1 Little-Known Advantage Most Investors Miss

Investors crave outperformance. However, figuring out which companies are built to yield market-smashing returns over the long haul isn't easy.

One intangible asset helps demystify strong corporate foundations: culture. It's a powerful competitive advantage that can provide a significant edge over the competition.

In a way, though, it's difficult to grasp what culture even means. Many definitions will start with the most important factor: how managements and employees interact with one another. There's also another element, which is stakeholder-friendliness. Companies that treat their stakeholders well and try to make the world better often make employees feel great about their daily endeavors.

Factors that are difficult to quantify can be easy to dismiss. Culture can't be broken out in financial statements. It's more of an art than a science, but ignoring its role in the bigger equation is one of the biggest mistakes investors can make.

A way to find the best
Increasing numbers of investors consult resources like Glassdoor or Fortune's annual Best Places to Work rankings for investing ideas. These help investors feel out how jazzed people are about their employers -- and happiness often transcends time clocks and large paychecks.

One thing to remember is that intangible factors aren't unknown in investing. Take goodwill accounting, which values intangible assets on balance sheets. And while theoreticians have argued over how to treat intangible assets for about 100 years, they haven't been dismissed.

Brand impacts and cultural policies are more closely tied to investment theses these days, as more consumers recognize socially responsible aspects in purchasing decisions. Goodwill strengthens companies' brands over their rivals'.

Unfortunately, many investors continue to believe that companies that take exceedingly good care of employees, suppliers, customers, and the environment are doomed to rack up costs instead of benefits -- and therefore underperform. That's not the case at all, but it's not easy to prove otherwise.

So let's look at a set of companies that have proven that a progressive culture pays.

The proof is in the portfolio
Raj Sisodia's book Firms of Endearment is a major resource about cultural philosophy in business. It extols the virtues of Conscious Capitalism, which entails commonsense stakeholder-friendly practices.

By definition, Firms of Endearment, or FoEs, focus on far more than the traditional bottom line. They are within the vanguard of the companies that show that "profit" and "purpose" go hand in hand. They treat their employees well, which leads to a dedicated workforce that not only believes in their employer but will take great care of customers. These companies tend to have "servant leadership" -- founders and CEOs who care about the entire organization more than their own pocketbooks. FoEs tend to use their businesses to benefit even more stakeholders, including suppliers, communities, the environment, and the world.

When Firms of Endearment was first published, the 22 publicly traded Firms of Endearment companies in the U.S. had already generated market-beating returns. When the second edition of the book hit last year, it turned out that over 15 years' time, those companies had gone gangbusters.

Here's a breakout of the returns over different time frames, showing the staggering results.

Source: firmsofendearment.com.

The FoE companies aren't obscure; many investors, regardless of investment philosophy, wish they had snapped up cheap shares way back when.

Companies like Costco (COST -0.33%), Starbucks (SBUX 0.01%), Chipotle (CMG 0.90%), and Whole Foods Market (WFM) are all publicly traded companies on the list.

Some FOE companies don't even spring to mind among consumers and investors, though. These include Adobe Systems (ADBE 0.49%), Toyota (TM 1.38%), 3M (MMM -0.51%), and Cognizant (CTSH 0.10%).

The policies that make these companies "Firms of Endearment" are difficult to measure and emulate -- and that makes them real competitive advantages. And these companies have survived and thrived over the long haul.

Moving beyond fixed philosophy
Granted, culture isn't the end-all, be-all factor in outperformance. A company may have a marvelous culture, but if management mishandles strategy, innovation, market share growth, debt load, and all kinds of other factors, culture alone won't save the company.

Regardless, any investment philosophy should take the risk of bad corporate culture into consideration. Intangible risks -- for example, how customers feel about companies -- have real effects on business results. Tarnished brands and negative cultures stealthily show up in performance eventually. While we investors obsess over sales, margins, and other balance-sheet highlights, spending in areas like employee happiness goes unnoticed, though it can decide a company's fate.

Circuit City is a perfect example of how an entire corporate structure can crumble due in part to internal forces. Its depressed workforce was just one more nail in its coffin as it implemented desperate strategies, such as removing its commission-based sales structure in 2002, and, toward the end of its run, laying off thousands of high-performing, seasoned workers in favor of inexperienced, "cheaper" ones.  Circuit City's lack of happy, motivated employees who could provide exemplary customer service left the company with no edge over its many rivals -- particularly the disruptive online competition.

Melding the art and the science of investing is an extremely defensive and often successful way to invest. The art is just as important as the science when you're pursuing high long-term returns. Focusing on culture is by no means a waste of time: It helps build strong corporate foundations and winning stocks.

Check back at Fool.com for more of Alyce Lomax's columns on environmental, social, and governance issues.

Editor's note: This story has been corrected to reflect that Circuit City removed its commission-based sales structure in 2002.