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The 80/20 Principle, Kaizen & the Productivity Revolution

Greg Sumner, CFA

This time each year, we often look back on our new year’s resolutions from a couple months ago and find that, all too often, they’ve already been abandoned. Self-improvement is hard; however, we keep trying because we know that on those occasions when we achieve our goals, the reward can be considerable. The same is true for businesses. Many companies undergo large restructurings in an attempt to improve operations, but more often than not results remain disappointing and they’re restructuring again within a couple of years. However, some companies’ efforts at self-improvement are successful and ultimately lead to significantly higher organic growth, margins and free cash flow. We have found that these firms’ efforts are often grounded in the 80/20 principle and business systems based on lean manufacturing and the Japanese business philosophy of continuous improvement known as Kaizen.

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As of January 31, 2022, Diamond Hill owned shares of Colfax Corp., General Motors Co. and SPX Flow, Inc. As of November 30, 2021, Diamond Hill owned debt in Ford Motor Co.

The views expressed are those of the speaker as of January 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

The 80/20 principle, also referred to as the Pareto Principle, is the idea that roughly 80% of outputs come from about 20% of inputs. Since its discovery in 1906 by Italian economist Vilfredo Pareto, the 80/20 principle has been found to hold true in many areas–income and wealth distribution, software bugs and even sports, such as the 2007-2008 NBA season where the top 20% of players accounted for 79.5% of all points scored. It’s particularly relevant in business where, upon close examination and careful allocation of expenses, companies will usually find that about 80% of profits come from about 20% of customers, as well as about 20% of their products. Furthermore, numerous companies have seen dramatic improvement in organic growth and profit margins by shifting resources away from less profitable areas of their business to focus on these key customers and product lines.

We first initiated a position in flow control equipment maker SPX Flow in late 2015, in part because we thought its food and beverage business had attractive secular growth potential, but largely because we believed the company had been poorly run for many years under prior management, creating a bloated cost structure that the new, more operationally focused CEO vowed to improve. Our confidence in SPX’s operational initiatives increased dramatically a few years later as it detailed how the company incorporated the 80/20 principle in its efforts, including segmenting products by profitability and disproportionately investing in high-value product lines like pumps, valves and mixers for food and beverage and industrial end markets.

In 2019, the company took a major step and sold most its power and energy business–which had consistently underperformed and was a significant distraction for management–freeing up resources to invest in higher-quality areas of the business. While these efforts led to solid margin improvement, with gross profit margin expanding 250 basis points in two years, the benefits of the 80/20 principle did not stop there. As resources were redeployed into the most attractive segments of the business, SPX was able to increase margins while significantly expanding research and development. This led to a dramatic improvement in new product development–including doubling new product launches in 2020 versus 2019–while also lowering lead times, increasing on-time delivery of key products and improving workplace safety. In 2021, Ingersoll Rand recognized SPX’s strong improvements and made an offer to acquire the company, which led to a review of strategic alternatives and the decision to go private at a price almost triple our initial purchase price.

SPX Flow used 80/20 thinking to make sweeping changes to its business, but the principle can be implemented at the micro level of an organization as well. Engineer and consultant Joseph Juran realized that about 80% of product defects were caused by roughly 20% of errors and that massive improvements in quality could be made by finding and fixing a vital few underlying problems. His work was largely ignored in the US at the time, but in 1953 he found a receptive audience in Japan, where his work was incorporated into the Toyota Production System (TPS), which Toyota used over the next few decades to reach a level of operational efficiency and product quality that American industry hadn’t thought possible.

A key component of TPS is the philosophy of Kaizen, which emphasizes a culture of continuous process improvement through innumerable small changes that compound over time to improve quality, reduce waste and create a lean organization. This process works, in part, because of the 80/20 principle. For example, 80% of the time and effort in a production process generates only 20% of the value and is therefore extremely inefficient. Employees who work directly on the production line are in the best position to identify wasteful efforts and provide suggestions as to how they can be more productive.

While the US auto industry was eventually forced to adopt TPS-style systems to compete with their Japanese peers, other American industries were slower to adapt. One early convert was Danaher Corporation, which designs and manufactures medical, industrial and commercial products. Danaher brought two TPS architects into one of its plants in 1988 and then, impressed with the remarkable improvements achieved there, created its own system based on TPS. The system became a competitive advantage for Danaher, which it used to dramatically improve operations at the myriad companies it acquired over the years, helping Danaher become one of the best performing stocks in the market at the time.

Danaher’s founders started Colfax Corporation in 1995 with the intention of using the Danaher Business System (DBS) to acquire and improve companies in industries in which Danaher did not compete. Similar to SPX Flow, Colfax recently sold off its most cyclical assets (mainly power and energy businesses) and plans to spin off two other businesses into independent companies: ESAB, a global leader in welding and Enovis, a specialty medical technology company focused on the orthopedic sector. Both ESAB and Enovis have already shown signs of operational improvement, suggesting the DBS system has taken hold in both company cultures. We believe both companies have a long runway of future growth as they follow Danaher’s footsteps–acquiring and improving the operations of smaller companies in their respective industries, which should drive attractive long-term earnings growth.

The 80/20 principle and the philosophy of continuous improvement might seem like common sense, but as the famous French writer Voltaire said, “Common sense is not so common.” And we’d argue that rigorously applying it is even rarer. Like forgotten new year’s resolutions, self-improvement initiatives at companies don’t amount to much unless they become integral to the culture. But when business systems based on the 80/20 principle and continuous improvement are central in a culture, massive competitive advantages can result, driving significantly above-market revenue growth, earnings and free cash flow for decades, creating truly compelling investment opportunities.

As of 31 Jan 2022, Diamond Hill owned shares of Colfax Corp. and SPX Flow, Inc.

The views expressed are those of the author as of February 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

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