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Q2 2019: United States

Previous visits to the US Midwest and Seattle have left us wondering how and why clusters of quality companies develop. On this trip, an “unexpected” snowstorm in New York and the Midwest gave us cause and some time to contemplate a possible connection between extreme weather and risk aware cultures.

Perhaps one has to plan better, withstand difficult working conditions, and be better prepared for externalities that can harm a business directly or indirectly? And is the opposite true in Silicon Valley, where the weather is seldom a distraction or a disruptor?

The San Francisco Bay Area in northern California is home to some of the world’s most inventive and largest companies. The bay area has historically served us a weird cocktail of a massive investment universe but few investment opportunities. We must surely have been wrong? There must surely be conservative company cultures bubbling beneath the slick surfaces? Not for the first time, we head to The Valley seeking answers to these questions.

And not for this first time, we are struck by the energetic pace of innovation, a fail fast mentality, and a desire for control. Some aspects of this prevalent corporate culture sit uncomfortably with our investment philosophy, which places more emphasis on what could go wrong than what might go right. In this context, it was encouraging to come across some companies that appear to have chosen a more conservative path.

KLA Tencor is a leading provider of equipment to semiconductor chip manufacturers. The company had an options1 accounting scandal more than a decade ago. This, among other things, led them to simplify their approach to compensation. They have turned their back on the issuance of options and the use of complex performance metrics in their remuneration policies. This has helped the company focus on the long-term, attract and retain the right people, and foster a culture which is slowly but steadily heading in a different – and we think more positive – direction. Their compensation practices are far from perfect, but they stand in quite stark contrast to most in the valley.

Fortinet, a founder-controlled and managed security software company, has had to fight recent battles on two fronts. First, an activist investor showed up on the share register for less than a year and demanded bigger profits, a ‘return’ of cash to investors (which these days almost invariably means share buybacks rather than dividends), and a riskier balance sheet. Meanwhile the company was dealing with ever-greater competitive pressure, including from the well-funded Palo Alto Networks, where management are on option steroids. Fortinet has seen off the first battle: the activist investor sold its stake for a quick buck. The experience has helped Fortinet to better balance profitability and long-term aspirations without losing the sanctity of their balance sheet.

None of this is new to the founder, whose previous company’s fortunes were dictated by venture capitalists. That experience led him to be wary of short-term influences determining the future direction of Fortinet. However, Fortinet continues to fight the battle of retaining high quality people; their fiercest competitor down the road just offered USD130 million to their new CEO.

Intuitive Surgical is a pioneer in the world of robotic surgery and now almost ubiquitous in the American surgical ecosystem. But the journey to get to this position involved some interesting twists and turns. Intuitive had to part ways with founder Fred Moll in 2002 because of differences over the company’s future direction of travel. It was a bold decision for professionals and the Board directors to disagree with their iconic founder and inventor. But their decision to focus on the company’s core strengths has proven to be the right one for a wide range of stakeholders. Over the last two decades, Intuitive has been competing mostly with its founder, who recently sold his latest venture to Johnson and Johnson. History might suggest neither were wrong but only if financial returns to shareholders are the sole criterion used to gauge success.

What companies like KLA Tencor, Fortinet and Intuitive share is a desire to remain independent, to be second to none in their respective fields, and to safeguard a conservative balance sheet. Their size and profitability enable them to keep spending more than their peers on developing technologies of the future. Huge research budgets are no guarantee of future success, but they are a necessary condition to survive and succeed in the technology arena. Even more importantly perhaps, they are evidence of a long-term mindset and culture.

Circumstances and events have played a decisive role in shaping the histories of these companies. And the responses and choices of those who have stewarded them have instilled some attractive traits in their cultures. Understanding company histories is an important part of the quality puzzle for us.

A trip that got off to a difficult start due to poor weather ended with a pleasant surprise in the sunny valley. We have enough reasons to believe there is quality lurking beneath that bubbly surface.

  1. Options are financial instruments that are derivatives or based on underlying securities such as stocks, bonds, commodities

Source for company information: Stewart Investors investment team and company data. For illustrative purposes only. Reference to the names of each company in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of Stewart Investors.


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