The Culture Club's Good Karma Chris Davis of Davis Advisors judges companies by their value systems--and makes money doing it.
By David Rynecki; Chris Davis

(FORTUNE Magazine) – Chris Davis is a fanatic about corporate culture. Why? The 38-year-old CEO of Davis Advisors says that finding managers with honesty and integrity is essential to picking winning stocks. He should know: His family has been managing money for three generations, and his mutual funds are some of the best performers on the Street (the Davis Opportunity fund has a five-year annualized return of 11%). We asked him for some pointers on cultural sleuthing. --David Rynecki

Why should the culture of a company matter to investors?

We've all had our noses rubbed in the result of bad cultures. Accounting problems don't usually happen in companies with a strong culture of being honest and showing integrity.

And it's a profitable approach?

Absolutely. The markets tend not to pay attention to culture. You can buy [quality companies] cheap and hold them while they grow.

Define a good culture.

Intellectual honesty, recognizing the true nature of their business, admitting mistakes, understanding the risks. An owner-operator mentality is essential. A company like Golden West Financial (GDW, $90) has no structural advantage over other S&Ls, and yet somehow it has compounded at over 20% for 30 years while most of its competitors went bankrupt. This happened because of an obsessive focus on low costs, managing risk, and responding to problems.

How do you learn about the culture?

I construct a mosaic of clues. The proxy statement is a great place to start. The evidence can turn up in financial statements, employee morale, customer-satisfaction surveys, CEO letters, stock-ownership records. I'll give you a direct quote from the 2000 annual report Jamie Dimon wrote just after taking over Bank One (ONE, $38): "These results are absolutely unacceptable to you and Bank One's management." There were no excuses. We owned some of the stock at the time of the report, but we added more after we saw that report and have done very well.

What are some other great cultures?

Golden West and Progressive (PGR, $70) are good examples. Costco (COST, $32) is a culture that is nutty about cost controls. UPS (UPS, $64) is fanatical and not at all short-term-oriented. Colgate (CL, $56) is another. It has no corporate jets. Wal-Mart (WMT, $57). Did you know that Lee Scott at Wal-Mart shares hotel rooms with other executives on business trips? After Sept. 11, Hank Greenberg at AIG (AIG, $58) gave up his bonus, and the whole management team followed suit. Hank told me, "You have to lead from the front."

But does that make these companies good investments?

Culture is a small short-term advantage because the Street has a really hard time quantifying it. But it compounds into an enormous advantage over long periods. Progressive has had double-digit earnings growth for 30 years. The thing is, those companies don't care about pleasing Wall Street. I keep this quote from an analyst who had a sell on Costco. He said that Costco appears to value its customers more than its shareholders. I think that's a good thing.