Why Fairness is the Most Sustainable Competitive Advantage: Part III

“The worship of premium pricing always creates a market for the competitor. And high profit margins do not equal maximum profits. Total profit is profit margin multiplied by turnover. Maximum profit is thus obtained by the profit margin that yields the largest total profit flow”  Peter Drucker: #1 of his 5 deadly business sins

Bill Gurley – a highly successful venture capital investor, and blogger- wrote a piece called  The Rake Too Far, discussing the optimal pricing strategy for internet platforms. The “FANG’s” (Facebook, Amazon, Netflix, Google) are the most famous variants of these business models today.

So what does he mean by “The Rake Too Far”?

Taken from the casino industry, the “rake” is the share that a player must pay the house to participate. It’s what you have to pay to play. The more attractive the game is, the more tempting it is for the house to increase their rake.

Bringing it back to internet platforms, you can imagine that given the huge network effects and potential for global scale the internet can offer, it must be very tempting for a successful platform to increase its rake. As Gurley explains though, this can be exactly the wrong thing to do if you want to build the most profitable business model.

“There is a big difference between what you can extract and what you should extract”  Bill Gurley

When the world is your oyster (i.e. you have a scalable platform and a very large addressable market) the key goal should be to minimise transaction friction. The rake is a form of friction. Too much friction and transaction volume will fall. Alternatives will be sought. It may be very difficult to find an alternative, but as I mentioned in my previous blogs in this series (Part I and Part II), unhappy customers are spring loaded to go elsewhere when they are being taken advantage of.

“A sustainable platform or marketplace is one where the value of being in the network clearly outshines the transactional costs charged for being in the network…. Everyone wins in this scenario, but particularly the platform provider. A high rake will allow you to achieve larger revenues faster, but it will eventually represent a strategic red flag – a pricing umbrella that can be exploited by others in the ecosystem, perhaps by someone with a more disruptive business model.”   Bill Gurley

Whilst the rake charged by many internet platforms is high (often 20-30%), the most extreme example highlighted by Bill Gurley (in this table below from 2013) is Shutterstock, which took an astounding 70% rake from its customers in 2013.

Source: Above the Crowds: A Rake Too Far, 2013

That is vicious and the market has been equally vicious in return. Gurley was spot on – looking at how this has played out, there seems to be clear link between excessive rake and platform failure. Whilst Apple’s iOS remains a dominant platform, it could arguably have been a much larger portion of Apple’s profits (whilst also more effectively containing competition from Amazon and Google) had they not been so greedy with their unnegotiable 30% rake. Note, OpenTable was acquired by Priceline (now called Booking Holdings) in 2014 at a 46% premium.

Source: Factset

Greed is obviously not good. Building a sustainable business and maximising your total profits and returns over the long-term requires fairness and respect for your customer. These are valuable lessons for any business manager or investor. This might seem obvious but the key point is that it’s actually very difficult, and is thus a way for companies and investors to differentiate themselves. It requires the courage to think strategically (i.e. long-term) rather than thinking tactically (i.e. short-term). Long-term sustainable thinking involves sacrificing near-term profitability to maximise total profitability in the long-run. Gouging your customer is a risky business, as is chasing short-term returns if you are an investor.  Perhaps it is best summed up by a pithy quote from the disruptor-in-chief and leader of the biggest platform winner in of all.

 “Your margin is my opportunity”  Jeff Besos

Previous Articles in series
Is fairness the most sustainable competitive advantage of all? Part II
Is fairness the most sustainable competitive advantage of all?

 

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience*.

*As at 30 November 2018.

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Open and Honest

Ever worked in a company that required you report ‘near miss’ events? That is, events that could have or nearly did result in an accident. The rationale is straightforward; an open reporting culture and investigating the near misses should help avoid the real thing, which at the extreme can be both fatal and catastrophic. In heavy industries where safety is critical, ‘sweating the small stuff’ is important.

Slightly different, but there are safety parallels in a recent study* which looked at whistle-blowing data from US listed companies. A requirement of many markets (for example, Sarbanes-Oxley in the US), whistle-blower systems are intended to provide a secure and anonymous means to report issues and provide an alternative to the traditional reporting and monitoring mechanisms that companies employ. And they are important, because employees, as insiders, are best placed to identify inappropriate behaviour within a company*.

What did the study find? In a nutshell, evidence of more whistle-blowers is a good thing at a company. Counterintuitively, more internal whistle-blowers doesn’t mean more (frequent or serious) problems. Rather, it showed (in US companies at least) that the more employees use internal whistleblowing hotlines, the less lawsuits companies face, and the less money they pay out in settlements. Use of whistle-blowing is actually a sign of open and effective communication channels; employees believe that problems will get sorted. Conversely, it’s not hard to imagine that when management abuse these processes (insert name of UK-listed bank here), this belief is eroded. Avoid the ‘accident’ (and the associated public relations disaster), address internally and learn from your mistakes.

And from a governance perspective, did the study identify any particular company traits? Yes. Autocratic executive management teams with governance protocols that limit minority shareholders are less likely to pay heed to these systems. As are fast growing companies (where other studies have shown that accounting misstatements are more prevalent) which is important for us to bear in mind given our focus!

Finally, remember, this is for companies in the US, a nation which psychologists and sociologists would classify as having ‘low power distance’*. Psycho-babble what? Power distance is the ‘extent to which the lower ranking individuals of a society accept and expect that power is distributed unequally’*. This been measured on a country by country basis and it has been found that many developing countries have ‘high power distance’. To stretch the safety parallels to their limits, safety stats in developing markets often look great. At face value, the data says, ‘nothing to see here’. But accidents often go unreported because employees are (more) respectful and submissive to their employer. Taiwan, India, Japan et. al all require whistle-blowing systems and processes like the US does, but I imagine the hotlines in these countries probably don’t get a lot of calls.

In case you were in any doubt, open and honest corporate cultures work best. If management teams are targeting ‘zero’ whistle-blower reports they are missing the point.

*Stubben, S. and Welch, K.T, (2018); Evidence on the Use and Efficiency of Internal Whistleblowing Systems
*Dyck, A., Morse, A., and Zingales, L. (2010); Who blows the whistle on corporate fraud?; The Journal of Finance; 65(6), 2213-2253.
*Outliers: The Story of Success; Malcolm Gladwell (2008)
*https://en.wikipedia.org/wiki/Power_distance

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.

*As at 30 November 2018.

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The (sustainable) Founder

If you’ve not seen the movie ‘The Founder’, I highly recommend it. Michael Keaton brilliantly plays the archetypal ruthless businessman Ray Kroc who is recognised as the founder of McDonalds.  This is a key scene that defines the Kroc character….. ruthless Kroc

Hollywood usually likes to portray successful businessmen in this way and whilst these types undoubtedly exist, history shows that the most successful are usually good at heart. From the philanthropy and global peace initiatives of Andrew Carnegie to the Gates Foundation of today, it’s clear that not all successful businessmen and women are bad. So we would be wise to treat negative media narratives – usually targeted at the most successful – with scepticism.

From a business perspective, successful founder CEO’s tend to have an inordinate amount of power within the companies they start. The companies often have dual-class shareholder structures and use stock based compensation liberally. None of this tends to look good on traditional governance screens and is grist to the mill for detractors. But founders invariably care about their companies in a way that a ‘corporate MBA type’ never will. They usually know their businesses better than everyone else.  They are often billionaires and are usually motivated by delivering on a long-term vision rather than the next bonus cheque.

In my experience the combination of deep business knowledge, a long-term vision and the conviction to make bold decisions tends to deliver long-term shareholder returns.  Founders use their mandate to make tough decisions. I believe they share many similarities with long-serving management teams in this respect, which I discussed in a previous soapbox. Indeed, a 2016 Harvard Business Review study found that:

‘companies which have founders as their CEOs or actively involved in running the business are more likely to make bold investments to reinvigorate and adapt their business models showing that they are willing to take more risks to invent the future’[1]

Many (maybe even most) founders also identify themselves with delivering societal value via philanthropy or deploying corporate capital towards solving meaningful social or environmental problems.  We believe this is increasingly evident in the smaller and mid cap end of the market where #SustainableDisruptors often have a product vision that is inextricably linked to sustainability. When it comes to finding sustainable investments, this is where we are focussed and that is evident in a representative Kames global sustainable equity strategy from the number of companies that are run by founders.


Source: Kames Capital, as at 31 October 2018

We’ve acknowledged that unlike Hollywood movies, most founders are probably nice guys, so I suspect this is actually one of the key factors that has led to their success. Whilst Amazon has attracted negative press attention recently (with great size comes great responsibility), I strongly suspect that Jeff Bezos is not only a business visionary and exceptional leader, but also a nice guy as well. These highlights from a Jeff Bezos 60 minutes interview in 1999 seem to suggest that anyway. It’s 12 minutes long but definitely worth a watch.

 

[1] Lee, Kim and Bae; Founder CEOs and Innovation: Evidence from S&P 500 Firms; February 2016

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience (as at 30 September 2018).

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If you believe in nothing, you fall for everything

I have some sympathy with Mike Ashley’s recent comments about how certain shareholders have treated Sports Direct.

“Sorry, what!?” I hear you say.

Bear with me, I’ll try to explain….

Loyal soapbox readers will recall we referenced Sports Direct in one of our first Soapboxes. Our comments included, A maverick CEO, who blurs his own activities with those of the company and ‘alternative retailers do not offer the same forecast EPS growth but compensate by better cash generation, less aggressive strategies and greater respect between shareholders and managers’.

It wasn’t suitable for Kames, but a number of other (active) institutional investors obviously felt the risk reward trade-off was favourable – especially if their ‘engagement’ efforts could lead to improvements in corporate governance. Good luck with that. Yes, the chairman has recently been replaced, but does anybody honestly think that Sports Direct’s governance is really changing? Engagement can be effective, especially when you are a relatively large shareholder and the company in question is receptive. But let’s be honest, engagement can also be a convenient excuse to hold something that’s a wee bit awkward to explain from an ESG perspective.

Love him or loath him, at least Mike Ashley doesn’t pretend to be something he isn’t.

And from an investment perspective, an entrepreneurial spirit is to be encouraged. However, you also have to have certain corporate governance backstops because companies (and omnipotent CEOs) occasionally try to push things through that our experience tells us don’t work (or aren’t in the interests of minority shareholders). These are the things we are never willing to support. As with most cases, “if you believe in nothing, you fall for everything” (ironically taken from the album ‘How you sell to soulless people who sold their soul’ by Public Enemy).

Our approach to reviewing the corporate governance of the companies in which we invest therefore tries to marry evidence of formal corporate governance policies (committees, independence etc.) alongside behaviours (how shareholder friendly is the company?) and always with an eye on ownership. Ideally, we want the right governance framework and evidence of demonstrable shareholder friendly practices, but we are experienced enough to recognise that the two don’t always go hand in hand. Owner/founder managers are good (they know their businesses intricately), providing their egos are kept in check!

I’m off to spend some House of Fraser vouchers…

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.

*As at 30 June 2018.

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Is fairness the most sustainable competitive advantage of all? Part II

In September last year I wrote a Soapbox about fairness being a source of competitive advantage here. My focus was on the increasing price transparency in business-to-consumer (B2C) relationships and the risks to those companies that have historically abused their customers’ lack of price visibility. But what about abusing suppliers? Can companies still get away with this? Do consumers really care? The dominant business in any value chain usually has pricing power, but we believe there is a difference between pricing power and abuse of power. A business with a high return on capital that is built on the abuse of suppliers is every bit as frail as one built on the abuse of its customers.

As discussed in our recent Soapbox about Hotel Chocolat, the Fairtrade movement is an excellent example of society responding to supplier abuse. This ultimately resulted in companies changing their behaviour because real (or perceived) abuse of third world farmers was damaging their brands.

As part of the sustainability analysis of potential investments, we take great care to assess the supply chain of our investments, particularly when they involve low wage labour or the use of finite and polluting resources. Interestingly, we are regularly drawn to vertically integrated businesses that appreciate the value of controlling their entire supply chain, something that went out of fashion during the ‘outsourcing’ trend. These are often the most disruptive companies and we also find they are usually the most sustainable as well. Why? In my experience it’s because vertical integration means that these companies have a deep understanding of where their products come from, whilst also having a close relationship with their customers.

“It’s a bold move growing our own cocoa and it’s one that goes against the overall trend in the chocolate industry – to specialise more and more in a particular part of the chocolate making process. But Rabot Estate allows us to create a direct connection between our customers and the very origin of chocolate, cocoa. We’re one of the very few in the world able to do this.”

Angus Thirlwell, Co-Founder, Hotel Chocolat

Organisations that excel in managing their supply chain tend to see the benefits of this as self-evident. Quite simply, it creates a competitive advantage that helps improve the rate and sustainability of their returns on capital.

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for co-managing global equities portfolios. He joined us in 2014 from SWIP, where he was investment director in global equities. In addition Craig also had analysis responsibilities for the tech, energy and utility sectors. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors, a member of the global environmental equity team. Craig has a 1st Class honours degree in Building Surveying, an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 17 years’ industry experience (as at 30 June 2018).

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A change of climate in the boardroom

From 12 foot deep snow drifts in spring to melting roads and wildfires in summer, extreme weather is becoming the new normal. At what point does the unexpected become the expected?

While the theory of global warming has been around for many years, making a direct link between individual extreme weather events and climate change has been difficult. Climate researchers, however, are now explicitly stating that some weather events could never have occurred without the warming influence of human-induced greenhouse gas emissions.

Companies and investors are taking notice. In 2017, 15% of S&P 500 companies publicly disclosed an effect on earnings from weather-related events. 4% of them quantified that effect, resulting in an average materiality on earnings of 6%.

Over the past decade the terms “climate” and “weather” were among the most frequently used words in the transcripts of the quarterly earnings calls of S&P 500 companies, beating “oil,” “the dollar,” “recession,” and even “Trump”.

As ever, there are winners and losers at a company level. While British wines were once laughed at, they are set for a vintage year in 2018. But not all companies are raising a glass:

  • Stora Enso, the Scandinavian paper company, reported lower than expected profits this month, warning that forest fires in Scandinavia will cause raw material disruptions as a result of the tight Nordic timber supply
  • Ryanair reported that recent bookings have been impacted by warm Northern European weather. Why go to Tenerife when you can go to the Lake District?
  • Rank Group issued a profit warning in April, blaming poor weather for reduced visits at its Mecca bingo halls
  • Greggs issued a profit warning at its AGM in May, following the period of extreme cold weather in the UK. We expect the recent spell of hot weather in the UK to get a mention in their next announcement

Disclosing the impact of extreme weather in company announcements is one thing, but many companies are also taking action around climate change. Industries such as logistics and transportation rely on weather and climate data to stay on schedule and reduce risks. UPS even has its own meteorology department, which helps it to prepare for major weather events. Do more companies need to adapt to keep things moving?

We expect more companies to be discussing climate change at the highest level. For sustainable investors, that should be warmly welcomed.

About the author

Georgina Laird is a sustainable investment analyst. She is responsible for analysing and monitoring environmental, social and governance factors within the Global Sustainable Equity Strategy. Georgina joined us in 2015 from Russell Investments where she was an index analyst. She joined Kames as a performance analyst before moving to the ESG Research team in 2016. Georgina has a BSc in Mathematics from Heriot-Watt University in Edinburgh. She has the IMC professional qualification and has 6 years’ industry experience (as at 30 June 2018).

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