Family Owners Often Smother Returns

The Dow Jones saga highlights how common shareholders lose out under the family-control setup.
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On Main Street, businesses are quick to advertise family ownership as a sign of quality and integrity that can't be replicated by the cookie-cutter chain stores springing up across the U.S. and beyond.

On Wall Street, however, family businesses are getting a bad rep. And judging by the returns these companies deliver to their shareholders, they deserve it.

The tug of war over

Dow Jones

(DJ)

between the Bancroft family and

News Corp.

(NWS) - Get Report

adds to Wall Street's impatience in recent months over family-controlled companies as varied as

Ford

(F) - Get Report

,

Cablevision

(CVC)

and

New York Times

(NYT) - Get Report

. The tumult at these companies highlights how the interests of the common investor and a controlling shareholder can diverge, especially when family ties are added to the mix.

Belen Villalonga, an associate professor at Harvard Business School, published a study in 2004 based on six years' worth of proxy data from all Fortune 500 companies showing that family control over publicly traded companies resulted in lower market value.

"Family-controlled companies trade at a discount -- the size of which depends on the specific mechanisms through which families exert control over and above their equity interest," says Villalonga. "So the market is skeptical of these arrangements, perhaps with good reasons."

In the case of Dow Jones, the Bancrofts control the venerable publisher of

The Wall Street Journal

through the ownership of a second class of stock endowed with disproportionate voting power to the shares held by the public. A majority of the family initially resisted the $5 billion offer from Rupert Murdoch's News Corp., even though the $60-a-share bid came at an extraordinary 67% premium to where the stock was trading before the proposal became public a month ago. They recently agreed to consider the offer, but only after dire forecasts about Dow Jones' ability to compete as an independent company.

For the average investor, Murdoch's offer amounts to a jackpot -- especially considering the dismal outlook for the newspaper industry and the Dow Jones' weak financial performance in recent years. For the Bancrofts, a decision to sell will be more complicated.

"Most investors buy stocks just to make money, but shareholders with majority or controlling stakes in companies that were founded or have been run by their parents or their grandparents often times have other, softer goals," says Tim Speiss, a partner with the personal wealth advisors practice at Eisner LLP. "The company has become part of the family's identity, and there is a sense of honor, tradition and obligation that can sometimes compete with pure economic interests."

The Bancrofts aren't the only clan with a piece of media on their mantle. The newspaper industry is rife with family controlled publishing companies, such as New York Times and

E.W. Scripps

(SSP) - Get Report

-- both of which are facing pressure from Wall Street to sell underperforming newspaper assets.

Outside of the newspaper industry, Cablevision has sparked an uproar with investors by accepting a $36.26-per-share buyout bid from its controlling shareholder, the Dolan family, whose shares make up 20% of the economic interest in the company and 70% of the voting rights.

Critics in Cablevision's base of public shareholders accuse the company's chairman, Charles Dolan, and his son, CEO James Dolan, of trying to steal the company from them on the cheap when competitors such as

Time Warner

(TWX)

and

Comcast

(CMCSA) - Get Report

likely would offer a richer premium.

The Trouble With Nepotism

Along with such conflicts of interest as those at Cablevision, family loyalties often result in business practices that fly in the face of one of the hallmarks of a well-run company -- meritocracy. For instance, is Arthur Sulzberger Jr., whose family controls New York Times through a dual-class share structure, really the most qualified person inside or outside that company to be chairman and publisher of the world's newspaper of record?

At the company's recent annual meeting, roughly 42% of the shares voted by New York Times' Class A shareholders, the public investors who own the vast majority of its equity, were in favor of withholding support from the company's four Class A directors. That was a big jump from the 30% that voted to withhold support last year.

The result marked a rebuke to the publisher's share structure, which allows the company's Class B shares to elect nine of the 13 directors on its board, even though they make up a small minority of its equity interest.

At Ford, Bill Ford, the great-grandson of the company's founder, decided he wasn't the right person to be CEO of the No. 2 U.S. automaker, but not before the company was teetering on the brink of bankruptcy. It continued to lag behind rival

General Motors

(GM) - Get Report

in Detroit's efforts to restructure itself to compete with lower-cost competitors from abroad.

At Ford's recent annual meeting, about 27% of its shareholders who voted supported a "one share, one vote" initiative designed to diminish the power of the Ford family, which owns supervoting shares giving it 40% of the company's voting power. Last year, a similar measure won 23% of the vote. Now, the family is reportedly considering selling some its stake.

"One of the downsides of these family businesses, particularly as they get older, is that people are often times put in charge who don't deserve to be in charge," says Howard Davidowitz, chairman of the retail consulting and investment banking firm Davidowitz & Associates. "As generations go by, the younger people lack ambition, drive and smarts. Their promotion is automatic, and that lack of incentive leads to poor performance."

Take the case of

Dillard's

(DDS) - Get Report

, a department-store chain based in the Southeast that was founded in 1938 by William Dillard. Now, his children run the company, including CEO William Dillard II, President Alex Dillard and Executive Vice Presidents Mike Dillard and Drue Corbusier. The family controls almost 100% of the company's Class B voting shares, which hold the right to elect two-thirds of the 12-member board.

"Of the five highest-paid executives at the company, four are Dillard family members and have been paid quite handsomely in recent years despite the company's poor performance," said Morningstar analyst Kim Picciola in a recent report. "We have our doubts as to whether management operates in the interest of the firm's other shareholders, and we believe that overall corporate governance is pitiful."

Dillard's has been a perennial underperformer in the retail sector, most recently reporting a 30% drop in first-quarter profits. The ongoing weak results have led investors to call for a sale of the company that could unlock the underlying value of its real estate assets. While a sale would likely result in a hefty lump-sum payout for its founding family, along with other shareholders, it would also mean an end to the Dillard's quarterly dividend payment of 4 cents a share.

For Dillard's public investors, the company's dividend provides an annual yield of roughly 0.4% on shares, which are priced around $35.90. For the family, which held over 4 million Class B shares at the end of last year, according to the company's most recent proxy statement, it amounts to a total annual cash payout of at least $640,000.

Controlling family members of major public companies such as Dow Jones and New York Times often depend on a steady stream of dividend payments to support their lifestyle -- another factor that can lead to complacency at a company in the face of poor stock performance. Ford suspended its dividend payments last September, shortly after the automaker hired a new CEO and just before it used its U.S. auto plants and substantially all of its other domestic automotive assets and intellectual property -- including the Ford brand -- as collateral to secure $18 billion in financing.

Earlier in 2006, Ford reduced its quarterly dividend payment to 5 cents a share from 10 cents, where it had stood for about five years. That 10-cent dividend amounted to an annual payout of roughly $283.2 million to holders of the company's Class B shares, which are exclusively owned by the Ford family. During that period, shares of the company lost almost half their value.

'Lucky Sperm Club'

Hedge fund activist Daniel Loeb of Third Point LLC is known for taking aim at such situations with devastating effects. In 2003, he waged a legendary proxy fight at

Potlatch

(PCH) - Get Report

, a wood and paper company where two major holders, William T. Weyerhaeuser and Frederick T. Weyerhaeuser, are great-grandsons of the founder.

Loeb referred to them as members of the "Lucky Sperm Club," excoriating the company for its "asleep-at-the-wheel" board of directors and its CEO, Pendleton Siegel, whom he branded "CVD'' -- chief value destroyer.

Loeb says there are three concepts that should be fundamental to public ownership of corporations in the U.S.: capitalism, democracy and meritocracy.

"Any time one of those three pillars are eroded, it weakens the foundation of the company and makes it less desirable," says Loeb. "Once you make the decision to go public, the board of the company should be accountable to public shareholders. Dual-share classes erode that democracy, and then the other two pillars can suffer too."

On the other hand, Carl Sibilski of Oyster Capital Management points to companies such as

Cabela's

(CAB)

and

Columbia Sportswear

(COLM) - Get Report

as examples where family control has been a strength.

"It's hard to imagine that those families would ever give in to short-term pressures that would allow their companies to be cheapened for the long term," says Sibilski. "Family ownership can be a good thing for investors, but you want to make sure that it's a family whose overall assets are heavily invested in their company, so their wealth is on the line along with yours. They should also have a succession plan in place that ensures meritocracy."

At Dow Jones, the Bancroft family members are not active in management of the company, so nepotism isn't an issue, but its share structure may have insulated the company's managers from making decisions necessary to keep the business in good financial health. Meanwhile, News Corp. itself is controlled by Murdoch's family through a 30% stake, and he has expressed interest in having one of his children succeed him at the helm. Could the Murdochs of today become the Bancrofts of tomorrow?

"If there was a great company run by a very competent family, would I put up with family control as an outside investor?" asks Loeb. "Possibly, but I haven't found that company yet. After the second generation and certainly the third generation, the apples tend to fall further and further from the tree."