When All You Have Is a Hammer...
Goodhart’s Law is an adage that states ‘when a measure becomes a target, it ceases to be a good measure’.
The law is usually illustrated by the (almost certainly made-up) example of the Soviet factory producing nails: when the state rewarded workers based on volume, the factory produced hundreds of thousands of tiny, useless tacks; when the incentive shifted to the weight of items produced, the factory produced exceedingly heavy and impractically large rail-road spikes.
While one might be tempted to dismiss this anecdote as a joke at the expense of Soviet central planning, we believe that the underlying reality of Goodhart’s Law is universal: metrics used as targets to incentivize performance can ultimately end up negatively influencing the very behaviour that leads to the performance being delivered.
Investing seems to us to be increasingly characteristic of Goodhart’s Law. With markets obsessing on quantifiable short-term outputs such as revenue growth, profit margins and earnings per share, management teams that are excessively focused on delivering against such metrics risk confusing the output (the stock price) with the input (business performance), and attempt to influence the former rather than manage the latter.
In our view, the best business managers have long realised that a company’s stock price is a function of long-term business performance. Solve for the latter, and the share price will almost certainly look after itself over time. While this may seem like an obvious statement, the fact that as of June 2020, the average holding period of a stock in the US is down to 5.5 months (per a New York Stock Exchange study) vividly illustrates that the vast bulk of market participants take a very short-term view.
As such, the temptation for management to turn the relationship on its head by managing the business to beat short-term market expectations is extremely powerful. This behaviour can be taken to extremes: markets are littered with examples where management, in an effort to ‘make the numbers’, simply make up the numbers.(This is a topic for another day).
As investment time horizons continue to compress, we believe that having the patience to take a view of value creation beyond twelve months is increasingly a competitive edge.
The (Other) War on Waste
One only has to skim the headlines to know that cost cutting is all the rage at present. In fact, we can hardly think of any recent earnings calls which did not feature an analyst quizzing management about the scope to protect margins through cost cutting during a period of slowing growth.
In principle, we have no objection against management running the proverbial ruler over the list of expenses to make sure there are no extraneous costs within a business. However, whereas markets frequently applaud such large-scale cost cutting measures, we question the mindset that allows a business to operate with unnecessary costs for long periods of time. If we really think through the deeper reality of such actions, management teams touting efficiency programmes are really admitting to not paying attention to the proverbial pennies and cents during the good years, necessitating large scale cutbacks in the lean ones.
To quote Buffett, ‘whenever I read about some company undertaking a cost-cutting program, I know it's not a company that really knows what costs are all about. Spurts don't work in this area. The really good manager does not wake up in the morning and say, “this is the day I'm going to cut costs” any more than he wakes up and decides to start breathing.'
We agree. In our observation, exceptional firms are always engaged in a permanent war on wasteful costs and tend to embed some aspect of prudence and frugality in to their operating culture.
With all that being said, it may therefore surprise readers to learn that we don’t think the purpose of a business is to maximise profits under every conceivable scenario. In fact, there are times when we want management to keep the foot on the pedal when it comes to spending: specifically, when doing so will generate higher returns in future.
Short-term Gain; Long-term Pain
One of the most powerful tools to manage for short-term profitability is simply to cut costs and halt investment. Optically, it looks like margins are improving and cash is building up in the business – something the market (with an average 5.5-month investment horizon!) tends to reward. This kind of behaviour is particularly likely to manifest when the economy is slowing, as is presently the case.
However, for a competitively advantaged business with little or no debt, this is precisely the time to forgo the short-term focus on margins, profits and return on capital, and to take advantage of weaker competitors who are forced to curtail their spending.
Management teams that have been watchful of costs in the goodyears will likely find that their ability to maintain service levels or product quality leads to market share gains during such periods. Equally, those that have been disciplined on capital deployment during the preceding economic expansion may find opportunities to invest in M&A at much more attractive prices, setting the business up for the next expansion.
Counterintuitive though it may be, our observation is that markets frequently do not distinguish between businesses that willingly absorb (as opposed to forcibly suffer) margin compression during periods of economic headwinds.
In our opinion, investors would do well to distinguish between management teams that choose to absorb higher costs for future benefit and those that are cutting costs and halting investment because they are simply responding to Goodhart’s Law in trying to beat short-term expectations.
Not all cost cutting is beneficial in the long term. In that sense, management teams seeking to create value should be wary of becoming the proverbial man with a hammer in search of a nail.