Hathaway), and stock overhang when the owner-manager dies (Paul Ramsay Foundation stock in Ramsay Health Care).

The challenge for investors is to find the right owner-managed companies. Airlie portfolio managers have constructed portfolios with a backbone of five owner-manager companies for almost 20 years; namely, Event Hospitality, Flight Centre, Nick Scali, Premier Investments and Reece. These stocks have played a central, or backbone, role in our portfolio construction.

Owner-managed success

The ASX is home to about 35 owner-managed companies that have been listed for a minimum of 10 years.[3] (Please note that these stocks include Magellan Financial Group, the owner of Airlie Funds Management.) The definition of ‘owner-managed company’ has two parts:

Analysis by Macquarie Group shows owner-managed companies have outperformed their peers in Australia. As Chart 1 shows, a market-cap-weighted portfolio of owner-managed stocks has beaten the S&P/ASX 300 Accumulation Index over the 10 years to 30 June 2018.

While the owner-managed portfolios only include companies that have been listed for at least 10 years, the survivorship bias probably underplays the outperformance of such companies. Most owner-manager businesses are usually delisted after a takeover rather than disappear due to mismanagement. (The property group, Vealls, for example, was recently taken private by the owner-manager family at about a 30% premium.)

Chart 1. Owner-managed companies outperformed over 10 years to 30 June 2018

Source. Macquarie Group. Accumulated returns.   

Global experience

The same outperformance from owner-managed stocks is evident overseas. A study by Credit Suisse published in 2017 analysed nearly 1,000 family-owned businesses listed around the world (though more than half are listed in Asia) and found family-owned companies outperformed non-family-owned peers.[4] The study built on analysis Credit Suisse undertook in 2015 and included household-name companies such as Alphabet, BMW, Facebook, Nike, Roche, Samsung Electronics, Toyota and Walmart.

Credit Suisse’s 2015 report established that family-owned companies had outperformed equity markets across the globe over the preceding nine years. On a sector-adjusted basis, this outperformance equalled an annual average of 4.5% between 2006 and 2015.

The 2017 report confirmed the 2015 results. From 2006 to mid-2017, the companies Credit Suisse evaluated generated a cumulative return of 126%, which equalled an outperformance over the MSCI AC World Index of 55%. The analysis found that family-owned business outperformed on a risk-adjusted basis and across all sectors. The extent of family ownership did not seem to matter though younger-family-owned businesses (first- and second-generation owned) performed better than older ones (in what might be called hereditary risk).

In its analysis, Credit Suisse defined family-owned companies as ones where direct shareholding by founders or descendants reached at least 20% or when voting rights held by founders or descendants came to at least 20%. It showed that family-owned companies outperformed in every region – annual excess returns ranged from 310 basis points in non-Japan Asia to 510 basis points in Europe.

Credit Suisse found that the operating performance of family-owned companies was superior to that of non-family owned businesses across the globe. Revenue and profit (EBITDA) growth were stronger, profit margins were higher, cash flow returns were higher and momentum in gearing was more moderate. Family-owned companies appeared to manage capital is a more conservative way and have a greater focus on innovation as research and development spending was higher. Funding for R&D was made easier as family-owned companies had lower pay-out ratios.

The owner-managed advantages

The obvious question to ask after absorbing this analysis is: “Why do owner-manager companies excel?” We have isolated three reasons:

1/ A focus on core

 
   

Owner managers generally grow up in the business and know every facet and nuance of their customers and the industry in which they operate, unlike many corporate managers. This long-term experience results in superior company standards, employee expectations and culture.

2/ Long-term planning

 
   

The owner-manager business is generally able to ignore calls for short-term rewards at the expense of long-term planning and growth. Owner-managers have a long-term mindset as they look to handing over a stronger and better business to future generations. The ability to invest for long-term paybacks can be a competitive advantage against more corporately managed competitors.

3/ A conservative approach

Owner-managed companies are generally managed conservatively and hence balance sheets are usually strong. These companies are often asset rich with property and lower debt levels (if any) compared with their corporate counterparts. When economic conditions become unfavourable or an unexpected event occurs, owner-managed companies usually prove resilient due to their solid balance sheets. Additionally, as valuations contract at the bottom of the cycle, these companies are well placed to take advantage of attractive prices in terms of expanding via takeovers. 

Comparing owner-managed versus corporately managed

One way to show the advantages of owner-manager companies is to compare how an owner-managed company performed against a corporate-managed company in the same industry. Let’s compare Reece and Tradelink, two plumbing wholesalers, and start from 1998. Tradelink has nationwide presence, more stores and double the sales of Reece, which is mainly concentrated in Victoria and has a few stores along the east coast. (See Chart 2.)

The key difference is the ownership structure. The Wilson family own 75% of shares of Reece, and has since 1969. Tradelink was originally a founder-led business, but it was sold into corporate hands in the 1980s and had changed hands since then, to end up as a division of Crane, a larger building products company that was acquired by Fletcher Challenge in 2011.

Chart 2. Reece vs Tradelink. Sales and earnings in 1998

Source: Company data

What are the behaviours of the owner-shareholders at Reece that determined its destiny in this two-horse race?

1. A focus on the core: Reece invested only in its store network, rolling out stores from 150 in 1998 to 450 today. The Wilson family knew plumbers and their needs and it recognised that plumbers want a dense store network; if they forget a part or need to pick something up, they are never too far away from a Reece store. So as the store network grew, the value the business provided to its customers grew.

2. Long-term planning: You may not think of plumbing wholesalers as technology companies but Reece has more than 50 software developers in the business because management think its apps plus online offerings are a way to be a step ahead of the competition. Plumbers value the Reece app because they can order online the night before and be confident that by early the next day the product will be ready to be picked up at nearby Reece outlet.

3. A conservative approach: Over the years, Reece has managed its balance sheet in a conservative manner to ensure it is resilient and gives management optionality. The company owns $500 million worth of property and has operated with little to no debt for 20 years. This strength has allowed Reece to move with confidence to take over Morsco.What has been the result? Chart 3 below shows that since 1998 Reece’s sales are up six-fold and its EBIT has soared 18-fold over the past 20 years, while Tradelink’s sales have been flat and profit has shrunk. Over those two decades, Tradelink has had five management teams while Reece has seen Alan Wilson (now chairman) hand over to his son Peter (CEO) in 2007 in the same period.

Chart 3. Reece versus Tradelink. Sales and EBIT 1998-2017

 Source: Company data

The obvious conclusion is that the right owner-managed companies provide superior returns over the longer term due to their focus on the core, their long-term planning and their conservative approach.

 

[1] Alan Wilson became CEO of Reece when he merged his plumbing business with that of rival HJ Reece after the death of its namesake who founded the company in Melbourne in 1920.

[2] The Australian Financial Review. ‘Reece and Reliance create our plumbing billionaires.’ 11 May 2018. afr.com/business/construction/reece-and-reliance-create-our-plumbing-billionaires-20180510-h0zvu2

[3] These stocks include Ainsworth Game Technology (AGI), AMA (AMA), AP Eagers (APE), Australian Agricultural Company (AAC), ARB (ARB), Ausdrill (ASL), Brickworks (BKW), Computershare (CPU), Crown Resorts (CWN), Event Hospitality and Entertainment (EVT), Flight Centre (FLT), Fortescue Metals (FMG), Goodman Group (GMG), Gazal (GZL), Gowing Bros (GOW), Hansen Technologies (HSN), Harvey Norman (HVN), Magellan Financial (MFG), Monadelphous (MND), Mineral Resources (MIN), Navitas (NVT), News (NWS), Nick Scali (NCK), Oroton Group (ORL), Premier Investments (PMV), Primary Health Care (PRY), Platinum Asset Management (PTM), Pro Medicus (PME), Ramsay Health Care (RHC), ResMed (RMD), Reckon (RKN), Servcorp (SRV), Sunland (SDG), Seven (SVW), TechnologyOne (TNE), TPG Telecom (TPM), Washington H Soul Pattison (SOL) and Westfield (WFD).

 

[4] Credit Suisse Research Institute. ‘The CS Family 1000’. September 2017.

Important Information: This material has been prepared by Magellan Asset Management Limited (‘Magellan’) (ABN 31 120 593 946, AFS Licence No 304 301). Units in the Airlie Australian Share Fund (‘Fund’) are issued by Magellan, who is also the responsible entity of the Fund.  The investment manager of the Fund is Airlie Funds Management Pty Limited (‘Airlie’).  Airlie is a wholly owned subsidiary of Magellan.  Past performance is not necessarily indicative of future results. This material has been provided for general information purposes and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances and should read the relevant Product Disclosure Statement (‘PDS’) applicable to the Fund prior to making any investment decisions. The PDS for the fund is available at www.airlieaustraliansharefund.com.au or can be obtained by calling 02 9235 4760. Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. No part of this material may be reproduced or disclosed, in whole or in part, without the prior written consent of Magellan.