12 Ways how the “Ideal Company” should be run

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Introduction:

Some years ago I introduced a 27 point  “beta version” of an investment check list. This check list contained a lot of quantitative aspects, such as P/E, P/B or other multiples as well as some qualitative aspects. I used this as a rough guideline for analyzing potential long-term holdings but I found out that the quantitative aspects in a check list are not very helpful, because it leads to discarding really well run companies at a very early stage.

On the qualitative side however some things were missing, especially how a company is run for me became more and more important over the past years.

I think this aspect is not well covered by many other investors as most concentrate (only) on the “what”:

  • What moat does a company have ?
  • What industry  are they in ?
  • What ROE/ROIC/EBIT Margin does the company generate ?
  • At what EPS/EBIT/Book multiples does the stock trade ?
  • What is the “Magic Formula” that generates Alpha without actually looking into the companies I invest

For me the “what” in many cases is actually only a secondary result of the “how”. Moats for instance are not created out of thin air.

Take German supermarket chain Aldi for instance. They are the lowest cost operator in the industry. Where did this come from ? In my opinion this is the result of how the company was run by the founders, in a very frugal way, long-term oriented and an almost religious cost consciousness at every level to the benefit of the customer. On the other hand, unlike like now-bankrupt Schlecker, they pay their employees relatively well which I think is also a part of their spectacular long-term success, as this ensures that over the long run, managers, employees, customers and finally shareholders are well aligned.

So let’s look at what I think are the most important aspects of how a company should be run to be succesful in the long-term. Please keep in mind that this is a very subjective list based on my own experience and a “wish list”.

 

1. The Company is run by the founder with many years to go and/or run by management with “real skin in the game”

This is something I came to appreciate more and more over time. A founder or a management with a meaningful equity interest (high enough that it is meaningful compared to salary, low enough that they still are aligned with minority shareholders) clearly increases the chance that both, management takes a view on the long-term and doesn’t do something really stupid. Of course it is no guarantee. Sometimes founders start doing weird things or a long-term CEO with a large stake thinks he is invincible. Sometimes CEOs with short-term option plans create something great. But on average, companies which are manged by people with skin in the game do better.

A “nice to have” is when management can communicate their strategy and goals easily and transparent.

2. Goals for management compensation are long-term aligned with shareholders (including ROIC/ROE) 

Even with meaningful equity interests, I think it still makes sense that the ongoing compensation is related to more than next year’s Adjusted Operating Profit before cost. So any longer term “bottom line” targets, especially if they include also return on capital are a good sign.

The worst case in my experience is management in large companies with absurd targets like “increase absolute adjusted EBITDA” or “increase cloud software sales”. If this is combined with “automatically cash converted virtual shares” one can often see great short-term results but long-term value destruction.

3. Goals for management are aligned with employees (profit-sharing, etc.)

Whereas alignment of management and shareholders is important, I think one thing which generally is overlooked is the fact that it also helps a lot  if employees are aligned as well with management and shareholders. This can be done via share purchase programs (at a discount) for employees, intelligent profit participation or ideally like in the Handelsbanken case with a long-term incentive.

In general and we come to this in a later point, a decentralized structure of a company also increases the likelihood that employees are aligned with the other stakeholders.

4. Majority of shareholders are long-term oriented (family or proven long-term investors) 

A long-term oriented management who has to report quarterly to short-term oriented shareholders who in turn  have to beat the benchmark in the next quarter is a really bad fit. Those shareholders will rebel against anything which creates short-term pain but long-term gain. Especially in current times, with activist investors being very popular, one really needs to be careful who is “in the boat”.

There are many cases where dividend were kept high even if it was not wise to pay dividends or share repurchases were demanded independent of intrinsic value of the shares. A stable, proactive shareholder base of either (well organised) family investors or true “Long term” guys can add a lot of stability and long-term value to a company.

5. Zero tolerance for suspicious behaviour of management and/or shareholders

Moral integrity of the key players is in my opinion extremely important. If anyone of the management or shareholders (and supervisory board) shows conspicuous behaviour or has been involved in murky stuff in the past, stay away.

Big red flags are for instance self dealing (selling companies from the private portfolio to the controlled company), insider trading or extravagant “perks”.

6. Cost consciousness &  decentralized structure

Especially in large companies, there is a strong tendency that corporate headquarters inflate themselves at incredible speed. Super smart HQ employees then try to tell the local business what to do which almost always leads to frustration and ultimately failure. Especially in times like now with a lot of change underway, I think it is much smarter to run a company decentralized and give power to the people who actually serve the customers and bring in the money.

A certain amount of coordination is clearly necessary and not everyone can run a 300 bn USD market cap company with 20 people like good old Warren, but in many cases, a modest, thinly staffed headquarter for me is a good sign that a company is run efficiently and well.

There are many great examples of companies headquartered in the middle of nowhere that have become tremendously succesful. Interestingly in my experience, cost conscious companies are often also organized in a very decentralized way and vice versa. Delegating responsibility “down the chain” in my opinion is a very good way to keep costs under control. Also flat hierarchies are a very good way to keep costs down (less expensive managers needed) and increase the flexibility in an organization.

7. Preferably organic growth, opportunistic M&A mostly in crisis years at depressed prices (or other bargain situations)

Readers of my blog know that I am not a fan of roll ups or “Buy and build” style of companies. For me, organic growth is a lot more valuable than M&A driven growth.

What I do like is when companies opportunistically do M&A. Especially if they do so in times of real crisis then this is often a sign that they have strong capital allocation skills. Why ? Because in order do have “dry powder” in those situations you have first to be disciplined and not invest into the boom and secondly you must have the backbone to put money to work when everyone else already is up on the trees.

8. Reasonable dividend policy  / share buyback

Fo most companies there will be years when a dividend just doesn’t make sense. For instance if they have barely earned  enough money to pay for their normal business or if they have so many great investment opportunities. As many investors are absolutely fixated on dividends, few management teams have the stamina to lower the dividend or either don’t pay a dividend at all. They will then either invest less or take on debt to pay the dividend which in many cases id the first step into financial distress if the problems are of a more fundamental nature.

The same goes for share buy backs. Buy backs are generally viewed as good capital allocation. However if you buy into peak prices or just if the share price drops a little than clearly it is not. Also debt financed share buy backs in my opinion are rarely value enhancing.

A good company will pay dividend if it is appropriate and buy back shares if they are cheap.

9. Conservative financial structure, conservative accounting

Different business models allow different levels of debt. Whereas I do like companies which have actually net cash, for financial businesses or very capital-intensive businesses some debt can benefit the shareholder. However in those cases it is important that the companies are relatively more conservative than their competitors. This will help them to outperform and survive when (inevitably) times get worse.

Conservative accounting is not so easy to spot but for instance capitalizing own software developments or inflating receivables are not a sign of conservative accounting. Also net profit should in the long term be qual to comprehensive income. Often leveraged balance sheets and aggresive accounting are “twin brothers”…..

10. The company has a distinctive and positive company culture

Company culture in my opinion is a very underappreciated source of competitive advantages or “Moats”. Most people focus on existing “classic” moats, but in my opinion moats are often created out of a specific company culture. How do you become the most succesful low-cost supermarket like Aldi for instance ? You start out with a very specific cost centric company culture and work hard to keep that.

I have looked at a couple of companies (AQ Group, Thermador etc) where the culture is pretty much the only moat they have which then resulted in spectacular success over the years. Be careful when companies use exchangeable, prefabricated “company missions and values” which were provided by some consultants. They are often not worth the paper they are written on and rather a sign of no culture at all.

11. The company does things fundamentally differently

Often this is connected with company culture, but companies which run their business very different from their competitors can be very succesful in the long run.

Often those things are not easy to copy. Running a Seismic company without owning ships (TGS Nopec) ? Doing insurance without keeping the float (admiral)? As obvious as those things sound now, these fundamental differences often create long-lasting success stories.

12. The company does not take an unfair advantage of the customer

This is also an important point. You can align shareholders, management and employees very well and then they screw the customer. UK banks are a good example for this by pushing people into profitable but unnecessary PPI products which they sold in a rather “predatory” manner, or pharmaceutical companies pushing up prices into the stratosphere by applying every kind of trick and thereby bankrupting seriously ill people.

In the long run, a company can only be succesful if it creates real value for the customer as well as for all the other stakeholders.

And just to make this clear (following the discussions of my PFG post): This is not about a formal “ESG” or “Ecological Sustainable” style of investing.Rather about how one comment nailed it: “Will the customer gladly like to come back again after this experience or will he take another provider if he has the (economic) freedom to choose?” 

Summary:

I know that it sounds almost like an anachronism in a time when Index and Quant funds seem to have taken over, but in my opinion qualitative aspects of companies have actually become more important.

Many Buffett fans will counter this with the quote that you should only buy companies which could be run by idiots (and have moats), but I disaggree on that one. In current times, with all the changes underway and social media etc., a company run by an idiot will hit the brick wall at some point in time. Berkshire itself is a good example for a company which would have been bankrupt long ago if it was not run in the way Warren Buffett did.

These days, many traditional moats seem to crumble real quickly and  in my opinion a company with aligned stakeholders and a strong positive culture has better chances to adapt and prosper under these circumstances.

Majestic Wine was for instance a stock that I would not have bought purely based on quantitative criteria, but it scored high on the 12 mentioned characteristics. We will see how this turns out, but the benfit will most likely only show up in the long term.

Finally a call to my readers: If you know any companies which score high on many of those charcteristics, let me know. There will be no reward other than a potential block post 😉

P.S.: All this is still “work in progress”……..

P.s.2: And yes, I will still do special situations where different criteria apply……..

41 comments

  • Like an exceptional complement to your wine-related investments in ( Tonellerie François Freres and MajesticWine) you may consider as well the niche market of Wine Corks, where the world leader is a Portuguese family-run company with exceptional track record: Corticeira Amorim, (www.amorim.com/en/).

    Enjoy and review with a nice wine !

  • A very great sharing. Will add these 12 criteria to my list.
    A company may meet your list. Old Dominion Freight Line (ODFL). A US trucking company which is majority owned by its founder and family. It is still run by the founder’s family members. It grows organically and rarely do M&A. Allways makes CAPEX during downturn to widen its gap from its competitors.

  • A company that fits perfectly in this list is Grazziotin SA (CGRA4,CGRA3) listed on the Bovespa. It is a retailer of clothes and home supplies in the south of Brazil run by the Grazziotin family. Where other companies took on debt in the golden years, they grew organically. They have a employee profit sharing plan, focus a lot on cost reduction, pay out 25% of net profits as dividend. Even though it stayed profitable during one of the worst recessions in Brazil, its share price sits below NAV. Not a bad moment to buy back shares, which they have been doing since September.

  • Ferrovial, despite is not a small company, is still run by the family… and scores high in the above benchmarks

  • Hi MMI,

    another idea: Safestyle, a small British company that is in the boring business of replacing windows and doors. They seem to be very customer friendly and have increased market share in each of the last ten years. CEO and non-executive director just bought a significant no. of shares. Unlike many other “ideal companies” they seem to be not yet too expensive according to my own evaluation. ROE (even if you don’t like quantitative valuation too much) is in the 40ies.

  • Another great post. I have a few suggestions you may or may not know that are relatively good fits with your criteria:

    MSC Industrial – An NYSE listed family founded (grandson is the CEO) industrial products distributor
    Constellation Software – A Canadian vertical software conglomerate

    And because I know you like looking in Australia:
    SNL – A conservatively run truck and bus parts distributor
    PWR Holdings – Manufacturer of cooling products for auto sports market

  • Pingback: Weekly Commentary November 28, 2016 – December 4, 2016 | REPERIO CAPITAL- EMERGING MARKETS SMALL AND MID CAP VALUE

  • CTS Eventim and Pandora. Both companies have great financials, long term growth rate and margins, and are able to growth further with same metrics. Draw back in case of CTS, fair prices?? and in case of Pandora: fashion company, where I usually stay away of…

  • You may also want to have meta-check-point, that a selection criteria should tend to be under-rated by the market. I suspect it’s likely the case for most of your criteria but maybe not all.

    In the case of management incentives I suspect the shares of companies that simply pays fair executive salaries with no extra incentives do as well, or maybe better on average, than those with incentives. A fair salary plus potential for career advancement (and fame for execs of larger companies) should be more than enough reward for most execs (who are usually cash rich and time poor anyway…), and narrow monetary incentives easily have perverse effects (as we know). You say that companies with “skin in the game” management do better on average. Is it a data-based conclusion?

    I’m also skeptical about employee profit sharing. Not that it’s a bad thing as such, and it may have a little effect on morale, but at the normal individual employee level the company-level outcome is almost completely decoupled from how well you do your little job, so it’s more like getting a free lottery ticket for the employee. And any effect on morale may be greater by spending the same kind of budget on competitive salaries…

    • Two points here:

      – Executive salaries with no incentives can work but there is always the risk that Capital allocation is then done on an “other people’s money” bases. I prefer long term alignement.
      – émployee participation: Again, I see the upside. It also helps in hard times to have part of the salary variable. It is not easy but if done right can boost a company trmendously, especially agian if it is long term oriented. best in class is Handelsbanken.

  • On dividend vs. share buyback, they are arithmetically the very same thing (a cash flow from company to shareholders in aggregate) so they should ideally be treated the same. There is no rational scenario, other than catering at innumerate folks among your investor base, under which paying (or not) one and not the other makes sense.

    • #cig,

      in almost any jursidiction, share buy backs are (much) more tax efficient than dividends.

      mmi

    • I don’t think this is correct. Buying back an overvalued stock has a dilutive impact that dividends do not have. Buybacks are a powerful tool when done below intrinsic value, a potentially tax efficient method of returning capital when done at intrinsic value and a very bad idea for all when done at above intrinsic value.

  • Cmpr is vistaprint’ owner?

  • Have you looked at industrial conglomerates like Addtech or Indutrade? They consist of lots of smaller, nische companies and somehow usually manage to buy new business at surprisingly low multiples. My guess is that they offer other things like a decentralized structure where the company can carry on the founder’s legacy, which is valued higher than more cash.

  • Completely agree with all the points above, especially # 10 about moats not being created out of thin air but rather emerging from a strong “owner-driven” culture.

    I’d add to that that judging moats, particularly whether they will develop/strengthen or weaken/vanish is really difficult — much more difficult then many investors make it out to be. The iPhone came along in 2007 and disrupted everything — no one investing in taxis was looking at Apple as a threat but now as a byproduct we have Uber. There are companies with strong moats who will get crushed by disruption / change in coming decade or two from threats we aren’t even considering. Others without moats will develop them (and that’s where the real returns will be). None of this is overly predictable.

    On other hand, strong leadership (and the corporate culture that results from it) is a lot easier to identify. As long as that leadership has another 10+ years to go career-wise and a long, stable record of “doing the right thing”, it seems to be a reasonable bet that will persist so long as unrealistic growth expectations aren’t baked into the valuation.

    Here are three off the top of my head that meet much of your listed criteria…

    Armanino (AMNF) – https://traviswiedower.com/2016/07/06/armanino-foods-amnf/

    Good brief write-up above from Travis, plus links to other articles within. Only issue is the CEO (who’s done well) is 75 years old, but I think this company may make for a nice acquisition target once the CEO is done if there’s no logical successor.

    Bank of Utica (BKUTK) – http://seekingalpha.com/article/3974620-bank-utica-community-bank-local-franchise-safe-cheap-cash-substitute

    This one has a weird spot in my portfolio because I don’t expect it to do much more than 5%-6% ROE or so in a low interest rate environment, but it definitely meets the criteria of long-term oriented, family ownership, conservative and “different”. Trades around half book value. I’m not a “dividend guy” (in fact I like investing on the opposite side of yield chasers), but they haven’t missed a semi-annual dividend since the bank opened in 1927 (which obviously includes the Great Depression). That’s impressive.

    Amerco, i.e. U-Haul (UHAL) – http://seekingalpha.com/article/4010584-amerco-recent-earnings-weakness-impugn-core-strengths-risk-reward-appears-favorably-tilted

    Great business and a nice free cash flow re-investment opportunity expanding into complimentary greenfield storage. Long-term, family ownership that isn’t going to do the hedge fund thing and spin off the storage assets for a quick bump. Biggest question I have is what will be the impact of driver-less vehicles on them — brings both threats and opportunities. Hard to predict but I feel ok with U-Haul management’s odds of adapting.

    Agree both Majestic Wine and AQ Group (trading on the Nasdaq Stockholm within a couple weeks) would fit the above criteria very nicely.

  • Hi MMI. Very nice ‘checklist’. The only company that comes to my mind is Ubiquiti Networks (UBNT). Only negative points may be that the founder/CEO owns too much and that the company is much more expensive now compared to for example February.

  • I can think of a few examples from the top of my mind :

    Colruyt Group (kind of the Belgian Aldi, but becoming more and more a holding company with different start-ups in the group).

    Sioen industries. Specialised safety textile, now a new venture into marine agriculture due to r&d in textile.

    Lotus bakeries. Luxury and niche cookies.

    Sofina holding. Investing in PE, startups and listed cie by Boel family.

    Fonar. Managment of MRI scan centres by inventor’s son. New patented techology. Better bet then Premier Diversified Holdings?

    All great cies @ not so great prices…

    • #Zephir,

      thanks for the comments. I looked at Lotus 3 or 4 years ago and thought it is too expensive….Haven’t heard about the others though.

      • And the issue with Lotus is that is just gets more and more expensive. Such an amazing company but I have never managed to buy. When it was at 300 I thought I would get a chance a bit lower. before I knew the price was at 600 etc.
        Mind you, I did not only look at the price. In a way I knew they have great products (as a consumer of speculaaspasta myself) but still.
        The past months (say since may) the stock price has increased by about 50%. Even for such a great company, this is unsustainable.

        But not buying the company has taught me some valuable lessons….

  • hi mmi,
    thanks for sharing. I agree on all points. It’s hard screening for companies with these qualities though as these are often subject to interpretation of some information. It’s actually a really good idea to ask people reading your blog for recommendations or their assessment of ideas. This increases the value of your fantastic blog even further. It also helps to verify their views and make better decisions. Maybe this analysis can be run on blogs too ;-))

  • Fastenal in the US springs to mind. I’ve never owned them, but they seem to have the same attitude to costs as Aldi. Also, I quite like Techniche (TCN) and ITL (ITD) in Australia. Lots of French small caps too , Linedata for example. Also OAK in the US springs to mind. Thanks for the article by the way, and all the others you write.

    • thanks. Fastenal is indeed an obvious candidate. Haven’t heard about the Australian stocks…..

      • The asx ones don’t tick all your boxes, and I mentioned them as management has significant skin in the game, and certainly in the case of TCN is still reasonable value. Discl. Long both.

  • Great post and great opportunity to challenge it.
    I do not think you have to be less financially leveraged than your competitor (point 9). If you have a cost advantage, he will go out of business first, when you have the the same interest burden.
    Second, a company has not to be loved by customers to be successful (last point). Look at Rightmove in the UK (and possibly other classified adds or think about Google and Microsoft). They are constantly raising prices and are the subject of complaints (simple look here:http://www.propertyindustryeye.com/is-rightmove-behaving-like-a-monopoly-asks-agent-setting-up-new-business/). But their moat allows them to suck value out of the customers (until a certain point).

    • #ivan,

      I disaggree slightly on leverage. There will be times when rolling debt is very difficult and you don’t want to get caught by the “vultures”. Tail protection is important in my opinion. Ask Pabrai and Spiers 😉

  • Very nice post. This afternoon I listened to Glen Greenberg’s talk to some students at Colombia (https://www.youtube.com/watch?v=DtjTKAHAxBw&list=FLeTsH9e9cEV8Nv82H8SowVA&index=13) and I got thinking along these same lines. I’ve had a “my perfect business” list in qualitative form for a while, but just added a couple points this morning. I’ll vote that TCX and CMPR tick most of these boxes in my mind.

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