By Investment Master Class
What is ‘Culture‘ and how does it affect the operational success of an organisation?
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Without doubt, if there is one aspect of an organisation that will separate the great businesses from the mediocre or the poor, it has to be the company's Culture. Businesses with healthy Cultures tend to be successful and provide attractive investment opportunities whilst those with cultures that are sick or decidedly unhealthy tend to perform poorly, leading to share price under-performance or even worse, the permanent loss of capital. It is for this reason, the Investment Masters recognise the importance of Culture in the investment decision-making process.
“Culture is king” Sam Zell
"The real glue of investing is understanding what the Cultures are in the businesses" Thomas Russo
A company's intrinsic value is determined by it's future earnings, and while past financial statements may provide clues to the quality of the business, changing conditions can make extrapolation of past results unreliable. In a large part, a company's future success will be a function of the culture. And culture is difficult to measure given its qualitative rather than quantitative nature. It is for this reason that culture often gets overlooked in the investment process.
Marianne Jennings, in her book, 'The Seven Signs of Ethical Collapse' [nb. recommended reading by Jim Chanos, the world's most famous short-seller] noted that "A good analysis of where a company is headed demands a look at the qualitative factors , those touchy-feely, squishy, from-the-gut factors that are ignored despite the fact that they often determine the company's fate".
James Heskett, a leading authority on corporate culture, noted that culture can be a better indicator of a company's future financial performance than hard numbers... "The decline of an organization's culture may well precede financial decline".
Great companies have great cultures. Ed Catmull, co-founder of Pixar, discussed culture in the first paragraph of his great book 'Creativity Inc' [new blogpost on this book coming soon!]. The book's introductory paragraph highlighted that what made Pixar was 'the unique culture that defines this place'.
So why is it so important?
A company could 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 great products, you might find that many customers have complained about slow delivery, or poor service, or rude employees in that business. These are all indicators of the health of a company's culture.
Companies with great service and employees that go the extra mile rarely have complaints made against them. And if they are not making complaints, then customers will return to the better businesses, leading of course to better business results. Its that simple.
"As much as half the difference in operating profit between organisations can be attributed to effective cultures" James Heskett
“A rotten culture can be a firm’s undoing” Marathon Asset Management
"Long term, culture is enormous in terms of one business doing better than another," Paul Black
“Perhaps the best known study on the subject is Corporate Culture and Performance by John Kotter and James Heskett. This work examines the relationship between corporate culture and company performance in over 200 firms during the 1980’s. The authors asked employees their opinions of attitudes to customers and shareholders at competitor firms. Shares in companies exhibiting strong and positive cultures outperformed rivals by more than 800% during the study period” Marathon Asset Management
A successful culture is a competitive advantage that can be difficult to compete with and challenging to replicate.
"In many organisations, culture is the most potent and hard-to-replicate source of competitive advantage - far more important, for example than technological innovation" James Heskett
“A strong corporate culture constitutes an intangible asset, potentially as valuable as a high profile brand or network of customer relationships” Marathon Asset Management
"Organisations with strong, adaptive and open cultures that foster employee loyalty and productivity are not concerned that competitors may find it possible to borrow policies, methods and processes. They are convinced that the real key to making those policies, methods and processes, and yes, strategies work is something much more difficult to emulate - culture," James Heskett
How do you describe what an organisation's Culture is?
Look at it this way: if we are asked to 'describe' a person, the answer lies in their personality and behaviours sets. They could be confident, assertive, organised, decisive, and pragmatic as an example.
If you then consider the Culture of an organisation to be much the same thing, when we describe it, we will be outlining how we see the business' 'personality'. By the same standard, it could be defined as competitive, aggressive, customer-focused, mature, cost-conscious and well-respected. On the other hand, a company with a poor culture could be described as lacking in Leadership or Integrity, and with a non-customer centric focus.
How is a company's Culture created?
In a nutshell, there are two things that determine a company's Culture. These are either 1/. a Company's Vision and Values, and/or 2/. the Behaviours of the Management/Leadership Team.
Company Values have long been touted by some companies as HR rubbish, or soft and fluffy BS that wastes everyone's time. The reality is actually something else entirely. If a company goes to the effort of creating a set of Values, it is essentially defining the organisation's Code of Conduct.
So taking this one step further, if the company's Vision and Purpose determines What it wants to be in the future, and the Strategies outline How it will get there, think of the Values as the Manner in which it will behave along the way. Values could also be seen as the company's behaviour set.
In the case of Vision, Amazon's vision is “to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online.” or Southwest Airlines vision to be the "Airline for the Common Man". Google has a purpose "to organise and make accessible all the world's information". Successful companies have a purpose and vision other than 'making money'. In all cases, these Visions will contribute to each of these company's behaviour sets.
Values will also differ from business to business. When setting their Code of Conduct, many use words like Integrity, Customer, Quality, Profitability, etc to define what it is important to that company. Basically, the list of potentials is endless. And they're also just words, unless definitions and measures are put in place beside them to ensure they are 'lived' within the business. In the end, words don't define a Culture, people and their behaviours do.
“Culture, more than rule books, determines how an organisation behaves” Warren Buffett
"In a 2004 study from the Journal of Business ethics, employees stunned most academics by saying that code of ethics for their company had very little influence on whether they make ethically correct choices. It was the culture of their companies and the examples set by their leaders that influenced their conduct" Marianne Jennings
Where organisations measure and reward staff for living company Values, the cultures are typically healthy and consistent - i.e. everyone behaves in the same way. If there is a Value of 'Integrity', the staff behave honestly and professionally. If they Value 'Customers', then they will treat every client as a valuable commodity that they do not want to lose.
Inversely, I have seen many organisations with sets of Values that are framed in reception or have been placed on the back of every employee's business cards, yet when staff are asked to name them, virtually no one can remember what the Values are. This typically defines businesses that do not measure their Values and therefore do not place any importance in them. They have gone to the effort and expense of creating the list in the first place, and then have never followed up to ensure their staff and management are living the behaviours. This is very common unfortunately. One example I have seen was a Sales Director who lied and cheated customers, yet the Company had a Value of 'Customer'. And in another, a CEO of a company touted 'Respect' and 'Professionalism' as key Values in that organisation, yet openly vilified minority staff in front of their peers. I have often seen Employees showing confusion in these instances - "If the company wants me to behave professionally, then why can't the CEO set the example?"
"Behaviours count only if they are monitored and if the measures trigger corrective action when behaviours are out of alignment with values" James Heskett
Where Values fail to drive the Culture however, or they have never been put in place, then the set of Behaviours exhibited by the Management and Leadership team will fill the void. Once again, if the leadership is sound, you'll generally find the business' Culture to be healthy.
"Credibility is a key component of an ethical culture, and hypocrisy is its death knell" Marianne Jennings
In a business with a healthy Culture, you might see behaviours of Respect and Accountability, or of Reward and Recognition; in all cases like this staff want to work there and so will inevitably push harder for greater results. Basically if management set the right example then a healthy Culture will surely follow. And if the Culture is right, then the business will typically be a successful one.
“To me culture is everything. It’s the glue that holds people in the firm together and it also provides the vision for all the people in the firm to know just what they’re driving to. Culture is really important. Tone at the top matters a lot. No one person can drive or create that culture, it’s more like a Oiji board where a lot of people have a handle on it, but what comes out of it is very important.” Jim Tisch
“The culture of a company is one of the major keys to its success” Stephen Errico
“Culture is the most important thing to understand about a company, and to understand about one’s self” Simeon Wallis
On the other hand, poor Cultures are driven by ineffective management or leadership behaviours. This could be exhibited by zero accountability by those in charge (meaning everyone else is to blame for the results), high staff turnover, absenteeism or apathy; all are examples of where the leaders have created a poor Culture.
Poor cultures can lead to ethical, and then corporate collapse. Revisiting Marianne Jennings' 'The Seven Signs of Ethical Collapse', she observed that companies with an excessive focus on meeting quantitative goals at all costs [eg profit guidance] or oppressive cultures of fear and silence are tell-tale signs of potential ethical collapse.
"Cultures of fear and silence nurture the team player concept, borrowing the buy-in and stronghold that comes from groupthink and the inability, as Solomon Asch's studies on social conformity pressure concluded, of most of us to speak up when we see something wrong, if those around us either do not see the problem or have chosen to remain silent. Even the most honorable people are submissive in a culture of fear and silence" Marianne Jennings
Another aspect that is important when reviewing Values and Management Behaviours is to ensure the two are aligned. Setting the right example starts with the Leaders of the business, and if they are not showing the way, it is wrong to expect that the staff will follow. I have seen businesses that set Values reflecting Teamwork and Recognition and Fun, while the managers are reclusive, negative and independent. How likely is it, do you think, that this business' Culture is effective? And just as importantly, how likely is it that the business will be delivering sound results?
So how do you measure Culture?
Measuring a company's culture is vital and of course is one of the easiest things to overlook. Because it can't be seen on a balance sheet, and it certainly isn't evident in any marketing or PR activities a company may undertake, when analysing investments we tend to only look at the hard business results, the fiscal capabilities of the business rather than its behaviours.
Because Culture is formed by people, the answers to measuring it lie with the same group. You need to TALK to all the appropriate stakeholders. These could include Staff, Suppliers, Customers, Management, Shareholders or the Board, and of course the Community it exists within. If you're only talking to one group, you are likely to skew your information and present a bias when looking at your investment opportunity. Management will only present one side of the argument, and if there is a potential upside to them in the investment, then they are likely to only reflect on the positive aspects of the Culture, or what they believe is there. By talking with Staff, Suppliers, Customers and the local Communities, you will attain the big picture. It is the ONLY way you can ensure you have applied appropriate due diligence with regards to investigating a company's Culture.
"Give me a one-on-one with an employee and I can tap a vein. I always offer companies: After I do my research, using the [seven signs of ethical collapse] give me just five minutes alone with a frontline employee and I can tell you the culture of your organisation and whether it is at risk" Marianne Jennings
It's no wonder the Investment Masters talk to those who manage and interact with the company ...
“Understanding culture before we acquire a business could be the most important thing we do. And it’s been one of the hardest things to do. You have to talk to the employees, customers, and suppliers. You learn a lot about how the company treats them” Steve Feilmeier, Koch
“I do talk to management of many companies. I like to figure out their human values, the culture they nurture and their long-term goals.” Francois Rochon
So what should you be looking for when talking to the stakeholders?
Beyond successful business results, positive Cultures are typically indicated by the following: Strong Leadership, Long Standing Employees, Collaboration and Team Work, Accountability, an excellent Customer Service Ethic, Strong Repeat Business, Role Clarity, Integrity, Transparency, Effective Reward Systems and Recognition Programs, Staff Engagement, Genuine Respect, Humility, Innovative Thinking, Staff Development Programs, Learning, Community Standing and Social Responsibility, Values that are Measured and 'Lived', Quality Products, Diversity of Workforce and Strong Ethics. Just to name a few.
“The three best operating companies I’m aware of are Costco, Kiewit and Glenair. There is nothing remarkable about the product or field for any of these. But there is something remarkable about the culture of all three.” Charlie Munger
“There is one thing I have been doing for many years now and has in my view been absolutely central to the fund’s performance. I mention it not in the spirit of self-congratulation, but because there is far too little attention paid to it and it would be far better for society, not to mention individual fund’s performance, if this was not the case. I am referring to building an understanding of and conviction around a company manager’s integrity and more broadly speaking a firm’s culture (the two are closely connected as the tone basically comes from the top). Nothing has been more important to managing the fund over the last years than understanding management character.” Robert Vinali
You can see how important Culture is to the Investment Masters in determining the success of an Investment. Don't simply rely on the business results and balance sheet; the answer to your investment question could well lie with the people and the Culture....