In my last Jim Collins article, I talked about how core ideology might be useful in judging a management’s determination to find new products and processes to spur growth, and in understanding corporate DNA. The topic of this article will be more specific and therefore maybe more relevant and reliable in understanding a company’s growth and actions. The topic is the hedgehog concept from Good to Great. If you did not read the book, read it immediately. It is more shareholder-centric than Built to Last as the research sample include companies that had a period of mediocre stock performance followed by a period of outperfomring the market by 10 times. As a result, the hedgehog concept somehow embodies core ideology while caring as much about profit maximization.
Profit + Passion + Competence = Hedgehog Concept
The Hedgehog concept is about doing in a profitable way what you are passionate about and what you can be the best in the world at. The three elements that make up the hedgehog concept are what you can be the best in the world at, a metric on what you will need to improve to become the best in the world at, and what you are deeply passionate about:
To have a fully developed Hedgehog Concept, you need all three circles. If you make a lot of money doing things at which you could never be the best, you'll only build a successful company, not a great one. If you become the best at something, you'll never remain on top if you don't have intrinsic passion for what you are doing. Finally, you can be passionate all you want, but if you can't be the best at it or it doesn't make economic sense, then you might have a lot of fun, but you won't produce great results.
Value investors, especially Warren Buffett followers, might be quick to find the hedgehog concept interesting because it is similar to staying within our circle of competence, doing only what we can be the best at. By focusing on a metric to maximize profit, we simultaneously widen our moat. Passion about what we are doing is important in achieving the goal to become the best as well as in remaining on top as shown in my discussion on productivity and customer loyalty in the previous article.
The example in Good to Great is Walgreen (WAG). Walgreen’s concept is “the best, most convenient drugstores, with high profit per customer visit.” This concept gave guidance to all Walgreen’s initiatives:
Walgreens then linked its convenience concept to a simple economic idea, profit per customer visit. Tight clustering…leads to local economies of scale, which provides the cash for more clustering, which in turn draws more customers. By adding high-margin services, like one-hour photo developing, Walgreens increased its profit per customer visit. More convenience led to more customer visits, which, when multiplied times increased profit per customer visit, threw cash back into the system to build even more convenient stores. Store by store, block by block, city by city, region by region, Walgreens became more and more of a hedgehog with this incredibly simple idea.
Warren Buffett: Hedgehog Hunter?
I once asked Geoff how he thought the hedgehog concept was relevant to Warren Buffett’s investments. This is what he said:
I think the Hedgehog concept is very important. And I think it is an idea Warren Buffett applies. I think he is often focused on a single key matric – a powerful trend, process, self-reinforcing cycle – that once it gets in motion will provide good benefits to him economically for a long, long time.
In the case of See's Candy, he saw that they had pricing power. And he did everything he could to keep their prices up. He did not skimp on ingredients, etc. He never complained about them spending too much on that. And did not try to cut costs. He even had trouble expanding them into new areas. He wanted to – but geographically it never really happened. The hedgehog concept at See's was that they had mindshare with certain consumers. That their products were bought for emotional times (like Valentine's Day) and that price was a mark of quality. In this way, he could raise prices pretty aggressively and still get people to buy similar amounts of chocolate.
At GEICO, the hedgehog concept was direct selling. Other insurers were using agents. And they were stuck with that system because they would face a revolt from agents if they tried to change. It would be disruptive. So a lot of companies – not Progressive (PGR), but a lot of big insurers – were at a consistent disadvantage to GEICO. Buffett was willing to press this continual cost advantage and even advertise a lot.
With Wells Fargo (WFC), it is cross-selling. Buffett sees that Wells isn’t just different by accident. They\e see themselves differently. WFC thinks like a retailer. And so Buffett believes that they can maximize their profits per customer and in so doing get the lowest cost deposits while growing. This means WFC becomes a growth company as much as a bank. EPS can grow strongly. And it is easier to grow revenues per customer rather than grow customers, branches, etc. Making more money from existing customers is always easy.
Coca-Cola (KO) was simple. If you read Buffett on Coke – it’s clear he was focused on one metric: consumption per capita. He thought it was much lower around the world than in the U.S. And he saw it rising everywhere. Therefore, he didn't assume Coke would necessarily break into new markets, launch new products, etc. He just thought Coke would sell more ounces of cola per person in the countries – outside the U.S. – that it was already in. This was the key to understanding that investment. He’s mentioned several times that cola has no taste memory, Coke was already in a lot of countries, and consumption per capita was rising in these countries. His margin of safety in Coke came from a hedgehog concept: increasing per capita consumption of Coke.
Two of My Favorite Hedgehogs: Nutrisystem and Ebix
One of my favorite stocks, Nutrisystem (NTRI), found its own hedgehog concept. Its expertise is providing weight loss programs, and its metric is profit per customer. Its focus on profit per customers results in product development programs that help to improve customer satisfaction and increase length of stay. Customer satisfaction strengthens its reputation and creates words of mouth, which increases marketing efficiency, lowering marketing expense per customer and widening its marketing advantage over competitors. As ex-customers tend to be more profitable than a new customer, Nutrisystem focuses on increase reactivation rate. To nourish customer loyalty, it launched a weight loss community site. To deal with the inherent problem in its business model, which is customers stopping using its products once they achieve their target weight, it introduce retail line of healthy snacks and meal replacement shakes and bars that would attract ex-customers in their weight maintenance efforts.
Another favorite stock of mine is Ebix (EBIX), a double-digit grower with 10 year average ROE of 28%. Ebix provides electronic communication services between entities in the insurance industry. Its goal is to become the leading backend powerhouse of insurance transactions in the world, and its metric seems to be profit per order. The CEO is a Warren Buffett follower. He understands the power of network effect in this business and only enters markets where EBIX can become the number one. Maximizing profit per order is perhaps the reason for EBIX’s numerous acquisitions in order to incorporate new services into its products to cross-sell to existing customers. Offering a lot of services in its products increases switching cost for customers while increasing profit per order and reinforcing its leadership position.
Applying the Hedgehog Concept
So, how is hedgehog concept useful to investors? The hedgehog concept is more practical than core ideology. It is more specific in stating what a company should do and how a company makes money. Therefore, investors can easily understand a company’s management if there exists a hedgehog concept in the company, especially if the company promotes from within. Hedgehog concept is a level closer to practices than core ideology so investors should give more weight to hedgehog concept than to core ideology in the qualitative analysis of a company. That said, core ideology, including core purpose and core value, acts as the guiding force to hedgehog concept. Moreover, core ideology creates a cult-like culture that boosts productivity, nourishes employee loyalty, and makes it easier for the company to remain on top than hedgehog concept. Therefore, my advice is to examine whether a company has a hedgehog concept first, and then consider the existence of core ideology. Other things being equal, a company with both hedgehog concept and core ideology would be more valuable than a company with only a hedgehog concept.