From med-school student Christopher Brown, who can operate on me any time (well, assuming I need surgery):
I was wondering if you have ever read the 1996 book What Works on Wall Street by James O’Shaughnessy. Its conclusions, at least, are worth mentioning to your readers. I browsed through it at the bookstore in January, and it has fundamentally changed the way I pick stocks. The author takes a look at a number of widely-used measures of valuation since 1951, and how useful they have been. Although the analysis is lacking completeness (he only considers companies with extremely high or extremely low values for most variables, not the ones nearer the middle), there are two powerful points:
1. The “value” indicator most closely correlated with share performance is a low price/sales ratio. [A.T.: Stocks selling at a low ratio tend to do well.]
2. The “growth” indicator most closely correlated with share performance is a high relative share price gain over the last 12 months; past performance was, overall, the single best measure of future performance. [A.T.: Stocks that went up a lot last year are likely to do well this year.]
When you put these two factors together, you would have outperformed the market by a lot (several percentage points) over time. Of course, past performance doesn’t mean that this trend will necessarily continue (it seems that nowadays companies with low price/sales rations are the most commodity/least franchise and are in general a sad lot), but it’s at the very least an interesting correlation.
So… on February 3rd, Ameritrade opened up my first ever IRA, and feeling empowered by the low commissions, I spread my $2000 out among five companies (and $2 cash :-)). I combined O’Shaughnessy’s observations with a search for companies with strong positions in growing industries. They were:
- Lucent and Nortel: both incredible growth companies with a great history of growing share price and trading well under 2 times sales.
- Accustaff: growth company with a very low price-to-sales ratio (as is characteristic of their industry) and a good last five years when you took it as a whole (sure, the shares hadn’t been doing well the last couple of years; but sometimes you need to consolidate after an 1100% run).
- Iona Technologies: tiny software stock that had recently started to rally after a slow first year. To get a low price/sales on IONAY I had to look a few years into the future, but in middleware, the rising tide is sure to lift many revenue boats by the tune of 50% annually, so it wasn’t really that much of a gamble.
- SCI Systems: #1 contract electronics manufacturer by revenue. Selling for less than 0.4 price/sales (a steep discount to its peers), and a great last two years in terms of stock movement.
So far SCI is under the weight of Apple and Compaq, but thanks to the other four companies, my account is up 28% (after commission) in its first two months. Since January, I have also used this book to justify to myself the purchase of MSFT, CSCO, and PFE (in other accounts); in summary, thank you James O’Shaughnessy. Never again will I say, “but that stock’s already had a big run.”
Response from Andy: In the first place, What Works on Wall Street is a worthy effort. Whether what has worked on Wall Street will continue to work, and whether it will work for you, is no small question. But Chris has done the thinking and homework to develop an investment style that makes sense, that appeals to him, and that because he is smart and does his homework, could work out fine.
The low price/sales ratio part of it has always appealed to me.
Let’s say you have a company doing $120 million in annual sales. Let’s say, further, the company has 14 million shares outstanding, currently trading at $1.50 each. That values the whole company at just $21 million (14 million times $1.50). So what is its p/s ratio-price-to-sales? Well, its price is $1.50 and its sales-per-share works out to $8.57 ($120 million in sales divided over 14 million shares), so its p/s ratio is $1.50/$8.57 or 0.175. Very low.
What the ratio “should” be very much depends on the industry. In the supermarket business, you need lots of sales to eke out a sliver of a profit. In the hair care business, you would hope for much wider margins; and in software, when everything is clicking, much wider profit margins still.
Lots of mature companies sell for around “one or two times sales.” Why? Because on $1 in sales, the after-tax profit might be a nickel or a dime. And a nickel or a dime of annual earnings, at 20 times earnings, is worth maybe a buck or two. (If interest rates were higher, or the market less buoyant, that “20 times earnings” I so blithely use in this example might be more like 10 or 15 times earnings instead.)
Anyway, the appeal of the low sales/price ratio is two-fold: First, it may reflect Wall Street’s general disgust with this particular stock. That’s good, because the market tends to overreact in both directions. Maybe with all those ten-foot poles not wanting to touch this dog, this dog represents a bargain. Second, it means there’s a chance – though only a chance – that profit margins might improve. A company making 50 cents after tax on every dollar of sales is much more likely to see its profit margin erode than see it improve; but a hair gook company earning a penny on each dollar just might be able to boost that to two pennies. And if it can – doubling the profits per share with no increase in sales – its stock could double also.
Anyway, being a bottom-fisher, I’ve always been emotionally compatible with the low price/sales ratio. (Another of its advantages: You can be fairly confident of a company’s reported annual sales. Its earnings, as in its price/earnings ratio, are subject to a lot more accounting games, smoke and mirrors.)
What I’ve always had great trouble with – and this is why I wish I had had Chris’s smarts when I was his age, even if it may not work as well in the immediate future – is buying something at 40 that not long ago was 15. I just can’t bring myself to do it.
This is why I skipped buying Berkshire Hathaway when I first wrote about it at 300 (up from 19), figuring I’d wait til it fell back; and skipped it again at 3,000 and again at 30,000 – it was $30,000 a share a couple of years ago – and certainly plan to skip it this week at $70,000.
I’m relatively good about holding a stock that’s gone up a lot. That’s easy – it gives you a very nice smug feeling, not to mention tax deferral until you sell it. But buying something everybody else is buying that’s already quadrupled? Instead of its reminding me how smart I am every time I looked at it, it would remind me how stupid I was.
It is exactly this kind of dumb human emotion that should figure into your investing only in the sense that you recognize it in others and attempt to profit from their irrationality. You yourself should be coldly rational. Missed the first 69,700 point run-up in Berkshire Hathaway? No sweat. That’s irrelevant to the question of whether to buy it (or Microsoft or Amazon.com, etc.) today.
I’m not buying them today, and Chris isn’t buying all of them. But he’s freed himself from the irrational inability to buy a great stock just because he’s missed the first 1000% or 10,000% of its growth.
That’s something I doubt I’ll ever be able to free myself of. I know myself well enough to know my nature, and so have adopted a different investing style.
One last note: Imagine being able to buy a diversified portfolio of five stocks with $2,000 (not to mention the $2 Chris had left over). Until just a couple of years ago, the commissions would surely have come to at least $150 – a prohibitive 7.5%. Today you can do it for $40. It still costs you to play, but in this and a couple of other ways,* the playing field has become a lot more level. Three cheers for the little guy.
*Narrower spreads; cheap and timely access to information.
Quote of the Day
That I'm their competition.~Famed hedge fund manager Michael Steinhardt, when asked the most important thing an investor could learn from him.
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