It's been some time since I last wrote. I've been busy working on a few ideas and reading some great writing like Howard Marks' brilliant investor letter comparing investing to sports.
I am also winding down my current day job of 3ish years to move on to a new opportunity. On the eve of this change, I thought I would spend some time reflecting on my role over the last three years because I think that there are wonderful investment learnings to be had. Learnings that have benefitted my investing abilities tremendously. Warren Buffett has said a lot of great things over the last few decades, but this one personally resonates with me and is particularly applicable in this circumstance:
"I am a better investor because I am a businessman and a better businessman because I am an investor.”
I took the Oracle of Omaha's advice to heart and left the investing world as my day job several years ago to get some operational experience. What's it like to actually run a business? What are the inherent challenges of running a business? And how can I learn from this experience to make me a better investor?
And if we're all being honest here, most of us that are in the investing world have never really run a business. We know how to read 10-Ks and spread the numbers like the best of them and we know how to call out bone-headed decisions by management teams, but we have never actually been in the driver's seat making the decisions that impact those 10-Ks and numbers. Analyzing a business as an outsider and running it are two very different things. I realized some time ago that being on the operational side of the business would help me understand a business and business models better, help me empathize with the challenges of the businessman and ultimately impact my investing in a beneficial way. And in the circular way that things work sometimes, my investment experience would in return be invaluable in providing me with that big picture lens with which to evaluate my actions as a businessman. In other words, what would a long term investor in this company think of this project or initiative? Is it a decision that is right for the long term or just for the now? I do have to say that my investor lens made my day job challenging at times as I was forced to question the rationale of certain projects and tasks rather than go with the flow.
To provide more context, I have spent the last few years working in the consumer packaged goods (CPG) industry, which is a great perch from which to evaluate the travails of a businessman. It is a very traditional industry that manufactures goods and sells them to retailers that ultimately sell those goods (whether they be cleaning products like Clorox cleaning spray or food products like Lays potato chips) to consumers. As with many traditional industries, the threats are many and come from many different places. However, the experience has provided me with amazing exposure to general management and running a very traditional business- even if there are many other cooks in the kitchen involved in decision making at times (one of the learnings but let me not get ahead of myself). The experience of operating a business (albeit at a quasi junior level) over the last few years has been humbling to say the least. It's not always easy and the pressure to make decisions that may not always be in the best interest of the long term business comes from many different directions.
Being on the operational side has provided me with a several lessons on sound management and running a business. There are a few (5 to be exact) lessons that I thought all of us investors could embrace or learn from as we evaluate management teams, provide advice to management, serve on boards or just analyze businesses. Some of the thoughts are more specific to brand building (CPG speak) but brands are merely the reputation of a business so I believe that the lessons are also applicable for almost any business.
Make big bold bets and put all (or most) your chips in on them.
Within every company, every division and person is competing for their share of limited resources. Frankly, there aren't enough to go around. But every division and person wants to work on exciting projects like new product launches. However, companies usually do not have the resources to support several new product launches in a given year. Alternatively, they spread their resources too thin by supporting multiple projects with resources and investment that are insignificant to have any impact on such launches. Spreading resources thin across a multitude of projects is not a recipe for success. Rather, it is up to management to make the tough choices and decide on which products or services can meaningfully drive the business for the long term and invest in making those launches as big and successful as possible. Yes, these are not easy decisions and there is the risk of angering team members but good leaders know that execution is compromised when a company tries to do too much. Thus, management teams must choose impactful projects from a set of competing priorities and allot those projects with the resources necessary for success. I often listen to management earnings calls with an eye towards evaluating management strategy with regard to this principle. I have seen management teams that try to do too much impulsively and reactively and other teams that behave pro-actively with focused strategies. I'll take the latter any day and direct my capital in that direction.
Autonomy is a recipe for success while micro management is a recipe for failure.
Managers need to hire really smart people, give them some structure and let them loose (give them autonomy). The reasons for autonomy are many. First, autonomy motivates employees in a way that is relatively inexpensive. Yes, there are other ways to motivate employees like money, free meals, gym memberships, etc. but these are expensive forms of motivation and also usually do not provide enduring motivation for the long term. They make employees temporarily content but autonomy has the power to provide enduring motivation. In reality, smart people do not like to be micro managed. They are typically intelligent enough to make smart decisions and by micro-managing, managers are often self-selecting for people that are less intelligent, lack conviction or incapable of leading without direction. These aren't the people that we want running the organization one day. Second, autonomy leads to better decisions. The people closest to a decision often have the best information and data and are in the optimal position to make the best decision if they are empowered to do so. However, what often happens is that senior managers don't feel comfortable relenting such autonomy or have not established a structure that enables subordinates to fail within reason or to feel confident about such decisions. This is poor management and one that is not likely to endure. The scrutiny of subordinates should not happen when they are making decisions on behalf of the company. Rather, all of the scrutiny needs to happen in the hiring decision. Managers need to selectively hire people that are very smart and capable of making the decisions for which they are being hired. As an investor, the management style of the senior ranks is more challenging to evaluate. However a deep management team with several capable leaders with tenure is a good sign - good people don't stick around if they aren't given autonomy. Furthermore, CEOs that provide the limelight to other senior leaders in the company during external facing meetings is also a good sign that they are pushing down authority and decision making.
Controlling the primary channel of distribution is a significant competitive advantage that is often under-appreciated.
In CPG brand building or marketing, we often reference the 4 "P's" of marketing - Product, Price, Promotion and Place. It is a simple mnemonic for thinking through the levers that are within the control of brand managers. Imagine a fictional company - Acme Widget Corporation. Widget products are created by the company with certain attributes and features that consumers want or need. Prices for the widgets are set based on consumer willingness to pay, retailer margins and input costs. Promotions for the widgets are created to build awareness, communicate product benefits and ultimately generate demand for the product. Finally, the widgets are sold in to retailers or distributors to sell on to consumers. This last leg of the widget product journey is critical because if it does not happen, consumers can never actually purchase the intended widgets. However, the Place or distribution piece is also the "P" over which Acme managers have the least control. Ultimately, the retailers or distributors (not Acme) get to decide how the widgets are merchandized on shelf and communicated to consumers within the store (whether it is a brick and mortar store, a catalog or an online store). Sure, there is some input that the sales team of Acme Corporation can provide to retailers to ensure that Acme widgets get prominent placement and attention, but it is a guarantee that the sales team of competitor Ajax Corporation is providing similar guidance for Ajax widgets. Ultimately, consumers will see and experience Acme widgets how the retailer wants, not how Acme Corporation wants. This leads me to my key learning - Businesses that control their channel of distribution have a significant competitive advantage. They have a lot of control over how consumers see and experience their product or service. Granted that this is not always possible in every business and industry. For example, in the world of consumer packaged goods - consumers don't really want to shop at one store to buy Tide detergent (made by P&G) and then go to another store to buy Colgate toothpaste (made by Colgate Palmolive). Consumers would rather just go to Target or Walmart and buy all the brands that they need (with little regard to which company actually made the product). However, there are several other businesses where such a strategy can make sense.
Think Starbucks Coffee. Starbucks produces all of its own products (or works closely with vendors to manufacture on its behalf) and then sells those products through it own stores. Whether or not you like the taste of Starbucks coffee, you would probably agree that the store experience and environment is pretty darn good. They do a great job bringing new products to stores and displaying those products prominently with signage and pictures. The experience is tightly controlled because the company is more or less, vertically integrated. When Howard Schultz retook the reins at Starbucks in 2008 to stage a turnaround, he implemented changes to improve the store experience. He was able to implement these changes quickly because they own the stores. Furthermore, Schultz did not believe in franchising and ensured that Starbucks retained ownership of every domestic outlet - he understood the power of tight control over your channel of distribution.
A second example of success with controlling the channel of distribution is the Apple store. There was a time when all Apple products were sold through third party channels like big box retailers (Best Buy, Sears, Circuit City, etc.). However, Apple had been through some tough times and Apple products had been given short shrift by many major retailers - poor placement within stores and poorly trained salespeople that could not communicate the product benefits versus PCs. Jobs realized these shortcomings of third party retailing and worked on developing the Apple store concept. Initial predictions for the Apple Store were doom and gloom when the store first launched in 2001, but with nearly 500 stores and significantly higher sales per square foot than any other retailer in the world, Apple has been extremely successful in its endeavor to control a significant aspect of its distribution. Selling product through its own stores has the benefits of tightly controlling the presentation of the Apple brand and its products to consumers, providing a wonderful brand and retail experience for consumers, a knowledgable salesforce that can educate consumers on product benefits, an interactive environment where consumers can try before they buy and a place where consumers can go to receive high touch, high quality after-sales support. The Apple stores also have an added benefit - they shift some of the balance of power back into the hands of Apple versus retailers. Apple still sells a majority (76% of sales) of its products through third party retailers (Best Buy, Target, etc.), but by exercising control over a channel like its own stores (26% of sales), it can influence retailers to carry certain products or merchandise products in a way that benefits the company and brand (the Apple store within a store that you see at other retailers are a good example of this).
It does not directly follow that every business that controls it channel of distribution will be successful, but it does provide a significant competitive advantage. There are businesses that have not had as much success despite controlling their distribution channel- think fashion apparel retailers like GAP. I attribute this lack of success partly to the challenges of the business model itself - predicting fashion trends and staying trendy is difficult even when the distribution model is successful. While somewhat different, the success of franchised restaurants has also been predicted partly on the amount of control that the franchisor exerts on the franchisees. Franchised restaurants that are tightly controlled have generally had much more success (think Subway) versus franchised restaurants that have been able to operate fast and loose (think Blimpie - I don't blame you if you have never heard of it).
I realized early on in my foray into the CPG industry that many companies in the space did benefit from a durable competitive advantage in the form of a strong existing brand name but they lacked control of their primary channel of distribution. And this is a characteristic of the industry that was not likely to change meaningfully. The lack of control over this "P" in no way signals doom for the industry but is merely one aspect of its business model that will be more challenged than the other aspects. There have been some CPG players, like P&G for example, that have tried to remedy this situation by launching e-commerce storefronts, but these are unlikely to comprise a significant portion of revenue in the near term given that companies have been careful not to dis-intermediate their existing channel partners by providing uncompetitive pricing in owned channels. This latter fact has proved a boon for start-ups trying to disrupt these traditional players. With nearly all of these start-up players (whether it is Dollar Shave Club or Casper mattresses), they have chosen to control their channel of distribution by selling directly to consumers.
The application to investing is more obvious here. Businesses that control their primary channel of distribution aren't necessarily going to be successful as there may be deficiencies in other aspects of the business. However, these businesses do possess a significant competitive advantage that makes for a powerful combination when coupled with a great product or service.
Don't dilute the brand in the name of short term growth. Don't forsake the long term for the short term.
Managers don't typically stay in the same position at companies for longer than a couple years. Thus they are typically not necessarily incentivized to build businesses for the long term, but rather drive share growth or some similar target in the current year. Given the mis-aligned incentives, managers often take outsized risks, sacrifice profitability or dilute brand equity in the name of short term growth. The issues that result from this short-term thinking typically become "the next manager's problem". In fact, sticking to a sound strategy and enduring some interim pain as a result is typically not the way to get promoted in middle management. Unfortunately, managers typically don't have the patience to see a strategy through even if it is the right decision for the business in the long term. However, as the owners or stockholders of a business, we don't want managers that operate this way. We want managers that are acting in the best interests of the brand and the company in the long term. If higher input costs necessitate a price increase, then we (as investors) want them to stick to a price increase despite some volume losses in the short term.
The applications to investing are clear. We want to invest in businesses that are creating strategies and executing on these strategies to build long term businesses. We need to keep an eye out for red flags that the business is forsaking the long term for the short term like diluting profit margins substantially in the name of cannibalistic growth, taking big risks to grow market share that cannot be retained or expensive product launches that will juice revenue growth in the current year only to be discontinued in Year 2.
Continuity and consistency in strategy and messaging is critical for resonating with consumers and ultimate business success.
Even when you have a great product, high quality communications and you spend a lot of media on it, strategies can often be ineffective. This is because strategy and supporting messaging can take a long time to resonate with consumers - often several years. Think about how cluttered mass media has become and how many messages you get a day as a consumer. Consumers have become desensitized to advertising, especially traditional advertising. However, marketers and managers are often ready to evaluate the success of a product launch or a media campaign in only a few months. They are ready to kill a new product launch or completely revamp their strategy fairly quickly, well before it has had a fighting chance to succeed. Sometimes, new products require a fair degree of consumer education or just time to traverse the adoption curve. The impulsiveness for immediate gratification comes from the top down (and could be driven by Wall Street's lack of patience) and is dangerous to sound decision making and strategy. But time and time again, companies make discontinuation or kill decisions too quickly, only to see a competitor launch the same or similar product the following year. The media reaction is often that Company X was too early while Company Y timed it just right. "Bullhockey!" to quote a guy I once worked with. Rather, it was that Company X's execution was poor or they were too impatient and wanted immediate results. Often, Company X did some of heavy lifting (consumer education and introduction) to make Company Y's launch a success.
As an investor, I often evaluate companies based on their continuity and consistency in strategy and messaging. The latter often provides insight into the former. Continuity and consistency is critical for building businesses for the long term. This is often easier to evaluate for consumer businesses because they break out advertising expenses as a separate line item in their financial statements. I want to first judge the continuity of strategy and messaging - is the company spending similar or greater amounts on marketing and advertising (as a % of revenue) over the last ~5 or so years. Does senior management understand the importance of continuity in messaging and cut waste and fat to ensure that the organization can invest back into marketing? Has the management team wavered back and forth with new plans and strategies every year?This can often be evaluated by reading earnings call transcripts and paying close attention to the tone of management. Furthermore, the consistency of messaging and the patience to stick with a strategy or product launch and see it through is critical. This requires a bit more of the "scuttlebutt" method to evaluate, but involves reading through filings, transcripts, engaging with TV, social media communications and talking to people with familiarity to the industry to understand how consistent the company has been with its strategies and communications supporting those strategies.
These are merely five of the learnings I have had from the operational side. There have been many more but thought that these were the most important and relevant. I know that this post was a bit of a departure from my usual writing focused on fundamental analysis of businesses but these learnings do provide tremendous insight into the latter and I thought it was a important to convey them while they were fresh and lucid. Working on the operational side of a business has provided me with tremendous insight into both the workings and failings of companies today - insights that have improved my investing for the better. I know that most of you readers out there are in the investing world so I hope that there are some takeaways for you, but I also hope that some of you folks on the operational side (of any type of business) might find a few things that you agree with.
Send me your thoughts: firstname.lastname@example.org. I would love to hear from you.