Family Firms Power Market-Beating Returns

I've always been a big believer that countries with royal families, like the U.K., should keep them. Royal families simply possess incentives that shortsighted elected politicians lack. If they do a poor job of watching over their kingdom, their heirs will have to bear the consequences.

I think a similar arrangement works for corporate governance as well. I can sleep better at night as a shareholder if a monarch-like family with a huge block of shares is monitoring the CEO.

Keep it in the family
Does anyone think that Wal-Mart (NYSE: WMT  ) would be where it is today without the Walton family's watchful eye? Is it any accident that Wal-Mart continues to deliver returns on invested capital in the 14% range, exceeding the cost of that capital, in a very difficult industry?

I think a large part of Wal-Mart's success lies in avoiding The Big Stupid Acquisition. Note that such blunders are practically the entry requirement for megacap stocks in the Dow (INDEX: ^DJI). Having a family member minding the store helps to prevent this kind of thing ... most of the time. Bill Hewlett's son, Walter, fought until the end to prevent Hewlett-Packard (NYSE: HPQ  ) from merging with Compaq. Lacking a majority stake, Walter Hewlett barely lost that fight. We all know how that deal turned out for shareholders.

Market-beating performance
Roughly one-third of the companies in the major indices have significant family ownership. And as a group, family-owned companies have historically beaten the S&P 500, according to a 2003 paper by Ronald Anderson and David Reeb. The authors also find that companies perform even better when a family member is also the CEO. I find this research very compelling, though I had Anderson as a professor in business school at American University, so I'm a bit biased.

(Note to ETF makers: Please make an ETF that tracks family-owned companies. Thanks.)

Warren Buffett, no stranger to good investments, has shown his own preference for family-controlled firms over the years. As he told a group of MBAs in 2008 following Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) acquisition of family-owned Iscar: "Family owned businesses share our long-term orientation, belief in hard work and a no-nonsense approach and respect for a strong corporate culture ... Family businesses and Berkshire Hathaway have a common philosophy and make a good team."

Trouble in paradise
Not all family-owned firms are magical money fountains. One very big potential downside can sandbag their success.

In another paper, Anderson, Reeb, and Dr. Wanli Zhao find that family-controlled firms are more likely to exhibit abnormal short-selling prior to negative earnings announcements. Hmmm … I wonder who could possibly be doing that? Looks like Great Uncle Buford might not just be playing Yahtzee after all.

The effect is so large that Anderson, Reeb, and Zhao find that buying the stocks of family companies with the least short interest, and going short those with greatest short-interest, would have earned investors an extra 0.61% per month!

Pitfalls and profits
Even if family members are playing by the rules, success remains no sure thing. For every Washington Post, one of Buffett's best investments, there's a Wang Laboratories driven into the ground by heirs. Even Washington Post isn't doing so hot today; the best family management in the world can't counteract a declining business model. That's why I suggest looking hard at family companies that are as future-proof as their leading shareholders.

Campbell Soup (NYSE: CPB  ) , J.M. Smucker (NYSE: SJM  ) , and Brown-Forman (NYSE: BF-B  ) -- maker of Jack Daniels and Southern Comfort -- all produce brand-name products that are as American as apple pie, with family benches that give Britain's royal family a run for its money. Brown-Forman, for example, is currently preparing fifth- and sixth-generation members for boardroom duty!

As long as you can verify that external factors aren't eroding their strengths, companies that keep their business all in the family could help you create a long-term investing dynasty of your own.

Fool contributor Chris Baines is a value investor. Follow him on Twitter @askchrisbaines. Chris's stock picks and pans have outperformed 77% of players on CAPS. Chris owns shares of Berkshire Hathaway. The Motley Fool owns shares of Wal-Mart and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Wal-Mart and Berkshire Hathaway. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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