To understand this ratio, you need two documents that every public company publishes and three numbers that come from them.

The income statement shows how much the company sold over a period of time and what it cost to run the business during that period. It starts at the top with total sales and subtracts costs in steps until it reaches the final profit at the bottom.

The balance sheet is a snapshot at a single point in time of what the company owns and what it owes. The line that matters here is total assets, which is the value of everything the company owns: cash, inventory, buildings, equipment, and so on.

From those two documents, you need three figures.

Revenue is the total amount the company sold. It is the top line of the income statement.

Cost of goods sold (COGS) is the direct cost of making the product or delivering the service. It sits just below revenue on the income statement.

Total assets comes from the balance sheet.

From the first two, you get a fourth figure:

Gross profit = Revenue minus COGS. This is what is left from sales after paying the direct costs of production, and before any other expenses are taken out. On many income statements it is printed as its own line called gross profit.

The formula

Here is the ratio:

Gross Profitability = Gross Profit / Total Assets

which is the same as:

Gross Profitability = (Revenue minus COGS) / Total Assets

The result is usually written as a percentage or a decimal. Novy-Marx shortens the name to GP/A, for gross profits over assets.

An example

Suppose Company A reports the following:

• Revenue: 1,000

• COGS: 400

• Total assets: 1,200

Step 1, find gross profit: 1,000 minus 400 = 600.

Step 2, divide by total assets: 600 divided by 1,200 = 0.50.

Step 3, read it as a percentage: 0.50 = 50 percent.

So Company A produces 50 cents of gross profit for every dollar of assets it owns.

Now take Company B:

• Revenue: 1,000

• COGS: 700

• Total assets: 3,000

Gross profit: 1,000 minus 700 = 300. Divided by total assets: 300 divided by 3,000 = 0.10, or 10 percent. Company B produces 10 cents of gross profit per dollar of assets.

The two companies sold the same amount (1,000 each), but Company A generates far more gross profit per dollar of assets than Company B does. That difference is what the ratio captures.

Why gross profit and not the bottom-line profit

Most people, asked how profitable a company is, would look at net income, the final profit line at the very bottom of the income statement. Novy-Marx used gross profit instead.

Between gross profit and net income, a company subtracts many other expenses. Some of them are not really running costs. They are spending on the future: research and development, advertising etc.. These lower the reported profit today but are meant to produce higher profits later.

Suppose two companies have identical production, both with revenue of 1,000, COGS of 400, and gross profit of 600. Company A then spends 300 on research and marketing to widen its lead, and 100 on other costs, leaving net income of 200. Company B spends only 50 on research and marketing and 100 on other costs, leaving net income of 450.

Judged by net income, Company B looks more profitable, 450 against 200. Judged by gross profit, the two are identical at 600. The gross profitability ratio treats them the same, while a net-income-based ratio makes Company A look worse purely because it is investing more in its own future.

Novy-Marx’s argument was that gross profit is a cleaner measure because it is not reduced by spending that is really investment. The paper reports that gross profit predicted future returns more strongly than net income, cash flow, or dividends did.

When to use it

Do not use it on financial companies. Novy-Marx left banks, insurers, and financial firms out of the study. Revenue minus COGS is not a useful figure for a bank, and financial firms hold large asset bases, so the ratio comes out very low for reasons that have nothing to do with how well the company is run.

Compare companies within the same industry. The level of GP/A varies a lot from one industry to another, regardless of company quality. Capital-light businesses like software or consumer brands tend to show high GP/A. Capital-heavy businesses like utilities, airlines, or inventory-heavy retailers tend to show low GP/A. Comparing a software company’s ratio to a utility’s does not tell you much. Novy-Marx reported that comparing each company against the average for its own industry predicted returns more strongly than the raw figure. So the useful comparison is a company against its direct competitors, not against the whole market.

It measures profitability, not price. The ratio tells you whether a business is productive. It says nothing about whether the stock is cheap or expensive. Analysts have documented cases where highly profitable companies bought at high prices went on to disappoint, a pattern called gross profitability trap. Novy-Marx presented the ratio as something to use alongside a measure of price, not on its own.

What is a “high” ratio?

There is no fixed number. A company with a GP/A of 0.40 might be highly profitable in one industry and ordinary in another. The word “high” only means something once you compare the number against other companies, against the same company’s own past, or against the market as a whole.

Novy-Marx ranked companies. Each year he took all non-financial companies, sorted them from lowest GP/A to highest, split them into five equal groups (these groups are called quintiles), and labeled the top fifth the high-profitability group and the bottom fifth the low-profitability group. The dividing lines were based on the range seen among stocks on the New York Stock Exchange, and the sort was redone every year.

Two things follow from this:

First, “high” is a rank, not an absolute level. A stock is in the high group because it produces more gross profit per dollar of assets than most other stocks that year, not because it cleared some set line.

Second, as the mix of companies changes over time, the number that puts a company in the top group changes with it. So “high” is a moving, relative idea by design, not a fixed target.

A reference point that I use

Across a broad group of non-financial companies, GP/A has historically sat somewhere around 0.33, meaning roughly 33 cents of gross profit per dollar of assets. The most profitable group of stocks tends to sit well above that level, and the least profitable group well below it.

I use 0.33 as a rough marker.

How to compare companies

The level of GP/A depends on what kind of business you are looking at, regardless of how well that business is run.

Capital-light businesses, which need few assets to operate, tend to show a high GP/A. Software companies and branded consumer-goods companies are common examples, and their ratios can run well above 0.5.

Capital-heavy businesses, which need large amounts of assets, tend to show a low GP/A. Utilities, airlines, telecom networks, heavy manufacturers, and asset-heavy retailers are common examples, and their ratios are often below 0.2, sometimes below 0.1.

This is why comparing a software company’s GP/A to a utility’s does not mean much. Novy-Marx reported that comparing each company against the average for its own industry predicted returns more strongly than the raw figure did.

So the more useful question is not “is this number high in absolute terms,” it is “is this number high compared with the company’s direct competitors.” A utility with a higher GP/A than other utilities is above-average in its industry, even though its absolute figure would look low next to a software firm.

It also helps to look at the same company over several years. A GP/A that has stayed high year after year describes a business that is consistently productive with its assets. A GP/A that jumped this year after being ordinary for a long time might be due to a one-time effect.

Every stock in our portfolio scores above average on this ratio, so let's take a closer look at three of them from three different industries, a real-life application that shows what the ratio actually tells us about the quality of the businesses we invest in and what we can learn from it:

Read more

In a market where operational excellence and reasonable valuations are increasingly difficult to find, nearly all of our holdings delivered outstanding results across the board.

Recently, two of our small-cap positions reported their quarterly earnings, and it appears the broader market is finally waking up to these hidden, niche businesses:

Let’s dive into the latest update:

Read more

Now, it’s time to look elsewhere. The U.S. market is once again showing symptoms of mania, and history has taught us what comes next. Beyond investors handing billions to a 25-year-old with zero experience to manage (or rather, gamble), Robinhood recently revealed that they now generate more revenue from prediction markets (essentially a gambling platform) than they do from traditional equities.

This is a highly concerning trend that should serve as a wake-up call (though it likely won’t). In such a manic market, the best strategic move, aside from holding elite businesses with rock-solid fundamentals, is to explore what the rest of the world has to offer.

Why Japan? There are many reasons, but the two most critical are the lack of mainstream coverage and the country’s conservative business culture.

First, Japan simply isn’t on the radar for most Western investors because of the language and coverage barrier. Few Japanese companies maintain English websites, and even fewer translate their financial reports. As a result, stock analysis is largely confined to Japanese finance blogs that U.S. investors never see. But where few people are looking, opportunity lies.

Second, the nature of Japanese corporate culture is highly appealing. Many of these businesses are founder-led, operating with a long-term vision and closely aligned shareholder interests. Furthermore, they often dominate highly profitable niche industries that the mainstream ignores simply because they don’t have “tech” in the name.

Ultimately, Japan offers a fantastic playground for value investors looking to uncover hidden gems while simultaneously hedging against U.S. market risk.

Which brings me to today’s stock.

Today, we are looking at a highly profitable Japanese small-cap that is dominating a massive, government-backed transition.

Here is why this hidden champion demands your attention right now:

• The Government Mandate: Japan’s strict 2024 overtime caps and the Ministry’s digitalization initiative have forced the country’s massive construction sector to digitize overnight just to survive an unprecedented labor shortage.

• The “Picks and Shovels” Play: This company doesn’t take on the operational risks of construction; it simply supplies the required ecosystem that makes automation and legal compliance possible.

• Ignored by the West: As a purely domestic player, it has been completely overlooked by Western analysts and institutions, leaving a cash-generating business trading at an attractive valuation.

Behind the paywall, we’ll uncover the ticker, break down their competitive moat, and explore why this company might be the smartest backdoor play on Japan’s demographic shift.

Read more

Last week another company from our portfolio reported the best quarter in its history.

If you are a new subscriber, consider becoming a paid member. Our current portfolio consists of 11 industry leaders from the U.S. and Canada, across all market caps, that get almost no coverage on social media. Several are debt free. Several hold a dominant position in their niche. Most pay a regular dividend and convert more than 100% of their net income into free cash flow. All of them have a Sloan Ratio in the “excellent” range.

While Wall Street chases what is currently trending, we focus on reasonable valuations and rock solid fundamentals.

Let’s get into the latest update.

Read more

Five companies from our portfolio reported, four of them with exceptional results above expectations, one with average results that management had already guided for.

Once again we see the value of sticking to the fundamentals and putting money only into businesses with a long track record of operational excellence.

Meanwhile, the Wall Street lemmings keep making the same mistakes. They buy tech companies that are expected to be free cash flow negative for at least two to three years. They ignore the inflation risk coming out of the ongoing conflict in the Middle East. They borrow from their broker to buy securities, which is one of the dumbest things you can do.

The leading brokerage platforms all reported record margin loan balances in Q2.

Charles Schwab: $165B (+98%)

Interactive Brokers: $97B (+59%)

Robinhood: $22B (+127%)

You don’t need to be a genius to see how this will end. Investing in fundamentals is now more important that ever.

We, on the other hand, do not have to worry as much. Our portfolio is diversified across industries, which reduces idiosyncratic risk, and every holding is free cash flow positive year after year, carries high margins, leads its niche, and almost all of them confirmed a positive outlook.

Now to the latest earnings call updates.

Read more

Oil prices have skyrocketed over the past two weeks because of an unresolved Middle East conflict, and yet people don't seem bothered by the implications: when energy prices rise, everything rises in price.

An end to the conflict is not in sight, and the impact on stocks will be felt in the coming quarters.

Nothing new under the Wall Street sun.

Our stocks, on the other hand, are protected from most of the inflationary effects to come, because their business models don’t require large amounts of capital to keep running. Several of our portfolio stocks are trading at all-time highs, backed by rock-solid fundamentals rather than hopes and expectations.

As fundamental value investors, we are well positioned to weather any future market storms and to capture future upside, first, because we don’t overpay for a business, and second, because we only invest in companies that have passed a strict, time-proven screening process before they earn a place in our portfolio.

Here’s the latest update from earnings season:

Read more

Meanwhile, the real risks go unpriced. Inflation remains a problem, fueled by the unresolved war in Iran, and inflation is the single biggest danger to most businesses. Yet the market keeps looking the other way.

We do the opposite. We hold a portfolio of (currently) eleven elite, capital-light businesses: leaders in their niches, trading at reasonable valuations, and using AI to streamline their own operations. We don’t avoid AI, we refuse to overpay for it.

The approach is working. Several of our picks have reached all-time highs after years of being ignored and misunderstood by investors.

Two of them reported earnings last week. Let’s get into the details:

Read more

Everything below has been tested for three decades with my own money at risk. That matters, because books and backtests only give you half a framework. They tell you what to do. They do not tell you what it is like to do it while a position you researched for months is down forty percent and every headline agrees that you were wrong. The missing half is psychology, and it is the half that decides whether a framework survives contact with a real market. A framework that works on paper and fails in your hands is worth nothing.

So let me start with the misconception that costs the most.

The wrong question: how do I find multibagger stocks?

You don’t. And the question itself is the problem.

A multibagger is not a category you can shop in. It is a verdict the market passes on a business after ten or fifteen years of execution. You cannot screen for a verdict that has not been reached yet. You can only own the company long enough to be there when it arrives.

If anyone could identify these businesses in advance with a decent hit rate, they would be among the richest people alive. Look around the financial community and count how many are. Most investors have not mastered basic valuation. Predicting which company will compound for a decade is a far harder task than valuation, and people who cannot do the easy thing are trying to do the hard one.

Multibaggers are a byproduct of a good screening process. They are not a target.

The better question: how do I achieve multibagger returns?

It looks like the same question. It is the opposite of it.

The first version hands your outcome to a stock. The second hands it to you. It does not ask which company will multiply. It asks what you have to do so that multiplication can happen in your account. That problem is mostly inside your control.

Three things are required:

1. Buy an above average business at a fair price, or better, at a cheap one.

2. Set a very high bar for selling it.

3. Accept that the perfect stock does not exist, and build a portfolio that behaves like one instead.

I have published eleven reports so far, so you know what I mean by above average. None of them was a hot tip or the next anything. All of them are highly profitable operators in their niche with a record long enough to be judged by. On the third point I have written separately, and if you are new here, read those pieces first:

That leaves point two, which is where most of the damage in a portfolio gets done.

Read more

And it is, if you can stomach it, your single biggest edge.

Most people can’t stomach it. They let the headlines rattle them. They swallow the noise, buy into the misinformation, and dump world-class companies at exactly the wrong moment.

You don’t have to be one of them.

Every time the crowd flinches, it hands patient investors like us a gift: a great business, suddenly on sale, mispriced for no good reason at all.

Which brings me to today’s company.

It’s been on my watchlist for a while. Analysts have been wrong about it for years with their constant doom and gloom forecasts, and I mean years, even though it’s quietly been one of the best-performing stocks of the last two decades.

This company has built one of the most compelling AI models I’ve come across. And yet the market doesn’t even file it under “AI”, never mind the double-digit growth, never mind that it reinvents itself again and again.

Today, I’m going to show you exactly why I’m buying. And I’ll walk you through every single point the market has gotten wrong.

(If you subscribe today you’ll also get immediate access to all 10 stock reports I’ve published so far)

Read more

This is partly true. But it leaves out a good deal, and the part it leaves out matters most during the periods when inflation is actually high.

The asset manager Schroders looked at how often U.S. stocks have beaten inflation in different environments, using rolling twelve-month periods going back to 1973. The results depend heavily on the type of inflation.

When inflation was low and rising, stocks beat it about 90% of the time. That is the environment most investors have experienced for most of the last forty years, and it is where the “stocks beat inflation” advice holds up well.

But when inflation was high and rising, the environment people most want protection from, stocks beat it only about 48% of the time. Less often than not. Over those same high-inflation periods, commodities beat inflation about 83% of the time and real estate about 67%.

So the advice is not wrong, exactly. Stocks have tended to outpace inflation when inflation was mild, and to struggle when inflation was severe.

Warren Buffett made a version of the argument in a 1977 article in Fortune titled “How Inflation Swindles the Equity Investor.” At the time, inflation was high and the stock market had performed poorly for years, and Buffett set out to explain why.

His main point was that stocks have more in common with bonds than most investors assume. A company tends to earn a fairly stable return on the capital invested in it. In Buffett’s era, large American companies earned around 12% on their equity year after year, regardless of inflation. He argued that this return behaves somewhat like the fixed coupon on a bond, and that because it does not automatically rise with inflation, stocks do not protect against inflation as cleanly as people expect.

To see what he meant, it helps to look closely at what inflation does to a single business.

A simple example

Consider a small company that makes wooden chairs. The numbers below are made up and kept round, but they illustrate the mechanics.

In a normal year with no inflation, the company sells 1,000 chairs at $100 each, for $100,000 in revenue. Wood and materials cost $40 per chair, and labor costs $30 per chair. The company also owns an industrial saw that cost $50,000 and is expected to last ten years, so the accounts record $5,000 a year for its wear and tear (this is called depreciation). After all of that, pre-tax profit is $25,000. With a 25% tax, the owner keeps about $18,750. He has $150,000 of his own money tied up in the business, so he is earning roughly 12.5% on it.

Now suppose inflation runs at 10%. The simple version of the “stocks beat inflation” story assumes that everything rises 10% together, prices, costs, and profits, so the business treads water in real terms. In practice, inflation arrives through several separate effects, and they work against the owner.

Prices tend to lag costs

When inflation hits, a company’s costs usually rise right away. The lumber yard raises its prices, and workers ask for higher wages to keep up with their own rising expenses. Raising the company’s own prices is harder. Competitors may not have raised theirs yet, large customers may be on fixed contracts, and pushing prices up too quickly can cost sales.

So in the example, costs rise the full 10% but the company only manages to raise its chair price by 5%, to $105. The cost of building a chair goes from $70 to $77, while the price goes from $100 to $105. Profit per chair falls from $30 to $28, and after adjusting for inflation, pre-tax profit drops from $25,000 to about $20,900, a decline of roughly 16% in real terms.

The general point is that inflation does not affect a company’s costs and its prices equally. Only businesses that can raise prices freely, because they have a strong brand or sell something customers cannot easily do without, avoid this squeeze. Many companies cannot, and their profit margins shrink.

Reported profits can be overstated

Two further effects make reported profits look better than they are.

The first involves inventory. Suppose the company has 200 finished chairs in stock that were made last year at a cost of $70 each. After inflation, those chairs sell for $115. Standard accounting records the cost of the oldest inventory first, so each sale shows a profit of $45 ($115 minus the recorded $70 cost). But replacing each of those chairs now costs $77, not $70. So about $7 of the $45 is not really profit; it is the extra money needed to restock the same item at today’s prices. Across 200 chairs, that is roughly $1,400 of profit that appears in the accounts but is consumed by higher replacement costs. Accountants call this a phantom profit.

The second involves the saw. The accounts still record $5,000 a year for its wear and tear, because depreciation is based on what the saw originally cost. But replacing the saw after inflation costs $55,000, not $50,000. The $5,000 figure therefore understates the real cost of using the machine, which makes reported profit look higher than it truly is.

Taxes are charged on the overstated figure

Tax is calculated on reported profit, not on the lower, more realistic figure. Because inflation causes reported profit to be overstated, through both the inventory effect and the depreciation effect, the company ends up paying tax on earnings that are partly illusory. The cash leaves the business regardless. In effect, the company’s real tax rate rises above the stated rate during inflation. This was the effect Buffett emphasized most, partly because nothing on the financial statements points to it directly.

More cash is needed simply to stay the same size

There is one more effect that is easy to miss. To operate day to day, the company keeps some money tied up in wood inventory and in amounts owed by customers. Say that is $20,000 in a normal year. Under 10% inflation, the same physical inventory and the same customer accounts are worth more in dollars, so the company now needs about $22,000 to run the identical business. That extra $2,000 has to come from somewhere, usually from profits that could otherwise have gone to the owner (you).

The more inventory and equipment a business carries, the larger this effect.

Companies that need a lot of capital to operate do not simply ride inflation upward; they have to put more cash in just to maintain the same output, and that cash does not reach shareholders. This was the heart of Buffett’s argument: a company’s return on capital tends to stay roughly fixed, so during inflation a stock starts to resemble a bond whose value is being eroded.

The long run

It is important to be fair to the other side of this, because over long horizons the picture changes.

Over roughly the past century, U.S. stocks have returned about 7% a year above inflation. Over a period of several decades, stocks have reliably grown an investor’s purchasing power, and there is no comparable asset that has done so as dependably.

The distinction is between a long-run store of value and a hedge. A hedge is something that protects you while inflation is actually happening, over the few years you feel it. Stocks have not done that job consistently; the 48% figure reflects how often they kept up during high and rising inflation. Over thirty years they have grown wealth in real terms, but over the shorter periods when inflation spikes, they have often fallen behind.

So both statements are true. Stocks are a good long-term store of value, and they are an unreliable short-term inflation hedge. The advice to “buy stocks to beat inflation” runs into trouble when it treats those two things as the same.

How to navigate this problem

But there are sane, framework-consistent moves, and Buffett spent decades proving them out:

Read more

That paper became the seed of what we now call Modern Portfolio Theory (MPT). It earned Harry Markowitz a share of the 1990 Nobel Memorial Prize in Economic Sciences (alongside William Sharpe and Merton Miller), and the framework it launched now guides how trillions of dollars are managed, from giant pension funds down to the robo-advisor on your phone.

It guides everyone, except the retail investor who still chases “the right stock”.

Finding #1: Stop judging stocks one at a time

The first finding sounds simple and is anything but.

Before Markowitz, picking investments was like judging ingredients one by one. Is this stock good? Is that bond good? Stack up the “good” ones and you’ve got a good portfolio, right?

Wrong.

Markowitz said a stock isn’t good or bad on its own. What matters is what it does to your whole portfolio. The unit you should be analyzing isn’t the individual holding, it’s the entire collection, working together.

A jalapeño is “too spicy” by itself. In the right dish, it’s perfect.

This is why a wild, volatile asset that looks terrifying in isolation can actually make your portfolio safer.

Finding #2: Risk doesn’t add up the way you think

Here’s the counterintuitive part of the whole theory.

You’d assume that if you combine a bunch of risky assets, you get a risky portfolio. Risk in, risk out.

Nope.

A portfolio’s risk is not the average of its parts. It depends on how those parts move in relation to each other. The technical word is correlation. The plain-English version: do these things tend to rise and fall at the same time, or at different times?

Picture two businesses in the same beach town.

One sells ice cream. One sells umbrellas.

Sunny week? The ice cream shop is printing money and the umbrella shop is dead. Rainy week? Flip it, umbrellas fly off the shelves and the ice cream melts.

Each business on its own is a roller coaster. Wildly unpredictable, month to month.

But own a piece of both? Suddenly your income smooths out. Rain or shine, one side is always working. The ups and downs cancel.

You didn’t reduce risk by picking “safer” businesses. Both are volatile. You reduced risk by combining things that zig when the other zags.

And it means a volatile asset can lower your total risk, as long as it doesn’t move in lockstep with everything else you own. The more your holdings dance to different music, the more the bumps cancel out.

Finding #3: The closest thing to free money in finance

Normally in investing, more reward means more risk (which is wrong btw, but I’ll get to that in a separate article). You want a shot at bigger returns? You have to stomach bigger swings and bigger potential losses. There’s a price for everything.

Except here.

By combining assets that don’t move together, Markowitz showed you can do something that feels like cheating: cut your risk without cutting your expected return, or raise your expected return without taking on more risk.

You get something for nothing.

Markowitz himself reportedly called diversification “the only free lunch in investing.” Everywhere else on Wall Street, you pay for what you get. Diversification is the one table where the meal arrives and the check never does, purely because you were smart about how your holdings relate to each other.

Most people spend their entire investing life paying full price at every other table and never notice this one is free.

An example

Numbers make this concrete. Suppose you’re choosing between two building blocks:

• Stocks — expected return 8%, volatility (standard deviation) 18%

• Bonds — expected return 4%, volatility 7%

Hold them 60% stocks / 40% bonds. Your expected return is just the weighted average:

0.60 × 8% + 0.40 × 4% = 6.4%

Risk is where it gets interesting, because risk depends on correlation.

The number you’d get if portfolio risk really were just the average of the parts is 13.6% (0.60 × 18% + 0.40 × 7%). That’s exactly what you get only when the two assets are perfectly correlated. The moment their correlation drops below 1, the portfolio’s volatility falls below 13.6% while the expected return stays put at 6.4%. You bought down your risk without paying for it in return.

That gap is what Markowitz formalized, and it’s what people mean by the line widely attributed to him: diversification is the only “free lunch” in investing. It’s the rare case where you genuinely get something (lower risk) for nothing (no give-up in expected return). The lower the correlation between your holdings, the bigger the free lunch.

Can you get even more “free lunch”?

Yes, you can. Here’s how:

Read more

Here are the facts about today’s stock:

• Industrial manufacturer

• An excellent Sloan Ratio, year after year

• Shrinking share count, year after year

• Gross margins around 44%, operating margins around 26%

• A low Capex to cash flow ratio of around 13%

• Return on capital of around 34%

• Trading -15% from its high

If you subscribe today you’ll get immediate access to all 9 stock reports that I’ve published so far.

Read more

The first is cash, money the business genuinely received this period. The second is accruals, accounting estimates layered on top. Revenue booked before the customer has paid. Expenses pushed into the future. Inventory that’s piling up. Accruals aren’t fraud; they’re a normal, required part of accounting. But they’re also where manipulation can hide.

The Sloan ratio puts a single number on the question every serious investor should be asking: how much of this profit is real cash, and how much is paper?

The metric is named after Richard Sloan, an accounting professor who published a now-famous 1996 paper in The Accounting Review. His finding became known as the “accruals anomaly”.

The problem it solves

Here’s what Sloan discovered. The cash portion of earnings is durable, it tends to persist into future years. The accrual portion is fragile, it tends to reverse. A dollar of profit backed by cash is worth a lot more than a dollar of profit backed by accounting estimates, because the cash dollar is far more likely to show up again next year.

The market, it turns out, doesn’t make that distinction. Investors fixate on the headline earnings number and price both kinds of dollars as if they’re equally reliable.

So a predictable pattern emerges: companies whose profits lean heavily on accruals tend to disappoint later, and their stocks underperform. Companies whose profits are backed by cash tend to hold up. The Sloan ratio is your early detector for which camp a company is in, before the writedowns, the restatements, and the analyst downgrades arrive.

Why everyone should use it

A few reasons this earns a permanent spot in how you screen companies:

It’s an early warning, not a lagging one. The divergence between earnings and cash shows up in the numbers well before it shows up in the share price.

It’s backed by decades of evidence. It’s a well studied effect in academic finance.

It uses only public data. Everything you need sits in the income statement, the cash flow statement, and the balance sheet of any 10-K or annual report.

And it’s fast. Once you know the formula, you can run it in about sixty seconds. That makes it a brilliant filter, a way to decide which companies are worth your time and which ones have numbers that don’t tie out.

The formula is short:

Sloan Ratio = (Net Income − Cash Flow from Operations − Cash Flow from Investing) ÷ Total Assets

Then multiply by 100 to express it as a percentage.

Three quick notes before the example:

• Net income comes from the income statement.

• Cash flow from operations (CFO) and cash flow from investing (CFI) come from the cash flow statement.

• Total assets comes from the balance sheet.

One thing trips people up: cash flow from investing is almost always a negative number (companies spend on equipment, acquisitions, and so on). Because the formula subtracts CFI, that negative typically gets added back, which pushes the ratio up. That’s intentional. It captures the accruals tied to a company’s investment activity, not just its day-to-day operations.

A worked example. Say we’re looking at a healthy company:

• Net income: $400M

• Cash from operations: $520M

• Cash from investing: −$180M

• Total assets: $6,000M

Plug it in:

(400 − 520 − (−180)) ÷ 6,000 = (400 − 520 + 180) ÷ 6,000 = 60 ÷ 6,000 = 1.0%

A ratio of 1% is clean. Notice why: this company’s operating cash flow ($520M) actually exceeded its reported profit ($400M). The earnings are more than backed by cash. That’s exactly what you want to see.

Now contrast it with a company reporting the same $400M profit, but bleeding cash. Net income $400M, CFO of −$1,000M, CFI −$180M, total assets $6,000M:

(400 − (−1,000) − (−180)) ÷ 6,000 = 1,580 ÷ 6,000 = 26.3%

Same headline profit. Wildly different reality. One company collected more cash than it reported in profit; the other reported $400M of profit while burning over a billion in cash. The Sloan ratio is what lets you see the difference at a glance.

How to read the result. Here’s the standard interpretation:

• Between −10% and +10%: Safe zone, earnings are backed by cash

• −25% to −10%, or +10% to +25%: Warning zone, accruals are creeping up; dig deeper

• Below −25%, or above +25%: Danger zone, earnings and cash have seriously diverged

Is negative good or bad?

This is where the direction matters:

• A negative Sloan ratio means cash flow exceeds reported net income, the company is generating more cash than it’s booking as earnings. This is the conservative direction.

• A positive Sloan ratio means net income exceeds cash flow, earnings are being propped up by accruals. That’s the classic earnings-inflation red flag and the one Sloan’s original research focused on as predicting weak future returns.

So a negative ratio is generally the less worrying direction. A company that under-reports relative to its actual cash generation is usually lower-risk than one inflating its numbers.

(You’ll occasionally see a simplified version that uses only operating cash flow — (Net Income − CFO) ÷ Total Assets. It’s a reasonable shortcut, but the full version above, which folds in investing cash flow, is the one Sloan’s work points to and the one I use.)

When to use it

Use it as a screen, before you commit real research time to a company. And reach for it especially on any high-flying grower that seems too good to be true, those are often the situations where earnings and cash quietly drift apart.

A few points so you don’t misuse it:

Look at it across several years, not one. A single-year spike is often innocent, an acquisition, a one-time charge, a timing quirk. It’s the trend that tells the story. A ratio that climbs year after year is the real signal.

Judge it within its industry. Capital-intensive businesses and fast growers naturally carry heavier accruals. Compare a company to its peers, not to an abstract ideal. (And skip it entirely for banks and insurers, their financial statements work differently enough that the ratio doesn’t apply cleanly.)

And never treat it as a standalone buy or sell trigger.

Now, I’m going to take this exact test and run it across the companies I currently hold, the same portfolio I share with paid subscribers.

One thing up front: every company in our portfolio scores “excellent” on this metric.

Read more

There’s a number that explains how this happens. It’s sitting in every company’s financial statements right now. Almost nobody talks about it. Analysts skip past it. Management rarely mentions it. And that’s exactly why it’s worth your attention, because the few investors who track it can read a company’s competitive power long before any of it reaches the headlines.

It’s called the cash conversion cycle. Let me show you why it might be the most useful number nobody is looking at.

Forget formulas for a second. Picture a small shop.

You order $10,000 of goods from a supplier. The boxes arrive. Now your money, or your supplier’s money, we’ll get to that, is locked inside those products sitting on your shelves. They don’t sell instantly. They sit there for, say, 40 days before the last unit walks out the door.

Then a customer buys. Great, except a lot of business isn’t paid in cash on the spot. If you sell to other businesses, they often pay you weeks later. Say it takes 30 days to actually collect the money after the sale.

So from the moment goods hit your shelf to the moment cash hits your account, 70 days have passed. For 70 days, that money is frozen. You can’t use it to pay rent, hire, or buy more inventory.

But here’s the part that flips everything: you didn’t necessarily pay your supplier up front either. Suppliers extend credit too. Say you don’t have to pay them until 45 days after the goods arrive.

Now do the math on your actual cash gap. Your money is tied up for 70 days, 40 in inventory, 30 waiting to get paid, but for the first 45 of those days, you’re holding your supplier’s money, not your own. So the real stretch where your own cash is on the line is 70 minus 45 = 25 days.

That 25 days is your cash conversion cycle. It’s how long your money stays trapped in the business before the cycle spits it back out, ready to be used again.

Here’s the formula:

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding − Days Payables Outstanding

Three pieces, each answering a simple question.

Days Inventory Outstanding (DIO): how long does inventory sit before it sells? Forty days in our shop. Lower is usually better: product moves fast, ties up less cash, and is less likely to go stale, obsolete, or out of fashion.

Days Sales Outstanding (DSO): after you make a sale, how long until you actually collect the cash? Thirty days in our example. Lower means customers pay quickly and you’re not effectively lending them money for free.

Days Payables Outstanding (DPO): how long do you take to pay your own suppliers? Forty-five days for us. Here, higher is better for you: every extra day is a day you’re running on someone else’s money instead of your own.

Add the first two, the cash going out and waiting to come back. Subtract the third, the time you get to delay paying. What’s left is the number of days your cash is locked up.

Here’s where it gets interesting.

What happens if you pay your suppliers slower than you sell your inventory and collect from your customers? What if your DPO is bigger than your DIO and DSO combined?

The number goes negative. And a negative cash conversion cycle is one of the most powerful things a business can have.

Think about what it actually means. A negative cycle says you collect cash from your customers before you have to pay your suppliers. Your customers are, in effect, handing you the money to run your business. Your suppliers are giving you an interest-free loan. You are funding your operations, and your growth, with other people’s money.

Picture a business that sells products fast, gets paid by customers immediately (or even before delivery), and pays its suppliers two months later. Every time it grows, it generates cash instead of consuming it. It can expand without taking on debt or diluting shareholders, because expansion throws off the very fuel it needs to expand.

That’s not an accounting trick.

It’s a huge advantage, and it usually reflects enormous leverage over both customers and suppliers.

Most businesses are the opposite. They pay for inventory and labor up front, wait to sell, then wait again to get paid. Growth eats cash. The faster they grow, the more cash they need, which is precisely how a “successful,” fast-growing company can starve to death (as we see it with many hyped-up IPOs).

Here are more reasons to use this metric:

It exposes the quality of growth. Anyone can grow revenue. Offer customers absurdly generous payment terms and sales jump. Stuff your warehouses and distribution channels with product and shipments look great. But both moves quietly lengthen the cash conversion cycle. When you see revenue climbing while the cycle creeps up right alongside it, that’s a flag: the growth may be bought, not earned. Healthy growth tends to keep the cycle stable or shrinking.

It’s an early-warning system. Because the cycle is built from inventory, receivables, and payables, it moves when the underlying business moves, often before earnings catch up. Inventory piling up (rising DIO) can mean demand is softening and product isn’t selling. Customers taking longer to pay (rising DSO) can mean they’re in trouble, or that you’re leaning on weaker buyers to hit your targets. A company stretching its own payables to the breaking point (spiking DPO) can signal a cash squeeze. None of this shows up cleanly in a single quarter’s profit number.

It reveals competitive power. The terms a company can dictate are a direct readout of its leverage. A business with a real moat can make suppliers wait and still get customers to pay fast, because everyone needs to do business with it more than it needs any one of them. A weak business is forced into the reverse: pay suppliers promptly to keep them, and offer customers generous credit to win them. Read the cash conversion cycle and its trend, and you’re reading the balance of power around a company, without a single word of management spin.

It connects earnings to reality. Profit is an opinion; cash is a fact. The income statement is full of judgment calls about when to recognize revenue and costs. The cash conversion cycle is harder to dress up, because it’s anchored to actual inventory on hand and actual money owed and owing. When a company’s reported earnings and its cash generation start drifting apart, the cycle is often where you’ll find the explanation. It’s a reality check on the story the headline numbers are telling.

If it’s this useful, why is it ignored?

Partly because it’s invisible by design. There’s no “cash conversion cycle” line in any report. You have to assemble it yourself, inventory, receivables, and payables off the balance sheet, revenue and cost of goods off the income statement, and most people simply don’t bother.

Partly because it’s unglamorous. Markets run on stories: growth, disruption, a charismatic founder, a blowout quarter. Working-capital management is the financial equivalent of plumbing. Nobody posts hot takes about days payable outstanding. But plumbing is exactly what keeps the building habitable.

And partly because management has little reason to spotlight it. Companies promote the metrics that flatter them. Most cash conversion cycles are high and a deteriorating one is the last thing a management team wants in the headline.

When a genuinely useful number is sitting in plain sight and almost no one is doing the work to track it, the person who does has an edge.

A few rules keep this from misleading you.

Never compare across industries. A software company with no inventory and prepaid subscriptions might run a deeply negative cycle. A heavy manufacturer building complex machinery over months will run a long positive one. Neither is “good” or “bad” in the abstract, they’re just different businesses. Comparing their raw numbers is meaningless.

Watch the trend, not the snapshot. A single quarter’s figure tells you very little. The signal is in the direction over time. Is the cycle steadily shortening, holding, or quietly lengthening quarter after quarter, year after year?

Compare like with like. The useful comparison is a company against its own history and against direct competitors with similar business models. That’s where a number drifting the wrong way actually means something.

Always ask why it’s moving. The number tells you that something changed; it doesn’t tell you what or why. A falling cycle could mean sharper operations, or it could mean management is squeezing suppliers so hard it’s straining relationships it will pay for later. A rising cycle could mean trouble, or a deliberate decision to hold more inventory to guard against shortages.

Mind the seasonality. Businesses with seasonal swings can show wildly different figures depending on when in the year you measure. Use averages or full-year numbers so a holiday inventory build doesn’t masquerade as a problem.

The cash conversion cycle won’t show up on the front page of a stock screener or in a scrolling ticker. It takes a little work to calculate and a little judgment to interpret.

The metrics everyone watches are already baked into the price. The ones that quietly reveal how a business actually runs, how much power it holds, whether its growth creates cash or destroys it, are where an attentive investor finds an edge.

Learn to read this one number and its trend, and you’ll understand companies in a way most of the market doesn’t bother to. You’ll spot the cash machines, and you’ll spot the cash traps, often well before the crowd does.

Now let me show you the cash conversion cycle of t a real company, with real filings, calculated quarter by quarter. A company whose cycle doesn’t just shrink toward zero.

It goes negative.

Up to -70 days.

Quarter after quarter, year after year.

It has turned its own suppliers and customers into a giant, interest-free bank, and the numbers prove it.

Let’s point everything we’ve learned at one of the best businesses in the world:

Read more

• Large cap

• Double-digit revenue growth

• Less than 3% of operating cash flow goes to capex

• 70% return on capital

• 60% free cash flow margin

• 45% net income margin

• No bloated A.I. spending, the business model doesn’t demand it

• Trades below its 10-year mean on multiple valuation metrics, despite improving fundamentals and new revenue streams

(Become a subscriber today and you’ll get immediate access to the archive and every previous stock report.)

Read more

And the further prices have drifted from reality, the further they have to fall to get back to it. The reverse holds at bottoms: you don’t find cash-burning companies priced for perfection, because reality has already done its work and investors have sobered up.

Intel is the latest example.

The stock is up nearly 180% this year.

The business isn't.

Capex is eating through cash flow, operating margins sit at multi-year lows, and revenue has been flat for three years running. A 180% gain would make sense for a company compounding double digits with fat margins, Intel is doing neither. There are plenty more like it in this market, which is why stockpicking has rarely mattered more than it does right now.

For contrast, take one of our holdings that just reported Q1 2026: a small-cap food producer growing double digits across nearly every metric, debt-free, free cash flow positive, and a growing dividend. Quiet, necessity-driven, almost entirely off the market’s radar, which is exactly why it’s in the portfolio.

Read more

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

— Warren Buffett, 1985 Letter to Shareholders

This is an often quoted line, and one of the least followed. Every earnings season, analysts and investors fall in love with a new operator who is going to “turn around” a broken business. Most of the time, the broken business wins. The CEO leaves with a battered reputation, while the business continues to do what its economics force it to do.

If you choose a business with favorable economics and pay a fair price, time is your friend. If you choose a business with bad economics, even an exceptional manager is fighting gravity for you, and gravity is patient.

What Makes a Business Favorable

A business is not a person. It is a set of rules, customers, suppliers, regulations, and competitive dynamics that determines what return on capital is achievable.

Management plays the game; it does not write the rules.

When you own a structurally favorable business, the rules of its game produce attractive returns almost regardless of who sits in the corner office. When you own a structurally unfavorable business, the same rules grind those returns down regardless of how clever the operator is. Brilliant capital allocation in a commodity steel mill still produces commodity steel mill returns over a full cycle. Average capital allocation in a toll-bridge business still produces toll-bridge returns.

Three forces drive this asymmetry, and all three favor the business over the manager.

The first is duration. A favorable business often has structural advantages, a network effect, a regulated monopoly, a habituated customer base that took decades to build and would take decades to dismantle. A CEO has, on average, six to eight years. The business outlives its operators.

The second is reinvestment. The compounding power of a stock comes overwhelmingly from the rate at which retained earnings can be redeployed inside the business. A favorable business reinvests at high incremental returns on capital almost automatically, because its competitive position generates opportunities that earn well above the cost of capital. A bad business reinvests at low or negative incremental returns no matter who is choosing where to spend. You cannot intelligence your way out of a fifteen-year capex cycle in a deflating industry.

The third is the cost of mistakes. In a favorable business, a strategic error is usually recoverable: the moat absorbs the damage. In an unfavorable business, a strategic error is often fatal, and the operator gets blamed for what was, at root, not his fault.

Buffett’s textile experience at the original Berkshire Hathaway, where he spent two decades trying to outwork the economics of New England textile manufacturing, is the lived version of the quote. He was good. The textile mills closed anyway.

The fourth feature is less a separate moat than a multiplier on the others: capital intensity. A favorable business with low capital requirements compounds harder than the same business with high capital requirements, because the cash thrown off can be redeployed into new growth, share repurchases, or dividends rather than swallowed by maintenance capex.

Read more

While the hyperscalers spend the next decade convincing the market that today’s AI buildout will eventually earn its cost of capital, the businesses we own are doing something less glamorous and considerably more reliable: generating cash, raising prices, and returning capital. Two of the three beat estimates and raised guidance last week. The third trimmed its outlook, but it was already priced in and the stock hardly moved.

Here’s what each report actually said, what changed in the guidance, and what’s worth taking forward from the calls.

Read more

• Return on equity: 29%

• Return on capital: 35%

• Free cash flow yield: ~6% (upper end of the cash-cow range)

• Demand profile: built-in replacement cycle, products break down, customers come back

• A.I. exposure: none. This is an “old-school” industry the algorithm crowd has ignored

• Dividend track record: more than three decades of consecutive increases

• Valuation: trading near five-year lows on multiple metrics

The beauty of the stock market is that it lets you own a slice of almost everything happening in the world, at whatever scale your wallet allows. Can’t afford to open a McDonald’s franchise? Buy the shares. Can’t launch a luxury fashion house? Hermès and LVMH are one click away. Behind almost every product, service, and trend is a company, and most of the good ones are publicly traded. You and your laptop have access to a buffet that previous generations of investors could only dream of.

And yet most people squander it.

They pile into the same handful of names everyone else is talking about, convinced that high conviction means making a few big bets on whatever’s trending. I think that’s backwards. The real edge of being a small, individual investor is that you face none of the restrictions that hamstring large funds. You can roam freely across small caps, mid caps, large caps, industries, and countries. You can be a business collector. Someone who patiently assembles a portfolio of great companies bought at reasonable prices, then steps back and lets capable management do the compounding for you.

That’s the game.

Lurking in investing forums this year, one obsession keeps surfacing: A.I. and what it will do to software stocks. Generational buying opportunity, or money pit? Everyone has a take. Everyone is staring at the same names. The crowd isn’t there because that’s where the best returns live, it’s there because that’s where the spotlight is. Meanwhile, industries that are boring, under-covered, or simply A.I.-immune sit quietly in the dark, doing what they’ve always done: making money.

This reminds me a bit of the "streetlight effect" parable. It goes like this:

Which brings me to today’s company…

Read more

“All happy families are alike; each unhappy family is unhappy in its own way.”

He wasn’t writing about stocks. But he might as well have been.

The idea, later formalized as the Anna Karenina principle by biologist Jared Diamond in Guns, Germs, and Steel, describes a class of problems where success requires satisfying every condition simultaneously, while failure needs only one condition to go wrong.

Diamond used it to explain why humans managed to domesticate only 14 of the 148 large mammals on earth: horses, cows, sheep, and a handful of others checked every box. The rest failed on at least one dimension, too aggressive, too slow to reproduce, too picky about diet, too resistant to captivity.

There’s a parallel to investing.

Why Winning Stocks Are All Alike

Ask yourself what a truly great compounding stock looks like. You get a familiar list: durable competitive moat, capital-light business model, expanding addressable market, high returns on invested capital, shareholder-aligned management, strong balance sheet, reasonable valuation. The great ones, the S&P Globals, the Visa and Mastercard of the world, share these traits. They are structurally similar in the ways that matter most.

This is not a coincidence.

It is the Anna Karenina principle at work.

A business that compounds value over decades must satisfy multiple independent conditions at once. The moat protects returns. The capital efficiency allows those returns to be reinvested. Management discipline ensures reinvestment happens rather than being squandered. The balance sheet provides durability through cycles. The valuation determines whether those fundamentals actually translate to shareholder returns.

Remove any one of these conditions and the thesis breaks, in its own unique way.

The Asymmetry of Failure

This is the insight most investors underweight: the failure modes are vastly more diverse than the success modes.

A stock can be destroyed by:

• A moat that proves shallower than it appeared (Kodak, Blockbuster)

• Leverage that was manageable until it wasn’t (countless energy and retail names)

• A management team that is brilliant operators but catastrophic capital allocators (GE under Jeff Immelt)

• A genuine business that was priced so richly it couldn’t survive its own success (Cisco in 2000, priced for a future that arrived, just not on a timeline that rewarded shareholders)

• Regulatory risk that was dismissed as remote (Bet-at-home, the European gambling website)

• Accounting that turned out to be creative rather than conservative (Enron, Wirecard)

• A dominant market position that regulators eventually decided was a problem (AT&T, various utilities)

Notice that this list is not a neat taxonomy. It sprawls. Every blowup has its own texture, its own villain, its own specific chain of causation. But every great compounder looks, at its core, much like the others.

The Portfolio Is the Real Compounder

This is where this research service comes into play, and where, if you’ve been reading my reports, you’ve already seen the principle at work.

Read more