Focusing on the mother of all fundamentals

Investors analyse "fundamentals", factors that determine the profitability of a businesses. In the final analysis, though, Richard Beddard believes there is only one fundamental that matters.

I am guessing I am not unusual in reflecting at this time of year: thinking about how things have gone, and whether I could do anything better in the year ahead. 

Although I didn't explicitly frame it as a resolution, last year I turned my attention to my sources, attempting to get closer to the truth about how businesses make money by listening to customers, suppliers, competitors, regulators and trade bodies for example.

The year before I resolved to stop thinking of businesses as though they are stuck in the moment I analyse them, and focus on how they are changing, principally through the lens of profitability. By understanding what has affected profitability in the past, we can better understand what might happen in future.

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An earlier resolution required me to visit more Annual General Meetings, every investor's opportunity to shake the hand, look into the eyes, and most importantly ask questions of the men and women who we trust to grow a portion of our future wealth.

Thankfully, these resolutions have stuck with me. I still try to go to the Annual General Meeting of every company that I own shares in at least once, I still incorporate my expectations of future profitability into my calculations. And, tricky though it is, I substantiate the impressions I get of businesses by talking to the people who deal with them, and reading what they say.

There is a unifying theme in my New Year's resolutions, which is to better understand the businesses that will one day fund my retirement. That is because I want to make sure my money will earn a sufficient return, but a happy by-product is I am also making sure these are firms I want to do well.

I was thinking about this bigger picture while reading an interview with the outgoing boss of a huge American railroad company in Railway Age. I am not a trainspotter or moonlighting as a researcher for Have I Got News for You, so you may be wondering why I was interested in the views of this person. 

When Berkshire Hathaway bought BNSF, the railroad, in 2009, it was big news. Berkshire Hathaway, perhaps the world's most feted investment company, run by Warren Buffett, probably the world's most famous investor, had just made its biggest ever investment. Matt Rose, BNSF's boss, had already been running the railroad for nine years. Since Buffett's method is to buy good businesses and let the managers get on with running them, his continuing faith in Rose is tantamount to an endorsement. Rose's reflections on his long and successful career would probably make interesting reading.

Asked whether he thought the investment industry's focus on shareholder value (aka relentless pressure to increase the share price) is overdone, Rose replied:

"Yes. We've always looked at the value proposition of the railroad as a three-legged stool. Shareholders are a very important leg of that stool because they provide the capital for us to make investments. The second leg of the stool is the employees. They provide the services that allow us to make the investments that allow us to make the returns to provide to the shareholders. And then finally, there are the customers. People are always asking, 'What's the most important?' Well, they're all important. And if you think about a three-legged stool, if one of those legs gets a little out of whack, things don't work very well."

Now, I think analogies with three legged stools are overdone. Four legged stools are much more common and much more stable, but they are still destabilised if one of the legs is out of whack. So while Rose is essentially right, I think a value proposition with four legs is much stronger, so long as they are all in whack (if that is a thing). The missing leg in Rose's analogy is suppliers, they provide the products and services required for the company to operate. 

This year my resolution is to be more rigorous in my investigations into corporate culture, how companies treat their employees, and how those employees treat customers, suppliers and shareholders. This is a big challenge, but probably worth it. A company's culture is the foundation of its strategy, how it will make more money, and therefore its profitability -  but companies do not often write much about their cultures, and we cannot easily quantify them. 

For inspiration, I am reaching for a book that has been lying on my desk for much of the year: Intelligent Fanatics: Standing on the Shoulders of Giants. It is a collection of case studies of corporate leaders who turned small businesses into really big ones, and an attempt to distil common factors that might explain how they did it. It is a sequel to a different collection of case studies gathered for the same purpose: Intelligent Fanatics Project, which I reviewed in August 2017.

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At the risk of overloading a perfectly good metaphor by screwing in two additional legs, the authors say intelligent fanatics treat: 

"...each of their business relationships as equals. In other words, they set up win-win, mutually beneficial relationships with customers, shareholders, employees, communities, suppliers and the government."

Even if it were possible to build a business around exploitative relationships, by mistreating some or all of these stakeholders, I would be uncomfortable prospering from it. Happily, though, I think Jim Sinegal, co-founder of Costco and quoted in the book, was right when he said:

"This is not altruism, it is good business."

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.