“Whatever affects one directly, affects all indirectly. I can never be what I ought to be until you are what you ought to be. This is the interrelated structure of reality.” ― Martin Luther King Jr.

Every investment is made in search of profits. But where do those profits come from? Are they created out of thin air? Are they extracted from someone else?

In this post we’re going to discuss a holistic theory of where profits come from. While this theory is grounded in the everyday “interrelated structure of reality” that business owners will recognize immediately, it challenges the commonly accepted assumption that business is a zero-sum game in which every unit of value that accrues to stakeholders is one less unit of value available to shareholders. In fact, we will argue that the reverse is true. That every unit of value that accrues to stakeholders is one more unit of value available to shareholders.

• Shareholder: A person or entity that owns a business.
• Stakeholder: A person or entity with a stake in the actions taken by a business. This includes customers, employees, suppliers, society at large, and depending on the business may include a broader set of entities that participate in a company’s ecosystem, such as regulators. While shareholders are one type of stakeholder, we’ll use the word stakeholder in this post to mean non-shareholder stakeholders.

Consumer & Producer Surplus

One of the first things learned in an introduction to economics class is the basics of supply and demand. A chart similar to the one below is shown where the Y axis is price (P) and the X axis is quantity (Q). Demand (D) is shown as a downward sloping line illustrating how customers will buy a larger quantity of a given item as the price declines. Supply (S) is shown as an upward sloping line illustrating how companies will sell a larger quantity of a given item as the price increases.

The chart shows that in a free market, the demand and supply curves intersect at quantity Q1 and price P1. This is the market clearing price where the same quantity is supplied by the seller as is demanded by the customers.

The miracle of capitalism, when it works as intended, is that the free market is able to discover the market clearing price without any central authority trying to figure out what the “right” price is. Even more miraculous is that at this price, both the customer and the company win.

The chart above illustrates that at price P1 and quantity Q1, a consumer surplus is created as is a producer surplus (labeled on the chart as “company surplus”). A consumer surplus is the amount that the buyers as a group would have been willing to pay minus what they actually paid. So the positive consumer surplus shown on the chart represents the value that consumers received in excess of what they paid. A big win for the customers!

A producer surplus is the amount that the seller was able to charge minus what they would have been willing to charge. The positive producer surplus shown on the chart represents the value that the seller received in excess of what the product was worth to them. A big win for the company!

This surplus is created because some customers would have been happy to buy at least some units at a higher price and because the company would have been happy to sell at least some units at a lower price. It is only the very last incremental unit that is sold for exactly the amount it is worth to the customer and exactly the amount it is worth to the company.

By specializing in the creation of the product in question, a company produces the product at a cost that is lower than the same product is worth to other people. When you hand over $2 for a cup of coffee or $40,000 for a new car, or millions of dollars for a piece of luxury real estate, you are implicitly deciding that the coffee, car or house is worth more to you than what you paid for it. While at the same time the seller is implicitly deciding that the same item is worth less to them then what they sold it for. Both sides win. Both sides walk away with more value than they started with.

Assuming the buyer and seller are free to engage in the transaction or walk away, then the profit earned by the company and the surplus value that accrues to the customer, are a form of value creation. Some total amount of value was created and split between the buyer and the seller.

All that we’ve written above is completely traditional economic analysis. It is a bedrock principle of capitalism that trade occurring in free markets results in value being created for both the buyer and the seller.

Value Creation vs Value Extraction

In our 2017 post Pricing Power: Delighting Customers vs Mortgaging Your Moat, we explained how companies that seek to capture as much of the surplus value as possible for themselves and leave as little as possible in the hands of their customers, do not have nearly the opportunity to maximize long term shareholder profits as those companies that relentless try to increase consumer surplus.

A company that is “mortgaging its moat” as described in the post, is one that seeks to extract as much of the consumer surplus as possible from their customers and capture the value as profit for themselves. This is what a monopoly is all about. Monopoly conditions disconnect sellers from needing to worry about competition and allows them to set pricing at the level that wins the maximum amount of profits while minimizing consumer surplus. Under these conditions, there is some end point at which the company has extracted every dollar of consumer surplus for themselves and 1) they are unable to extract any more, while 2) consumers are willing to try any other even barely viable alternative just to attempt to exit the exploitative relationship they are in with the seller.

Conversely, a company that is “delighting customers” is one that, because they relentless drive up the value of their products and services by creating so much additional consumer surplus, gets no push back from consumers when they raise prices. Under these conditions, there is no theoretical limit to the amount of consumer surplus a company can create nor on the value they can capture as producer surplus (profits) via raising prices.

As a simple example of mortgaging your moat, think about how cable TV companies relentless raised prices until many consumers took a certain pleasure in “cutting the cord” and moving to a streaming service. And while early streaming services were clearly inferior to cable TV, today many people would argue that the leading streaming services offer more total value to consumers than a cable TV package and far, far more consumer surplus given the radically lower cost of a streaming subscription vs cable TV. This dynamic is a key element of our investment thesis for Netflix.

On the other hand, think about the huge increases in the price of an iPhone over the years. These increases were not possible because Apple had trapped their customers (cheaper Android phones were always available), but because Apple has always focused on delighting their customers. Heck, some Apple customers are so enamored with their products that they have literally tattooed the company’s logo on themselves. This focus on delighting customers, driving up consumer surplus as much as possible, is a key reason we owned Apple from 2009 to 2018.

While we hope our pricing power post added important nuance to the topic, we think most businesses and investors today recognize the importance of generating value for customers. After all, “putting customers first” is a mantra at many companies, and Jeff Bezos, the founder of Amazon and one of the most successful business people in history, famously said about the Amazon Prime membership, “We want Prime to be such a good value, you’d be irresponsible not to be a member.”

Putting Employees First

But customers are just one stakeholder. What about employees? What about suppliers? What about society? The traditional economic chart illustrating the supply and demand curves implies that the company is a single actor. But that’s flat out wrong.

Companies are collections of people. They exist in an “interconnected reality.” The supply curve illustrating the price at which a company will offer a given quantity of a product is shaped by a series of additional supply and demand curves representing the relationship between a company and its employees, its suppliers, and even society at large. In other words, a company’s supply curve is a function of the company’s relationships with other key stakeholders.

For instance, here is a chart showing the supply and demand curves of an employer and its employees. As you can see, just as customers and companies generate consumer and producer surplus, employees and employers generate employee and employer surplus.

For an employee, the surplus they get from their relationship with an employer is all of the value (not just salary, but non-monetary value as well) that they get out of the relationship minus the value of the time and energy they put into the job. Likewise, the employer surplus represents the value the company gets from its employees in excess of the all-in cost of employing them.

Just like the company/customer relationship can be one-sided or mutually beneficial, a company can seek to pay its employees as little as possible and invest as little as possible in building a positive corporate culture or it can approach the relationship from the standpoint of trying to make working for them as delightful of an experience as possible.

The first approach, a version of mortgaging your moat with employees, is one that may reduce costs and increase profits in the short term just as a company that exploits their customers can reap short term profits. But at some point, every unit of employee surplus has been extracted and transformed into profit with no other avenue for increases. Similar to companies exploiting their customers, those that exploit their employees will find that there is a wide range of intangible costs that accrue over time and their employees will jump at a chance to join even an inferior or higher risk firm, but one which is more focused on delighting their employees.

While some of the benefits of pursuing delightful rather than exploitative employee relationships cannot be quantitatively measured, they are still easily recognizable. As consumers, we’ve all had interactions with a company where the employees clearly loved the company and bent over backwards to make us happy. And we’ve also had far less positive interactions where employees have done the bare minimum and would self-evidently rather be anywhere else than working for the company.

Putting Employees Before Shareholders to Maximize Shareholder Value

In our portfolio we own First American Financial. This relatively small title insurance company ($6 billion market cap) has been named to Fortune magazine’s 100 Best Companies to Work For in each of the past five years. When the Coronavirus pandemic struck and the housing market came to a standstill, the company announced:

“Consistent with our people first philosophy, we have committed to our employees that we will not make any layoffs through the end of the second quarter. We strongly believe that this is the right approach given these unique circumstances. We’ve taken a long-term perspective in all this and although this action will negatively impact our short-term results, we believe the benefits to our people, our customers and ultimately our shareholders will be worth the investment.

However, if the economy continues to deteriorate for an extended period, we will review all measures to control expenses as we have done consistently in the past.”

The company wasn’t just being nice. They knew the reality was that with demand for their services falling by an unprecedented 50% nearly overnight, they simply did not have the financial ability to maintain the employment of their entire employee base absent a recovery in demand. But they also knew that during a crisis, you need your team operating at 110% performance levels and that simply is not possible if everyone is sitting around worrying that they are about to lose their job. And importantly, they knew that building a talented team takes time and if title insurance demand recovered quickly, it would prove to have been incredibly short sighted to have laid people off.

Meanwhile, here’s what their leading competitor Fidelity National Financial said on the same day:

“During the month of April, we made the difficult decision to reduce staffing in our field operations by 18% and in our corporate environment by 11%. We expect the annualized savings from these reductions to be approximately $200 million. We will continue to closely monitor the market and will utilize all available levers we can to manage our expenses, mitigate margin degradation and maximize our cash flow.

We remain committed to maximizing profitability in all market environments.”

$200 million is real money. During a crisis, companies must react in ways to preserve the long-term financial health of the business. There are times when a company simply must cut costs. But while these actions may well have helped maximize short term profits, were they the right move to maximize long term profits? Given that demand for title insurance has coming roaring back over the past few months and is now higher than it was before the pandemic, it seems unlikely with the benefit hindsight that significantly reducing staffing was the right move. While First American may still need to right size their organization, by explicitly accepting the negative effects on short term profitability, they set themselves up to better maximize long term profitability.

Knowing how each of these companies reacted to a crisis, if you were a highly talented employee who was offered the same salary to work at both companies, which one would you choose? Because there is more employee surplus in First American’s supply and demand relationship with their team, over the long term there is more total value available for the company to monetize into profits.

But again, this isn’t lost on many top performing business operators. Rather it is mostly investors who mistakenly think that “maximizing profitability in all market environments” is the right way to run a company and who think that caring about stakeholders somehow detracts from a company’s profit potential. If you talk to people who actually run a business, especially owner-operators who own the business they manage, the vast majority will tell you that their employees are their most valuable asset. This has become more and more true as the US economy has evolved away from capital intensive businesses that generated profit from controlling land, factories, natural resources and production equipment, and towards businesses based on intangible assets that employees develop and manage.

While most all retailers at least strive to put customers first, the best in class retailer Home Depot that we own in our portfolio said on their first post-pandemic earnings call,

“If we take care of our associates, they take care of the customers, and everything else takes care of itself.”

These supply and demand curves between a company and all its various stakeholders create the potential for exploitation or delight. While the textbooks teach us that companies should always put shareholder interests first, as mentioned above, many actual business owners know that the best way to maximize profits for shareholders involves putting customers and/or employees first. But there are other stakeholders as well.

Suppliers are Stakeholders Too

All companies require supplies from vendors. Both the supplier and the company generate surplus value from transacting with each other. But if a company seeks to foster a mutually beneficial relationship with its suppliers, rather than hammering them constantly to do as much as possible for the lowest possible price, they create an environment in which their ecosystem of suppliers is literally pulling for them to succeed.

While the idea of “supplier surplus” is not something investors discuss very often, a company’s relationship with its suppliers and the value created or extracted from the relationship is one of the drivers of long-term shareholder value.

This isn’t just a theoretical concept. Here’s Home Depot speaking during the national shelter in place order during the initial wave of the pandemic:

“We are grateful for our strong strategic partnerships. Our supplier partners are helping us in many ways, including supplying essential products for our own use. Let me give you an example.

Very early on in the pandemic, we reached out to PPG, one of our key paint suppliers, for help. We asked PPG if they could help supply hand sanitizer for our store associates. They quickly converted several of their manufacturing lines and within a few short weeks, they produced an initial order of approximately 100,000 gallons of hand sanitizer. They’re planning to produce three times that amount for future in-store use that will help our associates for the remainder of the year. This is just one of many examples. And I want to thank PPG and all of our other supplier partners that have stepped up to help us prioritize the safety and well-being of our associates and customers.”

This isn’t just smart management during a crisis, rather it is that seeking to maximize value creation through all your stakeholder relationships is at the heart of maximizing long term profits.

Can Stakeholder Value Creation Actually Drive Profits and Stock Performance?

In our portfolio, Fastenal, a distributor of parts and supplies to manufacturers, has been so successful as a company over the years that in 2012 BusinessWeek calculated that its 40,000% return (that’s not a typo) had made it the best performing US stock in the 25 years since the 1987 market crash.

How in the world did a distributor of nuts and bolts generate better returns for shareholders than Apple or Microsoft during the rise of the information age?

Here’s how the company’s CEO recently explained their approach to value creation:

“When I talk about earnings, I’m not talking just about Fastenal, I’m talking about our people, too… it’s not just about growth, it’s about profitable growth, and creating opportunities for your customers and your employees in the process.

I think the mantra is… let’s really hit all pieces and reward all constituencies. And speaking of constituencies, we keep it really simple here. There’s four: There’s customers, there’s employees, there’s suppliers and there’s shareholders. It has to work for all four [stakeholders] for our business to be successful short-term and long-term.”

That’s how you become the best performing stock over a quarter century. You understand all the supply and demand curves that make up the ecosystem of stakeholders in which you operate, and you focus relentlessly on creating value for all of them. It is the companies that succeed at doing this who maximize profit potential and whose shareholders are most rewarded through reaping a portion of that value into profits.

Externalities: The Costs and Benefits to Society of Free Market Transactions

What about society? Do companies somehow maximize profits by seeking to be good corporate citizens? Classical economics recognizes that “externalities,” the positive and negative value earned by entities not directly party to a transaction, are very real.

A positive externality occurs when a transaction produces a benefit to a third party. When you plant flowers in your front yard, you get more value from adding beauty to your life than the cost you incurred to buy them. But guess who else benefits? Your neighbors. This might seem like a stretch, but imagine a neighborhood split down the center where people on one side invested nothing in maintaining their yards while on the other side everyone maintained award winning gardens.

The cross sharing of benefits, the way that the positive externalities are captured by third parties, even nonresidents who just enjoy taking a walk through the neighborhood, are self-evident. In fact, the “interconnected nature of reality” ensures that the social value created by these positive externalities will indeed be partially monetized by the home owners via higher housing values in the section of the neighborhood where everyone invests in landscaping that creates value for the community.

Now let’s reverse it. A negative externality is when a transaction creates a cost for a third party. Let’s say your next-door neighbors are a bunch of college kids and one night they throw a raging party. They spend a bunch of money on beer and hire the loudest band they can find. Seemingly a thousand kids show up and the band plays until 4am. The next day, the kids who paid for the party had a great time and feel like it was money well spent. The beer company and the band also earned value through the transaction. How about you? Clearly there was a cost. A very real cost that you might experience as quite large. Now imagine everyone in the neighborhood making transaction decisions without accounting for externalities.

Externalities have been understood by the economics profession for a long time. The concept was first articulated in the 19^th century and the concept was formalized in 1920 by an economist who illustrated that the costs of sparks from railway engines igniting fires was not being captured in the cost of train travel.

Because externalities seem like “someone else’s problem” investors and many companies operate as if they are irrelevant. Sometimes that’s true. Many transactions include at least small positive and negative externalities that will never be relevant to either the buyer or the seller. But when negative externalities are large, they begin to accrue as an “off balance sheet liability” and the risk that society demands that these costs be crammed back to the buyer or seller becomes a very material risk.

• Is there no potential risk to long term profits if your pharmaceutical product is linked to a national epidemic of abuse?
• Is there no potential risk to long term profits if you lend money to people you know can’t afford to pay you back because you plan to sell the loan to someone else?
• Is there no potential risk to long term profits if your social media service disrupts the democratic process in the country in which you operate?

Even casual observers can see this potential off balance sheet liability accruing right now at Facebook, Amazon, Google, Apple, and Microsoft, all of whom are under active antitrust investigations. That is not to say that these companies are creating negative externalities. And if they are, it may be that even after incorporating the cost of this liability being crammed back to the companies, they may still be creating tremendous value across their stakeholder ecosystem and the stocks of these companies may still be great investments. Indeed, we own Google in our portfolio and discussed our thinking on risks related to the company’s stakeholder relationships on a client call last year.

“We believe unequivocally that the vast majority of Google’s profits are a function of the company offering one of the single most important services ever invented. A service that brings information to the 7 billion internet connected devices around the world to people of every walk of life. As an American working in an office job, I simply cannot imagine navigating personal and work tasks without Google.

Democratizing access to information across national boundaries has hugely positive social benefits. In fact, a hundred years ago the primary focus of philanthropists was to build libraries for just this reason. Viewed in this light, Google’s opening up of the collective knowledge of humanity to anyone with an internet connected device at no cost to the user can easily be seen as one of the most important social benefits ever created by any nonprofit or for-profit organization.

That being said, might there be changes to some of Google’s practices if they are subject to an in-depth investigation? Sure. But we do not think that these changes, should they happen, will strike at the core value that Google provides to the world and it is this value, not any particular business practice of their advertising offering, that is the root cause of the company’s profit stream.”

A liability on a company’s balance sheet does not mean it is worthless or that the company is a bad actor. But it is important for investors and companies to recognize that when a company’s relationship with a stakeholder tips from value creative to exploitative, the profits the company creates are at least in part being extracted, not created, and the counter party from which that value is extracted is unlikely to accept the situation over the long term.

Regulators Can be Stakeholders Too

Even regulators themselves can be involved in exploitative vs delight-based relationships with companies. When First Republic, a bank we hold in our portfolio that is one of the best performing bank stocks over most every long term time frame, reached out to us to discuss their stakeholder framework, they stated that their goal was to “create long-term value for our stakeholders including shareholders, clients, employees, local communities and regulators.”

As the company’s executive team explained to us, they feel it is extremely valuable to them as a profit seeking company to have a productive, friendly relationship with their regulators.

While a very short sighted executive team might instruct their team to provide regulators with the minimum possible information, a far sighted management team like the one at First Republic knows that they are going to have a multi-decade long relationship with regulators and there is simply no doubt that being known by regulators as the best, most cooperative bank in the industry will pay long term dividends.

While San Francisco-based First Republic has seen its stock appreciate by over 20% a year for the last decade, Wells Fargo – a much larger, more famous San Francisco-based bank – chose to exploit its customers and fall into an adversarial relationship with regulators who have accused the bank of “fostering an atmosphere that perpetuated improper and illegal conduct.”

This is the polar opposite of the culture we believe thrives at First Republic. This exploitation of the bank’s stakeholders have led to the destruction of shareholder value with Wells Fargo’s stock generating 3% annual returns for the last decade or total returns of just 35% versus the S&P 500’s 280% return and First Republic’s 760% return.

Stakeholder Value Creation vs Shareholder Primacy

The recognition of the importance of stakeholder value creation is still thought of by many investors as the domain of “socially responsible investors” who care more about making the world a better place than they do about making profits. But this limited and naive view speaks to a lack of understanding of where profits come from.

It seems like such common sense that companies, which are owned by shareholders after all, should focus exclusively on shareholder value with other stakeholders treated as nothing but a means to an end. This view seems like exactly what a hard-nosed, profit seeking capitalist should focus on and that any deviation from this orthodoxy to meet the needs of other stakeholders must by definition represent a distraction from the purpose of profit seeking.

But this view represents a caricature of how business works. It represents a simplistic understanding of where profits come from that ignores the “interrelated nature of reality.” It is rooted in the concept of shareholder primacy as advanced in Nobel Prize winning economist Milton Friedman’s 1962 book Capitalism and Freedom where he declared, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits.”

This was indeed a major contribution to the field at the time. By laying out a single, central goal on which to focus, Friedman provided a framework that provided clarity to managers and shareholders that aligned them in a shared purpose. In the 1970s, the concept of paying executives in the form of stock based compensation sought to operationalize Friedman’s guidance by aligning the incentives of managers and shareholders – a huge improvement over compensation systems under which management and shareholder incentives were disconnected.

But like most 60-year-old social science theories, what was once a radical insight is today simply an underdeveloped understanding of reality. This is how human knowledge is supposed to work. Knowledge builds on itself and grows, with our understanding of the nuances growing over time. To say that putting shareholders first is a wrongheaded belief is inaccurate. Rather it simply represents a shallower understanding of the complex nature of profits. While it once represented cutting edge wisdom, it would be a deeply pessimistic belief to think that our collective understanding of economics and business has not advanced over the last 60 years.

Profits are not the goal. They are the outcome that occurs when companies successfully create value across their stakeholder ecosystem.

This isn’t a statement rooted in values or beliefs about how the world should work, but an observation of where profits actually come from.

While the importance of stakeholder value creation has been discussed more and more in recent years, until recently it was more the domain of investors or academics who sought to put purpose over profits. But last year, the Business Roundtable, the leading association of the nation’s top CEOs who hold political views across the partisan spectrum updated their official “Statement of the Purpose of a Corporation” from its prior focus on shareholder value to say:

While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:

• • Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
  • Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
  • Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
  • Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
  • Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.

This statement does not put purpose over profits. It does not suggest that shareholder value is any less important than it always has been. It simply states the reality that the future success of a company is dependent on the organization creating value across its entire stakeholder ecosystem.

Just as shareholders benefit from supporting value creation across the company’s other stakeholders, so do those other stakeholders benefit from supporting economic value creation for shareholders.

Of course, the new statement from the Business Roundtable came under withering criticism from detractors who thought it was nothing more than lip service. Reading this article now and recognizing it is being written by a money manager whose clients’ evaluate him based on the value they earn as shareholders, not some abstract concept of “stakeholder value creation,” you may think this article is nothing more than lip service as well.

But the big advantage of a stakeholder value creation-based theory of where profits come from is that it happens to be true. If CEOs and investors are paying lip service, it isn’t to promising to put purpose over profits, but rather it is paying lip service to truly being committed to maximizing long term shareholder value – the inevitable outcome of creating value across the entire stakeholder ecosystem.

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.

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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