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Mark Gomes, PTT Research (1,251 clicks)
Long/short equity, research analyst, tech, IT channel checks
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"It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that." - Warren Buffett

Over the past 25-years, an investor couldn't do much better than to heed the advice provided by investing legends like Warren Buffett and Peter Lynch. One of the key lessons from Buffett is that small caps are the place to be (until you're too rich to do so). This meshes very well with the "invest in what you know" philosophy of Peter Lynch.

For my company, that means Information Technology and Consumer Trends. I've been a technology analyst (with a specific focus on Software and the Internet) going back to the early 90s. Using the software sector as an example, this article will demonstrate how price-to-earnings ratios (P/E) are holding most investors' profits in check.

Since the mid-2000s, I have watched the software industry shift from on-premise software to Software as a Service (SAAS). From my perspective, there are three classes of software vendors that help companies to automate their business processes:

* SAAS vendors, like Salesforce.com (CRM)
* Traditionally on-premise giants, like Oracle (ORCL) and SAP (SAP)
* Traditionally non-SAAS acquisition candidates, like QAD (QADA)

The SAAS vendors have been growing fantastically. The leaders tend to be Wall Street darlings. The non-SAAS giants have the largest customer bases and lots of customer control. However, they are under attack by the SAAS guys. Most of the remaining vendors should be "put out of their misery" (a.k.a. acquired), a belief I have held since the advent of SAAS. Indeed, many have been acquired since 2009. You can find more details in an article I recently published on the subject.

One of the reasons these companies have been acquired with regularity is the fact that small cap P/E ratios tend to be very deceiving. A big part of why institutions can rob investors of winning picks is that they know something most don't -- operating leverage and operating-margin potential are much better measures of potential / future stock value.

Growth stocks, like Salesforce and Amazon (AMZN), have been maligned for having high P/Es. However, this has been the case since their beginnings. If these stocks deserved to fall, they would have fallen long ago. Instead, both eventually became multi-bagger darlings.

The reason is that P/E is deceiving. Companies like CRM and AMZN invest a lot of money into their future growth. Thus, their expenses are higher. Their current expenses are supporting their current and future sales. Of course, revenue minus expenses equals earnings. As a result of their higher investment levels, the E in P/E has always been smaller than it could be. Consequently, their P/E ratios have historically been very high. Quite obviously, their high P/Es haven't been indicative of inflated value. Anyone who thought otherwise missed their multi-bagger runs.

In other words, companies like CRM and AMZN have been using their profits to build empires. Anyone who remembers when Amazon was just selling books can clearly see that they are a now a retailing empire. Ditto for CRM in the SAAS software arena. This rise to dominance wouldn't have been possible without investing their profits back into the business. As a result, they appeared to be unprofitable…but in actuality, they were simply investing more than they were pulling in.

This resulted in a seemingly horrible (and often negative) P/E ratio. Those who looked at their potential for future earnings were much more intrigued, particularly before key stages of share-price appreciation.

For those of you who are saying, "there's a lot more to it than that," you are absolutely right. However, at a basic level, this is often the key dynamic at work.

On the other end of the spectrum, I have often held out QAD Software as an example. The company is among the last of its breed - a publicly-traded independent on-premise software vendor. In the mid-2000s, I spearheaded a proprietary study which was recently released to the public. The findings led my company to conclude that ORCL would gobble up many of QADA's peers. We further concluded that private-equity shops and ORCL-wannabes would acquire many of those that remained.

The reasoning was simple. Most of the subjects of our study were cash cows in growth-stock clothing. In other words, they were still investing in the future growth of their business even though the world was moving in another direction. Their days as growth companies were over, but they didn't know it (or were simply in denial).

In reality, they should have shifted gears to optimize the benefits of being a cash cow. By cutting investments in R&D and SG&A, they could have maximized their profitability. Indeed, much of their large installed base of customers was paying annual maintenance fees - a great and high-profit stream of recurring revenue.

Those who followed this path experienced massive profit-expansion, as was to be expected. Because their R&D and SG&A investments were largely going to waste, cutting those expenses dropped almost entirely to the bottom line. Thus, all else being equal, a company with 1% operating margins and a P/E of 50 could quickly become a company with 10% operating margins, which would translate into a P/E of 5.

That's FIVE.

Larry Ellison knew this. This is why he hired one of Wall Street's top software analysts (Chuck Philips, a client of mine at the time) to help Oracle execute his acquisition strategy. The plan was brilliant. ORCL's stock killed the market from the time of its acquisition of PeopleSoft until the anniversary of its last large acquisition, Sun Microsystems. Since that time, the stock has been a woeful laggard. Coincidence? Absolutely not.

Getting back to QADA, in my opinion, the only reason they haven't been acquired is that Pamela and Karl Lopker hold a controlling stake in the company. I encountered Pam several times during my days at AMR Research. The Lopkers are great, family-oriented people and built a great company. In fact, Karl built two - the other was Deckers (DECK), the maker of Ugg boots!

Their controlling interest in QADA has enabled them to hold off any barbarians at the gate. Simultaneously, they have continued to invest heavily in the future growth of QADA. This has left QADA with a deceptively high P/E and little hope of being acquired unless the Lopkers decide to sell. This, combined with its history of lumpy earnings, has kept investors away.

However, if you take a close look at QADA's income statement you'll see that a mere 10% cut in R&D and SG&A would more than triple its fiscal 2013 earnings. That's a big jump in earnings for a small cut in expenses. Of course, that would also cut its P/E by two-thirds.

Yet, investors are more likely to comment on the company's P/E than recognize that the company offers a solid dividend and has bought back millions worth of its stock over the past couple of years. They are also unlikely to notice the complete lack of insider selling over the past year…or the fact that Karl Lopker's stake in the company has continuously been on the rise.

Moral of the Story

Whether you prefer growth stocks or value stocks, understanding the underlying dynamics of a company's P/E ratio is critical. Before allowing a simple P/E ratio to scare you away from an investment, be sure to gain an understanding of whether earnings (the E) are understated or if the company's future revenue growth will drop an abnormally large amount of profit to the bottom line.

If so, you'll know that the company's P/E ratio is artificially inflated and can "adjust" it. An adjusted P/E can help you determine if a stock is really overvalued or simply misunderstood, giving you a critical advantage over the average investor.

Source: P/E Ratios Are Robbing Your Returns!