Competitive Moats - Part 3

This is the third article of our series covering competitive moats, a key pillar for how companies can sustain advantages over their competitors. Doing a competitive moat analysis is a key pillar of Redeye’s business rating, which we conduct to rate the quality of a business. This article has been adapted from Björn Fahléns book Quality First Investing: A checklist approach to finding and sitting tight in multibaggers, 2021.

How corporate culture can be a moat

Professor Michael Porter created quite a stir with his long-ago insistence that operational excellence is not a sustainable competitive advantage (a.k.a., moat), as such improvements can be readily duplicated. However, there is a difference between operational excellence, and corporate culture as the former is about improvements in production processes whereas culture is about the people who perform those processes. Operational excellence is important, hard to achieve, and worthy of management mind share, but is not sufficient to gain a competitive moat. Culture nevertheless is. In fact, Costco founder Jim Sinegal even went so far to say, “Culture is not the most important thing in the world. It’s the only thing…It is the thing that drives the business.”

A virtuous corporate culture empowers employees to perform their day-to-day tasks slightly better than their competitors. Over time, these minor advantages add up to much more significant benefits that can last for longer than conventional wisdom predicts. In short, culture lives in the way things get done, is learned by osmosis and feels natural to employees, but often looks like magic to outsiders as it allows the company to accomplish a lot more with less.

A corporate culture is purely a result of the concrete directions and examples leaders give to its people. It is usually driven by whatever the leaders focus on, their actions, and the incentives set around the organisational deliverables. Leaders can’t impose a culture through just words, but if they embrace a system, use it consistently, and broadcast it to the organisation, then eventually they get a culture pretty close to whatever that system encourages. The more consistent the message and the longer the duration of the effort, the stronger the culture.

Culture is deeply rooted in organisations. As a result, culture tends to be slow-moving and persistent even as leadership changes or business conditions change. While founders typically establish a company’s initial culture, once the casting has set, culture can last for generations. CEOs brought in to turn around a company’s culture face an uphill battle, which, even if successful, can take many years.

The Toyota Production System (TPS) is a notable example. Toyota has been famously transparent about it and even created tours and a joint venture with GM, but other companies haven’t been able to replicate the processes of Toyota’s Japanese factories. They didn’t have the same culture of commitment – perhaps because this would involve uprooting legacy systems and bureaucracies, which may not be in the best interest of the management and employees. Cultures that thrive have leadership support, champions throughout the organisation, and people who believe in what is trying to be accomplished. Without the buy-in from those levels, it will flop. The bottom line is, when competitors have access to the success formula but cannot replicate it, there is culture power.

Finally, culture power has a strong multiplier effect when combined with other forms of competitive moats. It is no surprise that many of the most successful companies are still founder-led, as these companies typically benefit from an unusual intensity of purpose and vibrant culture.

Defining culture power

What specifically makes for culture power varies by industry. For example, a virtuous culture in a technology company may be one that’s obsessed with innovation. However, there are some common attributes and Daniel Coyle provides a nice summary in his fantastic book The Culture Code:

  • Build Safety: A sense of belonging and identity.
  • Share Vulnerability: Confidence to admit mistakes, accept feedback and ask for help.
  • Establish Purpose: Narratives create shared goals and values.
It may seem very difficult to evaluate these attributes, but they are all covered as part of Redeye’s Culture Power checklist. There is a high likelihood that the company have culture power if the company generates high returns on capital and you can answer all the following seven checklist questions with a ‘Yes’:

The culture power checklist

1. Does the CEO have a visionary attitude towards the business?

2. Is the business managed in a decentralised way?

3. Does management own its mistakes?

4. Does the CEO uphold company values and link them to its success?

5. Is management incentivised to create long-term shareholder value?

6. Does the company have purpose-driven leadership?

7. Do employees enjoy working for the company?

1. Does the CEO have a visionary attitude towards the business? 

Why does it matter?

Ultimately it takes visionary leadership to discover creative solutions and build a defensive moat. Great management can envision a great future and articulate a cohesive and logical strategy to get there. Such CEOs are rational long-term thinkers who look way ahead and are determined to drive things forward. With a clear vision for the company, they act like long-term owners of a business, not like caretakers.

Long-term thinking and adaptability are two sides of the same coin. CEOs who spend significantly more of their time thinking about the long term and have long-term plans generally excel at adapting to change. This focus helps because it makes CEOs more likely to pick up on early signals and make strategic moves to take advantage of it. As evolutionary biologist Charles Darwin said, ”It is not the strongest or the most intelligent who will survive but those who can best manage change.” In short, a visionary CEO is critical to balance short-term performance with long-term positioning.

Leaders who can’t see it, probably won’t find it. CEOs who lack vision cannot inspire teams, motivate performance, or create sustainable value. Poor vision, tunnel vision, vision that is fickle, or a non-existent vision will cause leaders to fail. After all, employees do not dedicate themselves for what a company is, but rather to what it is going to be. Every employee has the universal human need to feel part of something that’s important.

How to assess it?

Try to assess if the CEO has a vision that they can translate into a strategy to make the company a long-term winner, not just a good story. Such CEOs can articulate a worldview beyond company operations – one that factors in global social, environmental, and economic issues. There should be a vision based on analysis of future industry trends with good moat potential if they execute on it. This is a journey that will likely take decades and will necessitate course corrections from time to time as the competitive landscape changes. For example, Microsoft’s founding vision was “a computer on every desk and in every home.”

A CEO who exhibits a visionary attitude is typically convincing about their vision and how to achieve their objectives. They should be guided by the company’s core values and purpose. Always ask the CEO how he or she measures success in the company, by what means, where they want to be in the next 10 to 25 years and how they will get there? What does the CEO consider to be the most important long-term challenge facing the company? What initiatives are being taken today to grow the business further and increase shareholder value?

Without a strong vision statement that is likely to stimulate progress, a company is wandering directionless. Be very cautious if the CEO struggles to articulate a vision of where he or she sees the company in the next 10 years. Likewise, shun CEOs with an improbable (weak) long-term vision for the future, but keep in mind the fine line between passion and folly.

A classic example is Netflix founder Reed Hastings, who saw the possibility for a massive DVD-by-mail business that revolutionised the movie rental industry. Then he grasped that the future was streaming video and boldly positioned Netflix to be the industry leader, even at the cost of cannibalising a big chunk of his successful DVD business.

Hastings’s vision is that Netflix becomes the world’s best entertainment distribution platform. This is a challenge that is so audacious and ‘hairy’ that it might feel impossible to achieve. Still, what seems foolish or audacious in the short term might be brilliant over the longer term. Most people tend to underestimate what they can do in 10 years or more. In fact, a major part of success can be boiled down to doing one thing consistently for an uncommonly long period of time.

If the CEO is a rational long-term thinker with a clear and compelling vision for the company, the stock scores one point.

2. Is the business managed in a decentralised way?

Why does it matter?

Decentralisation is essential to a company’s ability to adapt and evolve ​​as it fosters independent thinking. Therefore, be very cautious towards arrogant, imperial CEOs who centralise power around themselves. These CEOs tend to have very little room for critique and if someone tries to do anything innovative, they are likely to be reprimanded.

Command-and-control leadership styles don’t play well in today’s world and will often result in a bureaucratic organisation with too many layers of management and a fractured culture. Autonomy motivates people: bureaucracy does the opposite. That’s why people don’t want to be micro-managed and monitored every moment of every day.

Even so, organisations exist where no one is trusted to do their job. The outcome is a non-productive organisation that struggles to recruit and retain competent employees, which undermines the company’s competitiveness over the long run. No one wants to be at a company where there is more candour in the hallways than in the rooms where decisions are made.

The best CEOs know they do not need to be the smartest person in the room. In fact, they surround themselves with people who are better than themselves. They understand that a large part of their job is acting as the democratic head of a team of subject matter experts instead of seeing their role as the chief know-it-all who simply gives unilateral orders. In other words, these leaders are known for delegating to their managers and empowering the people around them.

All the same, the vast majority of CEOs tend to focus on efficiently managing daily operations. Decentralisation tends to make them uncomfortable, so the focus is turned toward tighter central control and decision making.

How to assess it?

Talk to ex-employees. You will often be surprised by the amount of insight you get from this source. Ask them how decisions are made – if they are as close to the customer as possible with non-bureaucratic processes, you have identified a decentralised business. A business managed in this way typically has limited staff functions and organises itself into small, tight, agile teams with minimal supervision and earned trust. In such organisations, business unit managers are given much control over their activities, while pay is based on merit and performance.

Another sign of a decentralised organisation can be if the hiring process rests primarily with those who are in the best position to judge the candidates’ abilities instead of being done by the HR department.

Likewise, in a decentralised organisation, managers who pay attention to vision, strategies, culture and inspiration are often promoted, rather than skilled managers who are not necessarily leaders. This in turn incentivises entrepreneurship and makes employees more motivated and likely to take responsibility.

Yet another way is to listen to quarterly calls for evidence that the CEO calls out other members of the management team for their contributions. Keep in mind that decentralised organisations are typically run by CEOs who chose to operate in the background and do not seek fame. Similar compensation levels across the senior management team are also a good sign of a decentralised culture.

Titles are usually inordinately important in highly centralised organisations. Similarly, beware CEOs who hold multiple titles as this can be a signal that one person is making too many decisions.

Finally, employees who continuously must be told how to do their jobs require an overly large management team, and too many layers spell trouble.

If the business has a lean corporate culture that fosters independence and accountability, the stock scores one point.

Note: CEO-founders of younger and smaller companies often wear many hats, so their influence is multiplied. The reason for this is that small companies usually don’t have the money or the reputation to hire professional managers, and bad decisions can destroy them. The one-man show should typically change as the business model becomes more proven.

3. Does management own its mistakes?

Why does it matter?

You want management that doesn’t try to sweep anything under the rug – not even the smallest thing. As a shareholder you have a right to know the challenges and opportunities that face the company. How management communicates mistakes is very important. Being transparent when times are tough goes a long way in building trust and is genuinely appreciated by the investment community.

Great managers communicate both things they have done well and those they have done poorly, in order to paint the most accurate picture possible. Ideally, they do so early and publicly. Sharing good and bad news with the same degree of regularity and forthrightness enables the company to build its reputation on transparency. In contrast, be cautious towards an over-promotional management team that only emphasises good news in their communication.

The ability to openly admit mistakes openly can be a barometer of overall truthfulness. . If management owns up to its mistakes, that humility and ownership mentality probably exist in other parts of the business too. Conversely, if a top executive has proven to be less than truthful, there is no telling what other skeletons there are in the corporate closet that have not yet come to light.

How to assess it?

Compare three years of shareholder letters in the annual reports and see if they discuss problems openly and how they address them. Ask yourself if the CEO offers a frank report about mistakes that were made and challenges that were met, or do they only mention successes? If the company issues a press release about a problem that wasn’t previously known to the public, you should see that as a good sign.

Look for managers who openly discuss with investors about their mistakes, what happened and how they plan to get things back on track, rather than simply saying that they had a problem or push it off on someone else. All the same, you want management to have a healthy dose of paranoia and candour, as they are fully able to recognise and communicate the challenges they face. But they must not have all the answers on difficult strategic issues where the outcome is at best uncertain.

No one is mistake-free, so you should be really concerned about any company where shareholder letters don’t discuss problems. This approach tells you that either the team is unable to recognise the problems they face or is unwilling to communicate them. Either undermines management’s credibility. The same is true if management make excuses for not communicating with shareholders when confronted with adversity.

Another sign of poor shareholder communication is when managers offer excuses for weak results and downplay disappointments, rather than addressing the issues. In many of these letters, success is often attributed to management efforts, but failures are attributed to external factors like a weak economy, labour shortages, cost inflation etc. If so, this is a sign of a management team that avoids taking responsibility. This becomes even worse if management reacts aggressively to criticism.

If you start to see statements from companies operating in a similar business and they are increasingly cautious, don’t ignore them. Even if your company says things are still fine, it may only be a matter of time before the downtrend reaches them as well. The weakest see it first, but generally a downturn in an industry will catch everyone in the end. When a company forecasts improvements several quarters in the future despite a changing economic environment, it conveys hope rather than facts.

If management is sincere and upfront about the business’s difficulties and failures, almost as they seem to take pride in doing so, the stock scores one point.

4. Does the CEO uphold company values and link them to its success?

Why does it matter?

Almost every company defines a set of company values to underpin the efforts of employees to achieve its goals. Although stating values is common, they can still set a company apart from its competition by clarifying its identity and serving as a behavioural compass for employees.

Clearly defined and shared values directly impact the bottom line, as they create the foundation for day-to-day operational decisions. They guide employees in making moral and practical decisions.

However, what is written in a statement of values is of little importance unless those values are reflected in how the company operates. People act with integrity when their words and actions are aligned – culture lives in the way things get done.

As the industrialist Andrew Carnegie once said, “The older I get, the less I listen to what someone says, and the more I watch what they do.” The bottom line is that a company’s culture is highly important as it is one of the most stable aspects over time.

How to assess it?

Culture always starts at the top. It starts with leadership, particularly executives but the CEO in particular. Look for leaders who live their values and don’t just talk about them. The values of the CEO are transferred down in the company, but only incorporated into the culture when employees buy into them and become accountable for upholding them. That’s why the CEO plays a central role in how well employees understand and adopt the company’s values, viewing them as a guide to acceptable and unacceptable behaviour. And over time, employees self-select into or out of a culture.

To find meaningful statements of company values you must look at executive communications and shareholder letters for engaging stories that describe how the company’s history and strategies have been shaped by its values and how the company arrived at the present position. Look for business and leadership principles the company is built upon. To be appropriately described they must be directly linked to a company’s success. After all, stories are the foundation of identity and culture lives in the way things get done.

It’s a good sign if employees are recognised in shareholder letters as being essential to producing the desired business results as it signals that the CEO is focused on executing its strategy through a strong culture. In all cases you should be very cautious if CEOs spend too much time talking about themselves rather than the organisation by acknowledging the people they lead.

Similarly, it’s a good sign if the CEO hosts inspiring meetings for their employees where they reiterate the importance of the company’s values.

If the CEO upholds company values and links these to success in shareholder letters or other executive communications, the stock scores one point. If unsure, or company values cannot be found as meaningfully described, this check fails by default.

5. Is management incentivised to create long-term shareholder value?

Why does it matter?

Compensation is an important tool used by companies to drive long-term value creation. However, when compensation policies are not well-structured, and when outcomes are misaligned with performance, companies may face business and/or reputational risks. To that end, companies should clearly explain and justify their pay arrangements in a way that is consistent with the interests of long-term shareholders and specific to the business and its strategy.

However, given that the average CEO stays barely five years in the role, there is often a mismatch between their aims and those of shareholders. If incentives are tied to company performance managers will be prone to underinvest. The consequences of large investment decisions typically take so long to prove out that they have no impact on an executive’s bonus or promotion. Yet, the last thing an organisation wants to emphasise is the ‘sprint to the goal line’ behaviour that is so common in today’s business culture. It’s just not healthy, sustainable, or culturally positive.

The bottom line is that managers who are paid handsomely to misallocate capital will do so. Misaligned incentives tend to manifest themselves in bad decision-making, such as when compensation is roughly correlated with the size of the company and management do value-destroying M&A deals to grow. This could lead to a debt-fuelled buying spree, leaving a hole in the company’s balance sheet. Likewise, incentives matter when managers choose between optimising the appearance of accounting and maximising the present value of future cash flows. As Howard Marks advocates, we must be sure to give adequate attention to second-order effects.

How to assess it?

For an incentive plan to reward executives to deliver long-term performance, it must tie compensation to multiyear business goals based on relevant strategic metrics, especially those measuring operational and financial performance like cost control, customer satisfaction, and return on capital – the metrics which dictate the business’s success or failure. Such metrics should stop managers from focusing too much on short-term share price movements.

On the other hand, if the company targets simple growth in sales or earnings, this may lead to bad outcomes later on. Management will be encouraged to look for more deals, play with accounts and not care too much about the cost of doing this (cost of capital, leverage).

Make sure that compensation is based on multiple metrics rather than just one. No single metric can perfectly capture an underlying strategy as no single number tells the whole story. Moreover, employees are far less likely to substitute a performance metric for the strategy itself when they have to meet targets on multiple metrics.

Below are five guiding criteria listed that promote long-term value creation:

1) Incentive plan based on metrics that supports strategy

2) Tracking multiple financial and nonfinancial metrics that impact compensation

3) Rewards are tied to multi-year business goals that can be valued annually based on objective performance metrics.

4) No acceleration of long-term award vesting upon retirement or any other form of termination

5) Variable compensation spending is directly tied to company affordability metrics

Moreover, a good complementary sign is whether the company implements share ownership guidelines for executives to further align their interests with shareholders’. The best are those that replace long-term incentive pay with a requirement that executives own a multiple of their annual salary in company stock (or pay bonuses in the form of restricted stock) and hold it for long periods of time.

If incentive plans check all five long-term value creation criteria above, the stock scores one point. Likewise, if management has sufficient ‘skin in the game’. If management as a group owns 5% or more of equity or a majority of senior managers own shares with a value of five times or more their base salary, the stock is also scored one point. Unvested shares in incentive arrangements should not count towards the total. After all, you want to invest alongside managers who bring an owner’s perspective to their role and are focused on delivering long-term shareholder value.

6. Does the company have purpose-driven leadership?

Why does it matter?

The most successful corporate cultures are those that remain anchored to a common purpose that endures throughout the organisation. A corporate purpose is an expression of the change the company wants to bring about in the world, as well as a unique approach or ‘way’ that will bring it about.

Purpose is a key element for any company to stay relevant in a fast-changing world. It represents something more than profits that should guide the company’s operations – a ‘north star’ to follow in all major decisions. It is also something that helps employees feel more personally committed to the business.

The best performing businesses over the long term, as measured by shareholder returns, are very often purpose-driven. Their CEOs use purpose to generate sustained profitable growth, stay relevant in a rapidly changing world and deepen ties with their stakeholders as purpose creates a sense of community. Companies that survive are in essence communities that customers, employees and owners want to be a part of.

A strong purpose helps CEOs redefine their market as they look for opportunities in the larger ecosystem rather than feeling limited to their current playing field. Also, it allows them to reshape their value propositions by responding to trends, building on trust, and focusing on customer pain points. This in turn enables them to overcome the challenges of slowing growth and declining profitability.

How to assess it?

Purpose can be quite difficult to evaluate since even the worst companies will have some sort of generic mission statement that they pretend to believe in. Yet most companies were started because the founders were passionate about solving a problem – idealists whose vision was about making the world better in some way – not because they wanted to become wealthy.

Look for companies whose managers and employees are passionate about the company’s mission and want to do right by their stakeholders. Ask managers why they do what they do, what are their moral boundaries, why do they exist beyond financial gain? Do their employees have that sense of purpose? Why do they come to work every day?

This reason for existing isn’t meant to be a strategic differentiator, but an aspirational goal that drives the organisation. A good purpose should capture what a company aspires to be and do. It is an ambition, a cause, something which the company and its customers can strive for together, and something that makes the world a better place. Most importantly, it must be believed by most people in the organisation.

Many companies consider purpose merely an add-on to their strategy, but a truly purpose-driven company puts it at its core. One way of determining whether a company has properly translated its purpose into action is to ask management the following questions:

1) Does purpose contribute to increasing your company’s growth and profitability today?

2) Does purpose significantly influence your strategic decisions and investment choices?

3) Does purpose shape your core value proposition?

4) Does purpose affect how you build and manage your organisational capabilities?

5) Is purpose on the agenda of your leadership team every time you meet?

If management answers ‘yes’ to all of these guiding questions, you should try to verify this by doing some background work with employees outside the management team.

If the company has a well-defined purpose and its business decisions, products and actions are aligned with its mission, the stock scores one point.

7. Do employees enjoy working for the company?

Why does it matter?

Attracting and retaining talent are the most tangible benefits of a positive work environment. After all, one of the limiting factors for many companies is access to talent. Particularly in industries where the quality of ideas dictates success, the ability to attract talent should not be underestimated. Most talented employees will gladly sacrifice pay for the right work environment. When the employees of a business are excited to show up to work regardless of compensation, that’s when magic starts to happen.

If people are happy and feel good about coming to work, they work more productively and tend to stay with a company much longer than unfulfilled employees. Long-term employees provide better customer service due to their greater experience and knowledge. And when customers receive more knowledgeable service, they have a better experience and are more likely to do business with the company again. Also, they are less price-sensitive and generate positive word-of-mouth.

The bottom line is that happy employees lead to happy customers, and happy customers ensure that shareholders are happy too. Employees with positive attitudes towards their work carry this over to customers and strive to deliver high-quality service, resulting in increased customer happiness and loyalty. Moreover, employees who are happy and committed to their workplace genuinely want to see the company do well. They are a vital asset in maintaining a strong reputation, brand image and competitive advantage. However, all other things being equal, employees at strongly performing companies will always be more satisfied.

Businesses around the world have been trying to move the needle on employee engagement for decades, yet research shows that approximately 70% of employees are unengaged. In fact, about 15% of employees are so unengaged that they’re trying to sabotage their company. This directly contributes to high employee churn, leading to high employee search and training costs for most companies.

How to assess it?

Employees and former employees know the internal workings of a business. You can learn a lot by talking with some of them directly and visiting the headquarters. A company that values its people has a tangible electricity that is felt from the moment you walk through its doors or talk to its employees. It should be quite clear if employees enjoy working for the company and if there is a spirit of contentment and optimism. The ultimate is when the atmosphere feels friendly to the point of cultish. If the energy isn’t good and a happiness quotient is missing, it undermines decision-making, creativity and productivity – the corporate culture is deeply affected.

Look for a collegial and family-oriented environment where best practices are shared, significant efforts are praised and people are driven by the same overall desire to succeed. In such a collaborative culture, employees don’t fear political retaliation or tolerate verbal abuse. This usually translates into high employee engagement, meaning that people care, want to succeed and want to do a good job.

Collaboration has evolutionary been critical to survival. It’s the collaborative pack that survives, not the lone wolves. After all, competition comes from the Latin word competère, which means ‘to come together’ or ‘strive together’. Rivalry in the workplace doesn’t produce a collaborative culture. One common sign of a broken workplace is fiefdoms beset with egos. In its worst form this can turn into a seething, factional, back-stabbing, Lord of the Flies-like place.

How senior managers treat their employees is a good clue as to how they will treat their shareholders. Sir Richard Branson says, “Train people well enough so they can leave. Treat them well enough so they don’t want to.” Management investing significant resources in employee training and contributing to employees’ well-being is a great sign. Higher employee engagement typically follows when management promotes health and happiness through investment in employee safety and wellness programs, office architecture, furnishings and high-end technology, and other corporate perks. These are all worthwhile for frugal organisations that value long-term outcomes, as opposed to cheap managements that focus on minimising costs.

A good complementary sign is if the company’s employee churn is low compared to its closest competitors. Similarly, a low level of sick leave among employees is a good sign. A workplace offering many opportunities for development is yet another one. Looking at average salaries, employee shareholdings and bonus plans can also give sense of how involved employees are – particularly at professional services and similar companies.

Another way to get a sense of employee happiness is to read reviews on the recruiting portal Glassdoor. Look for red flags, but keep in mind that everybody loves to complain. So the reviews skew negative, but pay attention if you’re seeing a pattern of the same kind of complaints. A pattern in the positive reviews is also something to note. Likewise, a review of Twitter and LinkedIn for people who work at the company may offer some unusual insights.

If employees seem to enjoy working for the company, the stock scores one point.