Financial Ratios as a System Input

Companies are essentially dynamic systems comprising of numerous moving components subject to a myriad of internal (e.g. management) and external (e.g. competition) forces. Financial statements in turn provide periodic snapshots of the state of the system. From these snapshots, various financial ratios can be deduced to convey useful qualitative information about a company.

Whilst almost all investors have the ability to undertake first order analysis by determining that “high earnings margin” or “high return on capital” are favourable, the fact that these financial ratios can also be inputs into the system, essentially forming a feedback loop, is under-appreciated.

One obvious example is how Amazon “weaponised” its low earnings margins to form a formidable moat against its competitors. In its early years, many simply looked superficially at Amazon’s earnings margin and decided it was a company growing unprofitably and hence unsustainable. Fortunately for Amazon, astute investors realised what those margins were doing to the competition and continued to support the company.

Therefore, one pathway to potentially generating non-consensus insights is to work through how financial ratios (particularly if they’re outliers) affect the various participants in the system – and in turn their likely responses. Let me demonstrate through an example.

BWX Limited is a market darling with an enviable number one position in the Australian pharmacy natural skincare category. BWX possesses fat profit margins, a 30%+ earnings growth trajectory, secular tailwinds and huge blue sky potential offshore. There are few ASX companies that tick so many boxes and offer such a compelling growth story.

One financial ratio that is an outlier relative to its peers is BWX’s 37% EBITDA margin – phenomenally high and often cited as a key investment merit of the company:

Note that BWX is essentially a vertical roll-up and the company did not exist in its current incarnation until FY16 (i.e. it has limited financial history). Its EBITDA margins have thus only become public information recently (on this point, if you’ve ever hustled in an old school marketplace, no old timer will ever tell you that they’re “doing well” or that “business is good”. Invariably “business is bad” and “you’re killing me ”).

It is then a worthwhile exercise to work through how this phenomenally high EBITDA margin, simply as a piece of information, may affect the actions of the participants:

Example 1 – Like most FMCG companies, BWX does not sell directly to consumers but rather it is dependent on retail chains and distributors as sales channels. With a juicy 37% EBITDA margin dangled in front, how are retail sales channels (many wielding tremendous amount of market power) likely to respond in future price negotiations?

Example 2 – How will adjacent and potential competitors respond once they perceive that a sustainable 37% EBITDA margin was on offer in a highly attractive market segment with no real structural barriers to entry? And in turn will BWX need to increase its sales and marketing expenditure to defend market share?

We can see here that whilst the fact that BWX currently possesses attractively high EBITDA margins is consensus knowledge, taking that extra step and working through how this EBITDA margin affects the behaviour of other participants within the system can often yield an extra dimension in your analysis.

And ultimately, it’s only the non-consensus insights that will deliver true alpha.

Note: The above article constitutes the author’s personal views and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold no position in BWX at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION. Any position held by the author may, for example, be part of a pair trade or a hedging position so it is not informative in isolation).