Ratio Obscura

Est. Reading Time: 10-12 Minutes

There is some amount of unavoidable cognitive dissonance that occurs when one delves into the world of financial metrics. Even if just sticking to fundamentals (i.e., avoiding technical analysis) on quick glance it looks like there are well over seven hundred metrics.  

But, most go through a pretty standard path of starting with the common ratios such as Price to Earnings or Price to Book and, if venturing far enough, may land at highly specialized metrics such as Lifetime Customer Value or Annualized Recurring Revenue.  

These all have their place but eventually one finds that they all must be taken with a grain of salt depending on the situation you are evaluating. Despite the continual hope that there exists some short list of easy ratios that’ll make our investing lives easier, there will never be a catch-all approach that satisfies this desire.  

However, a few do capture quite a lot of information and are worth understanding.

A Quantitative Metric That is Secretly Qualitative

The Robustness Ratio is one that unfortunately you will not find on a screener. At least, none this author is aware of and if any readers happen upon one, please let us know.  

The Robustness Ratio was introduced by Nick Sleep in the May 2005 edition of the Global Investment Review, and it is a framework to help think about the size of the moat around a company.

A company’s “moat,” an idea often attributed to Warren Buffett, is a company’s ability to maintain its competitive advantage. Much like a moat around a castle, a company’s moat imparts certain advantages in staving off competition.

The idea is a useful one but inherently subjective. While all castle moats look roughly the same, a company’s moat can take on many different forms. For Coke or Nike, it is the entrenched power of their brand, while for a company like Oracle it might be the sheer frustration and pain of trying to switch to a competitor. That latter example is probably not as good of a moat.

So, although an extremely useful concept, it was relegated to the area of art rather than science until Nick Sleep talked about how he evaluates the strength of a moat via the Robustness Ratio.

The Robustness Ratio is effectively a division of benefits analysis. That is, how are the benefits of a company being distributed amongst the parties that interact with it. We’d bucket this into the categories of customer, employees and shareholders.

As no company is going to have long term success without happy customers and employees, it would follow that a company that produces a meaningful benefit for these groups over the shareholders has a much better chance of surviving than one that does not.

While not applicable to all business models, this would be calculated as the amount of money saved by customers and paid to employees divided by the amount of money earned for shareholders (owners).

Using the example offered by Nick Sleep when he proposed it in 2005, the calculation of the ratio for Costco would look like this (all in 2005 valued dollars):

Customers

On average, a Costco cardholder spends $1,100 per year in the store. Costco spends $980 at cost to supply these goods which, if one assumes similar buying power and a comparable basket of goods, would cost $1,300 at a competing supermarket such as Kroger or $1,250 at Wal-Mart (gross margins of 26% and 23% respectively, compared with 11% at Costco). We can estimate that, on average, a Costco cardholder saves somewhere in the region of $175 per year by shopping at Costco in return for paying an annual fee of $23 for membership, or a net gain in the region of $150 per cardholder per year.

Employees

From management meetings, we can assume that 70% of Costco’s SG&A is made up of wages/benefits and that Costco’s wage/benefit scales are 55% higher than the competition. Costco, in a sense, “overpays” its employees to the tune of $1.1B per year, or $26 per cardholder per year.

Shareholders

As of 2005, the pre-tax distribution to shareholders came out to $32 per cardholder or 15% of the distributable pie.

In all, this puts the ratio of customer plus employee distributions to shareholders’ at about 5.5x. Meaning, for every dollar of value that the owners of the company get, customers and employees get $5.5.

This is somewhat cherry picked as an example as Costco has one of the strongest moats around. Any company that can be evaluated with this approach and is landing at or above a 1:1 ratio is net positive in it’s “moatiness.”

But a word of warning. This is not some magic bullet that removes the need for thinking in investing. No metric is.

A robustness ratio must be looked at within the context of the environment the company operates within. A ratio below one may in fact be perfectly sufficient based on the industry or competition. Conversely, a very high ratio such as Costco’s in the above example may be an indicator of under-earning compared to its potential.

In the latter case, it may be more desirable to have a high ratio to grow the business towards economies of scale. Through this lens the ratio may be a better indicator of growth inevitability as the destination becomes much clearer with such a defensible position.

Many would (and did) pass over Costco at the time as their gross margin of 11%, which was less than half of their competition, was a signal of a lesser company. In fact, the Company’s share price was effectively flat for the six years leading up to 2005. Despite the company returning +14% annually between 2005 and the time of this writing (which ignores dividends by the way), it was not blatantly obvious to most at the time that this was what would come to pass.  

So, despite providing a quantitative method for assessing a moat, the catch here might be there is still a bit of art left in the endeavor. As a high ratio will likely come alongside less than stellar reported earnings, the Robustness Ratio is better thought as an indicator of super long-term investment opportunities.

Calculating the moat may have become easier with this method, but you’ll still have to trust it will keep the competition at bay while you sit inside the castle.

A Purely Qualitative Metric That Keeps You Sane

I’ll pair this overview of the Robustness Ratio with another that I know you will not find in any screener or analyst report. I know because I made it up. But, since moving to only focus on public markets after a stint in the private realm, it is an idea that I use more and more to evaluate investment and life decisions.

I call it the Return on Cortisol.

That is, how much is gained per unit of cortisol that one has to absorb along the way to a given return.

Cortisol, known as the stress hormone, functions to increase blood sugar, suppresses the immune system and aids in metabolism as well as decreases bone formation. It is great in a pinch, say if you have to run from a lion, but when it is chronic in nature it degrades the body.

In finance, a lot of energy is spent evaluating how much capital needs to be put at risk to achieve a certain reward. But, there is little constructive thought around what you might have to give up qualitatively. It is typically only addressed after the fact, like when someone quits a soul sucking job for family or health.

It is something rarely done premortem. 

While obviously not based on calculated measurements, the Return on Cortisol ratio is more of a question to ask oneself before embarking on anything that will require money, time, energy or some combination of all three.

I’ll use personal experience to highlight.

Before New West Capital, the entirety of my focus was on private investments involving the purchase of commercial real estate or privately held businesses. The process would look something like this:

• We have $X of available capital to deploy into investments.

• We can raise 10x that amount when pooling our funds with outside investors.

• With our team, we can reasonably shoulder four investment acquisitions simultaneously.

• To reach four investments, we will have to pursue somewhere around 40 as we might be outbid by competing firms, find something in the financials we don’t like, not have our offer accepted, etc.

• For each investment we want to acquire, we will have to source, evaluate, get an offer accepted, perform in-depth due diligence, allocate the capital (debt and equity), take ownership and then implement the investment thesis (increase cash flow, sell of the parts, etc.).

The number of parties along the way in that process would include outside investors, representatives for potential acquisitions, third party service providers during the due diligence phase, banking institutions if using any debt, legal teams for paperwork and ultimately dealing with the business or property itself once we closed on an acquisition. Multiply that by the number of opportunities you must pursue in order to reach the target number of four in the above example and you get a sense of how many balls are in the air.

Note how much work is involved before even making an acquisition. That is a lot of movement for very little action. It is a lot of stress per unit of return.

But, many will naturally ask, don’t private markets provide higher returns to compensate for this?

Bain & Co. would say this not universally true per their research with several periods of private markets being more expensive (per unit of yield) than public markets. Personally, this has been my experience as my public market track record had been beating my private market track record by about nine percentage points annually leading up to the switch. All without the above characteristics. 

Although only a singular isolated example, why might a lower stress/friction path prove more profitable?

I will not extrapolate my experience to the broader market, but an explanation might be found in the area of decision-making science. This is a rapidly expanding field and has recently entered the common conversation with the success of Daniel Kahneman’s work and book Thinking Fast and Slow.

For the sake of brevity, I’ll address one area of decision making that might help to support the idea of thinking in cortisol adjusted returns. That is the area of risk taking.

While the subject of stress’s effect on financial risk taking is somewhat new within decision making research, early studies indicate that both chronic and acute stress may promote risk-taking/reward-seeking behavior even when it leads to a less desirable outcome. Further, a growing body of research suggests that when moderating for factors such as age or sex, risk seeking behavior increases in adolescence and in instances where data was missing or ambiguous, and specifically in the realm of finance women tend to be more risk adverse.

But here is the takeaway, unless you are an extreme outlier, stress in any form is going to degrade your decision making. For those that can claim to be an outlier, it still doesn’t improve your decision making so unless it is absolutely necessary why sign up for it?  

Going back to my private vs public markets example, it is true that a more complex price discovery system (i.e. the private markets) should lead to larger discrepancies between price and true value that can be captured by those willing to do the work. That is an engineering approach to defining the system. And while technically correct, once you factor in the human element this can still hold true while producing very different results for the participants. From the erosion of sound decision making mentioned above or phenomenon like the Winner’s Curse, the juice may not be worth the squeeze as they say.

So, how might one implement a Return on Cortisol filter?

While this is going to be tied to an individual’s particular situation, some of the ways I gauge this are as follows;

If being offered a speaking/advisory opportunity, my fee is at least whatever the last one was. It serves as my low water mark. In this way opportunities that pop up that are tangential to, but not part of, the core focus must be increasing in value for me to allocate time to them.

When making an investment decision, expected upside is weighed against how often one must check in to monitor the thesis driving the investment. The pinnacle of this would be a high compounder in which quarterly updates are all that is required. If it is a special situation stemming from say a legal proceeding, keeping up with those developments will require many more touch points. The upside must increase with the required touch points.

In life, my wife and I have arrived at a handful of non-negotiable “buckets” we are working towards individually and as a family unit. If something does not fall into one of these buckets, there are far more stringent criteria it must pass to get a time allocation.

As an equation it might look like this:

(Quality Time Gained) / (Stress Time Contributed)

If the value is positive, then proceed.

Or stated financially,

(Financial Gain) / (Stress Time Contributed)

If one option has a higher ratio than another, then choose the former.

Ultimately this is subjective to each person’s situation. But, as the expanding body of research is proving out, there might be something to the phrase Work Smarter Not Harder.