Recently, two Wall Street Journal (WSJ) articles caught my attention with their reports of innovations in performance measurement. Given the significant role that accounting and financial reporting plays in evaluating performance, I just couldn’t resist digging deeper into these claims. The result: disappointment! There’s not even any creative accounting to excite me. There is little new here for those of us versed in traditional financial analysis…just some blatant marketing spin.
The first piece titled “Have Investors Finally Cracked the Stock Picking Code?” suggests that the “holy grail” for stock-picking may have been found. What is it? Well, it’s simply a twist on two very familiar ratios: gross profit percentage and return on assets. The new measure is called “gross profitability” and is touted as a measure of “quality.” The metric is nothing more than a Company’s reported gross profit divided by total assets. What does it do? Well, when used in conjunction with other more traditional metrics (i.e., price to book), it purportedly identifies companies with high future growth potential. And here is what the researcher who came up with this innovative metric concludes:
Basically, Novy-Marx seems to suggest that value investors should consider adding his new metric to their stock picking models. This sounds reasonable enough to me. After all, a new piece of relevant information (in this case related to profitability) does usually tend to improve the quality of our decisions, right?
Then why am I getting so grumpy about this alleged innovation? I’m just stunned to learn that simply adding a profitability measure to the value investing decision is considered innovative and unique enough to justify launching new funds! According to the same WSJ article, “new funds are launching based partly on it,” and four funds were launched last December and four more were planned for this past March that incorporated this new “quality” measure. Oh, please let this just be marketing spin…
And then there is the following quote:
Actually, this earnings-based measure is founded on the argument that operating expenses mask a company’s future prospects, so they should be disregarded. This is similar to the same argument we hear for using EBITDA, adjusted EBITDA, and a host of other non-GAAP measures. But I’m sorry, the above reactions to what appears to be sound research results is troubling. If profitability is truly something new to the value investing community…wow! I suspect what we really have here is a marketing gimmick to draw some attention to new funds…
Also, this could just be the latest in a long line of “silver bullets” that analysts hope will provide that one quantitative metric that obviates the need for fundamental financial analysis, experience, and insight. Presumably, those using the “gross profitability” metric are using it to focus on some aspect of longer term growth. If so, I would highly recommend another quantitative model which truly is innovative and has withstood the test of time: the DuPont Model. This model explains how a company’s return on equity (a driver of long-term value) is affected by return on assets, profit margin, and leverage. The problem is that the DuPont model is not very sexy, it has four ratios instead of one, and it requires the analyst to possess an understanding of a company’s strategy, model, etc. Oh, and by the way, we know how and why it works.
So, the gross profitability metric is not the “holy grail” this recent WSJ article might lead you to believe that it is, and Professor Novy-Marx likely never intended it to be so. When tempted to seek out that one key performance indicator, I would encourage you instead to consider the following:
The second WSJ article that intrigued me was titled “Citi’s CEO Is Keeping Score.” This piece describes Citigroup’s CEO Michael Corbat’s unveiling of a new performance measurement system. Now I hope you are reading this sitting down…Citigroup is going to introduce (emphasis added) “quantifiable targets that will allow analysts and investors to more-easily gauge the company’s performance.” Imagine that…how innovative can you get…using numbers to actually measure performance! And if this is not innovative enough, he’s going to use scorecards to assess the performance of top managers. And shockingly the new scorecard goals are going to grade “performance based on return on assets and tangible common equity.” Gee, I wonder if Citi senior leaders are familiar with Kaplan and Norton’s Balanced Scorecards, or even the previously noted DuPont Model. All of this makes you wonder just how troubled Citigroup is (was), if such performance measures are new to the Company. Maybe Michael Mayo’s criticism of Citi has been justified after all…
So, what’s my point here? Neither WSJ article is really describing anything new and innovative. What we have here really are parties trying to “sell” innovation for their own self-interests. We sure do live in a crazy world.
This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.