An Ecology of Success

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Oct. 15. With permission, we're reproducing it here in an edited form.

"Sometimes the questions are complicated and the answers are simple."
-- Dr. Seuss.

In 1970, Paul Orfalea noticed massive lines waiting for the copy machines in the library at the University of California, Santa Barbara, so he set up a copy machine right off campus. From this humble beginning to the time he sold it more than three decades later, Paul's company, Kinko's, grew to more than 1,100 stores and 23,000 employees worldwide. If you ask him the key to Kinko's success, Paul responds quite simply: "happy fingers."

Paul believed that the key to good business success was to do everything you could do to make your employees happy and satisfied. Paul felt that it was a manager's role to simply remove obstacles to employee productivity, that productive employees made for happy customers, and what followed was magic. "Make customers comfortable and they will give you their lives," Paul noted in his excellent business book Copy This!

Here's what fascinates me about Kinko's: It became a large commercial success in an industry that was dominated by mom-and-pop stores. The copy and print center business is traditionally pretty boring and not enormously profitable. And yet Paul turned it into a massive company that generated hundreds of millions of dollars of wealth for its shareholders.

There are commercial success stories like this all over the world. I once asked Sally Smith, the fabulous CEO of Buffalo Wild Wings (Nasdaq: BWLD  ) , how -- given that every bar in America serves Buffalo wings -- her company was the only one that had successfully cloned itself into a large chain. She immediately answered that it offered a superior product.

Which is great, except that it isn't true. Not in my opinion, at least.

The Buffalo wings at B-Wild are nothing to write home about. They're fine, but take it from someone who (back in the day, at least) has consumed a ton of Buffalo wings, they're not particularly noteworthy.

(Want noteworthy? Go to the original Duff's in Amherst, NY.)

It's not that I blame Sally Smith for her answer, because it would be hard for her to state the real reason without sounding obnoxious. Buffalo Wild Wings has succeeded because it has superior management and a great culture.

I would suspect that Paul Orfalea would recognize the key driver that has helped B-Wild grow to be 100 times larger than the next largest Buffalo wing concept restaurant. (Note: I totally made up that 100X number. Let's just all stipulate that the next largest wing joint chain is way smaller.) Not that he's an expert on wing joints or even restaurants, but Paul has a proven track record in implementing a successful process for replicating stores, and like B-Wild, he did it in a segment where few successful chains existed previously. In short, managements that have helped foster cultures where replicable success is possible have helped B-Wild generate wealth for shareholders in excess of what even a massively successful single-store concept could achieve.

Where is this asset listed on the balance sheet?
What is this magic these companies possess? It is usually a mistake to give all of the credit for success (or blame for failure) to the people sitting at the top of a company. But we believe fully that companies with superior cultures have a higher likelihood of superior returns, and it is an unmistakable truism that quality cultures usually start at the top. Paul Orfalea is right about the power of "happy fingers." If the employees who have the closest interactions with customers are happy, then there is a much greater likelihood that they will create a better environment for customers -- who may then return again and again.

There's a certain magic in this realization. Deep down we all have come across companies that provide superior products but achieve much lower levels of success. In the 1950s there were far more White Castle restaurants than McDonald's (NYSE: MCD  ) , and (particularly at the time) their food quality, cost, and experience were fairly similar. And yet, McDonald's grew to be a global powerhouse, while White Castle has stumbled along with -- at best -- a regional relevance. The best product doesn't always win, nor does the first to market.

It's not just customers, it's an ecology of success
I have two stories to relate. The first comes from Costco (Nasdaq: COST  ) , a longtime portfolio holding. Several years ago an acquaintance scored a job as a buyer for Costco, which means that his job was to identify products to be offered in Costco stores and to negotiate the price and terms from the supplier. Wanna know why Costco switched from big bags of dinosaur chicken nuggets to the Mickey Mouse-themed ones (a disaster, by the way, for parents of kids with milk allergies)? It's because a Costco buyer negotiated with a new provider, in this case, from Perdue to Pilgrim's Pride (NYSE: PPC  ) .

It's a great job, with lots of responsibility. My friend was once particularly happy about a great deal he had gotten from a supplier, and when Costco CEO Jim Sinegal asked to meet with him about the deal, he was sure he had an "attaboy" or two coming his way. Instead, Sinegal said "I've looked at this deal for a while, and I can't figure out how in the world they're going to make any money. I want you to call them back and increase the price we're going to pay by 2%."

When my friend relayed the news, the supplier's reaction was as follows: incredulity, followed by a profession that he was prepared to work with Costco forever. There's a reason that Costco is the largest wine retailer in America. There's a reason that its customer turnover is incredibly low. There's a reason that the average Costco employee tenure is significantly longer than at any of its competitors.

That reason is that Costco's corporate culture demands that it strike a balance between the interests of its employees, its shareholders, its suppliers, and its customers. For years I've been listening to Wall Street analysts bellyache that Costco is harming shareholders by paying employees too much and charging too little for its products. Meanwhile Costco shares have tripled in a decade. If that's harm, then give me three more, please.

On the flip side, I recently heard of a retiring financial advisor who had managed money for his friends and family for years. Two weeks before he was to retire, he moved every single client out of his or her existing funds and into different ones. There are lots of reasons why he might do this, but our friend who passed this story on to us mentioned that each of the new funds in her parents' account had something in common -- a 5% sales load. A survey of their friends showed that they, too, had been moved into funds that charged large front-end loads, from which commission is paid to the financial advisor who recommends the fund. If you take the dimmest view of this behavior, the financial advisor essentially helped himself to a portion of his clients' assets right before he rode off into the sunset. I'm sure there's a less dim view, but I'm not really seeing it.

Obviously the potential exists for bad behavior everywhere, but some companies have cultures where people want to behave differently. Or at least, on the balance, they attract the right kind of people.

This matters in the investing world. Companies with great cultures act differently. And many times, those cultures help create massive returns for shareholders who properly identify them. Think Southwest Airlines (NYSE: LUV  ) . Think Apple (Nasdaq: AAPL  ) . Think Chipotle (NYSE: CMG  ) and Procter & Gamble (NYSE: PG  ) . Think Almarai and Swatch.

Even on Wall Street, which seems to attract its share of intelligent sociopaths, culture matters. When Lehman Brothers got into trouble in 2008, no one lifted a finger to bail out the company, or its deeply unpopular CEO, Dick Fuld. Ditto Bear Stearns. But this past summer when Knight Capital (NYSE: KCG  ) had a software error that cost the firm some $440 million in trading losses, the company is reported to have received some 90 offers of assistance, and ended up receiving a financing lifeline with extremely generous terms. Thomas Joyce, the longtime CEO of Knight Capital, may not be a household name, but he is liked and admired throughout the financial services industry. There is little doubt in my mind that this played a huge role in how Knight was taken care of in its time of need.

Management integrity is an enormous part of our analysis that goes into the awesomeness continuum, our measure of a company's future potential (see "The Awesomeness Continuum," June 2011). We have always considered ourselves to be deep value investors -- and we do believe deeply in the precepts of buying companies for less than they are worth -- but as I've viewed our investment returns it has occurred to me that our biggest gains have been generated when we have properly assessed a company that has an underappreciatedly (new word!!) high level of quality, which can manifest itself as giving the company a longer period of resistance to competitive forces (technically, a longer period of time to generate supernormal profits).

In short, durable, sustainable franchises aren't accidental. They're rarely simply bestowed upon some undeserving company. Great brands come from great brand management. Apple's design process has been to gather people into a room and figure out what features they'd like to include in the next iteration of a product, and then figure out how to make it possible. Dell (Nasdaq: DELL  ) , on the other hand, started with "let's build a $1,500 computer," and then figured out what to include in order to justify the price point. It should be clear at this point which strategy has yielded better results and better customer loyalty.

Do this, not that
The Apple example continues to be fascinating to me, as it is one of the rare companies that has successfully redefined itself and gone into additional product lines (another is Amazon.com (Nasdaq: AMZN  ) ), with each move generally enhancing the value of the company's franchise. This isn't always the case. Generally speaking, one of the greatest tip-offs that a company is losing its way is when management announces that it is going into an entirely different business segment.

It's for this reason that the Awesomeness Continuum rating is something that we constantly review and change over time. Companies stagnate or founder, while others take their place. But one thing that we have noticed is that it is exceedingly rare for a company that has a poor culture to ever regain its footing. Companies where managers build Taj Mahal corporate headquarters and hire compensation consultants to justify massive pay packages for the top executives are rarely likely to have great cultures. And when such conditions exist, our hurdle to invest becomes that much higher.

In the end, while companies with bad cultures are not necessarily poor investments (in some ways, Apple's culture under Steve Jobs was horrifying), we like to invest in ways that maximize our potential for success. That means focusing on companies where we have the most faith that senior managers view each of their constituencies -- employees, shareholders, suppliers, and customers -- as being at least as important as their own paychecks.

In case you missed it
On Sept. 25, we held our semiannual conference call, in conjunction with Worldwide Invest Better Day. It was -- by far -- our best-attended call yet. Still, many of you sent messages to us stating that you were unable to attend the call during its scheduled time. We've posted the transcript and video for you here.

Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below. Bill does not own shares of any companies mentioned.

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The Motley Fool owns shares of Apple, Amazon.com, Buffalo Wild Wings, Chipotle Mexican Grill, Costco Wholesale, and McDonald's. Motley Fool newsletter services recommend Apple, Amazon.com, Buffalo Wild Wings, Chipotle Mexican Grill, Costco Wholesale, Dell, Southwest Airlines, McDonald's, and The Procter & Gamble Company. Motley Fool newsletter services have recommended creating a bull call spread position in both McDonald's and Apple. Motley Fool newsletter services have recommended writing covered calls on Buffalo Wild Wings. The Motley Fool has a disclosure policy.


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