What do you think of when you hear the phrase, ‘corporate culture’? More likely than not, you’ll recall awkward and cringeworthy attempts at workplace camaraderie and collaboration, reminiscent of an episode of The Office. Given this popularised concept of corporate culture, many investors tend to dismiss it as unimportant or simply overlook it when doing research. Further, the impacts of corporate culture aren’t easily quantified, often making it unpalatable for investors and analysts keen on crunching numbers.
By not including corporate culture as part of your research process, however, you may be selling yourself short. Not only are few investors doing this type of research – when was the last time you read a broker report that discussed corporate culture at length? – but it also has a far larger impact on the business’s long-term potential than many think. As such, if you’re a long-term investor, you’re well served to understand the company’s corporate culture before you make an investment.
Culture as a durable advantage
First, let’s redefine the term. Corporate culture isn’t the aforementioned workplace dystopia nor is it necessarily full of techy millennials riding around the office on scooters. Instead, it is better thought of as an esprit de corps – a fellowship felt by employers and employees committed to behaving in a way that sets them apart from their competition. In other words, you want to understand and identify what intrinsically motivates employees of Company A, who are in the same industry as Company B, to consistently outperform them on multiple metrics.
Investors (as opposed to traders) should always try to answer this question: if you had all the cash you needed to replicate a particular business, what are the intangibles that money couldn’t buy? Ultimately, it’s these exceptional factors that enable businesses to create sustainable long-term shareholder value.
In some cases this comes in the form of a valuable brand such as Coca-Cola, Johnnie Walker, or Louis Vuitton that provides the company with sustainable pricing power. It could also come in the form of network effect (think Facebook, eBay), switching costs (Sage, SGE) or patents (GlaxoSmithKline, GSK). Culture can also be thought of in this light. Like any other durable competitive advantage, it can’t be built overnight and needs years to be nurtured.
Consider the retail business – competition is fierce, margins are low, employee turnover is high, and consumer tastes are fickle. Jim Sinegal, the co-founder and former chief executive of retail giant Costco Wholesale (US:COST), understood this reality and set out to build a company that separated itself from the fate of most retailers. One of the ways he aimed to accomplish this was to foster a vibrant corporate culture. Indeed, Mr Sinegal is fond of saying: “Culture isn’t the most important thing. It’s the only thing.” Part of the Costco culture was to pay its store employees well, offer health benefits, and provide retirement savings options. This was in stark contrast to the common retail arrangement in the US, where most companies paid its front-line staff minimum wage with no benefits.
■ Which type of retailer would you want to work for? Unsurprisingly, Costco’s employee turnover in 2014 was just 6 per cent, far below the US retail industry average. By avoiding high employee turnover rates, Costco has been able to deliver more consistent customer service, keep hiring costs down, and staff its stores with experienced associates. All of those small advantages arose from the company’s culture.
Sentimental stuff?
Corporate culture may seem like a nice but ultimately inconsequential item, but as Warren Buffett pointed out in his 2005 letter to Berkshire Hathaway shareholders, it’s the little things that companies do each day that matter over time.
“If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength... On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat’.”
Culture matters precisely because it enables and encourages these small actions. Over time, this can have a tremendous impact on a company’s competitive position.
In his book, The Culture Cycle, Harvard Business School professor James Heskett found that “as much as half of the difference in operating profit between organisations can be attributed to effective cultures”. The difference, he found, was usually attributed to lower wage costs for talent, higher productivity, happier employees, more loyal customers and lower marketing costs. So what may seem to be a purely qualitative exercise can have a clear impact on the numbers. The little things add up.
Now, it’s true that a company that’s inherited a strong competitive position and has a miserable workforce may be able to produce solid results. At least for a time. Eventually, a toxic corporate culture will manifest itself through complacency, reckless decision-making, and perhaps unethical practices. We can all think of a few classic examples of corporate misbehaviour as evidence of this. Even if you’re buying into a well-established blue-chip company, it also pays to conclude that its corporate culture – at the very least – isn’t having a detrimental impact on the business.
Ways to research culture
‘Great’, you might be thinking, ‘but how can you begin to understand a company’s culture without working there?’ Well, thanks to Google search, YouTube, LinkedIn, Glassdoor and other public information sources, we can paint a much better picture than we could just 10 years ago. For one, companies with exemplary corporate cultures tend to get noticed in local newspapers and business publications. Netflix (US:NFLX), Henkel AG (GER:HEN3) and Canadian National Railway, for example, have each had Harvard Business School case studies done on their respective corporate cultures.
Anonymous employee reviews on Glassdoor should be taken with a pinch of salt, as some unbalanced reviews are written by jilted former employees. Still, by considering the general comments made by employees, you can get a feel for what the company is doing right and doing wrong. If a significant number of employees are complaining about lack of promotions or management not spending enough time with new hires, that could be a sign that there’s something wrong with the company’s culture.
Another tip is to read through the company’s career page on its website. If it’s proud of its culture or thinks it is special in some way, it will want to promote that fact.
Ultimately, through this research, you want to determine which companies have genuine, unique and valuable cultures. To help you do that, here are a few questions to ask yourself:
■ Does the culture reinforce and strengthen the company’s other competitive strengths?
If you consider one question about culture during your research process, this is it. If the company wants to be a leading innovator in its industry, for example, its culture should create an environment conducive to creativity. Google (US:GOOGL) allows employees to spend up to 20 per cent of their work week on projects that interest them. This initiative has reportedly led to, among other things, the creation of Gmail, AdSense and Google News – each of which has strengthened Google’s competitive position.
Similarly, if the company strives to be a low-cost operator, the culture should include an emphasis on reducing costs. To illustrate, when low-cost insurer Admiral (ADM) opened its first US office in 2009, it required employees to do a press-up for each piece of paper they printed off as a way to keep even small costs front of mind.
Privately owned Ritz-Carlton competes in the luxury hotel business where customer service is paramount given the rates guests must pay to stay there. To maintain its high service standards, Ritz-Carlton allots its frontline staff $2,000 per day per guest to use at their discretion to delight customers. This can come in the form of providing newly-weds with an upgraded room, giving guests a free extra night, gifting show tickets, and the like. These tiny actions help build life-long customer loyalty and positive word of mouth, which results in a high return on that small initial investment in customer satisfaction.
■ Does the culture permeate the organisation or is it restricted to the executive suite?
Most companies have a published list of corporate values on their website that have been prepared by well-meaning committees close to upper management. My guess, however, is that only a handful of those companies could say that all of their employees could list those values if called upon to do so. Either the values didn’t resonate with the employees or they weren’t properly disseminated. When employees from top to bottom of an organisation are whistling the same tune, however, great things can happen.
US canmaker Ball Corporation (US:BLL) – which is in the process of acquiring fellow canmaker Rexam – for example, employs the economic value added (EVA) metric that’s used to measure bonus pay from everyone in the head office to the canning plants. Because EVA considers the return on the company’s investment minus the cost of the capital to make that investment, employees are motivated to keep costs down at all levels of the business and run efficient operations. Daily operating metrics are posted at each canmaking plant for every employee to evaluate and compare their metrics to those of other plants around the world. This not only serves to motivate employees to find new ways of reducing costs, but also provides them with an unambiguous measure of their personal progress.
■ Has the company been frequently named ‘a best place to work’ in major publications?
Okay, one fair point of contention with this question is Enron. In its prime, Enron frequently topped such lists in the US and we all know how that story ended. It would be a logical fallacy, though, to assume that companies featured on such lists are also tinder boxes waiting to explode. On the contrary, inclusions on such lists should generally be seen as a positive sign.
In 2015, The Sunday Telegraph included Expedia (US:EXPE), Hays (HAS) and Unilever (ULVR) among the 10 best places to work in the UK. Such accolades not only help these companies attract top talent and reduce recruiting costs, but also speak to current employee satisfaction. In short, they’re doing something right. By digging into why these companies are making it to the top of the list, we can uncover some insights into the businesses’ staying power. Hays, for example, is generally well regarded by its staff for being a place where ambitious people can thrive. The company provides loads of training and a ‘work hard, play hard’ environment. This type of environment may not be right for companies in other industries, but it suits recruiting well and helps Hays stand out in a highly competitive industry.
■ Can you connect the culture to cash flows?
If we believe that the current value of a company is the sum of its future cash flows discounted back at an appropriate rate, then we shouldn’t pay a penny more for anything that doesn’t impact cash flows. Investors sometimes mistakenly rationalise paying up for a stock because it has a great brand, management team, or even culture, without being able to explain how those things affect cash flows.
The fruits of the aforementioned Admiral’s low-cost culture, for example, can be seen in its UK operations’ expense ratio, which was half the industry average in 2014. This helps the insurer generate cash flows in various insurance pricing environments.
Expedia has a robust ‘test and learn’ culture in which product ideas can come from anyone in any part of the business. This helps Expedia stay innovative relative to its competitors and makes its services more valuable to its customers. If Expedia is able to consistently delight its customers in ways its competition can’t, it should be able to maintain and grow its profit margins and cash flows for years to come.
■ Does the company typically promote from within?
All else being equal, a company with a healthy corporate culture shouldn’t need to hire an executive from the outside. In most cases, when a chief executive or chief finance officer (CFO) is hired from the outside, it’s a sign that something’s wrong and the board felt the culture needed to change. Conversely, a vibrant culture should have a clear pathway for promising leaders to be recognised early, trained, given opportunities to gain experience, and move up the ranks.
At Next (NXT), for example, its chief executive, finance director, operations director, and sales and marketing director have each been with the company for more than 20 years. This level of executive tenure is rare among major corporations and particularly so in the competitive retail industry.
My rule of thumb is that at least two of the top three executives at a company – usually the chief executive, finance director (CFO) and operations director (COO) – should have been with the company for at least 10 years each and served in a variety of roles before taking their current position. This not only shows the company has the infrastructure to train and retain promising talent, but that its leaders have wide-reaching connections across the business to get things done quickly and efficiently.
Bottom line
You won’t find corporate culture discussed in any investing textbooks, but by including it in your research process you can increase your odds of developing a differentiated viewpoint from other investors who are more focused elsewhere. A great corporate culture isn’t reason enough to invest in a company – you still need to pay attention to valuation, of course. That said, if you think a unique and valuable culture is being overlooked or under-appreciated by other investors, it could present a strong long-term buying opportunity.
Todd Wenning, CFA, is an analyst based in the US and is the author of the recently published book, Keeping Your Dividend Edge. He owns shares of Berkshire Hathaway, Admiral Group and Costco. His opinions here are his own and not those of his employer
