Friday, November 11, 2011

Beyond The Financials

Value investors, myself included, tend to prefer financials to "stories" about why a stock should outperform. But good financials are often the result of policies instituted by management that are not as easy to measure and compare as are financials. Investors who can identify companies on this basis have an opportunity to profit before the financials of said companies betray their success, resulting in extraordinary gains.

Philip Fisher was a pioneer who espoused methods of identifying such companies. (His book on the subject is available here, and a summary of all ten chapters of that book is available here.) Fisher's success in this regard brought him outstanding investment returns, and paved the way for Warren Buffett in this area, who calls his investing style 85% Graham and 15% Fisher.

One important aspect that distinguishes successful companies from also-rans is a corporate culture that encourages strong, co-operative relations between labour and management. In this way, employees are constantly striving for improved productivity, which leads to the success of the entire company.

How is this accomplished? Employee creativity and innovation should be rewarded. Decision-making responsibility should be made by individual units, rather than from the centralized, executive offices, making employees accountable but also rewarding them for success. The organizational structure should be flat (as opposed to a deep, hierarchical organization), leading to better communication between managers and workers, fewer bureaucratic layers, and a more nimble company. Employees should share in profits and should be trained across functions, resulting in a more flexible work force that takes an ownership rather than an employee view of their companies.

These features may indeed make a company stronger than its competition, but how can an investor ascertain these internal company workings? Obviously, poor labour relations will result in very public strikes. But Fisher recommends going beyond the public realm in order to determine how a company works. His scuttlebutt method seeks to answer whether the company has a long-term focus, how strong labour/executive relations are, how deep is management's talent pool, and other questions critical to a company's success.

As an example, such methods could probably have been applied to differentiate Southwest Airlines (LUV) and WestJet (WJA) from their unionized competition, long before their relative financial success was ever realized. (It should be noted that this is not an attempt to bash unions. Often times, companies will get the unions they deserve; but this results in an adversarial, rather than co-operative relationship between management and labour. By implementing the policies described above, however, employees will have no need for unions.)

Value investors cannot ignore company financials. But they can do quality, qualitative legwork to determine if strong financial results are sustainable or are subject to competitive erosion.

Disclosure: None

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