The Last Shall Be First: Costco's Counterintuitive (But Profitable) Approach to Shareholders

Or, how Costco's focus on everything but its shareholders nevertheless leads to outsized investment returns...

Happy New Year and welcome to our new subscribers!

Special thanks, too, to those who recently became paid supporters! ❤️

Costco has been on my mind a lot lately. In part because of CEO Craig Jelinek’s recent retirement — COST 0.00%↑ lifer Ron Vachris ascended to the top spot just yesterday — but also because the company meant so much to the late, great Charlie Munger.

Of the many lessons that I’ve learned from Munger over the years, perhaps none is more important than his exhortation to identify the “big idea” from a wide array of disciplines — and, then, to assemble those ideas into a latticework of mental models that can be used to make decisions, big or small, throughout the rest of your life.

“You must know the big ideas in the big disciplines and use them routinely,” Munger once said. “All of them. Not just a few. Most people are trained in one model — economics, for example — and try to solve problems in [only] one way.”

These words inspired me to look for the “big idea” in everything. From lofty pursuits such as the hard sciences, psychology, and history (as Munger suggested) down to the idiosyncratic success stories of extraordinary individuals and institutions.

Which brings me to Costco.

The company’s exemplary merits are well known to Berkshire Hathaway aficionados — after all, it’s not like Charlie Munger was ever shy about singing its praises — but a surface-level examination doesn’t tell the whole story.

What really enabled Costco’s rise from an upstart Pacific Northwest retailer into the wealth-creating powerhouse that it is today?

Or, in other words, what is the “big idea” behind Costco’s success?

---

---

After much thought, I believe that Costco’s success (and unique culture) boils down to its relentless focus on putting employees and customers first. And, in turn, kicking its shareholders to the back of the line.

(Yes, I understand how crazy that sounds. But, please, bear with me for a second.)

That’s a sentiment that will make any investor feel at least the teensiest bit uncomfortable — but it’s pretty hard to argue with the results. In Craig Jelinek’s twelve-year tenure as CEO, COST 0.00%↑ shareholders earned a 21.8% compounded annual return (with dividends reinvested). Far better than the S&P 500’s 13.1% mark during that period.

But, as Jelinek will explain below, those eye-popping results were achieved due to a laser-like focus on everything but the shareholders. And, because of that, those very same Costco shareholders have profited immensely.

By putting the shareholders last, they ended up coming first.

(Funny how that works.)

Jelinek always preferred to hold his cards pretty close to the vest — granting precious few interviews and media appearances. But, as is my wont, I’ve dug around and found some choice quotes from the erstwhile Costco boss.

Allowing him to explain — in his own words — how Costco has opted for the road less taken and chosen to elevate customers and employees over its own shareholders…

(1) “We have never been a company that puts the shareholders on top. You have a responsibility to the shareholder — you do — but if you take the shareholder first, you are going to be in it for the short-term. We [initially] had a difficult time [with Wall Street] with the wages that we paid and our refund policy, but we’ve gotten past that because we’ve been able to grow the business.”

(2) “Everything that we do at Costco is not to figure out how much we can make — it’s [about] how little we can make and still pay our bills because we want to sell more. We want to continue to lower the price and sell more units.”

A lot of companies pay lip service to the importance of delighting customers and taking care of employees. But very few walk the walk better than Costco.

Costco creates a perpetual motion virtuous circle by funneling all scale-induced savings back into lower costs for its members. The company has, no doubt, had countless opportunities to pad its margins a little — a move that shareholders would love and customers unlikely to even notice — but Costco steadfastly refuses to do it.

As I wrote a few months ago:

Whenever Costco discovers some new way to reduce costs, it passes those savings straight on through to the customer. And, therefore, it further entrenches its competitive advantage that little bit more. Nomad Investment Partnership coined this the “scale efficiencies shared” business model.

Membership numbers keep increasing because of Costco’s famously-low prices, which leads to both profits for Costco and reduced costs from additional scale advantages, which Costco then uses to lower prices even more, which attracts more members, etc.

Rinse and repeat. Everyone wins.

(3) “[If] you want to have a good company, you need good people and you have to pay good wages. You have to build loyalty. And we don’t have much of a turnover in our organization. We want people to stay long-term. We want people to make higher wages. We want people to be able to afford homes. It’s just the right thing to do.”

(4) “We want to make sure that our employees are at the higher end of the [pay] scale — and we believe that they are at the top end … We want to pay for longevity. We do not want to turn people. We want to keep our employees.”

Which made the recent news of Costco workers in Norfolk, Virginia, voting to unionize with the Teamsters a little surprising.

Jelinek and Vachris responded via a letter to all Costco employees:

To be honest, we’re disappointed by the result in Norfolk. We’re not disappointed in our employees; we’re disappointed in ourselves as managers and leaders. The fact that a majority of Norfolk employees felt that they wanted or needed a union constitutes a failure on our part.

At Costco, we take great pride in our relationships with each other. We’re not anti-union, but our core value of “taking care of employees” has never been the result of any union. It’s been part of Costco’s Mission Statement and the foundation of our Employee Agreement from the very beginnings of Costco’s business.

If nothing else, that’s a brilliant bit of PR.

(5) “If you keep the consumer and your employees [in mind] and do the right thing, things have a way of working out for you. You build trust with your employees and you build trust with your consumer — which is really just common sense and good business.”

• Jelinek added, “This isn’t rocket science … It’s simple. The hard part is keeping it simple.” Which sounds positively Munger-esque to me.

(6) “You take care of your customer, your member. You take care of your employees. You take care of your suppliers. Then, if you do all those things, you’re going to reward the shareholders. That’s always been our philosophy.”

(7) “If you get too short-sighted and you want to reward your shareholders as the most important thing, chances are you’re not going to be in business in five, ten, fifteen years. Our view is we want to have a company for the long haul and continue to grow the sales and grow the profits fairly — and make sure there’s always opportunity for our employees to grow.”

(8) “We are very paranoid about making sure we always do what’s best for our members.”

• Costco’s focus on membership benefits has paid off in spades — with a 90% renewal rate and 72 million paid members worldwide. In North America, that renewal number looks even better — clocking in at an impressive 93%.

(9) “People know that we have quality merchandise at a very good price. They’re not seconds. They’re not closeouts. It’s quality merchandise that you can buy at most department stores or high-end stores at a very good price.”

• At Costco, low cost does not mean low quality. All the sweet talk in the world about competitive wages and appreciating customers would mean very little if the merchandise at the warehouses was not up to snuff. Especially for a company like Costco, with its emphasis on lower prices and squeezing out more sales on razor-thin margins. But, happily, that’s not the case.

(10) “Trust me, [the $1.50 hot dog and soda combo] is never going to change. If I have to subsidize it personally, it’s not going to change.”

(11) “I know it sounds crazy making a big deal about a hot dog, but we spend a lot of time on it. We’re known for that hot dog. That’s something you don’t mess with.”

• To me, Costco’s $1.50 hot dog and soda combo — seemingly immune to the price pressures of inflation — is the most famous example of how the company “takes care” of its members.

(12) “I came to [Costco founder Jim Sinegal] once and said, ‘Jim, we can’t sell this hot dog for a buck-fifty. We are losing our rear ends.’ And he said, ‘If you raise [the price of] the effing hot dog, I will kill you. Figure it out.’ That’s all I really needed. By the way, if you raised it to $1.75, it would not be that big of a deal. People would still buy [it]. But it’s the mindset that when you think of Costco, you think of the $1.50 hot dog and soda.”

• Jelinek added, “By having the discipline to say, ‘You are not going to be able to raise your price. You have to figure it out,’ we took it over and started manufacturing our hot dogs [ourselves]. We keep it at $1.50 and make enough money to get a fair return.”

• And, by the way, Jelinek’s concern over the combo’s financial viability was perfectly reasonable. Especially for a company that keeps such a close eye on its costs and margins. But Sinegal recognized how the combo exemplified Costco’s value proposition to its members — and he impressed that fact upon his protege via death threat. Hey, whatever works.

(13) “I want to be able to go in the food court, 25 years from now when I’m old with my walker, and sit down and say, ‘I remember you when!’ to some of our employees. That’s very important, to be able to create a company long-term that’s going to continue to grow and provide opportunities. You do that by taking care of the member and creating them great value.”

(14) “Success is a lot of different things to a lot of different people. If you can continue to provide value to the consumer, your business is going to continue to grow. [And] if your business continues to grow, you’re going to provide opportunity for your employees. If you can provide opportunity for your employees, your employees are also going to be able to grow. They’re going to be able to support their families — and enjoy a better quality of life. If those things happen, you will just continue to reward the shareholders.”

(15) “We want to keep what we do simple. If you start to drift and become complicated, it costs you a lot of money to be complicated.”

At Costco, the mission is indeed simple: the customers and employees always come first — even if (in the short-term) that comes at the expense of shareholders.

Hopefully, under new CEO Ron Vachris, it will stay that way.