Introduction: What is lean manufacturing?
Some weeks ago, Larry Culp, chairman and CEO of General Electric (GE, Financial), was hosted by Southeastern Asset Management's Vice Chairman Staley Cates in an interview focused on lean manufacturing principles and culture.
Before becoming CEO of GE, Culp was president and CEO of Danaher from 2000 to 2014. During this time, both the company's revenue and stock price went up five-fold. His secret sauce is the lean approach to manufacturing.
This discussion will explore how some of the lean culture principles can be applied to our value investing framework.
The parallelism between those two apparently distant scopes will become more evident once we get deep down into what lean actually means.
When asked about the best definition of lean manufacturing, Culp said:
"The definition that I like to use to start any lean conversation is one I developed in trying to bring order to a lot that sits under the lean umbrella. It's four simple words: common sense vigorously applied."
Culp goes on to say that almost everything he learned about lean comes from the famous Toyota Production System. Over the years, that system evolved to include much more than a manufacturing tool that helps to achieve better production metrics. Lean principles also can be applied to something intangible like services, and to non-manufacturing aspects of the corporate life.
He also stresses the concept that, for him, lean is "a comprehensive way to run a business and ultimately to shape a culture."
This is arguable a crucial aspect both of lean and value investing. Indeed, in both environments, culture (that is the way you think about things) is more important than processes.
Your investment process should derive from your beliefs and philosophy, not the opposite; so, it must be a dynamic process, continuously subject to revision and reality checks, instead of a static set of rules to comply with.
Culp added that the lean process is designed to drive business results. Everything that is not achieving that target could be just too theoretical, even if it sounds good reading about it and teaching it to your team.
The same holds with our investment process: it could be a set of very elegant rules and, in the case of investment managers, this can also be seen as beneficial when communicating with their investors community, but if it does't produce measurable results in the long term, it's either just words or something they're not really seriously applying.
Let's now see what is Lean manufacturing really made of.
Here's how Culp defines lean principles:
" [..] at its core, I think there are three fundamental and important principles: one, a maniacal focus on the customer; two, waste elimination at every turn; and three, what the Japanese call Kaizen or this commitment to continuous improvement that never ever ends."
Customer and root cause focus
Referring to customer focus, Culp says that one of the most important things is acknowledging problems, as opposed to being not aware, ignoring or, even worse, hiding them.
In the engineering world, everything starts with understanding root causes: if you don't get a sense of what is the real issue, you can't solve anything.
He says that, usually, in a typical company, "messengers have gotten shot," meaning that senior management doesn't like people carrying bad news. The direct consequence of this behavior is that people who really care about their work and know where the problems are start to avoid speaking up as they fear this will have bad consequences on their career.
This is a typical example of cultural issue. Culp has been busy trying to instill the right attitude since day one at GE. Nobody is punished for speaking up, but every discovered issue is welcomed and taken care of. It could be a problem the company has directly with a customer or a product issue the customer is not yet aware of. In either case, the sooner it pops up, the better.
If we think to our portfolio as a set of businesses we own (even if usually we don't have any way to influence them), admitting our mistakes and being focused on what goes wrong is also very important.
Learning from our mistakes can change the course of our long term investment result in a very significant way.
Moreover, drilling down on the "root cause" of our holding's problems means avoiding to fall too much in love with our best ideas and being always very critical on them, continuously checking if our investment thesis still holds and trying to "kill" them with several stress scenarios, even if they have a low probability. Probability is not the only thing to consider when analyzing risk: the degree of a negative impact associated with those events must also be considered.
Just as lean pratictioners get down to "gemba," which Culp translates from Japanese as the place where "the real work gets done," we as investors should not be content with Wall Street headlines or an investment advice easily pronounced in a TV show. We need to browse the company website, download reports and SEC filings and get an understanding of what really makes the company's heart beat.
Waste elimination
Lean manufacturing's waste elimination principle is one of the core aspects of this methodology.
Waste can come in many forms. It can be a too high inventory or a manufacturing machine or a group of employees who are temporarily idle. Culp and his team are so manic about eliminating waste, that they even count the words in their prepared remarks before an earnings call.
One important strategy is that of creating a value stream map that helps to visualize all the aspects of the process and identify where the blocking parts actually are.
In managing a stock portfolio, we can also identify waste, defining as anything that can potentially harm our investment results.
It can be a stock for which our investment thesis does not hold anymore (because, for example, we misjudged it) and that we don't want to remove from our portfolio, either because it's bleeding red ink or because we don't want to admit being wrong about it with our investment partners or to ourselves.
It can also be a successful investment that we don´t want to sell because we fell so in love with it (maybe it compounded nicely and it's now a substantial part of our portfolio) that we're reluctant to admit that its price is extremely overvalued compared to the intrinsic value of the company.
Finally, it can be a company for which exists (maybe in the same sector or market) a much better alternative, so it's about better managing the opportunity cost of holding on with anything that is suboptimal.
Continuous improvement
The third principle of lean manufacturing is aimed at maintaining the advantages obtained with the first two principles and making them sustainable over time.
This can mean testing your products continuously in order to detect any regression (that is, loss of quality or performances compared to the previous situation) when adding new features or modifications to the product. We need to make sure to get incremental improvements, so every change to our process must ensure that the benefits obtained in the past are not lost over time.
Moreover, continuous improvement also means being always focused on what can be done in a better or more efficient way. This is a permanent activity, so it depends on having an inquisitive attitude on what you can improve day by day.
In investing, this kind of approach is also producing better results. It's not enough to learn new investment concepts and apply them sporadically, but we need to make sure they get integrated into our investment framework and continue to produce their positive effect in the long run.
For example, consistently applying our quantitative filters across the investable spectrum will ensure that we dedicate our time to only analyze companies that have surpassed a minimum amount of checks, as opposed to spending too much time on low-quality companies.
Continuous improvement also means being open to changes in the environment in which we operate. Our basic investing principles will not change, but we should not ignore micro or macroeconomic events and developments, especially when there's evidence that they will have an impact on our portfolio. As the world changes, we should make the necessary adjustments to make sure that the risk profile of our holdings is still adequate.
Lastly, when asked on how to understand if lean manufacturing is actually working, Culp replied:
"I think at the end of the day, since it's not about the process, but about the results, real organic growth, operating margin expansion and free cash generation to me are really good ways every 90 days to see if these approaches, these tools, are being applied with effect."
Here the parallelism is straightforward: every company which is intelligently applying a lean approach to manufacturing and to its corporate culture will produce measurable financial results (apart from the ones they can only measure with internal metrics) and consequently better results for its investors.
Conclusion
Southeastern Asset Management's interview with Culp is an interesting take on the principles of lean manufacturing, which can help us to explain why General Electric's CEO has been so successful in the past.
The same common sense principles can conveniently be applied to our investment process and help us to see how to improve the way we're managing our portfolio (or that of our investment partners).
As Charlie Munger (Trades, Portfolio) has repeatedly taught us, investment wisdom can (and should) be also found in environment and scopes different from the stock market.
Disclosure: The author owns shares of General Electric.
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