12 Ways how the “Ideal Company” should be run
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?”
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……..