Surrogate Endpoint

A surrogate endpoint is a measure or indicator used as a substitute for a more definitive, meaningful outcome that is harder or takes longer to measure. Think of it as a proxy. The term originates from medical trials, where a doctor might measure a change in cholesterol levels (the surrogate endpoint) as a stand-in for the ultimate goal: preventing heart attacks (the true endpoint). The assumption is that lower cholesterol reliably leads to fewer heart attacks. In the investment world, a surrogate endpoint is a metric—like quarterly user growth or a specific financial ratio—that investors and companies use to predict or signal long-term success. While often useful for a quick check-up, blindly trusting these proxies can be incredibly dangerous. The connection between the surrogate and the true outcome can be weak or even break down entirely, leading investors to celebrate a “healthy” sign right before the patient—their investment—takes a turn for the worse.

Why do we love surrogate endpoints so much? Because they are easy. They offer instant feedback in a world where the true results of a business strategy may not be clear for a decade. A company's management can point to rising Daily Active Users (DAUs) in a quarterly report, which is much faster and more straightforward than proving they are building a business that will generate mountains of free cash flow over the next 20 years. The stock market, with its obsession with short-term performance, often rewards companies for hitting these surrogate targets. The danger, as famously highlighted by Goodhart's Law, is that “When a measure becomes a target, it ceases to be a good measure.” Once managers or investors fixate on a proxy, they can start making decisions to boost that specific number, even at the expense of the real goal: long-term value creation. This is a critical concept for anyone practicing value investing, which demands looking past the convenient, short-term signals to understand the durable reality of the business.

These proxies are everywhere. The key is to learn to spot them and question their validity.

Company management is under immense pressure to show progress. This can lead them to highlight, and even manipulate, metrics that look good but don't necessarily reflect the underlying health of the business.

• Chasing User Growth: A new social media app might burn through cash to acquire new users with aggressive marketing, celebrating its booming user count. Here, user growth is the surrogate endpoint. But if these new users don't stick around or can't be monetized effectively, the true endpoint—sustainable profitability—is never reached. The company is just an empty shell with a big user list.
• Meeting Quarterly EPS Targets: To hit a specific earnings per share (EPS) number expected by Wall Street, a manager might slash the research and development (R&D) budget. The company hits its surrogate target, and the stock price might even pop. However, cutting R&D sacrifices future innovation, damaging the company's long-term competitive advantage. Investors focused on the EPS number are cheering while the company's future is being hollowed out. This is also why it's crucial to scrutinize GAAP vs. non-GAAP earnings adjustments.

Investors are just as susceptible to the siren song of surrogate endpoints. We often create mental shortcuts that can lead us astray.

• Fixating on Price Momentum: Using a rising stock price as a surrogate for a great company. “The stock is up 50% this year, so it must be a good business!” is a common refrain. But price is just a measure of market sentiment, not a reliable indicator of a company's intrinsic value. A value investor knows that price is what you pay, but value is what you get.
• Worshipping a Single Ratio: An investor might only buy stocks with a low P/E ratio, using it as a proxy for a “cheap” stock. But a low P/E can be a massive value trap. The true endpoint is buying a wonderful business at a fair price. A low P/E might simply be a surrogate for a terrible business with no growth prospects, a broken balance sheet, or an incompetent management team.

To protect yourself from the pitfalls of surrogate endpoints, you must cultivate a mindset of healthy skepticism. Always ask two simple questions when you see a metric being celebrated:

1. **What is this a proxy //for//?** What is the //real//, long-term outcome that this metric is supposed to predict? (e.g., EPS is a proxy for owner earnings).
2. **How reliable is that link?** Is there strong, logical evidence that improving this metric will //always// lead to that desired long-term outcome? Or could the metric be "gamed"?

Instead of getting mesmerized by proxies, focus your analysis on the true endpoints of a successful investment. Look for evidence of a durable competitive advantage, a history of rational capital allocation by management, and the potential for strong, sustained free cash flow generation. These are harder to quantify on a quarterly basis, but they are the ultimate drivers of long-term value. Surrogate endpoints can be useful signposts, but they are no substitute for a deep understanding of the business itself.