Warren Buffett's partner, Charlie Munger, once said, "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. And never a year passes but I get some surprise that pushes my limit a little farther."
When corporate boards use bad incentives for management's pay, disaster often ensues. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, ROE, or earning per share are easily manipulated and gamed. Fortunately, there is a better way: EVA momentum.
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 EVA momentum reading means a company has created more value by increasing its EVA while a negative EVA momentum reading means EVA has decreased, signaling less value creation. EVA momentum is one of the few, if not the only, performance measures 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 electrical equipment industry and see the most effective producers of value as measured by EVA momentum over the past quarter, year, and three-year period. The companies are ranked by percentile versus the Russell 3000. The limitations I've set are the company must have more than a $500 million market cap and be traded on a major U.S. exchange.
Russell 3000 Percentile
3 Year Trend
II-VI (NAS: IIVI)
Polypore International (NYS: PPO)
EnerSys (NYS: ENS)
Ametek (NYS: AME)
Franklin Electric (NAS: FELE)
Roper Industries (NYS: ROP)
Hubbell (NYS: HUB.B)
Source: EVA Dimensions.
II-VI leads the industry with a 8.1% EVA momentum in the past year as well as a three-year trend of 2.3%, beating over 89% 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 for companies and investors. If it lives up to its promise, EVA momentum 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.
If you are interested in continuing your research on a stock mentioned here, add it to My Watchlist to stay abreast of all of our Foolish analysis.
At the time thisarticle was published Dan Dzombak's musings and articles he finds interesting can be found on his Twitter account: @DanDzombak.The Motley Fool owns shares of II-VI. Motley Fool newsletter services have recommended buying shares of II-VI. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.