New Thought to Financial Metrics

Equity and credit analysis rely on accounting principles and future financial performance. Analysts regularly determine a company’s fiscal strength by comparing financial ratios and accounting statements (income statements, balance sheets, cash flow statements, etc.) to their peers. This evidently results in a relatively positive or negative opinion of a particular company. However, this traditional and numerical approach may not capture the full “credit quality” of a company.

Let us start by explaining what “credit quality” encompasses. This term acts as a catch-all phrase referring to the current financial strength of a firm. Unfortunately, what many individuals and investors forget is that “credit quality” also encompasses future financial strength and business performance. Depending on the investor’s time horizon this term can also be interpreted differently. A company can be financially stable in the near term, but a long-term perspective can be questionable and vice versa. However, despite the relativity of the term “credit quality”, we must take into consideration the accounting principles and financial metrics used.

Do the current accounting principles take into consideration intangibles and other intellectual property? In essence, “sort of”. Intangible assets like patents, brands, copyrights, information technology, research, and development (R&D), etc. function as value-creating investments that incompletely translate into regular expenses (salaries and rent) without taking into consideration their future benefit. Personally, this could be problematic as we live in a world of technology consumed by intangibles and intellectual property. Cloud services, social media platforms, artificial intelligence (AI), algorithmic learning, etc., represent a few of these influential intangibles. Some company’s entire business models build off these continuously evolving assets. It can be argued that reported earnings and financial statements, in general, no longer “completely” reflect the reality of businesses. This can be evidenced in the likes of Tesla, Netflix, and Amazon who all (at different moments in their history), have experienced excessive growth amid poor financial metrics.

But how do you determine a company’s financial strength with stagnant accounting principles? In short, think past the financial statements. Fundamental metrics of future performance such as customer growth, churn rate, test results, policy renewals, and cancellation rates illustrate some of the indicators of quality. Strategic assets (like intangibles) generate sustainable competitive advantages that illustrates a different story than the current financials. Evaluating a company’s operating strategic assets provides a competitive advantage for the investors. Looking at the customer franchise, product pipeline, brand strength, unique talent, and patents/other intangibles can illustrate a general fundamental opinion. Next, how these companies maintain and create strategic assets provide performance value. Lastly, successfully determining deployment of these strategic assets display the effectiveness of the company’s business model and lays the foundation for continued future credit strength. An investment analysis encompassing this three-step approach delivers strong arguments of future outperformance.

Accounting is a product of continued regulation and consistency. Though beneficial, it does present a multitude of issues. One of the most noteworthy resides in accounting principles lack of evolution. In short, as the world evolved into a “social distanced” society amid the quick and continually improving technological advancements, accounting procedures and standards have remained relatively stagnant. It is hard to argue when comparing financial reports from 20, 30, and even 50 years ago. The info between the lines are essentially the same. This may be due to the harsh regulatory hand and the pursuit to make these metrics as uniform as possible amid various industries, countries, and local economies. But this pursuit of uniformity delivers a derivative result of incompleteness when referring to specific strategic assets.

Understanding accounting’s limitations presents an opportunity to determine future outperformancers from an equity and fixed income perspective. As investors, we take advantage of this inconsistency by combining traditional financial metrics (credit ratios, etc.) with a fundamental analysis overlay. This allows us to fill in the gaps left by strategic assets. Technology and biological innovation amid society’s shift to intellectual property allows investors to take advantage of the arbitrage opportunities left in these sector’s wake.