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Lawrence A. Cunningham’s Quality Investing: Success breeds excess: Make sure you own stock in companies where employees are competitive, not complacent.

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Companies with substantial competitive advantages have always had to guard against employee complacency. With employees now a top priority of ESG advocates and regulators, it is more important than ever for investors to discern how a company balances between employee protection and employee encouragement.

Investors beware: from the Great Resignation, the ESG movement and other social forces are making employee welfare a high priority in corporate America. Securities regulators are pondering requiring disclosure about corporate investment in human capital.

These trends may add value to the extent that they promote employee satisfaction and productivity. But companies and regulators must be careful not to overdo their solicitude or veer into pampering. Investors should monitor regulatory and labor enthusiasm amid these trends. Rewarding and caring for employees is desirable and valuable. Encouraging workers to go easy, coast, be lazy or content with the status quo is not.

When companies generate extraordinary profits, constituents naturally make claims. For employees, higher salaries and bonuses are sought, as well as other creature comforts. It may also be natural for employees to relax and rest on their laurels. Managers and other leaders should take care to prevent this from lapsing into complacency. They need to find ways to take care of their people without allowing them become lazy or smug.

Finding that balance can be difficult, as a short list from history’s legions of fallen giants attests: AIG; Arthur Andersen; Blockbuster Video; Borders Books; Compaq Computer; Kodak; Toys “R” Us, and Xerox.  Each one’s rise and fall has a distinctive story, but a common feature is a certain comfortable arrogance among the workforce.

External pressure — demanding customers, savvy competitors — can motivate a corporate culture and improve performance.  While many investors probe for pricing power associated with monopolistic businesses, it may be wiser to look for healthy competition. Ruthless rivals can kill businesses, but rational ones may encourage a culture of product innovation and customer service that increases sales and profits.  

Absent external pressure, due to pricing power and other competitive advantages, a company may need to generate its own internal pressure. This has always been difficult in fields that stress human capital and cultivate a caring culture, and will be increasingly difficult in a world catering to employee comfort.  In all such environments, the internal pressure must be of a productive form and channeled to a worthwhile aim. 

Hosting contests, offering rewards or inducing other forms of rivalry are healthy when offered in the spirit of achieving a collective goal that all employees can claim a share in.  Flawed designs can promote political chicanery, backbiting, and the dangers individualism can inflict in group settings. Positive aims, such as improved customer satisfaction ratings, are superior to negative ones, such as aggressively targeted cost-cutting.  

Many companies use core ratios or key performance indicators (KPIs) to reflect such aspirations for optimal internal pressure as they define rewards or penalties and promote accountability.  These can produce clear and current feedback as an effective substitute for the external market.  Employees not given such feedback may glide easily into comfortable patterns that retard innovation and creativity.

Decentralizing a company into small business units also helps. Companies as diverse as Amphenol
APH,
+1.55%
,
Berkshire Hathaway
BRK.A,
+0.96%
,
BRK.B,
+0.88%

Constellation Software
CSU,
+3.43%
,
Danaher
DHR,
+0.10%
,
IAC
IAC,
+3.35%
,
Kelly Partners Group Holdings
KPG,
-5.79%

and Mettler Toledo
MTD,
+0.83%

illustrate a variety of approaches to decentralized operations. Some distribute almost all responsibility as deeply into the organization as possible (Amphenol is at that extreme) while others centralize only certain functions, such as capital allocation (Berkshire is at this end).

But all recognize that autonomy motivates people, without either shackling or pampering them. The key is to maintain a balance between autonomy and control. Pure autonomy risks anarchy and pure control is suffocating. Unleashing the power of autonomy requires leading managers and their troops that they command to a high degree of control over their own business fate. Promoting the likelihood of desired business outcomes requires stimulating them to embrace certain ways of thinking in their exercise of that control.

Methods vary because companies are unique, but a nudge is preferable to a mandate. Leaders must listen for feedback signals and monitor how the strategy and culture work, given the authority arrangements and organizational structure. In response, they use “communicate to influence” over “command-and-control” to generate desired shifts.  The aspiration might be called intelligent autonomy — neither unbridled discretion nor excessive control, neither too much comfort nor too little.

Investors should incorporate such corporate culture analysis into their investment process. They should seek companies whose employee engagement enhances both employee satisfaction and productivity. Finding that balance has always been pivotal for companies enjoying pricing power and other competitive advantages that can induce complacency. It will now be critical for all companies in a world of increasing attentiveness to the workforce. 

Lawrence Cunningham is a public company director and founder of Quality Shareholders Group, a boutique that facilitates relationships between long-term, concentrated shareholders and the companies that would like to attract them. He is the author of many books and is well-known for “The Essays of Warren Buffett: Lessons for Corporate America.” Cunningham is a director and shareholder of Constellation Software, a director of Kelly Partners Group, and a shareholder of Berkshire Hathaway. 

More: Here’s how a company can boost shareholder value and its growth rate — especially in a bear market

Also read: With global stock markets in turmoil, a healthy corporate culture counts more than ever. Here’s what to know.

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