Widening Moats + Culture

If you've been keeping abreast of my posts in the last twelve months, you will no doubt have noticed the common trend of the Investment Masters to want to buy Great Businesses. These of course are companies with healthy rates of returns, strong future earnings potential and usually come with a significant competitive advantage. And when the Investment Masters look for competitive advantages, one of the most important a company can possess is a strong corporate culture. 

A couple of weeks ago I had the opportunity to attend a speech by Kurt Winrich about just that subject: 'Corporate Culture'. Winrich and his partner Paul Black run WCM Investment Management, and together manage a $26b global equities portfolio out of Laguna Beach, California. 

A good corporate culture is key to business performance. It is clear that Companies with good cultures outperform those with poor ones. In the recent Robert Cialdini post we talked about a 'cultural flywheel' driven by the powerful trait of human nature, reciprocation. If Corporates treat their staff well, the staff reciprocate by working harder, customers benefit and reciprocate, and the company prospers. In a recent CNBC interview, Paul Tudor-Jones discussed research showing companies that look after their staff and customers and produce quality products, typically earn an average 7% higher ROIC and heavily outperform those that don't. Basically, companies that prioritise staff and customers above shareholders and management perform better.

Culture can be a competitive advantage that's almost impossible to replicate. Winrich and Black's WCM spend 95% of their time looking for companies whose moats are growing and who have corporate cultures that are aligned with those competitive advantages.

And they're not alone in recognising that an expanding moat is a key trait to success. Buffett himself has said that widening the moat is more important in any given year than a company's profit.

"If you are evaluating a business year-to-year, you want to — the number one question you want to ask yourself is whether the — could the competitive advantage have been made stronger and more durable before — and that’s more important than the P&L for a given year." Warren Buffett

Widening the moat.. that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence." Warren Buffett

"We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well." Warren Buffett

It's WCM's recognition of culture as a key input into a company's competitive positioning that makes their investment process somewhat unique. And with outperformance of 500bps pa over the last 10 years, they were clearly something worth digging into. In my quest to learn more about WCM's partners, I found some great interviews and podcasts. One of my favourites was Ted Seides, Capital Allocator's podcast interview with Paul Black. Below you'll find insights from that interview and a few others with links below.

Learning From Failure

"We got here from a lot of hard work, a lot of good fortune and learning from past mistakes and making almost every one you could possibly make, but using that as a source of strength to get better and better. Anyone who doesn't believe that most of life is learning from your failures just doesn't quite get it or they're too young to get it." Paul Black

Focus on Great Companies

"A growth stock investor has a different perspective on the world. You have to be optimistic about the future. I like it because I tend to see the world more positively. It's consistent with where I am psychologically. To me optimists rule the world. I think optimists are the ones who ultimately get it right. Buffett says it all the time, 'Never bet against America'. I'd say never bet against great growth companies with superior cultures that are highly competitively advantaged." Paul Black

People Matter

“A lot of people think it is all in the numbers, we think it’s all in the people Kurt Winrich

"If you read Phil Fisher's book Common Stocks and Uncommon Profits, I think he has a 25 point checklist on how to analyse a company and interestingly of the twenty-five, probably fifteen are qualitative elements. Which is just the reverse of what most people on Wall Street do." Paul Black

“My favourite example in the US is Costco vs Sam’s club (Walmart division). Those businesses look the same but Costco sales per square foot are more than double, revenue per employee stronger, employee turnover much lower (Sam’s club 44%). Costco pays employee more. Employees are the starting point of customer satisfaction. When people are really happy they give more. A lot of people think company should treat shareholders best. Costco thinks key is to treat employees best.” Kurt Winrich

Focus on the Direction of the Competitive Advantage

"95% of our work is around identifying businesses with growing competitive advantages." Paul Black

"A couple of things define a great growth company. [What we do] is very different from what most people do. We've found if you're just looking for high quality, wide-moat businesses selling cheaply, today you are going to find yourself in a lot of value traps. We've made the mistakes in the past buying high quality, wide-moat businesses cheaply. What we learned because of our mistakes of significantly under-performing the market, is that you have got to stay focused on the direction of the competitive advantage. Everybody's businesses is either getting strong versus your competitors or you're getting weaker. You want to be able to make the case, through pattern recognition and other tools around 'moat-typologies' as we classify it, that the company you're looking to invest in has a strong likelihood of growing its competitive advantage over the next five, ten and fifteen years. If you get that right, any valuation work you do is going to look ludicrously cheap five and ten years out. That's a huge part of what we do that's different." Paul Black

"A lot of people think you just want the biggest moat. Our contention is you need to pay attention to a moat that is growing. A moat that is shrinking can be dangerous. If we find a growing moat how do we have any confidence it will keep growing. We found the number one way that convinces us of that is the culture is aligned to the moat. We want to see behaviours that enhance the competitive position.” Paul Black

"What's more important than just a big competitive advantage is buying a business where the competitive advantage is actually getting stronger. Where you can make the case over the next 5, 10, 15 years the competitive advantage is going to be stronger. If you get that part of the equation rights your going to go a long way to having a successful investment." Paul Black

Place a Premium on Culture

Culture is a huge differentiator between successful organisations and unsuccessful organisations.” Kurt Winrich

"The second thing we do that's really significant and very different is that we put a huge premium on corporation's culture. That doesn't mean we just want shareholder friendly management team. We want to understand the DNA of the business. We want to know what the core values of the business are, and how those core values relate to the competitive advantage. Because if you can buy a company where the core values of the organisation are aligned with its competitive advantage." Paul Black

"To us the distinguishing characteristic in any investment has got to be determining what the core values are, what animates that culture and making sure there is an alignment." Paul Black

Ensure Culture aligns with Competitive Advantage

"We worked with a guy named James Heskett, a Harvard Business Professor, and wrote a book called the Culture Cycle. It's one of the more interesting books on culture. He's really the person who helped us understand that when you're assessing a culture, the strongest companies are going to be where the cultures and value are aligned with he competitive advantage." Paul Black

"What are the core values of great retailers? It's about taking care of your people. We take the example of Costco versus Sam's Club. Those are two companies in the same industries where the stores look the same. But you look at the financial metrics of Costco, they're twice Sam's Club on every metric. Same store sales 4-5% at Costco versus 1-2% at Costco, Sales per Sqft $1,000 versus $500, Employee Turnover 12% versus 50% at Sam's Club. ROIC 12% versus 4%.  What account for that? To us it has to come down to the culture and the values in the business. In Costco they truly care about their people, they want happy employees. In retail you want happy employees, because when people get a great experience they are going to come back and spend more. The whole value side comes directly from the top. The founder of the company, Jim Sinegal owned a lot of shares but never made more than $300k a year. How different is that from other companies where the CEO is making $20m, $30m, $40m or gets fired and gets a $200m golden parachute. That doesn't usually bode well for the long term cultural success of the firm." Paul Black

"Sam Walton really embraced the notion that you have to bring people along, you have to get people excited, you have to make people happy. You have to pay people well and tie them into the bottom line. He built this culture where people just loved coming to work and they had a lot of fun doing it. As a result they took on these old stale bureaucratic centralised organisations. That works for a retailer. But do you really need happy employees to run a railroad? Probably not. You want people that are highly accountable, that probably think in certain way, more linear, because it's all about delivering an on-time product in an efficient cost effective manner. There is a high cost of failure. Different stresses. Very difficult corporate culture is needed for that than for a retailer. We found there are different cultures you for different businesses that are effective." Paul Black

Assessing Culture and a Widening Moat

"When you are trying to assess a culture one of the best things to do is not just talk to the CEO or CFO but it would be to talk to people who have left on good terms. Of course you to talk to suppliers, vendors and competitors to find who do they/don't they respect. If you talk to people who used to work there and left on good terms you usually get a pretty good picture. What you are doing is building a mosaic when you're going after culture. A lot of people don't do it because you can't quantify it, you can't put it in a box and score it, or scale and number ranking. You really have to build a mosaic." Paul Black

"You can't just walk into a business and say tell me about the culture. If someone goes on for 30 minutes on culture it's important to them." Kurt Winrich

"One question [we ask on culture] is 'what would you tell a friend on how to be successful in your company? What are the three things to tell them to be successful? What's really hard for new hires to really get used to? What are some difficult scenarios? Tell me about your failures, where have you made mistakes. Most people don't want to talk about their mistakes. They move on as if their career was just filled with success." Paul Black

How do you measure if a moat is getting stronger? It’s pretty easy ex-post. It’s probably best seen in ROIC. Think about it from a competition perspective.  If you have a very profitable business and you have protection then your profits can continue to grow. If your competitors can attack you and copy you, your profits disappear. A rising ROIC is a great ex post measure of growing competitive advantage. Only one problem is that it’s practically useless because the good news is already in the stock price long before its shows up in the financials. You need to find a reliable ex ante measure. We settled on a simple form of pattern recognition. It comes from studying great examples of growing competitive advantages and their life cycle in the past. We’ve studied the great businesses of the past in a case study way and we’re trying to identify and catalogue the markers that tell us in a contemporaneous way whether the moat is growing or shrinking. We can learn something from these things. The ideas are that if the markers are present we feel confident, when they disappear we lose our confidence.” Kurt Winrich

“When you have a culture that isn’t empowering or doesn’t encourage engagement, you’re already hamstrung. A great incentive for engagement and empowerment is ownership - not just from the CEO but other employees.” Kurt Winrich

“To really know which businesses have an edge you’ve got to do the in-the trenches-research, it’s not getting more numbers, it’s just talking to people who know the business. That’s why we us a large network to talk to current employees, former employees, customers, vendors, competitors. Ask questions about competitive advantage and culture. Phil Fisher called it scuttlebutt research. That’s critical.” Kurt Winrich

Rising ROIC Correlates with Returns

"Most managers screen for a hurdle on ROIC over last 5 years. What we've found more valuable that just the level of the ROIC is the direction. There is a 1: 1 correlation between the direction of the ROIC over a 5 year period of time and stock performance. If you break the market down into five quintiles from the top quintile where they have the most rapidly rising ROIC to the bottom where they have declining ROICs, there is a 1:1 relationship between the best performing stocks on the top quintile and the poorest performing stocks on the bottom." Paul Black

"We'd prefer a company that maybe five years ago had a 4% ROIC  growing to five , six, seven, eight. That's a much better investment than a company that's at a 12% ROIC that might be stagnant over that period of time." Paul Black

Models Won't Give You The Answers

"Most people spend 95% of their time crunching numbers, running DCF models, which by the way has zero competitive advantage because you have thousands upon thousands of people doing the same work. Where we can get a massive competitive advantage is by doing the things that other people are not." Paul Black

Long Term Horizon

"There aren't that many great cultures with alignment to their competitive advantage, but when you find them, you hold them for a long time, ten years."  Paul Black

"In investing, time is your friend. The people who make a lot of money in investing are those that buy great businesses, in our case with expanding moats, and they give them time to work for them over 5, 10 and 15 year pulls. All the people that have created a lot of wealth for themselves didn't do it in a week, or 3 months or 6 months. They did it over a generation." Paul Black

A Tailwind

"You certainly want to have tailwinds. It's just an acknowledgement that is how life works. Anyone that doesn't acknowledge that is just not being honest. I think having tailwinds is essential to success. I think a big advantage we have is we tend to own businesses in the growthier sectors like tech, healthcare and consumer. If you think about the emerging middle class around the globe, as people get wealthier in Brazil, Indonesia, India and China, they're going to buy products from the companies we own. They sell products as these people get richer - that's a beautiful tailwind that not going away for fifteen or twenty years, it's something you can really take advantage of." Paul Black

Manage the Downside

"Everything we do in this portfolio is to manage on the downside. One way is being more times than right on direction of competitive advantage. Because in difficult times if you can own the company that isn't constrained by the financial markets and can allocate capital in to the space their weaker competitors cannot. what you find is that those companies hold up really well. Of course we do the basic portfolio construction and diversifying among sectors and industries and making sure we never have more than 4-5% in anyone name. At the end of the day, everything we manage is to to do well in tough markets. Where we really expect to do well is tough markets. Very counter intuitive. But to me it goes to the heart of what we are doing differently" Paul Black

Ignore the Pessimists

Our advice is ignore the pessimists. I think humans are naturally wired to look at everything that can go wrong and we tend to miss what is good which dominates most of the time. You watch the news are all you see is crises. Yet when you look back over the 20th century and into the 21st  you find out things end up working really well. Kurt Winrich

Out of Town

"It's a massive competitive advantage for us [being in Laguna Beach]. There's so much noise in New York and San Francisco and Chicago. The beauty of being in Laguna Beach is that you're not subject to the constant chatter that goes on, which really forces you to be short term in your orientation - to make decisions in 3 and 6 months periods of times versus five and seven year periods of times. We are able to be more thoughtful." Paul Black

Summary

I really like Winrich's comment that you can't just walk into a business and say, "tell me about the culture." Those without good cultures will lack substance in their reply. It clearly is not something they rate. If, as Kurt says someone goes on about culture for thirty minutes, however, then its obviously important to them.

It's clear that companies who build effective Corporate Cultures are better performers. They have a competitive advantage that sets them apart from the rest of the market, giving them a wide moat. And moats are hard to cross. Those businesses that can continually widen their moat each year will likely also continue to grow earnings for long periods of time because they become harder and harder to compete against. Its a no-brainer. Even Buffett says so. 

 

 

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Sources:

Gratitude, Fun and Growth Stocks - Capital Allocators
Global Investing Webinar with Paul Black
The Rules of Investing: Is value dead? - Livewire

 

Note: This post is for educational purposes only. I have no relationship with WCM IM.