"I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it," Warren Buffett's business partner, Charlie Munger, once said. "And never a year passes but I get some surprise that pushes my limit a little farther."
For corporate boards, using bad incentives for management pay can be disastrous. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, return on equity, or earnings per share are easily manipulated and gamed. Fortunately, EVA momentum provides a better alternative.
Creator Bennett Stewart of EVA Dimensions, who also co-created EVA (Economic Value Added), calls EVA momentum "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
So what does this mean for investors? A positive reading on EVA momentum means a company has created value by increasing its EVA, and a negative EVA momentum means EVA has decreased and less value is being created. EVA momentum is one of the few performance measurements, if not the only one, with such a clear dividing line between good and bad performance.
The best companies, then, create value in excess of their cost of capital, as reflected by positive EVA momentum. The higher the EVA momentum, the faster management is creating value.
Let's look at the pharmaceutical industry and see the most effective producers of value as measured by EVA momentum over the past quarter and year, as well as the three-year trend. The companies are ranked by percentile versus the Russell 3000. The limitations I've set are that the company must have more than a $500 million market cap and be traded on a major U.S. exchange.
Russell 3000 Percentile
Akorn (NAS: AKRX)
Jazz Pharmaceuticals (NAS: JAZZ)
Questcor Pharmaceuticals (NAS: QCOR)
Salix Pharmaceuticals (NAS: SLXP)
ViroPharma (NAS: VPHM)
Novo Nordisk (NYS: NVO)
Optimer Pharmaceuticals (NAS: OPTR)
Dr. Reddy's Laboratories (NYS: RDY)
Bristol-Myers Squibb (NYS: BMY)
Source: EVA Dimensions LLC.
Akorn leads the industry with a 39.5% EVA momentum in the past year, as well as with its three-year trend of 12.2%, placing the company in the top 1% of the Russell 3000.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this extremely new metric proves to be for companies and investors. If it lives up to its promise, it will be an essential tool in investors' arsenals.
Another tool for better investing
Most investors don't keep tabs on their companies' fundamental value. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.
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