Why culture eats strategy for breakfast

Five years ago, I would have said a company's culture was important, but the business model mattered more. I’ve since learnt the error of my ways.

If you get the culture wrong, almost nothing else matters. 

Just look at Enron and Wirecard. Both were stock market darlings for years before blowing up spectacularly. Both possessed toxic cultures, where fraud and corruption ran rife. This was all that mattered in the end. The stuff that 99% of the investment community focused on, including the reported numbers, proved meaningless. 

I’ve historically steered well clear of funeral operator Dignity because of its culture. In 2016, when I launched my first fund, Dignity looked like a great company. It had sailed through the financial crisis and had been increasing profits for years. 

But I was concerned about how that profit growth had been achieved – through substantial, unjustified price increases on a vulnerable customer base. This, in my view, left Dignity exposed to increasing competition and attention from regulators. 

In recent years, the story has unravelled. Prices have come down, profits have plummeted and the shares are around 80% below their peak. I see this as a lesson in the danger of just looking at profit figures, without understanding culture. 

Dignity's operating profit

Conversely, a good culture can be an enormous competitive advantage, turning an ordinary company into a great one. Berkshire Hathaway’s outstanding success has less to do with the nature of the businesses it owns (ranging from insurance companies to railroads and utilities – hardly the most exciting industries) and more to do with the genius of Warren Buffett and the environment he’s nurtured. The culture rests on decentralisation, trust, autonomy and, above all, highly astute capital allocation. 

Over the last couple of decades, fashion retailer Next, has delivered a total return of c. 1,000%; remember past performance isn’t a guide to the future. The economic textbooks will tell you this isn’t possible. Fashion is a notoriously difficult industry. You’re selling a commodity to fickle consumers, and competition is cutthroat. 

So how has it happened? In my opinion, a key reason is the sheer brilliance of Next’s longstanding CEO, Simon Wolfson, and the culture of constant incremental improvement and operational excellence he’s instilled.

If culture is so important, why do many investors gloss over it? 

Because it’s hard to define, and even harder to measure. Culture can’t be boiled down to a number on a spreadsheet. 

Building a picture of a firm’s culture may be difficult, but it isn’t impossible. My approach is to draw on both quantitative and qualitative elements, piecing together clues as I go. 

1. I watch management like a hawk

I pay close attention to what management writes, says and does, drawing on company meetings, annual reports, conference calls or industry events. 

I ask many questions when assessing management teams, including: 

• Do they answer the question directly and without jargon?
• Do they focus on things they can control?
• Are they being open and honest?
• Do they explain the business simply?
• Do their actions align with their words and stated intentions?

If the answer to any of these questions is ‘no’, it’s a potential red flag.  

I also pay close attention to how management is incentivised. In particular, I like management teams with a substantial shareholding in the business as this aligns their interest with shareholders. 

2. Attitudes to debt/leverage

Use of leverage is, in my view, one of the best ways of assessing the inherent conservatism of a management team. 

I prefer companies that conduct their financial affairs prudently. That means adopting a cautious attitude to debt and structuring the balance sheet to withstand crises and black swan events. 

An aggressive balance sheet makes me question whether the same attitude prevails towards internal controls, for example, or how they treat their customers and employees.

3. Attitudes to accounting

Accounting practices have a lot of scope for judgement. In simple terms, companies can report higher or lower profits depending on the accounting assumptions they employ.

For example, many businesses adopt a liberal interpretation of ‘exceptional’ items. By treating certain expenses, like ‘restructuring’ costs, share-based payments and legal fees as a ‘one-off’, underlying profits can be magically increased. This wouldn’t necessarily be a problem if such items genuinely were ‘one-off’. Unfortunately, they often aren’t. 

If a company has rather aggressive accounting practices, it makes me question the honesty and integrity of management. To me, it suggests the company might be more likely to:

• Prioritise short-term profits over the long-term health of the business
• Engage in risky acquisitions
• Be hiding something, especially if ‘exceptional’ items are buried at the bottom of the accounts and not well explained 

I’m much more willing to trust (and therefore invest in) a business with very clean accounts, since a) they’re more likely to present a complete and accurate picture of what’s going on and b) it suggests management exhibit honesty and integrity.

4. Capital allocation

I want to own companies that earn high returns on the money they invest – and steer well clear of those that don’t. 

I pay close attention to return on capital employed measures (operating profit divided by total capital). A declining trend over many years suggests the company’s culture prioritises growth over returns.

UK supermarkets are a prime example: they had a strategy of opening more and more stores for years. While profits initially rose, the incremental return on these investments was steadily falling, and yet they continued to expand. This expansion also caused them to take their eye off the ball with their existing stores and customer service suffered. Shareholders paid the price for this.

Supermarkets are far from alone. Many capital-intensive businesses are poor capital allocators. They expand when everyone else is expanding and retrench when everyone else is pulling in their horns. Companies with cultures that prioritise independent thought and return on capital rather than near-term profits are quite rare.

The willingness to zig when others are zagging is one of the key things I look for when assessing businesses because I’ve seen time and again how much long-term shareholder value it can create.

5. Cash generation

I firmly believe that it’s growth in cash, not profits, that creates long-term value for shareholders. The best companies understand this. 

To assess a company’s attitude to cash generation I look at both the cash flow statement and the language/metrics used in their reports and conference calls. Frequent referrals to ‘free cash flow per share’ is a good sign, as it shows management understands what creates value. If a company favours metrics like ‘Adjusted EBITDA’ over cash flow – or doesn’t mention cash flow at all – it’s a red flag for me.

6. Organisational structure

One of the great challenges businesses face as they grow is maintaining the entrepreneurialism and agility that got them there in the first place. More people usually means more complexity and bureaucracy. Neither is a great recipe for ongoing success. 

Companies with superior cultures tend to fight back against bureaucracy. They might split up into smaller teams as they grow, or adopt a decentralised business structure, where a number of smaller, distinct, autonomous units act independently. 

By studying the organisational make-up of a firm, in particular the degree of decentralisation, I believe I gain important clues about its culture. In general, a decentralised corporate structure tends to indicate a more entrepreneurial, agile and scalable business.

7. Employee, customer and other stakeholder relations 

With the advent of the internet, it’s much easier to get insights into how customers, suppliers and other stakeholders perceive a business.

For example, the website ‘Glassdoor’ allows a company’s former and current employees to post anonymous reviews. Similarly, customers can make their feelings known in various online forums and review websites. While these have to be taken with a pinch of salt, they can still prove illuminating.

A company’s annual report will usually give employee engagement and customer satisfaction metrics. I pay particular attention to what isn’t said in these reports, as it might suggest the company is hiding something. In these instances, I’ll dig further to determine whether there are any causes for concern.

The competitive edge of culture: Compass versus Sodexo

I can’t think of many better examples of the competitive edge a good culture gives you than Compass and Sodexo. The two are close rivals in the contract catering industry. It’s a tough gig – brutally competitive with low margins. All things being equal I’d expect a middling performance from both, without much to separate them. But that’s not how things have turned out.

Over the last 15 years, Compass has significantly outperformed its rival, delivering a total return of 591% versus 146% for Sodexo. I think the main reason for this is culture. To excel in a cutthroat industry like this, you need to execute really well. Compass has done that in spades, and the results speak for themselves.

Compass ticks many of the boxes I look for from a cultural perspective. It’s been expertly managed, first by the late Richard Cousins, an exceptionally shrewd operator, then by his successor, Dominic Blakemore. It has a decentralised, entrepreneurial culture with little bureaucracy and few layers of management. It excels at the basics and generates plenty of cash. And it’s done a great job of keeping customers and employees happy, while regularly returning cash to shareholders. 

Compass is a prime example of what a great culture can achieve, given enough time, even in a tough industry. It may be harder to pin down, but the rewards for investors can be substantial and, in my opinion, more than justify the effort it takes.