For the growth investor, identifying quality in companies, characteristics that increase the odds of those companies profitably exceeding expectations, should be central to the investment approach.
Identifying quality should not be limited to approximate yardsticks such as earnings standard deviation, a net debt/Ebitda ratio or even a slightly more elaborate Piotroski score. Instead, there is an interconnected relationship between competitive advantage and quality, which in itself is subjective.
Quality emerges when successfully turning a social problem into an economic opportunity
When we, at Comgest, talk about the “pricing power”, the earnings visibility or the exceptional franchise of a company, we are definitively talking about the quality of a business, but what is quality at its core? The UNESCO defines quality as “a measure of fitness to purpose”. And as Peter Drucker wrote, a business is defined by its purpose, which is to turn a social problem into an economic opportunity. So, based on the relevance of its purpose and its fitness to fulfill it, we can start to measure the quality of a company. How do you then turn a social problem into an economic opportunity? You achieve this through innovation and differentiation. The innovation solves the social problem while the differentiation secures the economic opportunity.
To monetise a problem-solving innovation, a company needs to be strongly, sustainably and distinctively associated with it. The competitive battle between companies occurs not in the marketplace but in the mind of the customer. It is impossible to assess the quality of company if we do not first understand what its purpose is and to what extent this purpose solves a social problem in the eyes of the customer. Only then can the relevance of that specific purpose for existing and potential customers be determined and evaluated.
Establishing a customer-centric purpose provides powerful and sustainable competitive advantages
What the customer thinks he is buying, and what he considers as value, is up for debate. Regardless, this determines what a business is, what it produces, and whether it will grow or decline. What the customer buys and considers value is never a product. It is always a perceived utility, i.e. what a product or service does for the customer.
Quality in a product or service has never been what the company puts in, rather it is what the customer is willing to pay for (this is notably why the software industry is so profitable). But the customer-centricity of a company is absolutely critical to the assessment of its quality for another reason: the relevance of its purpose will inevitably diminish at some point in time and only a customer-centric approach will enable the company to anticipate this and adapt itself. So a central question for a company should not be “how is our business doing?” but “what should our business be given the changing or still unmet needs of our customers?” In a sense, purpose, singularity, relevance and character are all pre-conditions for a product, a brand or a company to become successful and long lasting. Among the values that consumers increasingly seek after, let’s mention: fairness, accountability, sustainability and being a force for good.Due to the ever-changing nature of the world and of the future in particular, growth investing is fraught with risks that very few tool kits can reduce. Carefully understanding what the true quality of a company is one of them, which is what our style of quality growth investing is all about.
Anchoring a company’s purpose among employees is the duty of its leaders and allows for better corporate governance
Many large companies have allowed their culture to weaken under the burden of processes, controls and bureaucracy. It is even truer for those that have been through big mergers and acquisitions as cultures of different companies are not always aligned or interchangeable. In a fast changing world, startups usually do a better job than large organisations of defining their culture and creating a brand that makes sense and solves social problems, disrupting less meaningful value propositions of larger companies along the way.
Hence a firm’s culture and purpose should never be an afterthought to its strategy, as it is personal and path-dependent. Culture is something that needs to come from the history of the company and the legacy of its founder, not something that can be assigned by a CEO, out of thin air, just because it has some short-term commercial appeal.
As the ultimate custodian of the quality of a company, the board is accountable for its purpose and culture
The link between the quality of a company and its purpose and culture should be front and centre for the board of directors. When setting goals and assessing performances of senior executives, the board should ensure that the specific purpose of the company is clear and that everyone feels excited and accountable. Too often the question of governance is limited to the legal organisation of administrative powers and their counter-powers within the firm or the relationships between the principals and the agents. The strategic role of the board becomes even clearer if its mission actually lies in optimising the level of autonomy left to the executives to nurture their intrinsic motivations. Its responsibilities become paramount when it has to determine how to balance the company’s risk appetite with the need for critical oversight and deep understanding of the potential shortcomings of the senior executives on their way towards the company’s objectives.
One of the board’s most critical duties is to nurture and potentially refine the business purpose and the culture of the company, and ensure those two essential aspects of a company outlive any CEO in place. Ensuring the executives have superior intrinsic motivations for the job and excellent business ethics will always beat any systems based solely on financial rewards and punishments. Based on our experience, it is one of the main reasons why family-owned businesses usually outperform widely held companies, whose directors and executives do not have affection for the company, let alone a genuine understanding of their purpose and culture.
Corporate culture is nothing else than the set of moral values, social norms and implicit beliefs of a company, which shapes decisions and behaviours, through the common ground employees share and understand implicitly through verbal and nonverbal codes. These factors are absolutely critical for companies aiming at true innovation and differentiation.
Strong corporate cultures can indeed have numerous benefits. People recently hired into the firm as well as veterans of the organisation rapidly know how to take decisions and implement action plans due to clarity about how things should happen and why. Group integrity and its ethics are clearly defined and understood. It is in the culture of the company that the customer-centricity will be defined, that accountability standards are set and that key notions like trust, respect, meritocracy, adaptability and reciprocity come from.
A strong corporate culture and purpose creates a group of intrinsically motivated people brought together with an outstanding ability to give birth to genuine innovations, thanks to the trust that they share between them.It is a remarkable concept: only when individuals can trust the culture or organisation they belong to, will they take personal career risks in order to advance that culture or organisation as a whole.
So in order to grow with quality, the goal is not to hire people who simply have a skill set you need nor to persuade customers who simply have money to spend it with you, the goal is to hire people who believe what you believe and who are excited to solve the problems of those clients who actually also share those beliefs. Those traits are the ones that enable some companies to have corporate strategies and CSR / Sustainability strategies fully indistinguishable and which serve the greater good of civil society while making significant profits.
Sebastien Thevoux-Chabuel is an ESG analyst at Comgest.