SEPTEMBER 2019

Capitalizing Culture As An Asset

Category: Investment Research

Alex Chown, Reserach Associate, Athena Capital AdvisorsBy Alex Chown, CFA, Research Associate

“Can a great culture survive a poor strategy?  At the extreme of poor performance over a long period of time, probably not. But… it can help an organization bridge a period of poor performance while it seeks more successful strategies.

Can an organization with a great strategy or product survive a dysfunctional culture?  Perhaps for a time. But dysfunctional culture drives away talent. To the extent that talent is critical to the long-term success of a strategy, eventually that combination must fail.”
-James Heskett, author of The Culture Cycle

My least favorite course as an undergraduate business major was OB221: Organizational Behavior. Without a calculation in sight, the qualitative emphasis of the material was too abstract for my liking. As I transitioned from student to investment professional, it didn’t take long to realize many of my new peers shared a similar sentiment.

In my years of speaking with equity analysts about individual companies, every conversation has referenced a balance sheet, income statement, or cash flow metric. On the converse, very few of these analysts have ever discussed OB221 syllabus topics such as organizational charts, mission statements, company values, or the catch-all terminology of culture. Unsurprisingly, investment professionals traditionally consider these “softer” characteristics as ancillary to financial assessments.

In an industry focused on developing variant perceptions, most investors tend to create variance through interpretations of quantifiable metrics – brushing off the intangible factors as less consequential for financial success. Investors will acknowledge “culture is important” if you ask them directly, but without a defined framework for measurement, culture assessments are noticeably absent from the typical marketing materials and stock pitches.

The Culture CycleNeedless to say, I was hesitant when I started reading The Culture Cycle by James Heskett, as these types of organizational profiles are usually filled with more “fluff” than actionable takeaways. I was expecting platitudes such as ‘companies should adapt a culture of “fun and creativity” like Google while also being “hard working and meritocratic” like Goldman Sachs.’ Recommendations that are seemingly obvious—but near impossible to implement. Thankfully, Heskett doesn’t force this narrative upon the reader, but rather refreshingly embraces the notion that an examination of why and how culture matters is an inexact science. In his approach, he doesn’t attempt to bundle the strengths of various cultures into a “one-size fits all package.” Instead, he makes the claim that different culture profiles work for different strategic objectives. When alignment occurs, it creates a virtuous loop, and in Heskett’s perspective, this culture cycle has a material and often calculable effect on the bottom-line.

“A healthy culture, if it “fits” within an organization’s strategy and how that strategy is executed, produces remarkable results. It is characterized by a high degree of employee and customer satisfaction, loyalty, engagement, and ownership that in time produce growth and profit. In addition, it confirms and reinforces the “rightness” of a set of shared assumptions and values, triggering another turn of the culture cycle.” –James Heskett

Under this framework, one can begin to view an alignment between a company’s culture and its competitive advantage as an asset. An asset you know exists but is near impossible to quantify. Given the inexact science of linking culture with bottom-line performance (and the general aversion traditional investors have in doing so) means that most investors overlook and underappreciate the asset of a healthy culture—potentially giving an advantage to those that do.

I recently walked through this approach with a few investment firms that explicitly consider culture assessments a core tenet of their investment philosophy. During these conversations, we discussed examples of companies with aligned cultures and competitive moats, and how this alignment allows these companies to sustain above average rates of return. A few of these examples included:

  1. A railroad, where a culture of timeliness, efficiency, and safety results in a service that customers can count on for all the same reasons.
  2. A provider of online merchant software, where a growth-driven culture only celebrates when smaller merchants grow into larger merchants (as opposed to getting larger initial contracts), helping the company become the premier software supplier for retailers of all sizes.
  3. A precision instruments manufacturer, where an innovation-led culture that stresses “not going the escape route,” has organically developed a line of high-quality, recurring revenue products, and has thus become the dominant market share player with virtually no M&A.

While these companies operate in separate industries, have dissimilar organizational structures, and attract talent with relatively different skillsets, the key similarity is that each of their respective cultures matches that of their competitive advantages. The railroad is efficient, the software provider scales, and the instruments manufacturer is innovative. However, the respective strengths of each company are not necessarily appropriate or portable to the others. Does it make sense for a railroad to prioritize innovation in the 21st century? Should a high growth software firm ignore M&A opportunities? How does a manufacturer’s emphasis on timeliness affect the product’s precision? Whether each culture is “right” or “wrong” is somewhat irrelevant, as the important pattern to recognize is that the internal culture fits with the external strategic objectives.

In Heskett’s perspective, an alignment with the end-goal is an essential component in creating a healthy culture. But as the excerpt at the beginning of this passage illustrates, a healthy culture in isolation cannot work without an effective strategy, product, or service. The inverse of this statement is thought-provoking as well. If a healthy culture gets capitalized as an asset, should a dysfunctional culture be viewed as a liability? While The Culture Cycle provides various quantification techniques, the main takeaway for investors is to look for an alignment between the organization’s defining attributes and its competitive positioning. In my experience, most overlook these considerations given the perceived degree of subjectivity.  However, investors who establish a framework to establish a link between culture and the bottom-line, potentially gain an edge in assessing an organization’s directional success or failure. Given this realization, it might be time to dig up my old OB221 notebook.

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