Many funds mistakenly assess their portfolio's solely by financial metrics.
Moneyball, the bestseller by Michael Lewis, describes how Oakland Athletics used carefully chosen statistics to build a winning baseball team on the cheap. The book was published over a decade ago and its business implications have been thoroughly dissected. Still, the key lesson hasn’t sunk in.
Businesses continue to use the wrong statistics.
Before the A’s adopted the methods Lewis describes, the team relied on the opinion of talent scouts, who assessed players primarily by looking at their ability to run, throw, catch and hit.
Most scouts had been around the game nearly all their lives and had developed an intuitive sense of a player’s potential and of which statistics mattered most.
These measures, often based on league standards, usually failed.
Many fund managers seeking to assess their portfolios go down the same rabbit hole. Most lean heavily on traditional financial metrics to measure, manage and communicate portfolio results.
The equivalent of using batting averages to predict runs.
What does this mean? That funds make a mistake that’s exceedingly common in business: they measure the wrong things.
A portfolio’s performance cannot be judged solely by financials. Rather, non-financial metrics must also be considered.
"Non-financial metrics are quantitative measures that cannot be expressed in monetary units. Common financial metrics include earnings, profit margin, average order value, and return on assets. Measures such as customer satisfaction, market share, and new product adoption rate fall into the category of non-financial metrics."
- The Financial Times
Here are three advantages of measuring non-financial performance metrics.
1. Critics of traditional measure argue that drivers of success in many industries are “intangible assets” such as intellectual capital and customer loyalty, rather than the “hard assets” on balance sheets. Although it is difficult to quantify intangible assets in financial terms, non-financial data can provide indirect, quantitative indicators of a company’s intangible assets.
Here’s an example.
A study examined the ability of non-financial indicators of intangible assets to explain differences in US companies’ stock market values. It found that measures related to innovation, management capability, employee relations, quality and brand value explained a significant proportion of a company’s value.
By excluding these intangible assets, financially oriented measurement can encourage managers to make poor, even harmful, portfolio decisions.
2. Non-financial measures can be better indicators of future financial performance. In their 2003 Harvard Business Review article, accounting professors Christopher Ittner and David Larcker found that companies that bothered to measure non-financial factors earned returns on equity that were about 1.5 times greater than those of companies that did not.
Those are the type of returns portfolio managers strive for.
3. Another advantage of using non-financial indicators is their tight relationship with a company’s long-term organizational strategies. Financial metrics generally concentrate on yearly performance, namely on short-term performance. They do not deal with progress relative to customer requirements or competitors, nor other non-financial objectives that may be important in achieving profitability, competitive strength and longer-term strategic goals.
By tracking a portfolio's non-financial metrics fund managers can ensure ventures are always addressing their long-term strategy.
As managers and researchers have tried to remedy the inadequacies of current performance measurement systems, some have focused on making financial measures more relevant. Others have said, “Forget the financial measures. Improve non-financial measures like cycle time and defect rates; the financial results will follow.”
But managers should not choose between financial and non-financial metrics. In observing and working with many funds and their portfolio companies, we’ve found that the strongest do not rely on one set of measures to the exclusion of the other.
That no single measure can provide a clear performance target or focus attention on the critical areas of the business. To get a 360-degree view of a portfolio, manager's need a balanced presentation of both financial and non-financial metrics.