How Corporate Culture Can be a Moat

4 May 2018 | by Todd Wenning, CFA

The phrase “corporate culture” can be eye-roll inducing. It sounds like something right out of an M.B.A. textbook or the movie Office Space.

Culture nevertheless matters. In fact, Costco founder Jim Sinegal even went so far to say, “Culture is not the most important thing in the world. It’s the only thing…It is the thing that drives the business.”

Put another way, culture is the operating system from which all decisions – large and small – are made on a daily basis.

Or as Warren Buffett put it in his 2005 letter to Berkshire Hathaway shareholders:

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. 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.”

It’s precisely the imperceptible daily actions on which culture plays such an important role. Public companies are loaded with smart and talented managers capable of forming business strategy. But it’s those daily actions – good or bad – that add up and have a massive impact on the company’s economic moat.

Defining culture

What specifically makes for a virtuous culture varies by industry. For example, a virtuous culture in an industrial company may be one that’s obsessed with process. At a luxury apparel maker, perhaps creativity and design.

There are some common attributes, however, and Daniel Coyle provides a nice summary in his new book, The Culture Code: The Secrets of Highly Successful Groups:

  • Build Safety: A sense of belonging and identity.
  • Share Vulnerability: Ability to ask for help and admit mistakes.
  • Establish Purpose: Narratives create shared goals and values.

As an outside investor, it can be difficult to evaluate these attributes, but there are a few things that get our attention.

Coyle’s first point, about building a sense of belonging and identity, can often be found in the way management refers to its employees. Wal-Mart’s 1982 annual report, for example, referenced the “approximately 41,000 associates who are partners in the business.” (My emphasis.) Starbucks has also long referred to its employees as “partners.” Google employees are internally called “Googlers.”

From the outside, these phrases may seem silly or even empty, but having been part of the Vanguard “Crew” and The Motley Fool “Fools” earlier in my career, I can attest that they helped foster a unique sense of identity and teamwork. If they didn’t, they wouldn’t have stuck around.

It can also be encouraging to see management teams that openly admit mistakes. If management is admitting mistakes, that humility and ownership mentality likely exist in other parts of the business. A classic example is the Domino’s Pizza television advertisements from about ten years ago, where company president Patrick Doyle shared customer feedback saying Domino’s Pizza was terrible. These admitted weaknesses allowed Domino’s to revamp its menu rather than try to market its way around an inferior product.

Another way companies can hit on Coyle’s second attribute is by making all employees part owners of the business. This way, everyone has some skin in the game when making decisions. U.K.-based insurer Admiral Group, for example, immediately makes new employees shareholders. They are then eligible to receive up to £3,600 ($5,000) of shares every year with three-year vesting.

Finally, as Coyle points out, corporate narratives can help establish shared goals and values. In the mid-1980s, Danaher developed a lean manufacturing process called the “Danaher Business System,” which, as the company states, “drives every aspect of our culture and performance.” Over the last 30 years, Danaher used the DBS process to both evaluate and integrate a portfolio of acquired companies. A binding corporate narrative like DBS is the only way a conglomerate can keep so many business units working in harmony.

Bottom line

Culture can be a moat itself if it is virtuous, impacts return on invested capital, and is not easily replicable within its industry. This is one reason why First Republic Bank’s customer service-driven culture is a vital part of our investment thesis. To replicate its culture, First Republic’s traditional banking peers would need to uproot legacy systems and bureaucracies which may not be in the best interests of bank management and employees. Consequently, we think First Republic’s culture provides it with at least a decade’s head start on its main competitors.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Google (GOOGL) and First Republic Bank (FRC). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

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