Someone emailed me this question:
“How do you determine whether the management team in a company is cost conscious so [it] will take action (reduce cost) once the company’s sales slow down?
“For example, in a company that had reduced sales in a year, however in that year [its] cost/expenses (SGA expenses) are going up compared to previous year.
“Can you take a conclusion/judgment that the management of the company is not cost conscious (bad management) just from that year?”
No. You can’t conclude that management is not cost conscious – or that the management team is bad – from just one year’s results.
It’s not necessarily a good idea to cut costs because of a one-year change in sales. There is some tension between reporting the highest possible profit – and the highest possible margin – this year and getting a good long-term result. A technology company can cut R&D this year and post higher earnings and lower expenses. That may not be a good choice. A company that’s dependent on its brand image could cut its advertising expenses this year and report higher profits.
There’s a U.K. company called Howden Joinery (LSE:HWDN, Financial). That company’s new depots – they sell materials to customers who do remodeling type construction work – lose money for their first year or two of operation. Each depot is very profitable over five or 10 years. It earns an excellent return on the initial investment and endures early operating losses to get the local customer base it needs to succeed.
In the case of Howden Joinery, management could always report higher earnings this year by not opening depots instead of opening them. The long-term result – three to five years down the road – would be worse if it didn’t open new depots today. But it would have better earnings this year if it stopped growing.
The same is always true for companies like GEICO and Progressive (PGR, Financial). GEICO and Progressive have high customer acquisition costs. However, customer retention rates in the auto insurance industry are high. It’s not at all unusual to retain 80% to 90% of your policies from year to year. If you acquire a customer today, you may be able to reliably keep that policy for five to 10 years without additional marketing expense. The easiest way for GEICO or Progressive to report the best earnings this year is simply to stop trying to get any new customers. That would be a mistake.
The thing you really want to look at is the corporate culture. Is it cost conscious? In particular, is there an awareness of the difference between costs that benefit the customer and costs that don’t? When I was writing a stock newsletter, I picked a Texas bank called Prosperity (PB, Financial). In that issue, I wrote a little about a particular incident when the chief financial officer (CFO) of Prosperity and the head of a bank that Prosperity had acquired got into an argument. The argument was about whether certain expenses at the office were there to benefit customers or to benefit employees. The CFO was fine with expenses that could be justified from the perspective of improving the customer’s satisfaction. He was not fine with even the smallest expenses that only benefited employee satisfaction.
This is a common trait of most cost-conscious cultures. There is some tension in the relationship between a company’s management, its shareholders, its employees and its customers. The more a company is run to benefit its management, its employees and its customers the less it is being run to benefit its shareholders. Many times, this is not a zero-sum game. In fact, long-term shareholders will often benefit from extra costs which are meant to benefit a company’s customers. What about employees? A lot of companies – especially tech companies – argue that added expenses that improve a company’s ability to attract and retain employees are justified. That’s rarely ever the case.
There can be situations where reducing employee turnover is important. But that will tend to be true for very, very low-paying jobs. The companies that will benefit most from improving employee satisfaction are companies like Starbucks (SBUX, Financial), Costco (COST, Financial), Whole Foods (WFM, Financial), Chipotle (CMG, Financial), etc. When those companies make arguments that they need to invest in certain programs to improve the retention of newly hired employees – to reduce quit rates – I’m open to that argument on the economic merits. Quit rates are very, very high for certain kinds of work. For example, at full-service restaurants, the cost of employees quitting or being fired who were hired within the last year is a very meaningful expense.
There are search costs, there are training costs, etc. In some cases, an employee who might only receive something like $20,000 in wages in a year could conceivably be costing the employer more like $22,000 in all sorts of expenses related to hiring, training, getting rid of the employee (one way or the other) and controlling the employee's behavior. In addition, you have – especially at many low-paying customer facing jobs – costs related to absenteeism, theft, etc. There are companies where a couple percent of sales are lost to theft of some kind, and probably half that amount is caused by employees rather than customers. If you are running a supermarket or a pet supply store or a restaurant or a Walmart (WMT, Financial) – I would agree with the argument that it’s worth investing in testing out ways to increase the retention and satisfaction of employees.
What about highly paid employees?
I’m very skeptical that spending money to improve the retention of highly paid employees is a good idea. Increasing pay, benefits, etc., to highly paid employees is sometimes counterproductive. For one thing, at high levels of pay, you won’t reduce the quit rate – you’ll actually encourage quitting. No amount of additional pay and benefits at the low end will remove the need for low-paying employees to stay employed with you to maintain even the barest minimum of their standard of living. At the high end, it’s pretty difficult to argue that higher pay would really help retain employees. There is also competition for employees. So, the more you give your employees the more you encourage your competitors to do the same. You can create a situation where all the employers in your industry progressively give more and more to employees – but get no benefit from doing so. It’s simply the cost of doing business to match what competing employers are offering.
As a rule, most companies spend too much time worrying about their employees and not enough time worrying about their customers. You’re paying your employees to be there. And labor is a commodity that is widely available in a country like the U.S. If I had to choose between a company with really poor employee retention but really great customer retention and a company with really great employee retention but really poor customer retention – I’d pick the company that favors customers over employees every time.
For shareholders, there’s a very real danger of corporate “capture” from management or from employees. A corporation can end up being run largely for the benefit of top management or largely for the benefit of the rank-and-file employees. These groups have huge stakes in how the company is run, and it is in their interest to try to control the organization and shape it to their benefit. Overpaid management, underworked employees or a unionized workplace can be bad for shareholders, and it can be hard to root out the existing culture and focus more on maximizing profits.
I don’t mean this to be an anti-worker argument. At many public companies, top management is also a big competitor with shareholders for how spoils are shared. I’ve seen companies where all the top positions are held by family members who are paid two to five times more than a nonfamily member would cost. Obviously, this is a form of corporate capture where the business is being run to benefit the family. The same thing can happen with professional managers, a union, etc. At ad agencies and investment banks, shareholders almost always rank well behind the top-performing employees at the firm.
These are the kinds of costs you have to be careful about. What we’re talking about are long-standing trends of overcompensation, underutilization and even sometimes paternalistic tendencies. In the U.S., the last situation is rare. But it does sometimes happen in monopoly situations. I have seen companies that have had monopoly power in their markets and have become accustomed to never firing anyone ever. Honestly, the more pricing power a company has – the harder it is to know how efficiently it's run. Can you really tell whether Moody’s (MCO, Financial) is efficiently run? No.
There are industries where cost consciousness is obvious though. The classic example is banking. Banking is a really weird industry in that it is difficult – at least in the U.S. – for one bank to ever take a customer from another bank no matter how much better run it is. You can have two banks in the same state or even the same town and one of those banks can be much, much more efficiently run. The result though is not that the efficient bank will – as in retail or airlines or something similar – end up gobbling market share year after year. What will happen with a bank is that the more efficiently run bank will just have a higher return on assets and equity. However, both banks will have surplus earnings every year. The better run bank will just be in a position to pay a higher dividend or buy back stock.
Two banks can exist alongside each other for decades with the same market share year after year even though one bank is a lot more efficient than the other. Lower costs allow for lower prices. But lower prices – or higher interest rates on deposits, etc. – aren’t really effective in causing customer defections in the banking industry. Basically, if you have a bank and you’re satisfied with that bank – you’re not going to switch banks. That’s not true in retail. It’s not true in airlines. Even if you are a satisfied Southwest Airlines (LUV, Financial) customer, a $400 fare from American Airlines (AAL, Financial) on a flight where Southwest is charging $600 will be: a) something you search for and are aware of and b) enough of an incentive to get you to switch your flight plans.
What we’re talking about here is the difference between “necessary” and “sufficient.” For one company to put price pressure on another company long term, it is necessary that it be in a better cost position. It has to be cost conscious.
It is not “sufficient” to have just the ability to undercut a competitor. You also have to have the will to undercut the competitor on price. In cases where customers make decisions based almost entirely on price, you will undercut the competitor. But in cases where it is difficult to dislodge a customer from an existing relationship with your competitor, the situation is more complicated. It’s actually easier for you to be lax about costs.
Where there’s competitive pressure forcing you to push down your costs in order to push down your prices in order to keep market share – you’ll do that almost instinctively. What about situations where you could reduce costs and thereby benefit the owner of the business with more profits – but where you wouldn’t gain much (or any) market share?
That’s where corporate culture is so important. I can’t stress this enough when looking at banks. If you can find a bank where the management team is absolutely fanatical about making sure that every cost that can be wrung out of the organization is wrung out of the organization – you should buy that bank. A bank that is devoted to constantly driving down costs is going to be a much more lucrative long-term investment than a bank that is only going to cut its costs when there is a competitive reason to do so.
Honestly, cost reductions are usually the result of competitive pressure. Most companies cut costs because of external pressure to do so. Very few companies are able to internally create a driving force to find the maximum possible efficiency when there’s no external pressure to do so. Companies in the best competitive position are often the most lax about efficiency within the organization.
This is something Warren Buffett (Trades, Portfolio) has talked about. You can read his early shareholder letters where he talks about the bank in Rockford that Berkshire (BRK.A)(BRK.B) owned. A big reason for owning that bank was the person running it. He was obsessed with getting the highest possible return on assets for the bank even when there wasn’t a lot of external pressure forcing him to find expense reductions.
This is also the reason why 3G has been so successful. 3G’s investment strategy has been to take control of companies that have  obviously strong competitive positions but also have not been run as efficiently as they could be. Often, the return on equity at these companies is already high. They don’t look inefficient, but that’s just because their competitive positions are so strong they have historically been run inefficiently and still made much more money than companies with weak competitive positions that were run more efficiently. Companies in weak competitive positions must be run efficiently to survive. Companies with strong competitive positons will survive even if they are badly managed.
No, you can’t tell whether a company’s management is cost conscious from one year’s results. You have to look at the spending priorities and whether it focuses on pleasing employees or customers. You have to look at whether it is making long-term investments in new stores, R&D and advertising.
Finally, you want to look for those rare companies where management is putting internal pressure on the organization to see how efficiently the business can be run even when competitors aren’t in a position to force the company to be efficient just to survive.
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