“Experience has taught me that it’s easy to talk about values, hard to implement them, and even harder for an outsider to determine which values are heartfelt and which are window-dressing. Wall Street cannot place a value on values.” Howard Schultz
If you want to become a better investor, I can think of no better way than to study what works and why in business. Reading annual reports from years ago and books on companies is a great place to start. A lot of people will say something similar, but I bet very few people actually read 10-Ks from the 1990s (or earlier) to decide whether they would like to invest in that same company in 2016. As Munger says, “Investing is simple, but not easy.”
Back to what works and why. Once again, this is simple, but not easy. I have yet to find the magic calculation that goes into an excel spreadsheet to spit out whether a company is a good investment or not. I will be sure to update you as soon as I do. Said more directly, a company’s success or failure will most likely not be determined by the operating margins or days sales outstanding calculation, but instead by the passion of the people that work there. Investors want numbers because you can measure numbers, you can compare them, judge them. However, it is the passion, the values, the [insert fancy french word]* that create the winners in business. If you want to have an edge in investing, thinking deeply about these non-numerical metrics will provide a consistent advantage because no one else is looking there (just because it can be measured, doesn’t mean it matters).
Starbucks is a great lesson in these ideas.
Take a moment and think back to the 1980s. I can still remember my father scooping out coffee from a Folgers’ can. The cup of coffee cost pennies (literally 2) per cup. Imagine for a moment that your neighbor comes over and pitches you the idea of starting a chain of coffee stores where people have to drive to your location in the morning (or whenever they want coffee) to buy your coffee for about 75x the cost of a cup those same people can make in the convenience of their own home. Outrageous, but since you can’t kick your neighbor out in the first 3 minutes, you go on. After debating the issue of price and convenience, you decide to ask if your neighbor has some sort of special, patented machine to make this coffee? You are getting at the idea of barriers to entry, in other words, what happens if you somehow convince people to start drinking your coffee, what stops another company from doing the same thing in other cities? Maybe McDonalds, etc? His response:
“[Starbucks] has no lock on the world’s supply of fine coffee, no patent on the dark roast, no claim to the words caffè latte. [Anyone] could start up a neighborhood espresso bar and compete against us ”–Howard Schultz
Would you fund this idea?
The answer is obviously no–or at least my answer would have been no. It turns out, I would have been in the sad and unfortunate majority:
“In the course of the year I spent trying to raise money, I spoke to 242 people, and 217 of them said no. Try to imagine how disheartening it can be to hear that many times why your idea is not worth investing in. … It was a very humbling time.” Schultz
The super-brief back story is that Schultz fell in love with Starbucks when he came out to visit the retailer since they were buying an inordinate amount of drip coffee makers (this is almost eerily similar in the way Ray Kroc discovered McDonald’s). However, they didn’t actually sell “prepared coffee” as they do now. Schultz convinced the Starbucks owners to hire him in a sort of generic marketing role. Schultz visited Italy a year after being hired by Starbucks, where he discovered the idea of espresso bars. He came back and pitched this idea to the owners of Starbucks who declined, but encouraged him to go out on his own (an invested with him). Schultz started a new company called, Il Giornale. Two years later the Starbucks owners decided to buy Peet’s Coffee (Peet’s was the original store from where the Starbucks owners got the idea) and therefore offered the Starbucks locations to Schultz. He paid [$3.8m in 1987]. To put it in perspective, Starbucks’ equity value today is roughly $80B give or take a billion (over 40% CAGR during that period–leaving Buffett firmly in the dust).
Over the past two weeks, I read Schultz’s two books (Pour Your Heart Into It and Onward) and all the past annual reports since its IPO (which you can find at Starbucks website [1999-present] and pre-1999 here). The books and annual reports are almost assuredly a better value than any graduate school course on business. Each person would probably learn something different from this exercise, but I took away three things. I approached this task wanting to understand how in the world Starbucks succeeded with such a completely crazy idea. And second, if there was ever a point in time where I would have been smart enough to invest. The first question, although completely subjective, is probably easier to answer, and I will focus on that one.
My takeaway is that Starbucks and most businesses succeed for the following three reasons.
This is about as amorphous as any statement is and firmly in the camp of “I can’t enter this into my spreadsheet?” Figuring out if someone has a passion for what they do may be difficult and hard to measure, but I still believe it is vitally important to the success of an organization.
“Although Starbucks has grown enormously since those days, product quality is still at the top of the mission statement. But every so often, when executive decision making gets tough, when corporate bureaucratic thinking starts to prevail, I pay a visit to that first store in Pike Place Market. I run my hand over the worn wooden counters. I grab a fistful of dark-roasted beans and let them sift through my fingers, leaving a thin, fragrant coating of oil. I keep reminding myself and others around me that we have a responsibility to those who came before. We can innovate, we can reinvent almost every aspect of the business except one: Starbucks will always sell the highest quality fresh-roasted whole-bean coffee. That’s our legacy.”
The passion bleeds through the pages. Take this quote: “Believe it or not, the issue of nonfat milk led to one of the biggest debates in Starbucks’ history.” I am a very skeptical person when it comes to business and business people’s comments, however, over and over throughout the book, you can see the passion, the love for the product, the desire to share the product. There is a missionary zeal in the team at Starbucks that is expressed in their desire to share their love of coffee with the world and the transactional nature of the customer relationship is merely a by-product.
One easy way to find passion is to see where it is not. Take this one example (there are many similar ones) of Land’s End hiring a CEO. Land’s End (LE) is based in Dodgeville, Wisconsin (spoiler alert: Broadway’s hit show Hamilton is not making a tour stop in Dodgeville). When LE hired Federica Marchionni, she did not want to relocate to Dodgeville, but instead remained in New York City. Further, the employment contract actually stated that Ms. Marchionni was required to attend the company’s holiday party, “and (c) attend, in person, all social events (e.g., any Lands’ End holiday party) of import that are commonly held in Dodgeville, WI.” I can 100% guarantee you that Schultz has never been required by his contract to attend Starbucks’ holiday parties. Needless to say, Ms. Marchionni only lasted about 18 months, in which period LE’s lost almost half its market value (around 45%).
Invest for the Long Term:
From the outset, Schultz did not see Starbucks as a local coffee shop. Once he realized Starbucks’ potential to change the way people experienced coffee, he executed on his strategy to roll it out nationwide. There are many steps along the way that are short-term negative, but essential if your vision is long term in nature. A few of these items were:
1. Employee pay: Equity compensation and healthcare coverage for all employees, including part-time workers, were dramatic departures from Corporate America at the time (and still are). However, Schultz saw and still sees how vital to the brand each worker is, especially the workers that brew and hand you your coffee each day.
“If you treat your employees as interchangeable cogs in a wheel, they will view you with the same affection.” Many business leaders will recite similar words, but in 1988, Starbucks was the first company to ever give its part-time employees health coverage and to give its hourly workers stock compensation–prior to Starbucks’ IPO. It’s only a platitude if you just say it and never do anything about it. Starbucks says it and does it.
2. Control the Roasting Process: Starbucks decided early on that they would invest in the necessary equipment to control the roasting process. Until you are operating at scale, you are always going to underutilize this equipment, thus creating a drag on short-term profits. McDonald’s and Dunkin Donuts outsource this step in a “comparative advantage” type mentality that undercuts their ability to present the best coffee to their customers.
3. In-House Store Design: Early on in their history, Schultz built Starbucks’ own in-house design and architecture unit, so that Starbucks could have the speed to build out the stores it needed. This created a huge competitive advantage in its growing years as Starbucks was able to roll out its stores to the prime locations with speed unmatched by its competitors.
4. No Franchising: In a seemingly contradictory move, Schultz refused to franchise (they did eventually “license” their brand), but this inability to franchise slowed their growth plans in early years. Capital and manpower limited Starbucks ability to grow quickly. However, Schultz weighed this risk against the greater risk of losing control over the delivery of each cup of coffee, which he deemed even more important than the speed of growth.
There are others, but these four stood out to me in the course of my readings. You can notice this trend in other companies also. If you were thinking about this idea in the early years of Berkshire Hathaway, you could have seen Buffett’s ability to refuse to write insurance premiums at unprofitable prices. Its competitors were reporting “record revenues”, while Berkshire’s premiums were falling.
My astute fellow-contributor, John, sent me this recent WSJ article regarding Amazon’s ability to invest in India. You can see from the article that Amazon is bleeding money investing in India (and other international markets).
Connecting With Customers:
The third leg of this stool continues in the wishy-washy tradition of its fellow legs. Great companies, including Starbucks, want their customers to have their product because they themselves simply love the product. Great companies provide significant value to their customers, and almost as an afterthought figure out how to make money on the transaction. Greater value to the customer will always be the driving force of a great company’s business decisions, whether that decision involves product choice, logistics or human resources. There are few companies that have this sort of focus on the customers (please share if you know of any).
The second, and potentially more actionable question, is when should you or when would you feel comfortable investing in this sort of company. I plan to give my answer to that question, chalk full of hindsight bias, in the next post. In the meantime, I highly recommend both books from Schultz. They are quick reads and offer great historical context and behind the curtains look at how Starbucks became what it is today.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at firstname.lastname@example.org.