“The only rock I know that stays steady, the only institution I know that works, is the family.” Lee Iacocca
Family-Owned Firms: Trading At A Discount
With the age of financial-engineering-activism having failed to deliver sustained good performance, we think the timing is right to embrace a more holistic investment philosophy – one rooted in reality instead of illusory and ephemeral concoctions. We believe pursuing near-term profit maximization, for its own sake, often neglects vital pillars that underpin sound and leading companies. So much of Wall Street still doesn’t understand that it doesn’t create actual value – it merely allocates and sometimes exploits the wealth creation. Value and wealth creation is generated by the builders, creators, and doers of our economy.
Rather than cost-cutting and zero-based budgeting, companies that invest in the most talented employees, which are far more expensive than mediocre talent, will have a self-reinforcing cycle of success. Much of silicon valley exemplifies the great power of assembling a team of high-functioning talent that executes on goals rapidly. Gallup has proven that highly engaged workers who maximize their strengths at work increase the firm’s profitability by 21% over the long-run. Engaged customers are also vital to a thriving business. We’ve previously written about the great importance of measuring customer satisfaction, as companies that continuously delight their customers earn the success they are often rewarded with.
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Employees and customers are not the only stakeholders that matter. Short-term profit maximization also typically extracts as much flesh from suppliers and communities as possible. When your communities dislike you, and you treat your suppliers like dogs, you will receive the same treatment in time. We are not attacking intelligent capital allocation – in fact we think it’s one of the many important skills a good management and board can have. Yet, capital allocation doesn’t create wealth, good capital allocation merely enables wealth creation. Bad capital allocation, which is increasingly associated with financial engineering and profit maximization, often destroys value by exploiting current value at the expense of long-term viability. Leveraged private-equity companies being run for cash often starve these businesses of future opportunities. In the slow death of the retailers, the private-equity owned companies are clearly falling first and hardest.
Rare is the executive that understands both how to build a business and also how to properly allocate the capital of the firm. This beautiful combination yields excellent results for every stakeholder involved. Cheap access to capital maximizes the number of opportunities available to a successful business builder, but it’s not a pre-requisite for wealth creation. Just take a look at the Forbes list of richest people in the world. Business-building capability is far more important than financial engineering as there are very few investors and nearly no bankers that have been able to make the cut. The list is predominantly filled with business builders, with those at the top particularly adept at capital allocation.
Today, business-building acumen seems increasingly rare outside of Silicon Valley. Technological disruption in nearly every industry has kept incumbent firms playing defense rather than going on offense. Low or stagnant valuations given to these legacy companies also creates pressure for boards (often with no ownership in the company) to demand that management “do something,” to address both the need to placate restive investors and resist obsolescence. Unfortunately, for companies defending their turf from innovative business builders and disruptors, buying back stock, reducing staffing costs, squeezing suppliers and returning cash to shareholders doesn’t allow for the necessary investments the companies need to make in order to go back on the offense.
Of course, if we look beyond public markets, we can find family-run enterprises and owner-operated businesses that are typically more focused on building healthy businesses and lasting legacies. The management stye of these businesses is often very similar to the family itself, where investments in education and wellness divert resources away from near-term indulgences. Families routinely make investments in the human capital of its members. In fact, deferred gratification seems to be inherent in the functioning of healthy families. Research has already proved that the earliest important predictor of future success is whether or not a child is able to exhibit deferred gratification. Children who wait 15 minutes to receive two cookies, rather than an immediate 1, overwhelmingly exhibit greater success, happiness and better health later in life. Clearly many of the most successful and brightest minds on Wall Street have forgotten that they were once also likely willing to wait for the second cookie.
Deferring gratification can be translated into better business performance as well. And because corporate America increasingly raids the cookie jar, it’s easier to compete against the raiders than it ever has been.
In a handful of European holding companies, investors can harness this more reliable investing and management style by partnering with a few (but definitely not all) families that have a particularly excellent track record in building businesses. And because cookie jar raiding is en vogue on Wall Street, the companies who wait for the second cookie have been systematically shunned by robots and 3-week catalyst investors. As our friend David Marcus at Evermore Global likes to say, this stye is akin to the “smash and run,” robber who runs away from the jewelry store with a couple diamond necklaces instead of realizing he could have just owned part of the store.
The rise of the “smash and run” investors, fueled by a myopic institutional client base, has created unique opportunities for both investors and companies. One of the best business models in the world, reinsurance, has been lambasted recently by Warren Buffett, just as the industry was at the bottom of its pricing cycle. Not many investors were willing to ignore the Oracle’s loud microphone, but the market’s pessimism allowed enterprising investors to buy into the industry below book value and with single-digit earnings multiples at the exact time the pricing cycle was hitting its bottom.
One of those investors was EXOR, the Agnelli family holding company run by John Elkann, the great great grandson of Giovanni Agnelli. In 2016, EXOR bought a leading Bermuda reinsurer, PartnerRe (PRE), which has had among the best long-term track records in the industry. Thanks to the market pessimism, EXOR was able to buy PRE below book value, when accounting for reserve redundancies. Because of the very active 2017 hurricane season, which led to a minor third quarter loss of 1-1.5% of book value, catastrophic reinsurance industry pricing will be firmer in the 2018 pricing season. Not many investors were willing to consider reinsurance investments in the past few years. Such an endeavor required deferred gratification. The same kind of deferred gratification that families routinely exhibit. Small wonder that a family business was the one that ended up winning the bidding war for PRE.
Exhibit 1: Notable Career Investment Performance
We strongly identify with the investing style of EXOR, admire the incredibly adept managers it has been able to source for its controlled companies, and appreciate the compounding power of tax-advantaged permanent capital. We would have been happy to pay a premium to book value for exposure to such a compounding machine. But the beauty of the investment is that we paid well less than net asset value for the investment “because it’s always been that way.” Properly valuing its investment in The Economist at fair market value, the company trades at a 30% discount to NAV (valuing PRE at book value, which is conservative given today’s peer valuations). As Elkann told investors on Thursday, if one likes FCA, Ferrari and CNH Industrial, investors in EXOR are buying controlling stakes in such companies and getting one of the best reinsurers in the world for free. This is basically having your cake and eating it too.
EXOR, which hosted its first ever investor day this week, isn’t the only holding company with a venerable track record. In fact, Elkann showed performance data from the past two decades of large holding companies. Not only did the controlled investments of these holdings companies trounce the market, but the holding companies that owned them outperformed the underlying investments as many of these owner-operators actively repurchase shares at a discount to NAV and use modest leverage.
Exhibit 2: Holding Company 20-Year Performance
Source: EXOR 2017 Investor Day Presentation
Vincent Bolloré has also combined very shrewd capital allocation with a talent for business-building to produce a €12 billion holding company out of practical thin air. Bolloré infamously took control of the company’s equity in the early 1980s by giving the banks a single franc. While Vincent has gotten his entire family involved in the business, he also provides a great lesson about adhering to a meritocratic system. As long as nepotism doesn’t get in the way of a true meritocracy, the performance of the companies will not only not suffer, but benefit from its managers treating their positions as a passion and a family legacy instead of a job. Over 300,000 people today have a job because EXOR chose to believe in its family legacy. While short-term-focused Wall Street and City analysts had urged the company to break itself up and just shut down the bad parts, EXOR smartly ignored these myopic demands.
European holding companies have typically traded at discounts to NAV – with great fluctuation and variation in the degree of undervaluation. Some investment companies, who overtime demonstrate significant competitive advantages versus the typical investment fund, will escape this discount zone – as Tamburi Investment Partners (TIP) has shown is possible. Tamburi adds value to its underlying investments by actively helping its private businesses prepare for capital market debuts, and it consistently identifies new corporate actions and mergers for their underlying investments. Tamburi isn’t alone in adding significant value to its underlying holdings simply by being involved. Both EXOR and Bolloré are a gift to the companies they take an interest in – just like some other notable investors from the US whose company shares trade at a premium to book value despite their disadvantageous tax arrangements.
We are not ones that typically accept anything, “just because it’s always been that way.” We strenuously disagree with the market valuations that have been given to EXOR and Bolloré, not just because they trade at deep discounts, but because their involvement with their companies brings considerable added-value. Real estate investors would call this gamma. Fancy labels aside, the genius of the family investment style is really quite simple. Combine common sense with deferred gratification, and watch the compound interest effect work its magic. As a friend Federico Castro said, “Compound interest is very powerful, but it’s just as powerful as a concept applied to taking a genuine interest in people. The long-term life/network effects are astounding.” When we combine the compound interest effect in people that families naturally cultivate with the compounding effect of good investment returns, the results can be truly staggering. Not only will the road be more fruitful, but it will also be more fun.
“Life is too challenging for external rewards to sustain us. The joy is in the journey.” -Bradley Whitford