Three key attributes of great companies

Investors need to consider more than the hard numbers of target investments. They need to identify ‘softer’ aspects of companies to gain an advantage. Recent revelations of misconduct from the Financial Services Royal Commission also emphasise the need for investors to garner greater insights into the corporate culture of companies in which they invest.

We’ve identified three key attributes in great growth companies. They are:

1. A tailwind or growth path ahead

Is the company in an industry set for secular growth or secular decline?

If the global demand for a company’s products is shrinking, or worse, if the product has been made irrelevant by a change in consumer preferences, it can be severely detrimental to value. A recent example is any small- or mid-sized newspaper company.

This attribute is a ‘price of admission’ characteristic. Making sure it is present won’t set you apart much, but if you forget to think about it, you are asking for trouble.
 

2. An expanding ‘moat’

Warren Buffett used the ‘moat’ metaphor to describe an enduring competitive advantage. He likened a business to a castle and suggested that the company’s edge, the thing that keeps competitors from simply copying the business and destroying the company’s high profits, was the moat around the castle. A wide moat business can earn higher profits for a longer time. With Buffett’s success, this concept caught on. Today, for example, Morningstar publishes moat ratings for thousands of companies.

One financial metric that gives a good sense of the size of the moat is return on invested capital, or ROIC. High profitability attracts competitors, so an ROIC that has stayed high is a decent indication that there is some kind of valuable moat. But note the past tense. ROIC is a rearview mirror metric, in that it tells you where you have been, but really tells you nothing about where you are going.

The critical thing is not the size of the moat or the rearview mirror look at competitive advantage, but rather how the competitive advantage is changing – is it getting stronger, or weaker?

We call this dynamic aspect the ‘moat trajectory’, and our approach to identifying moat trajectories, as early as possible, has been to:

1. Analyse dozens of historical examples of moat lifecycles (essentially business case studies) and:

A. Look for common patterns.

B. Not expect those patterns to repeat exactly but check for where they tend to rhyme.

C. In those places where they rhyme, identify and catalogue the indicators of improving or deteriorating moats, and then construct a rough framework of what to look for.
 

2. Evaluate a prospective investment using that framework of indicators and:

A. If the markers are present, have confidence the moat is expanding.

B. If absent, conclude the moat is flat or deteriorating.

Deteriorating moats can be serious capital destroyers. And they are deceptive, because they usually start out as a great company that starts to look really cheap. Just ask the shareholders of Nokia or Blackberry or Yahoo, or others like them.

So, a “wide-moat company selling at a discount to intrinsic value” (an all-too common phrase in our industry) is not the answer. In particular, don’t let cheapness deceive you into believing you have a ‘safe’ investment.

The question to ask is, “Where is the company’s competitive edge in the future?” This is more important than the share price and value. For instance, some people will invest in the biggest company, or in market leaders, believing that this will provide safety for their investment. But if the organisation is losing its edge, either by declining market share or some other symptom of its shrinking moat, then that organisation will experience challenges and ultimately its share price will suffer.
 

3. An aligned corporate culture

An aligned corporate culture makes intuitive sense. If your employees hate working at a company, they will not put in their best efforts or ideas, and that will make it nearly impossible to have a good company (or investment). In contrast, if people enjoy working there, they will do more for it and their colleagues, and for the customers.

An organisation can have the greatest products, a robust brand and reputation, effective policies and processes and a long history of trading, but if the culture is poor, it is much less likely to succeed when compared with a business that has a healthy culture. Despite those good products, customer might complain about slow delivery, poor service or rude employees. These are all indicators of a company’s culture.

In contrast, companies with great service and employees that go the extra mile rarely have complaints made against them. If they are not making complaints, then customers will return to the better businesses, leading of course to better business results. It’s that simple.

Even when you have nearly identical businesses in the same industry, there can be big differences in business performance. Corporate culture is generally the explanation. For example, consider how Costco is so much more successful than Sam’s Club (a division of Walmart).

But how do you analyse corporate cultures? It’s not easy, and that’s why most investors skip it. We have an analyst dedicated to probe the cultures of companies in which we invest, and we have developed a proprietary methodology for assessing this subjective element. Assessment techniques we use to determine this include meeting with company management, and interviewing former employees, vendors, customers, and competitors. We also consider employee turnover rates, net promoter scores, online reviews, surveys, and many more inputs.

Visiting a business’s operations, for example, enables us to gather small yet highly informative details to evaluate its culture. Similarly, industry surveys and net promoter scores reveal hard-to-quantify appraisals of cultural reputations or overall customer satisfaction. The latter, for businesses with a significant proportion of customer-facing staff, is often reflective of its culture. Happy employees make happy customers, which make for happy shareholders.

The magic combination is a culture which encourages the behaviours that enhance the company’s competitive advantage. This can keep a business ahead of its competitors for years.

Accordingly, good investment research today is not just about getting hard financial numbers, it’s also about gaining a better understanding of the ‘softer’ aspects of businesses.

Content first published in the financial newsletter cuffelinks.com.au on 2 August 2018.