The soul of a business
Warren Buffett once wrote that "the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
Understanding the DNA or culture of a business helps define how wide the moat is of a business. In essence, the DNA of a company is comprised in how much they delight their customers/clients and what incentivizes management to perform.
“The trick, it seems to us, if one is to be a successful long-term investor, is to recognize the sources of enduring business success, get in early and own enough to make a difference. Which raises two questions: what are the sources of success and second, if these are so readily recognised up front why are they not discounted in prices already?” - Nick Sleep
We continuously look for companies with corporate character that are pursuing strategies designed to create sustainable value. To form a view on corporate character requires significant research, comparisons to what best in class companies do, and a significant amount of judgement. I share some ways to think about it.
“Culture eats strategy for breakfast”
Is the business owner operated or owner orientated?
The common thread in companies that are managed by their founders and where founders still hold a significant portion of the shares in a business is that they outperform their competitors in a similar industry. An owner, well, thinks like an owner. He or she will make decisions on the long-term success of the business, allocating capital wisely, as opposed to chasing short term performance in pursuit of some variable incentive scheme. An owner understands that to generate more free cash flow, he/she needs to sell more and collect quicker - only satisfied customers will provide that.
Some examples of well-known current and recent owner operated businesses with their respective total compounded annual growth rate over 10 years in USD:
Berkshire Hathaway (BRK) - Warren Buffet (12.4%)
Microsoft (MSFT) – Bill Gates (29.4%)
Amazon (AMZN) – Jeff Bezos (28.6%)
Louis Vuitton Moët Hennessy ((MC) – Bertrand Arnaut (21.2%)
Quality of managerial character is important
We spend a lot of time reading annual reports and proxy statements and listening to result presentations, especially the Q&A, trying to answer the questions: what are returns on incremental capital and the longevity of those returns, are management correctly incentivised to allocate capital appropriately?
In forming a view on the quality of management, we review their CV’s, the number of years they have spent with business, their previous roles and employers, age, how many years the core team has been together and the high-level organisational structure. We review in detail how well they have been allocating capital in the interest of shareholders in preceding years. Has ROIC and ROE improved over the past 5 to 10 years? What proportion of owners’ earnings have been spent on share buybacks and at what prices? Amounts spent on dividends paid, acquisitions and capital expenditure. (See earlier blog on capital allocation).
Most importantly, we seek to understand how their incentives work. Analysing the detail split in their total renumeration between fixed, variable and share-based compensation and how it is earned – do they do well when shareholders do well or is there a disconnect.
Incentives
“Show me the incentive and will show you the outcome.”
Incentives drives behavior; in evaluating the culture of a business, one needs to understand exactly how variable pay and share incentives are structured. On which metrics is variable pay determined, what proportions does each metric comprise of the total, do these metrics align with shareholder interest. Most importantly, do they foster good capital allocation principles?
Example of how effective the right incentives can work:
In my previous life as Group CFO of a pan European IT infrastructure business, we acquired the loss-making business in a management buy-out. The sellers thought it was going belly up and left just enough cash in the business to cover one year’s losses. As owners, there was lots of incentivised activity at senior management level, including slashing the costs and the workforce, whilst opening related channels, growing sales and profitability.
This business was previously acquired from BASF, the German chemicals business, and we inherited all the long serving BASF pension fund members as employees. As retrenchments go in Germany, and most of continental Europe, it works on a LIFO basis, we had to let go the good, new hires first, in the retrenchment rounds.
When it came to annual salary increase time, we agreed with the works councils that a small portion of the salespeople’s fixed salaries will be changed to variable pay, based on completed sales and their entire salary increase will also be variable. Our average debtors’ days outstanding was 58 days at that stage. We further implemented a new policy whereby variable can only be earned in the month end following the settlement of customer invoices. The sales were mostly big-ticket datacenter installations where the salesmen had good relations with customers senior management.
The salesforce realized, that to earn their variable portion, their customers need to pay, and they had the client contacts to expedite the process. Debtors’ days went down to 30 days in 3 months, and by the time we sold the business a few years later, debtors’ day was standing at 17 days. This freed up an incredible amount cash in the business.
Charlie Munger calls incentives, a superpower, and states: The most important rule in management is “Get the incentives right”. We spend a lot of time understanding the incentives.
How good is the “Per share discipline”
Per share discipline a concept much misunderstood by investors. As part owners in our investee companies, we care about the free cash flow generation, per share. This is what we own.
There is a crucial duration mismatch between issuing shares as part of incentive schemes and the term of employment contracts. Shares remain outstanding forever while employees move on.
We are not against shares issued under employment contracts as this aligns interest, we are however against excessive incentive share issues, to the detriment of outside shareholders.
Share buy backs forms part of this discussion, and here the price paid for own shares matter, if the price paid is significantly above true worth, this is dilutive to the existing shareholders.
The demonstrated per share discipline over preceding years is important in evaluating the soul of a business. An example of good per share discipline can be found at one of our portfolio companies, Auto Zone Inc (AZO), which has consistently reduced their total shares outstanding while growing their Earnings per share.
AZO share count and EPS
The golden rule – do you treat your customers the way you want to be treated?
“There is only one way to grow the business profitably. You make sure your customers are treated so well that they come back for more and bring their friends”
This was part of the beginning of what is now known as the Net Promotor Score or NPS for short, for measuring customer satisfaction. The basic system is simple with a single question: “Would you recommend our product/service to others?” A “yes” is a positive score, a “no” is a negative score and a “I am not sure” is neutral. Companies with a high NPS outperforms their competitors. We review the published NPS of our target companies and form a view on the durability of these scores.
“If your company works hard at being remarkable—at always acting in the customers’ best interest by providing products and services that really enrich their lives and finding ways to make them affordable—your customers will gladly pay for those innovations and will tell their friends.”
“Scale economics shared operations are quite different. As the firm grows, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods, which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. Scale economics shared incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance”
How are employees treated?
I came across a quote by a former Soviet communist factory manager asked about the lack or productivity: “They pretend to pay us, and we pretend to work.”
To sustainably delight customers is to build and inspire teams and employees that embrace the purpose of helping clients or customers achieve great results. We review the glass door (www.glassdoor.com) ratings to see what employees think about their work experiences at the firm and seek to link it back to how customers view the business. This cycle continuously re-enforces itself.
Finally
Once businesses are found with a great DNA, they can be multiyear winners provided capital allocation remains consistent with value creation and they continue to delight their customers/clients. . All too often however management become sidetracked or complacent and misallocate capital usually through diversification. The result of which is that aggregate returns on capital decline and the share price falls to discount poor performance. Quality of managerial character, correctly incentivised, is important to avoid capital misallocation.
“Are you a missionary or mercenary? ”