I came across a second-hand bookstore on the weekend and, on impulse, bought a very cheap edition of the Chambers Dictionary for the house.
Not long after, I had to consult its pages.
Epiphenomenon.
An accompanying phenomenon, a less important or irrelevant by-product; a secondary symptom of a disease.
This isn’t an undergraduate essay, so why am I starting with a definition?
Epiphenomena tie in what I’ve been thinking about lately — financial metrics and the usefulness of financial statement analysis.
Are popular financial ratios like Return on Equity (ROE) just epiphenomena of something more important?
Do ratios and items in financial statements focus on symptoms rather than causes?
Financial ratios focus on symptoms
Baruch Lev, a professor of accounting at New York University, wrote a whole book arguing that financial statements are losing their usefulness.
Lev attributed the decline to a misguided focus on symptoms rather than causes.
For him, traditional metrics wielded by equity analysts — like P/E or ROE — aren’t nearly as insightful as we think (emphasis added):
‘Traditional securities analysis focuses on symptoms, like sales, earnings, profitability (ROE, ROA), and solvency. But these are backward-looking consequences of past deployment of strategic assets (e.g., transforming patents into revenue-generating drugs in recent years), having limited predictive ability… In contrast, our proposed analysis focuses on the causal factors—the resources that determine the enterprise’s future performance.
‘Focusing on available strategic assets and their future potential, rather than on their past performance, leads to substantially improved investment decisions.’
Strategic assets are not accounting assets
Let’s take Lev’s strategic assets idea and explore it further.
A key upshot of the concept is its sidelining of standard items in financial statements.
Take Adore Beauty Group [ASX:ABY], an online beauty retailer.
Yesterday, Adore Beauty released its FY22 results. The balance sheet listed the usual items.
Cash, inventories, property, plant and equipment, goodwill, payables, lease liabilities…
How helpful are these entries to an investor uninitiated to the inner workings of ABY’s operations?
Lev would argue not much. He distinguishes strategic assets, or resources, from accounting assets — like property, inventories, goodwill, etc.:
‘The resources (input factors) enabling value creation, henceforth strategic resources, are different from accounting-recognised assets.’
Consider Adore Beauty’s business model levers.
What are its key value drivers? The variables that measure the efficacy of the business model?
What sets ABY apart from its competitors?
If you look at its balance sheet, you won’t find anything that can set it apart from the rest — either in a laudable or disparaging way.
Take another beauty retailer, BWX [ASX:BWX].
Its balance sheet will reveal the same generic assets as a competitor like Adore Beauty.
Lev thinks investors should focus on information concerning a firm’s efficient use of its strategic resources — not generic resources available to any rival or newcomer:
‘But not just any resources; office buildings, production machinery, airplanes, inventory, or drilling equipment — all those assets that populate corporate balance sheets — cannot create competitive advantage. They are just commodities, available to all competitors, and, therefore, their use cannot distinguish the user from its rivals.’
Lev corroborates the point by noting that a giant like Pfizer doesn’t set itself apart with laboratory equipment since similar equipment is used by all other pharma companies.
What sets Pfizer apart must be a different kind of asset.
Measuring strategic assets
That’s why a focus on strategic assets can drive an investor to assessments opposed to ones derived from standard accounting measures like earnings.
Lev used drug and insurance companies as examples:
‘A drug company’s current sales might be high and its earnings might beat the consensus, but if its product pipeline (a strategic asset) is thin, its future performance will soon deteriorate. An insurance company’s earnings may be currently low because it is improving the customers’ book by weeding out “high-risk customers, but future earnings will consequently rise.’
Buffett himself was reported to use non-standard measures when evaluating retailers.
In an older book on Buffett’s method, acolyte Richard Simmons wrote how Buffett identified a volume-per-square-foot-related measure for his investment in See’s Candies — ‘pounds of candy sold per outlet.’
Simmons wrote that Buffett tracked this measure ‘diligently’ to track See’s progress.
Simmons also had a great passage on why we should focus on key drivers of business performance even if drivers are represented via unconventional measures:
‘Often more useful is to develop your own notion of key drivers for the industry. Say you were considering an investment in a clothes retailer. You would certainly be interested in its gross and operating margins but also how much it sells per square foot, how much it has invested per square foot, how often it sells all its stock, how often it has to pay its creditors, how much growth is coming from existing sites versus new ones and so on.
‘You would want to look at these numbers over time and how competitors fared in the same terms. Then step away from the numbers: what are they telling you and does that fit in with your observations? Do the companies’ stores appear well-managed? Are they busier than their rivals? Are the locations appropriate for the strategy (main street/secondary/out-of-town)? What threats are there? Could rivals easily reproduce the best features of your company? Are there limits to growth? Will direct-mail/catalogue/online suppliers directly compete?’
Doing this kind of analysis takes more detective work than reading a financial statement with an Excel spreadsheet open and calculating ratios.
Investing is forward-looking.
So the best investing must involve some predictive qualities.
And prediction rests on genuine causes rather than direct correlations.
So we should ask whether the common ratios or items in financial statements give us enough information to derive causes or correlations.
For instance, ROE is an excellent ratio, and a detailed breakdown of ROE, like DuPont analysis, can yield great insights.
In fact, I highly value the insight produced by inspecting a company’s ROE, thanks in large part to learning from our Editorial Director, Greg Canavan.
(By the way, Greg wrote a terrific book on the matter here.)
But is ROE predictive?
If a company has a long history of high ROE, we can certainly infer some kind of sustained business advantage allowing the company to generate consistently high returns.
But, on this alone, can we conclude that the business will continue to generate high ROE?
For that, we’ll have to assess its strategic assets and its key business drivers.
In this case, a high ROE is an epiphenomenon of something larger — the efficient use of strategic assets leading to a competitive advantage.
But we’ll have to do the detective work to find out what that is and whether it can endure — simply looking at ROE won’t tell us.
As another accounting professor Stephen Penman explained:
‘To value a business one has to understand the business. That amounts to understanding the idea behind the business—the business model—and managements’ execution of the idea. Successful business rides on a good entrepreneurial idea and the translation of that idea into value through business operations. Valuation, in turn, is a matter of translating one’s knowledge of the business model and its execution into a price for the business.’
Until next week,
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Kiryll Prakapenka,
For Money Morning
