Jul 10 2013

Financial ratios and the New Church of Finance

Posted by: Nick Shaxson in: Thoughts

Clayton Christensen of Harvard Business School, one of the world’s foremost authorities on (genuine) business innovation, had a tremendously important article in the Deseret News recently, entitled The New Church of Finance: Deeply held belief systems and complex codes must be changed.

“Why is financial capital flowing disproportionately to innovations that do not produce jobs? I think the roots lie in a powerful new belief system.

About 40 years ago some people established what I describe as a new church. I call it the New Church of Finance.

The members of this church are finance professors at business schools, a lot of economists and the partners in hedge funds and private equity funds. I call it a church because it has many of the characteristics of a well-catechized belief system. For those committed true believers within this “church” it is inconceivable that the catechism isn’t true. People on the outside looking through the window, however, might be justifiably skeptical.”

This seems absolutely right. Increasingly, I think, there are ‘enlightened’ sections of the economics and business professions who would agree wholeheartedly. Christensen continues:

“In early Christian history, Christianity merged and consolidated with other belief systems in the Mediterranean. Emperor Constantine urged the leaders of the Christian church to get together and hammer out the orthodox beliefs. Similarly, the leaders of the New Church of Finance have formalized their orthodox beliefs regarding profit.

And it turns out that their definitions of profitability are mostly denominated in ratios. You have such concepts as Return on Net Assets (RONA), Economic Value Added (EVA), Internal Rate of Return (IRR), Earnings Per Share (EPS) and Gross Margin Percentage. They are all ratios.”

My latest New Statesman piece on private equity and hedge funds, asking why (on earth) people still invest in these things despite their inferior overall performance, illustrates this exactly. IRR is a typically preferred metric, and my article demonstrates how it not only becomes a metric that people bow down before – but can also be a tool of outrageous bamboozlement.

Christensen (no relation of my colleague John Christensen, by the way) points to the essence of the problem. You can improve your profitability ratio (such as RONA, which measures income divided by assets) by generating more revenue, and then putting that in the numerator at the top of the mathematical fraction. That may well be a very good thing, though it’s also often hard to do. He continues:

“But the other way to improve this ratio is to reduce the denominator by a company getting rid of assets. Reducing assets is much easier than increasing revenue. So if a CEO is rewarded for a good RONA ratio, the incentive is to outsource aggressively.

(Elsewhere, he says that Wall Street analysts have “outsourced their brains without realizing it.”) Back to Deseret News, following straight on from the points about RONA:

“When there are no assets on a balance sheet, then this rate of return is infinite, and according to this definition, it might seems like such a company is doing better and better.”

Back to IRR, and in Forbes magazine Christensen continues:

“There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Because if you ever use your money for something that doesn’t pay off for years, the IRR is so crummy that people who focus on IRR focus their capital on shorter and shorter term wins.”

Read the rest of his article to see the full argument.

It’s interesting that Peter Morris, whom I quoted in my New Statesman article on Private Equity and Hedge Funds, uses the same language, although with a slightly different focus. In an article for Financial World, he says:

“The economic catechism, as it developed up to the crisis, has many parts. . . A pervasive belief system tolerates no apostates.”

He identifies one as the idea that people involved in the market are, or are at least acting like, “principals” – that is as though they were dealing with their own money. One of the great reasons why private equity and hedge funds have performed so disamally for their investors, or course, is that they are largely playing with other people’s money.

These are all such important ideas that I hope they get circulated more widely. (I did mention Christensen’s thinking in my co-authored Finance Curse document; I interviewed him for my Vanity Fair story last year on Mitt Romney.)

Please do pass Christensen’s article on the New Church of Finance in particular, to others, if you agree with it. The “Church of Finance” is a most powerful way of expressing something that explain how the global economy has gone wrong in recent decades.

It’s high time for some new catechisms. Or, better still, none at all.

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