Company management, if they have a worthwhile ambition, it’s this one; to turn their businesses into world-class operations.
The reality is that few companies attain world-class status. Foreign companies that have achieved this feat include, Google, Intel, Toyota Motor and Walmart. Australian companies that have this standing include BHP Billiton, Domino’s Pizza Enterprises, Macquarie and Seek. What are the ingredients that led to success for these companies? Can other companies replicate them?
Answering these questions involves looking at the role of management and at company economics, among other things. The core answer, though, can be drilled down to what a company’s competitive advantage is and how management can exploit and sustain this winning attribute. It sounds simple. But it’s not.
Companies, to be sure, can have a sustainable competitive advantage and be second rate if they are monopolies or oligopolies that are protected by government fiat. Not all world-class companies display every attribute of a world-class company. World beaters can fade away. Being world class would prove beyond most companies because their industries are too open to newcomers. Nonetheless, aiming to become world class is a worthwhile goal for management teams. Even if they fall short, they are bound to improve their companies (and make them better investments) because aiming to be top notch means trying to be good in absolute, not just relative, terms.
So how do management teams turn a company into a world beater; one that can be so different from peers that it is often even hard to classify with others? Management teams have two underlying tasks. Their first duty is to choose where to compete. World-class companies find something they are skilled at and keep doing it. Walmart became the world’s biggest retailer by keeping prices as low as possible. To fulfil that goal, the Arkansas-based company became expert at volume selling. This meant Walmart had to maximise economies of scale, a task that included wielding market power to bargain down suppliers and becoming efficient at managing supply.
Walmart is unlikely to have stayed world class if it had ventured into luxury goods. Management would have been lost. Thus management teams need to understand that to step away from their strengths adds risk. The safest path to world-class status is to invest incrementally in the same successful business model and expand within the same country where the competitive position is known and similar throughout. The opposite, and thus riskier, approach would be to pursue different business models that come with varying levels of competitive advantage in different countries funded by a one-off, large investment (often done via takeovers).
Companies can expand in a low-risk way between these extremes if they venture into businesses that sit adjacent to their core operations. Macquarie’s rise to eminence is because it is one such “master of migration” into familiar but untrodden territory. The financial company’s success is built on its ability to spot unexploited but fleeting opportunities in related areas. It is capable of managing the risk because it is not venturing far from its core expertise. An example would be Macquarie’s corporate-finance division’s expansion into premium funding, which is about helping companies find cost-effective ways to pay insurance premiums monthly rather than annually.
The second obligation of management teams is to be the best in their field over the long term. It almost doesn’t need to be said but world-class management teams execute well. They plan, do, act and check in an expert fashion, driven by a desire to improve continuously. They understand that dominating their industry will generate reliable earnings growth and a higher share price over the long term. Second-rate companies tend to succumb to short-term temptations to prop up their share price, which can distract from long-term earnings growth. As they say; deliver the ‘E’ and the ‘PE’ will take care of itself.
Management teams can only become No.1 if they create a world-class culture, have a consistent operating framework and focus on what they can control. Google’s founders stirred much controversy in 2004 when the pair unveiled the moto, “Don’t be evil”, which was basically a provocative way to state the values of the company; that the duo didn’t care about maximising the short-term worth of their stock but would focus instead on the long-term welfare of their customers.[1] This attitude is still helping Google retain its world-class status.
Not by the textbook
Another helpful way to ponder how companies can attain world-class grading is to consider the role of companies within micro-economic theory, which is the study of the agents within an economy. The purpose of this exercise, ironically, is to find companies that defy the textbooks.
In the perfect world on which much economic theory is based, no company makes bumper profits for too long. Others see the jumbo returns and enter the industry to grab their share of the gains on offer. In theory, new competitors will enter the industry until returns decline to match the cost of capital. In the real world, companies stave off competitors with what Warren Buffett calls moats. Moats are basically anything that protects mega returns.
So how can companies enjoy the wealth-generating luxury of being protected by a moat? Four ways, to generalise. The first is by owning a scarce asset such as Sydney Airport’s Sydney airport. Another way is for the company to earn so much kudos by impressing enough customers over time that its brand becomes a moat. McDonalds achieved this feat in the 1960s because its golden arches stood for clean toilets and cheap and quick food for those travelling on US highways. The Apple brand merits this eminence these days due to its talent for designing and marketing devices that have changed daily habits. Thirdly, captured innovation, such as patented intellectual property, is a moat for it signifies copious returns if the invention is popular enough. Think Cochlear’s ear implant and Apple’s iPad. Lastly, and perhaps under-recognised (and not due to management efforts), an inert customer base can be a moat. The insurance industry enjoys the commercial advantage that most people renew their policies each year without comparing competitor pricing.
The ultimate world-class company is one with an expandable moat for that allows mammoth returns to be compounded. Such stocks naturally are rare for they must monetise innovation with mass appeal (sometimes known as the “network effect”). Railways, fax machines, Microsoft Office and TripAdvisor reviews are expandable moats. Much the same way as the more popular railways and fax machines became, the more railway owners and fax makers could charge, get someone hooked to Microsoft Office, Outlook and Excel and they are more likely to buy other Microsoft products, as now-withered (and IBM-owned) Lotus Development discovered. The same goes for how the popularity of Apple’s iMessage helps sells Apple iPhones.
Seek’s success is due to its ability to deepen and widen its moat. The company benefits from the virtuous cycle that the more job listings it wins, the more job seekers it attracts to its website and the more it can charge the next companies to list vacancies. Seek has used this money-making spiral to create and expand moats in Brazil, China, Mexico and southeast Asia.
Moat busters
The innovator’s dilemma is that better technology is likely to penetrate existing technology defences before too long, and fulfil the microeconomic theory that competition will compete away bumper returns. Microsoft’s success was built on its insight that software was more valuable than hardware but the company now fights mobile devices. Sydney Airports could one day face a second airport at Badgerys Creek on the city’s western outskirts (though it has first rights to develop any airport within 100 kilometres of Sydney’s CBD). Insurance companies now confront comparison websites where their clients can easily check competitor prices, even if most don’t.
There are other threats to moats besides competition. Changes in demand due, say, to swings in taste or fashion can wreck business models, as tie makers might attest. Another threat that is not always perceived as such is changing community standards for it means that what worked yesterday won’t protect a company today. One example of shifting standards is society’s higher expectations for safer employment conditions. In the 1950s, deaths in mining were considered an accepted risk of the industry. But that changed over time. As community expectations morphed, BHP Billiton and Rio Tinto realised they would be hounded out of business if they didn’t improve worker safety. Their greater focus on safety helped mining-related fatalities in Western Australia drop from 142 in the 1950s to 42 in the 2000s, even though the mining workforce and production soared over those five decades. Another example of a moat-eroding change in society norms is the McDonald’s struggle to adapt to the trend away from fast food towards healthier eating.
The challenge for world-class companies is to defend their moats by boosting their standards; to improve their absolute capability to maintain their relative advantage. Seek’s co-founder Paul Bassat likes to say that companies that disrupt industries based on technology are likely to get disrupted themselves. But, he says, a company that disrupts by providing a better user experience is more likely to endure. Don Meij, the CEO, MD and driving force behind Domino’s Pizza, is an expert at latching onto new technology to stretch internal standards and to keep competitors at bay. His latest innovation is to invest in an uber-style tracker that allows customers to see how soon their pizzas will be delivered (and lets the company check if drivers are loafing). Meij understands another ingredient of world-class companies: don’t just chase high returns; lower but longer-lasting excess returns may be more valuable over the longer term.
The ultimate world-class companies are those that disrupt themselves. World champions understand the life cycles of their industry and the size of and duration of their abnormal returns. Management at software-services companies need to recognise that their moats have a shorter duration than those protecting household and personal products or Telstra’s copper network. And the best ones do – and act accordingly. Intel founder Andy Grove recounts how in 1985 he asked Intel’s then chairman and CEO Gordon Moore: ‘“If we got kicked out and the board brought in a new CEO, what do you think he would do?’ Gordon answered without hesitation, ‘He would get us out of memories.’ I stared at him, numb, then said, ‘Why shouldn’t you and I walk out the door, come back and do it ourselves.’”[2] So they did, moving into microprocessors and other computer components with even more success. Such insight, backed by skill, wrapped up in praiseworthy ambition.

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Originally published by Fidelity