Getting serious about strategy
At this time of year many investors think about performance. They may review what went up, what went down and what they learned. Since I think monitoring short-term movements in share prices teaches me nothing about the long-term performance of companies, I'm not doing that...
I have been thinking about the year gone by and the year ahead, but my thoughts are leading me to consider the essence of business itself: Strategy.
I invest because at some point in the future I may need an income if I no longer earn one. Obviously, the shares must perform over many many years or it won't have been worth the time and effort spent picking them.
My guiding policy, the way I will achieve this objective, is to buy shares in good companies at reasonable prices and hold them for as long as I believe in them, preferably forever. Reflecting on 2017, I think I can improve on my understanding of what a good company is, work I stated a number of years ago when I read 'Understanding Michael Porter' by Joan Magretta.
Understanding Michael Porter is a great book. Porter is admired in business schools and management consultancies, most famously for inventing two frameworks for analysing the competitive position of businesses: the Value Chain, which describes the activities that deliver goods and services, and the Five Forces that drive competition.
I won't describe them in detail here (see my review of the book instead), but the nub of it is a company's competitive position depends on the activities it chooses to do. The activities it chooses to do are determined by its strategy.
You might think this is an obvious insight, but even though it's obvious, how many investors, people who depend on a company making the right choices actually take the trouble to work out what a company actually does?
Take Howden Joinery (HWDN). We know it supplies kitchens, but so do lots of companies. It doesn't make Howdens special or more likely to succeed. How many investors understand that unlike other kitchen companies it chooses only to sell to the trade. Why would it do that? Why doesn't it open kitchen showrooms and sell to the public?
There are at least two good reasons: selling to builders is cheaper, you don't need showrooms, delivery drivers, and fitters, and it's also easier. While you or I might come back for a new kitchen every 10 or 15 years, delight a trade customer and he'll come back week after week, month after month. The choices Howdens has made have made it a very profitable company.
The point about choice is rammed home in another book I'm reading now, 'Good Strategy, Bad Strategy' by Richard Rumelt. According to John Kay (I can think of no higher authority) Rumelt is "the strategist's strategist". I haven't finished his book, but I can tell you that, unlike Porter, he doesn't require a translator.
A review will surely follow, but I've read enough of the book to be able to tell you that Rumelt believes the kernel of good strategy is a diagnosis, a guiding policy , and coherent action. Rather than use one of the case studies in his book (Nvidia (NVDA) for example), I'll bring us back to Howdens.
I don't know for sure what led Matthew Ingle, Howdens' founder, to set up a trade only operation, but I can guess. He'd previously been managing director of Magnet's trade operation, which coexists with its retail showrooms. He probably experienced aggro from trade customers, for example, fed up that their customers could pop next door and get a price on the same kitchen from a Magnet retail showroom.
Whatever the problems Ingle diagnosed, Howdens would be better off serving the trade only and so that became it's guiding policy. From this policy, all manner of coherent actions flowed. Howdens provides enough credit so the builder can finish the job and receive payment before paying for the kitchen. It keeps nearly 100% of its range in stock, so builders can go back for components whenever they need them, without holding up the job. It sites depots out of town, where they are convenient for builders to get to and cheap to lease. It designs the kitchens so they are particularly easy to fit. It gives big incentives to depot managers, so they treat their repeat customers very well.
This is the essence of what Howdens does. I think Rumelt and Porter would recognise it as good strategy. The actions are coherent because they stem from a guiding policy.
Howdens probably had an advantage in starting from scratch. Bad strategy often emanates from organisations reconciling disparate ambitions in sprawling operations. Rumelt gives the example of Ford in 2000, which struggled to reconcile an old strategy, to achieve economies of scale through standardisation, with a new strategy to acquire popular brands. It acquired marques like Volvo and Jaguar, but Volvo drivers didn't want safe Jaguars and Jaguar drivers didn't want sporty Volvos.
Strategy links the financial statements, which give us information about how a firm is performing, to what the company is trying to achieve. A cohesive strategy should make a business more profitable. A discordant one may make it less profitable. These insights will influence how we value companies, probably for the better.
Rumelt's book is about bad strategy as well as good strategy. Bad strategies don't have a guiding policy from which coherent actions cascade. They are often guided by an objective, like increasing revenue or profit, from which discordant actions tumble. Incidentally, that's why I don't set myself performance targets as in investor. It's why I have a guiding policy instead.
Howdens, though, is a special case. Few companies lay their strategies out as well as Howdens does in its annual reports. I will have some thoughts on how to get around their reticence next week.
Happy Christmas! Thanks for reading, and extra thanks if you emailed me. It's much appreciated.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.