Saturday, November 29, 2014

The Difference Between a Good Company and a Great Company

Consider the largest stock holding in your portfolio. If I were to ask you to list ten reasons why you own the stock, what would you say?

You might talk about the company's strong competitive position, its attractive profit margins, its solid balance sheet, and provide additional commentary about its growth opportunities. And well you should, as these are important points to consider before making an investment.

Now, what if I asked you to list three to five reasons you're investing behind the company's management team? 

Perhaps that's not so simple to answer. I know I would struggle answering that question for some of my current portfolio holdings. 

The longer I invest, however, the more I've come to believe that what separates a good company from a great company is the people behind the business. A good horse with a mediocre jockey will win its fair share of races on talent alone, but a good horse with an elite jockey is even tougher to beat. 

Warren Buffett, for example, has stressed the importance of having a "knight" in the castle who is trying to widen the company's economic moat, the majority of Philip Fisher's "15 points" to look for in a stock are management- and employee-focused, and Ben Graham said in The Intelligent Investor that "It is fair to assume that an outstandingly successful company has unusually good management."

William Thorndike's modern classic, The Outsiders, also opened my eyes to the potential for material outperformance when you've invested in a good business run by top-notch capital allocators.

Admittedly, analyzing a company's management and corporate culture can be tricky and is far more qualitative than quantitative in nature, but therein lies an opportunity to separate yourself from other market participants.

As such, our research time would be well-spent learning more about the company's leaders and what it's like to be an employee of the company.

To illustrate, here are two companies in my portfolio and some reasons why I like the people behind each business.
WD-40 (WDFC)
  1. The company generates about $1 million in revenue per employee. This is a sign of a highly-motivated, very efficient business.
  2. WD-40 has a vibrant corporate culture. Employees are part of the "tribe," which may sound a little silly at first, but as Philip Fisher wrote in Developing an Investment Philosophy, "More successful firms usually have some unique personality traits...This is a positive not a negative sign." Companies with almost cult-like corporate cultures tend to have an uncommon ability to overcome challenges -- an intangible asset that should be considered when evaluating a company. 
  3. The company has a near-perfect score on Glassdoor, with every employee review approving of the CEO and willing to recommend the company to a friend. 
  4. Management has smartly focused on leveraging its WD-40 brand into other uses (bikes, specialist, etc.) and into new regions rather than trying to build up lesser-known brands in which it lacks a competitive advantage.
Sun Hydraulics (SNHY)
  1. Sun has a decentralized business structure, which puts decision-making power in the hands of all employees. If a customer needs something done right away, for instance, it doesn't need to go up five channels of bureaucracy to be approved.
  2. There are no formal job descriptions and employees are encouraged to learn other areas of the business. This greatly reduces "key employee risk" and if one person is out of the office for a week, the problem can still be solved.
  3. The board is only paid in stock in order to better align their interests with those of the shareholders. Very few boards do this, unfortunately, instead preferring considerable annual cash payments with some common stock as a kicker.
  4. The company has a low dividend payout ratio, but usually pays out a special dividend in particularly good years. This is an appropriate strategy given the cyclical nature of its products and is indicative of a leadership team interested in sharing rewards with shareholders.
How do you evaluate the people behind the businesses you own? Let me know in the comments section below or on Twitter @toddwenning.

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What I've been reading/watching this week: 
Stay patient, stay focused.