Continuing a recent thread of articles adding other well known value investing criteria to Magic Formula stocks, in this post, we'll take a look at the price-to-sales ratio. For those interested, previously we've looked at Magic Formula stocks with high dividend yields, as well as Magic Formula stocks with strong relative strength.
Dividend yield and relative strength are both fairly popular and well known screening criteria. Stocks with high dividend yields not only indicate a potential undervalued condition, but also pay cold hard cash to their shareholders that can compound over time. Relative strength as a concept is a fundamental statistic used by technical and momentum traders. Both have been proven to turn up stocks that outperform the market in aggregate.
However, it may come as a surprise that, according to the 50 years of mechanical investing research performed by James O'Shaughnessy and detailed in his book What Works on Wall Street (MagicDiligence review), the single best statistic for finding undervalued stocks that will outperform the market is the largely ignored price-to-sales ratio. O'Shaughnessy set up a portfolio that bought the lowest price-to-sales ratio stocks and renewed them every year, then compared against other portfolios that used the more popular (and some would argue more meaningful) price-to-earnings and price-to-book multiples. Here were the annualized 50 year results of each strategy:
Price-to-sales outperformed the others by a significant margin. Interestingly, price-to-earnings as the only criteria actually underperformed the market!
The phenomenon of low price-to-sales ratio stocks as a good mechanical screening strategy is not completely unknown. Ken Fisher, son of investing legend Philip Fisher and a member of the Forbes 400 richest people in the U.S., wrote the book Super Stocks, where the entire focus of the book is on choosing low price-to-sales issues.
Clearly there is something to this strategy, although it's use is not intuitive. Most stocks with low price-to-sales ratios also carry very low operating margins, which means the company relies on volume to drive profit growth. Examples of these kinds of stocks are retailers or resellers who buy in bulk and sell smaller lots at a markup. These kinds of businesses have difficulty building sustainable competitive advantages, as the industries they play in are either commodity or very competitive. Economies of scale are really the only competitive advantage that can survive the test of time, and economies of scale are one of the less durable ways of building an economic moat, a requirement for Top Buy consideration.
Interestingly, the Magic Formula stocks with the lowest price-to-sales ratio don't necessarily fall into the logical assessment made above. Here are the top 20 Magic Formula stocks with the lowest price-to-sales ratio as of last Friday:
|CITP||COMSYS IT Partners||0.09|
|FIX||Comfort Systems USA||0.26|
Two things jump out about this list of stocks. First of all, these are some remarkably low price-to-sales ratios, which historically even for low margin businesses are above 0.50. Second is the absence of traditionally low P/S industries. Only one (NYSE:RSH) is a true retailer, and several of these companies are relatively high margin businesses. For example, the two disk drive makers, Seagate (NASDAQ:STX) and Western Digital (NYSE:WDC), run operating margins of 9.6% and 13.3%, respectively, well above the sub-5% op margin expected of low price-to-sales stocks.
We've covered dividend yield, relative strength, and now price-to-sales in further ordering our universe of Magic Formula stocks. Next, we will look at price-to-book ratio, the second best performing single value statistic in O'Shaughnessy's studies.
Disclosure: Steve owns no position in any stocks discussed in this article.