In my opinion, culture is probably the single most important thing in business.
A good business model can be destroyed by bad management and poor cultural practices. The recent example of Wirecard is a case in point, but there are many others. Valeant Pharmaceutical’s strategy of significantly increasing drug prices worked, for a little while; but then massively backfired. If you exploit your customers in this way, I’m afraid it’s never going to end well.
A good culture on the other hand can become a huge competitive advantage, turning an ordinary business into a highly successful one. Howden Joinery, Next and Admiral, to name just three, operate in highly competitive industries but have been amongst the most successful companies in their sector for years. Economic textbooks will tell you their returns should have reverted to the mean decades ago. These texts of course don’t give culture a second thought.
Culture is hard to define, which I think is why many investors choose to ignore it or gloss over it (I think many professional investors are particularly guilty of this). It cannot be boiled down to a number on a spreadsheet. Anyone who’s worked in multiple businesses knows that some companies implicitly ‘get it’. They tend to make more good decisions than bad ones, and in doing so compound their advantage each year. Other companies always seem to make the wrong choices, despite often having good intentions.
For outside investors it can be a challenge to appraise the culture of a business. However, this doesn’t mean we should ignore it. Good investing is like being a detective or investigative journalist. You look for clues and try to build a picture that gets you closer to true understanding.
You will never get to ‘the answer’ and at times you will be surprised when the things you thought you knew turn out to be wrong or out-dated (remember, culture is always evolving). But in my view, investors ignore culture at their peril and should try as best they can to stack the cultural odds in their favour.
When I’m assessing the culture of a firm I consider two things – quantitative elements (including past financials, accounting and acquisitions) and more qualitative factors (like stakeholder relations). In this blog I focus on the former.
Attitudes to debt/leverage
We’ve seen a number of companies get into trouble during the COVID-19 crisis by running their finances in a way that left little room for anything to go wrong. We saw the same during the financial crisis. Some companies never seem to learn and always prioritise juicing short term returns at the expense of financial stability.
Use of leverage is, in my view, one of the best ways of assessing the inherent conservatism of a business. Personally, I prefer companies that conduct their affairs prudently. Business is risky enough and the world is a surprising place. I’m willing to give up the prospect of a few extra percentage points of return in exchange for knowing my companies can come through crises unscathed.
A company’s attitude to leverage can give important clues about how it conducts its other affairs. An aggressive balance sheet positioning makes me question whether the same attitude prevails towards how they approach internal controls, for example. Or how they treat their customers and employees.
So next time you’re doing a cultural assessment of a firm, start by asking this simple question: how conservative or aggressive has the company’s use of leverage been in the past? The answer may be revealing.
Attitudes to accounting
A crucial point for any investor to understand is that accounting practices have a lot of scope for judgement and interpretation. In simple terms, companies can choose whether to report higher or lower profits in the near term through the accounting assumptions they employ.
If a business spends £50 million on a new factory and depreciates it over 25 years as opposed to 10 years, annual profits for the next decade will be £3m higher. Another example is the choice of expensing or capitalising R&D, which can make an enormous difference to reported profits.
The degree of conservatism/aggression in a company’s accounting assumptions can be checked by comparing its policies to other businesses in the same industry. This can provide clues about the culture – for example, does the company think long term or obsess over short term results?
The propensity of a business to use ‘exceptional’ items should also be watched like a hawk. These items are excluded from the adjusted profit figures and are often buried at the bottom of the report and accounts (companies want you to ignore them). Sometimes these items are genuinely one-off in nature, but often they recur.
I’m wary of companies that have a penchant for exceptional items, partly because it seeds doubt in my mind about the company’s culture. If management are willing to try and pull the wool over investors’ eyes in this way, what else is going on behind the scenes?
In my experience, companies with strong cultures tend to have cleaner accounts since they have nothing to hide and usually want to be as open and transparent as possible with all stakeholders, including shareholders.
How well a company has allocated capital is an important guide to culture. The best metric to check is the return on capital employed (operating profit divided by total capital). A declining trend over many years may suggest the company has a culture that prioritises growth over returns.
A prime example would be the UK supermarkets which for many years had a strategy of opening more and more stores. While profits initially rose, the incremental return on these investments was steadily falling, and yet they continued to expand. This expansion also caused them to take their eye off the ball with their existing stores and customer service suffered. The end result was not a good one for shareholders.