Unlock Editor’s Digest for free
Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
I remember a long time ago as a Clever Clogs analyst tearing apart a friend’s new business venture. Why would you touch such a terrible industry? The profit margins are almost in the double-digit range! But when revenues exceeded eight figures, his earnings reached £1m a year. He realized before I did that money is absolute, while my financial models were full of percentages and ratios.
Relativism is not just a cultural problem. It is also prevalent in finance – as my friend has shown – as well as in economics and politics. We are constantly bombarded with comparisons that make no sense at all.
Take the news that Britain plans to increase its defense budget to 2.5 percent of gross domestic product by the end of the decade. What the hell does military spending have to do with the final value of goods and services produced in a country in a year? Even NATO believes its benchmark of 2 percent of GDP “serves as an indicator of a country’s political will to contribute.”
No, that’s not the case – the denominator has nothing to do with politics. If anything should be calculated on an absolute, bottom-up basis, it is national defense, where risk and performance are assessed. In any rational world, the number of 155mm artillery shells needed should be independent of consumer confidence (the biggest GDP driver). Armies should not starve if artificial intelligence fails to improve low productivity.
Carbon intensity metrics used to assess companies’ environmental performance are another example of relative nonsense. Our atmosphere needs fewer emissions, period – not that they rise less than revenues. It can also create a ridiculous situation where companies are praised when sales exceed emissions due to inflation alone.
The hot topic of unemployment also suffers from stubborn denominators. America has data on initial jobless claims, but the rest of the world rarely mentions the actual number of real people who are unemployed. Most often we talk about the unemployment rate, expressed as a percentage.
However, this is a fiction – usually an arbitrary definition of unemployment is divided by a poorer estimate of the number of economically active people. If someone feels worthless the day a survey lands on their doormat, they can check the “Not currently actively looking for work” box. Hey presto, they are not included in the unemployment rate.
And that, in my opinion, is the appeal of ratios and percentages. You are just one step away from being confronted with unpleasant truths, whether in the numerator (how many tanks do we actually have compared to Russia) or in the denominator (better prospects for defense spending are only due to a recession).
The inequality debate is another example. The left prefers to draw comparisons between rich and poor. Meanwhile, the right tends to focus only on the numerator, showing how much richer the poor are in absolute terms.
You may think that markets are above false relativities. And to their credit (and often to my shame), this is often the case. For example, no one cared that Amazon or Tesla had negative margins for years. Investors knew that the only thing to watch was the revenue line.
Likewise, the markets have hardly been deterred by rising national debt ratios for decades. Public sector liabilities in rich countries now average 100 percent of GDP. This could still prove disastrous. So far, however, government bond holders have been right not to panic.
However, investors still do silly things like comparing defense budgets to national income. For example, we rank companies by their price-to-earnings ratio, although every company and industry measures their net income differently.
Strategic reports are also devoured. These mostly consist of charts of variables that appear to move together (e.g. solar flare activity and Nasdaq year-over-year returns). Causation is claimed when the two numbers are merely correlated – if at all.
Perhaps our most common investing mistake is comparing today with the past. Of course, there are key figures that go back to an average – for example the return on equity. But extrapolating from historical context is often ruinous, as many a failed hedge fund – Long-Term Capital Management comes to mind – will tell you.
Of course, absolute numbers can also be misleading. Sure, Alphabet’s market cap rose by a headline-grabbing $250 billion on Friday – but it’s a big company. Likewise, during the Corona crisis it was wrong to report cases and deaths by country without reference to population size.
We all need to be more careful not to take relative or absolute facts for granted. But the former are particularly dangerous; Inaccuracies can lurk in two numbers. And very often these should not be compared at all.