This article is the final in a 6-part series examining how the drivers of value…
This article is the 3rd in a 6-part series examining how the drivers of value creation are the same as sustainability drivers. We will outline these drivers in these 6 posts and show how recent ESG efforts to define business sustainability fall very short.
The world was full of tension. Geopolitical conflict resulted in wars that had no ending. The public was also waking up to harsh realities over agrarian practices that were poisoning the environment and the population. Doctors were discovering the link between smoking and cancer, resulting in a warning from the United States Surgeon General. Racial injustices came to head with high profile deaths resulting in national outrage in the U.S..
It was a world full of tension, but also one of liberation. The counter-culture movement instigated challenges to broken habits and thought processes. At universities and in the streets across the country, political protests were increasingly targeting companies, who were pilloried as the culprits enabling such unsustainable behaviors.
In the 1960s and early 1970s, just as Burton Malkiel was writing A Random Walk Down Wall Street, only 7.6 mile walk north on Broadway from Wall Street, at Columbia University, students protested defense-related research. Protestors believed the university’s participation in advanced weapons development aided and abetted the tragic and never ending US war in Vietnam. These protests then spilled over to the students supporting the Harlem community’s objections to the university’s plans to build a gym in a push back against racial injustices that had little to do with the building of a gym.
Responding to the high profile counter-culture push back, union pensions and university endowments started an investor-led movement to stop investing in defense contractors, tobacco companies, chemical companies and many of the “culprits” behind all of the atrocities playing out on the global stage.
While it was the early beginning of the modern sustainable investing movement, it was hardly the first. Just as human misunderstanding and mis-judgement have a long history of affecting the course of events, there have almost always been well-intentioned efforts to evolve these dysfunctional patterns, often starting with investors.
Dating back to biblical times, Jewish law outlined many directives to bend investments towards ethical methods. Academics studying the history of sustainable investing have even noted that the Quaker and Methodist immigrants strictly prohibited investing in war or slavery. The Methodist church continues sustainability investing to this day, having invested church assets according to “social screens” for well over two hundred years.
The 1960s counter-culture fight back against companies as profit maximizers that didn’t care about social or environmental sustainability drove a wave of companies to establish or contribute to the emerging non-profits dedicated to improving such issues. While the tax code enabling tax-deductible charitable giving was established in the 1920s, the nonprofit movement didn’t gain critical mass until the 1960s, largely as a result of these social tensions and responses.
In the middle of all of this, in 1970, the most notable economist since WW2, free market evangelist Milton Friedman, penned an infamous op-ed in the New York Times pushing back against this trend. To this Nobel laureate’s career filled with extensive academic and mainstream publishing, a New York Times op-ed would have hardly been the place to make a career-defining statement. But in turns out this fateful opinion piece has been taken out of context and used to define his career, despite the fact that his breakthroughs in the field of economics actually had nothing to do with the profitability of corporations. In the opinion piece, Friedman argued that the social responsibility of a firm’s management team is to maximize the profits to shareholders, not allocate that profit to their favorite charities. From this point on, “profit maximization” was popularly labeled the “Friedman doctrine.”
When I first read this Op-Ed (click here to see the original) I had strong inclinations against it and actually started out the white paper that will conclude this series attacking it. Of course firms exist for many more reasons than to maximize profit for shareholders. Why would such a brilliant economist take such an extreme view, in such a lackadaisical format, I thought? Then John Mackey, the founder of Whole Foods who we heard from in part 2 of this series, challenged Friedman in a public debate over the role of corporations which allowed him to clarify the argument.
Mackey argued (as we did in part 1 of this series) that the firm’s customers came before investors, just as Adam Smith articulated at the founding of economics as a social science. He went on to argue that firms should try to create value for all stakeholders as opposed to only the one that Friedman seemed to argue for. When Friedman had the opportunity to answer Mackey’s public arguments, aside from a few caveats, Friedman largely agreed with Mackey and attributed much of the squabble to rhetorical misconceptions.
Having a few close friends that were very close to Friedman, they’ve said he would have never wanted anything to be called a “doctrine,” as the NYT Op-Ed became to be referred to as. Further, he had a deep respect for the customer being the primary driver of value creation in any enterprise- in fact, that’s part of the work that earned him the Nobel prize in economics. He also publicly affirmed it in the debate with Mackey as well.
As Friedman explained, he was merely pushing back against the trend towards corporations siphoning off profits to their own foundations or charities, which in turn had very little transparency or accountability into how those funds are used. Friedman questioned why an executive, whose fiduciary responsibility was to the owners of the business, was better suited to allocate wealth to charitable causes than the owners he had to answer to?
Seeing these arguments clarified, my early reluctance on Friedman’s point turned into full fledged support. But unfortunately the world doesn’t read footnotes and clarifications. “The Friedman doctrine” personified by Gordon Gekko in Wall Street, was used by many investors around the world to justify a greedy grab for nearly all the value of the enterprise’s activities.
Running Twice as Fast
Most asset pricing models on Wall Street use a firm’s profitability to justify its valuation, sometimes future profitability is discounted back to today, and sometimes only the most recent profits are used with some sort of multiple applied. Just as wages help guarantee employees show up, and rent allows real estate to be used, an owner requires profits to justify the ongoing investment.
Very simply, without a wage, there would be no labor. Without rent, there would be no buildings. Without profit, there would be no capital to fund businesses. Profitability is essential for sustainability. Labor union leaders have a social obligation to fight for better wages for their members, while real estate managers have a social obligation to collect rents and keep them at market rates. Similarly, managers of corporations have a social obligation to generate profits for shareholders while improving the underlying value of the business. We could all argue whether it is the most important factor for sustainability, but even Mackey & Friedman taking opposite sides of the argument both acknowledged the fundamental importance of profitability. And both acknowledged the crucial role played by customers and employees.
Asking which is more important is a bit like asking which came first, the chicken or the egg? It’s not even the right question to be asking in our opinion.
Many times, the various parties behind each of these three key inputs for value creation forget the others and only focus on their own self interest. But overall, over a reasonably long time-frame, the profitability of a company is essential for enabling all stakeholders in the enterprise to create products and services that both create value or make the world more productive. The only problem is, while it’s reasonable to assume the profits, say over five years, should be enough to justify an investment and sustain a business, that’s not the world we live in anymore.
Exhibit 1: Average Holding Period for US Stocks in Years
Data source: FRED
Investors’ time horizons have also gone to extremes, and in recent years have collapsed to just the next couple of quarters. The detrimental impact of this cannot be overstated. As Jack Welch popularized in the 90’s, “beating the quarter” has become a constant game where by most investors are only focused on how good the next couple of months will be as opposed to what the firm is doing to build its business.
Concurrently with the collapse of the investor’s holding period, “best practices” of proxy advisory firms increasingly stress the need for independent board members and urge shareholders to reject dual class structures which give the founder or family owners strategic control over the company. The detachment of the board of directors from the holders of the company has largely silenced the view of the owners. This may not be such a bad thing, for if the majority of owners are increasingly only hanging around for a couple of quarters, this group would destroy more value than build. It’s impossible to build a firm with a time horizon of just a couple of quarters, and profit maximizing the near-term, when taken to extremes, will typically borrow that value from the future.
Increasingly short-term oriented investors have joined the chorus of sell-side research analysts, who from experience never ask about longer-term strategic issues outside of the rare investor day. And when this audience combines a profit maximization view with very short time horizons, it has sped up the treadmill that most managers are on to an extreme pace. Managers in private surveys lament how frustrating quarterly guidance has been to their execution, as it becomes the primary mission of the organization in an ever demanding upward slope. This juxtaposes to owner-managed businesses, who have systematically shunned quarterly guidance versus their peers in the large indices.
Exhibit 2: Percentage of Companies Giving Quarterly Guidance
Data Source: CapIQ
This year’s pandemic has presented an issue for companies giving guidance, as most have withdrawn their annual or quarterly guidance rituals, providing many firms with an opportunity to reset the quarterly charade that has redirected so much energy away from building to one of “beating the quarter.”
As Fiat-Chrysler’s former CEO Sergio Marchionne concluded his seminal discussion, Confessions of a Capital Junkie, by quoting the Red Queen from Through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
Maybe it’s time to get off the treadmill to nowhere.
Between customers, employees and investors, the trade off between splitting the value created should be balanced to foster stability of the ecosystem. Marchionne always tried to balance the needs of labor versus the requests of the shareholders and even spoke about the philosophical trade offs on regular earnings calls. While he was a visionary manager that personally helped tens of thousands of leaders develop within the organizations he managed, he was also exceptionally lucky.
At Fiat-Chrysler, CNH and Ferrari, Sergio was anchored by Agnelli family holding company Exor. Family led businesses, like all of the ones Marchionne was running in the last 15 years of his life, are by nature fiduciaries. They seek to create and preserve long-term value, while respecting the communities that they operate in. This anchored control by Exor provided stability to execute on ambitious medium-term plans while ignoring the continuous calls for the company to close plants, cut capital spending and issue new equity to pay down leverage. In taking over Chrysler from near liquidation, Marchionne combined a medium-term reinvigoration and reinvestment plan with relatively quick wins. In short order, he introduced more premium interiors, some minor vehicle face-lifts, and even re-branded a few vehicles to help bring the company back from the dead.
The Chrysler Sebring underwent some minor plastic surgery, was re-branded the 200, and was given a powerful Super bowl advertisement to produce a more than tripling of monthly sales. As Marchionne reflected on it to a few investors and me in 2012, “I’ve never seen anything like this in automotive history.” But it was more than marketing lipstick that Marchionne applied to Chrysler, as he heavily invested in the Jeep and Ram brands to give them a very competitive and comprehensive line-up: something Jeep hasn’t had since the brand was created by Willys.
So Marchionne balanced both the short and the long-term when resuscitating both Fiat and Chrysler. But he also led with the same balancing act at Ferrari, where he delicately ramped volumes to produce a pronounced rise in profits that could fund a re-investment into more limited editions and a faster and more comprehensive product launch schedule.
Years later at its 2019 investor day, Exor began articulating its vision of sustainability with its purpose and values in a presentation called “Building Great Companies.” Management outlined competing dualities that Exor seeks to balance in equilibrium. Taken to an extreme, these values are perhaps dangerous, particularly for a controlling board member. When brought to extremes, few things or even virtues, are helpful. When these competing ideologies are balanced, as John Elkann postulated, true value creation happens.
Exhibit 3: Exor’s first stab at Sustainable Principles
Source: Exor 2019 Investor Day
My colleague Chris referenced this slide earlier this year in an article that discussed David Cote’s (former Honeywell CEO) management principles. Cote has said that successful management required executives to simultaneously do two conflicting things at the same time. They must both cut legacy costs while also reinvesting in growth. They need to run a lean organization, but not so lean that it jeopardizes the company’s ability to surprise and delight the customer. Both builders have articulated the same thing: we must balance dualities.
In his recently released book, Morgan Housel in The Psychology of Money discusses why there is so much volatility in the Forbes list of wealthiest people, which has 20% turnover a year in its top list.
“Getting money and keeping money are two different skills. Getting money requires taking risks, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility, and fear that what you’ve made can be taken away from you just as fast. It requires frugality and the acceptance that at least some of what you’ve made is attributable to luck, so past success can’t be relied upon to repeat indefinitely.”
He could have just as easily been writing about the dualities between a traditional board of directors and that of the entrepreneur or founder. The founder is inherently optimistic. In particular, entrepreneurs are very good at seeing the world or their companies as they should be, rather than how they currently are. Traditional boards of directors, on the other hand, are very good at assessing the company or the world as it is today. When they don’t have any skin in the game, as most no longer have, they favor risk-aversion and aim to keep the status quo for as long as possible. That kills the value creation potential of the organization, though as Housel points out, it is key to “keeping money.”
Exor has done a remarkable job as controlling shareholder in its investments in protecting what has been built, while also asking more of the companies. As articulated at its investor day, they “take a long term perspective but are relentless in getting things done.”
A very high profile disagreement at one of its holding companies, Ferrari, shows just how pivotal this balancing act is for both Marchionne and Elkann. Ferrari had been managed for decades by Luca Cordero di Montezemolo who was very close to the Fiat universe throughout his colorful career, which started in 1973 as Enzo Ferarri’s assistant and ended with him being Chairman of Fiat until 2010 and President of Ferrari until 2014. He was home grown, and it was hard to think of someone with more Ferrari running through his veins given his life long dedication to the group and personal relationship with Enzo.
But he resisted the expansion of the brand from its historical roots, and instead preferred to keep production steady no matter how long the waiting lists had stretched. He was hell bent on preserving Ferrari as it was when Enzo had passed away. But that form no longer fit the world in 2014.
The Profit-Value Trade-Off
Marchionne saw a global brand with far greater potential, as around the time Luca left as President of Ferrari, it was rated by Brand Finance as the most powerful brand in the world. One begins to wonder if that were the case, why the company was still only producing under 6,000 cars a year and generating €350 million in operating income. Once Marchionne took over as CEO of the company, he started to gradually lift production, while maintaining waiting lists for the company’s cars. He believed if waiting lists stretched beyond 18 months, it became detrimental to client loyalty. So he started gradually lifting production to 10,000 vehicles, which the company will hit this year, even with Covid-19 affecting production. Operating income prior to the effects of Covid-19 nearly hit €1 billion in 2019 (€0.9 billion to be exact), near tripling even prior to Marchionne’s most impactful product segment launch hit the income statement.
While the company is approaching a record level of production in 2020, waiting lists still stand at record highs. The company has merely matched the overall growth in the industry, which substantially trails the growth in the ultra-wealthy base of possible customers. The new models and range expansions that were introduced in the wake of Marchionne taking over have allowed the company to maintain price points while appealing to younger first-time buyers. This in turn has allowed the company to keep its infamous policy of always selling at least one car less than demand.
Exhibit 4: Ferrari & Industry Production History
Source: Ferrari 2019 Annual Report
This rigorous discipline to under-sell cars relative to the demand has allowed Ferrari to generate nearly all of the profits in the luxury car industry, despite consistently representing less than a quarter of the overall volumes. This starkly contrasts to peers, which sell to the full underlying demand, and sometimes even more.
In preparing for its public debut, Aston Martin sought to show a similar level of financial strength as Ferrari. Unfortunately the demand wasn’t there, and the rise in production resulted in dealer channel stuffing. While it perhaps led to a fancy IPO price for the company, the payback was hell. Trying to over-come the bloated inventory position while Covid-19 hit nearly bankrupted the company. After being saved by the now executive chairman Larry Stroll, the company is now owner-controlled. It is rebuilding itself into a more luxury-oriented company that will under-sell relative to demand while expanding the product launch cadence.
The cruel irony here is that profit maximization in the short-term leads to value destruction in the medium to long-term. The opposite has been the case for Ferrari. Under-selling and under-maximizing near-term profit has actually led it to take nearly the entire profitability of the industry today. So if Milton Friedman was correct that a manager’s social obligation to his shareholders is to maximize the profit, the real question is not whether or not he should also take care of customers and employees, which Friedman agreed was crucial, the real question is what time horizon is he working towards?
Given the median duration of a CEO tenure is 5 years, most are managing with that time horizon, or very likely even less. If they have little skin in the game, it’s more likely they’re managing for that year’s bonus. If they have no owners left on the board, and if they give quarterly guidance, it’s likely that nearly the entire echo-chamber the CEO hears is focused primarily on the next quarter.
What took thousands to build over time can be destroyed during a single CEO’s tenure if interests aren’t completely aligned. This is particularly the case in the luxury industry, where discounting of the products actually destroys the business model. It destroys the mystery, the element of scarcity and broadens the base of customers to make it no longer distinctive. Further, it trains all customers that they should never pay full price again. It’s no wonder that there are no luxury brands in the United States, despite many companies trying. Years or decades of creative energy and patient pricing strategies can get destroyed in a single recession if the company marks down its products and liquidates its inventory. Luxury houses of Europe routinely destroy inventory rather than see their products on the sale racks.
In his seminal work Luxury Strategy, sociologist Jean Noel Kapferer wrote:
“One characteristic of luxury is that, in general, it is built by several successive family generations, a fact that they freely mention (Rothschild, Mellerio, Krug). Moreover, family companies are often more profitable than anonymous groups, and survive well, at least while the family has the ability and will to manage the house… and is not too numerous! One of the biggest differences between family companies and listed companies is that the former think first and foremost of the maintenance of value and the image of the name, which is often their own name, whereas the latter seek growth at any price.
This is also true when the name is not that of the family: from this point of view, it is perhaps useful to remember that one of the factors in Chanel’s lasting, continual success is the fact that it was a family company from the beginning (the Wertheimer family); this is also the case with BMW (the Quandt family).”
The Universal Language of Building
While Europe is home to nearly all of the most successful luxury houses in the world, it’s also missing a key driver of economic growth today: information technologies companies. In Silicon Valley, firms are almost always led by the founders. Key employees are compensated with stock options which theoretically align these managers with the long-term value creation of the business. While growing tech firms have over-used the stock option tool almost to the point of destroying the underlying meaning of the options, European companies rarely grant options to key employees.
My colleague Chris, on the compensation committee at CTT, is seeking to change this in the place where we have the most influence. The board is now comprised of owners of more than 20% of the business, which has made a tremendous difference in challenging the status quo that was pervasive at the company a few years ago. Despite not owning a very substantial portion of shares, the refreshed management very much thinks like owners even prior to the compensation package being officially in place. So what is that “je ne sais quoi” that makes a manager or employee think like an owner?
Building. Being part of the building process gives a sense of ownership even without the actual ownership.
More than the stock options at startups, employees are motivated to create something new, to invent, to disrupt old and outmoded thought patterns. If you are at a startup, or doubtless have friends at one, you will know it’s not so much the stock options that motivate you to build, it’s the act of building itself. I believe our purpose as humans is to build. We are not happy if we are not creating in some way. An organization which seeks to protect the status quo, to “keep money,” as Morgan Housel wrote, typically is an organization devoid of creative energy. It’s a turn off to right-brain creative types, the entrepreneurial spirit, and the culture becomes mired in left-brain processes that are routine and stale. But you don’t have to be a tech startup to be an organization that taps into the co-creative spirit of employees.
Very far away from Silicon Valley, the founders of Home Depot, Arthur Blank and Bernie Marcus, used this same phenomenon to get its regular hourly employees to think like owners. Before a brand new Home Depot opens, the company has its hourly associates, managers and all staff finish the set up of the store – installing signs, light fixtures and the final touches. These employees aren’t the most efficient at getting these final tasks done, but it doesn’t matter. Taking part in the set up of the store before it publicly debuts gives all of the associates a sense of ownership, like it’s their own store. In a small way, they’ve actually co-created that store- and in doing so, have learned a thing or two about home repair. Even at its current massive scale, the staff at Home Depot is truly best-in-class and feels like a small business.
The Future Is Always Built
“To achieve great things, two things are needed: a plan and not quite enough time.” Leonard Bernstein
Furthermore, to have the creative drive and entrepreneurial spirit, an executive need not be the original founder, nor even a member of the family that built the business. The only thing that is needed is a medium-term focus with demanding and rigorous objectives.
One of the reasons why we’ve invested in so many European businesses is that we’re very much attracted to the widespread use of 3/5-year plans to guide the business. Investor days that outline the medium-term vision of the companies are key to us. But given the shrinking time horizons of investors, almost all ignore the importance of these plans, in fact, sometimes they’re even shunned. In 2014, Sergio committed to Fiat-Chrysler delivering a near 10x in earnings, from €0.6 billion in 2014 to €4.7-5.5 in 2018. The stock went down that day, by almost 10%. I remember buying more shares that day in protest, as did Sergio. While he passed away in 2018, the company ended up delivering €5.0 billion in net profit to investors in that year despite all the hurdles it needed to overcome.
At the beginning of that planning period in 2014, in seeking to build an equity story for Ferrari to ensure its successful stock market debut and business expansion, while Marchionne was given a decently long time horizon, he was also relentless at getting things done. In developing Ferrari into a more comprehensive luxury brand, Marchionne was looking for ways to honor the company’s past while tapping into the collector’s urge for more limited edition series, the most obvious source of very strong pricing power and unmet demand.
The problem with ramping limited edition series is that by making them a more regular feature of the company’s line-up, it would endanger the scarcity value that drives these price points up considerably over time. In our initial report on Ferrari, Manufacturing Art (posted on our public research page here), we showed that the buyers of Ferrari’s Limited Editions have actually outperformed the stock market indices with their investments. The key difference between Ferrari limited edition collectors and normal investors are, aside from the better performance, they actually get to feel the rush of adrenaline turning a corner and accelerating with 950 horsepower.
In designing Ferrari’s medium term plan, Sergio came up with the brilliant Icona series, which are a brand new, regular and ongoing part of the Ferrari production series. They are produced in limited quantities, and reimagine modern versions of the antique collector’s items that still clear auctions at price points in excess of $40 million. For collectors, it is the perfect addition to a garage- a modern version paired with the classic version of the same car, with the more modern version able to be driven and actually enjoyed. Without ruining the scarcity value, it has allowed the company in 2020 to start more regular limited edition production with very significant benefits to the company’s recurring profit margins.
And what is the company doing with that incremental profit? The spirit of business-building lives on in the current team, and they are doubling-down on new model introductions and electrifying the future of Ferrari. This, along with a forthcoming sport utility vehicle, is helping Ferrari truly pull away from the pack of other luxury sports car makers with the consistency and number of product launches. No other luxury auto house can compete with the number and frequency of product launches and innovation. Ferrari’s ecosystem is far more powerful today than it was when Sergio embarked on the plan to build it out in 2014, which is quite an accomplishment for a brand that was already declared most powerful in the world.
Underlining that power is an example that came from the year Ferrari IPO’ed. In 2015, the company sent 210 leather boxes to some of their most loyal collectors. Inside that box was an engraved key with the driver’s name on it. The note enclosed said something along the lines of, “we can’t tell you what this will turn on, what it looks like, or what it be called. We can only tell you the price, $2.2 million.” I’m sure there were other words spoken in that message, but in a staggering show of strength and knowledge of their individual customers (Ferraristi), they achieved 100% take rate on the first invitation. And when they took delivery of their car, that original key started the engine for the very first time.
That model turned out to be the LaFerrari Aperta (the convertible). Aside from its 949 horsepower, the thrill of being part of a family that shows such attention to detail and personalization makes the $2.2 million price tag worth it for Ferraristi. But it’s also a very solid investment. That car is now appraised at over $5 million, allowing those buyers to more than double their return on the invested capital, again, better than even the S&P 500 over that time period.
But that’s still not as good as shareholders of Ferrari, who have seen shares more than quadruple from the IPO in the same year. Those owners can thank the family control at the top and the ingenuity and industriousness of Sergio, who left more fingerprints on the soul of that business than anyone has since Enzo founded the company.
As it turned out, the most loyal manager that tried to keep the company preserved actually prevented the growth of the house into an even larger, more relevant global phenomenon.
In this ever-changing world, particularly now, the biggest risk is not that we take a risk and fail, it’s in falling into mediocrity and obscurity. In most cases, the biggest risk is in maintaining the status quo, the very thing most boards of directors inadvertently try to do. In a statement made on the one-year anniversary of the passing of Sergio, FCA and Ferrari Chairman John Elkann noted, “We will be eternally grateful to him for showing us, by example, that the only thing that really matters is never settling for mediocrity and always striving to change things for the better, for the benefit of society and the future, never for oneself.”
The only way for capitalism to survive for much longer, is for there to be an evolution in how we think about sustainability and how we think about investing. We need to think more like a founder, like a family, or like a builder. Just as Sergio has shown us, the only way to live a meaningful life is to build things for others. The only way to sustainably invest is to invest like a builder.
“I’m not a believer in the automatic recurrence of the past. The future is always built.”
To read the prior articles in this series on sustainability, click here to read the first article, Sustainability & The Ultimate Intangible, or click here to read the second article, Sustainability & A Kick Ass Culture.
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