Amazon and the Importance of Asset Turnover
On the stock market, 2017 has been the year of Amazon, from the acquisition of Whole Foods to the temporary crowning of CEO Jeff Bezos as the wealthiest man in the world. How can we explain Amazon’s success?
Jeff Bezos believes the secret to his early successes was an efficiency “flywheel.” Price decreases led to increased consumer traffic, which fostered an increase in revenue and attracted more third-party sellers to the site. Amazon could then better leverage its fixed assets like their fulfillment centers and servers. This increase is asset utilization enabled Amazon to further decrease prices. Make improvements at any juncture, Bezos reasoned, and it should enhance the entire process.
In the early 2000s, we can see this strategy play out in Amazon’s asset turnover ratio, which measures revenue divided by assets. The ratio shows how much revenue a company can generate with each dollar of assets and is therefore an optimal benchmark for efficiency and productivity. Amazon destroyed competitors like Barnes & Noble and Borders with dramatic increases in asset turnover.
Figure 1: Amazon’s Asset Turnover Ratio vs. Competitors
Source: CapitalIQ
Asset turnover tells the story of how a focus on efficiency rather than profits drove Amazon’s meteoric rise. Yet the asset turnover metric is unfamiliar to most on Wall Street.
Asset turnover as a metric comes from one of the few schools of investment analysis to predate the discounted cash flow model: DuPont analysis. Invented at DuPont, this tool decomposes return on equity into asset turnover (revenue/assets) and gross profit margin (gross profit/revenue) to better understand the drivers of future profits.
Figure 2: DuPont Analysis Model
Source: Investopedia
Most investors on Wall Street spend a disproportionate amount of time focused on the margin branch of the DuPont tree, exhibiting a strong preference for high-margin companies that they perceive to have competitive advantage. These preferences stem from Michael Porter’s Five Forces, which contend that managers should seek a certain market position in order to increase profit margins.
Amazon is fascinating because it directly contradicts traditional strategy. When most CEO’s are focused on profit margin, Bezos plays the other side of DuPont analysis. At Verdad, we follow the same strategy with investments.
We prefer to spend time looking at asset turnover rather than profit margins because empirical evidence suggests that profit margins have little predictive power. Margins do not predict future returns on equity, and they have a tendency to mean revert.
Asset turnover shows far more promise as a predictive tool. Asset turnover is a factor in Piotroski’s F-Score as well as other quantitative factor studies of quality. The goal of a manager, therefore, should not necessarily be higher margins, but rather higher asset turnover, which as an efficiency metric is more persistent and predictive.
From 1963 to 2010, investing in the stocks with the highest asset turnover ratios beat the universe of all stocks in 76% of rolling five-year periods. Investing in the stocks with the highest profit margins beat the all-stocks universe only 47% of the time.
Why is asset turnover so predictive? The literature suggests two primary reasons:
It is more difficult to imitate a firm’s deployment of assets than its cost structure because asset deployment often involves overhauling factories. Therefore, changes in asset turnover are more persistent than changes in profit margin.
Changes in profit margin can result from changes in accounting conservativism and thus do not necessarily reflect an increase in efficiency.
Our own regressions have demonstrated the predictive significance of the asset turnover ratio time and time again. It’s one of the most important – and neglected – metrics for analyzing companies.