Warren Buffett's partner, Charlie Munger, once said, "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
When corporate boards use bad incentives for management's pay, disaster often ensues. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, ROE, or earning per share are easily manipulated and gamed. Fortunately, there is a better way: EVA momentum.
Creator Bennett Stewart of EVA Dimensions, who also co-created EVA (economic value added), calls EVA momentum "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
So what does this mean for investors? A positive reading on EVA momentum means a company has created value by increasing its EVA, a negative EVA momentum means that EVA, and thus value, has decreased, signaling a destruction of value. EVA momentum is one of the few, if not the only, performance measures with such a clear dividing line between good and bad performance.
The best companies, then, create value in excess of their cost of capital, as reflected by positive EVA momentum. The higher the EVA momentum, the more value management's creating.
Let's look at Fastenal (Nasdaq: FAST ) and four of its distributors industry peers to see how effectively they create value. Here are the trailing four quarters' worth of EVA momentum figures for each company over the past three years, and rankings by percentile in the distributors industry for the past 12 months' EVA momentum.
|Barnes (NYSE: B )||0.4%||(4.2%)||1.0%||63|
|W.W. Grainger (NYSE: GWW )||1.0%||(0.8%)||1.0%||65|
|Lawson Products (Nasdaq: LAWS )||(0.3%)||(2.7%)||0.9%||61|
|MSC Industrial Direct (NYSE: MSM )||0.6%||(3.3%)||1.4%||86|
Source: EVA Dimensions LLC.
All of these distributors created value this past year, with Fastenal leading the pack with an EVA momentum of 2.0%, which puts it in the 87th percentile of all distributors. Besides MSC Industrial Direct, which also was exemplary, the rest fell in the midrange of the distributor industry. But notably, all have made more than their cost of capital, creating shareholder value.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this extremely new metric proves for companies and investors. If it lives up to its promise, EVA momentum will be an essential tool in investors' arsenals.
Another tool for better investing
Most investors don't keep tabs on their companies' fundamental value. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home run stocks that provide the market's best returns.
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