One of our favorite investing scenarios is finding a company with a remarkable culture taking share from incumbents that seem unwilling or unable to change.

We’ve talked about identifying companies with virtuous corporate cultures, but today we’ll discuss the other side of the equation: incumbent laziness.

This is important because a culture’s value is relative. If every company in an industry has a positive corporate culture (i.e. customer-focused, willingness to change, etc.), the value of any individual culture is null. There can be no predator without prey.

To be sure, incumbents are incumbents for a reason. They’ve been successful. They’re filled with smart people. But according to Richard Rumelt in his book Good Strategy, Bad Strategy, two themes expose incumbents’ weaknesses: inertia and entropy.

Inertia of routine

When there’s a blueprint for success, you want an Optimizer leader to establish processes that maximize efficiency. If the status quo persists, then “this is the way we’ve always done it” works just fine. Problems arise when there’s a shock to the system – a disruptive technology, a new regulation, or a change in consumer behavior. The processes and routines that carried the company’s success now have declining value.

On paper, these routines can be remedied, but as Rumelt notes, “The barriers are the perceptions of top management.” In practice, managers are reluctant to fire or reassign employees who oversee obsolete processes. (And who can blame them? We’re all human.) A generous dividend policy can be sacrosanct to shareholders and any effort to change it, even when strategically necessary, can be futile. This is especially true today, as dividend-paying stocks are trading at a premium in low-interest rate environments.

Indeed, one of the reasons we sold our position in Time Warner a few years ago and bought Netflix was it became apparent that Time Warner was unwilling to change its dividend policy to keep up with Netflix on streaming content spending.

Inertia of culture

When the status quo changes, the values and norms exuded by management and followed by tenured staff may not be what the company needs to compete and thrive. In 2018, the average U.S. bank had a Net Promoter Score (NPS) of 35 out of 100, according to SATMETRIX, implying their customers were unlikely to recommend them to their friends. A 2016 survey by Ernst & Young of 55,000 banking customers found that only 26% have “complete trust that their banks will provide truly unbiased advice.”

One explanation for low customer satisfaction is that most banks – large banks in particular – are driven to minimize overhead costs. This often results in a lack of personal service.

First Republic Bank flips that model on its head. By focusing on customer service (it boasts an 81 NPS when considered the customer’s “lead bank”), including getting assigned to a personal banker, First Republic doesn’t have to spend as much on customer acquisition. Between 2007 and 2018, 75% of the bank’s growth came from existing clients and referrals.

Inertia by proxy

Rumelt writes that “A business may choose (author’s emphasis) to not respond to change or attack because responding would undermine still-valuable streams of profit. These streams of profit persist because of their customers’ inertia – a form of inertia by proxy.”

We’ve written extensively about the decline of many consumer brands that relied on search cost advantages established and perpetuated by superior advertising and distribution. It can be tempting for companies who benefit from customers’ inertia – e.g. buying the same brand again and again – to raise prices too much and risk mortgaging their moat.

Gillette razors are a classic case in point. With a market share over 70% in 2010, Gillette felt it could raise prices without sacrificing market share. And that worked for a while. But it also opened up the opportunity for direct-to-consumer upstarts like Harry’s and Dollar Shave Club to dramatically underprice Gillette. Their rapid growth showed underlying customer frustration with Gillette’s prices.

In 2016, with its market share down to 54%, Gillette cut razor prices by up to 20%.

Entropy

Moat erosion typically begins behind castle walls. Without proper stewardship, a company – like an untended garden – will become disordered. Well-positioned competitors have a chance to storm the castle if management isn’t widening the moat.

Last year, we wrote about how the medical device company Masimo has been slowly taking market share in the pulse oximetry market from its once-dominant competitor, Nellcor (owned by Medtronic). We believe poor stewardship at Nellcor, when contrasted with Masimo’s exemplary stewardship, is a key reason this has occurred. Various owners passed Nellcor around over a 25-year period. In 2005, a federal court found that Nellcor (then owned by Tyco) had engaged in anti-competitive behavior to secure its then-70% market share in pulse oximetry.

Masimo capitalized on the opportunity to chip away at Nellcor’s dominance. Today, Masimo has about a 50% share of the U.S. pulse oximetry market.

Bottom line

It’s not enough to identify a company with a great corporate culture. For that culture to deliver consistent value, it must be up against competitors with weak cultures or poor stewardship. Knowing how to identify weak competition is critical to understanding the opportunity for strong companies.

 

For more information about the positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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