For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seem to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.
But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year, as companies replace equipment or facilities in one year rather than in another; use money for new research that will help reap profits later on; or change accounting methods.
While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price three to 10 times in value in a period of three to five years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: The price-to-sales ratio (PSR), which compared the total price of a company's stock (its market capitalization) to the sales the company generated.
Fisher's findings helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. Over the years, Fisher has changed his approach significantly. But the Guru Strategy I base on Super Stocks continues to beat the market by a wide margin. Since its July 2003 inception, a 10-stock, monthly rebalanced portfolio picked using my Fisher strategy has gained 163.3%, or 13.9% per year. The S&P 500 over the same period has gained just 25.8%, or 3.1% per year.
Currently, access to this market-beating strategy (and several of my other Guru Strategies) is available through Seeking Alpha's Investing App Store. Let's take a look at just how the approach works.
Price-to-Sales and "The Glitch"
Fisher's observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then they have a setback: Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.
But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. By buying shares in a good company when its stock is temporarily down due to a "glitch," you can make a bundle. The key, of course, is finding a way to evaluate a firm when its earnings are down (or when it is losing money). The answer: By looking at sales, and the PSR.
According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a "Super Stock." To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales. For what Fisher called "smokestack" industries -- that is, industrial or manufacturing-type firms that make the everyday products we use -- lower PSRs are sought. They should have PSRs between 0.4 and 0.8, since their un-glamorous industries and businesses generally don’t command as high a price as other stocks.
Beyond the PSR
While the PSR was key to Fisher's Super Stocks strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.
Other quantitative measures Fisher used include profit margins (my Fisher-based model looks for three-year average net margins to be at least 5%); the debt/equity ratio (this should be no greater than 40%, and is not applied to financial firms); free cash per share (this should be positive); and earnings growth (the inflation-adjusted long-term earnings per share growth rate should be at least 15% per year).
What stocks currently meet these targets? Here's a look at a handful that my Fisher-inspired portfolio is keen on. Keep in mind that I always invest in baskets of at least 10 stocks, to diversify away some of the stock-specific risk that comes with using quantitative strategies.
Raytheon Company (NYSE:RTN): This Massachusetts-based aerospace & defense giant is one of the few stocks that currently gets a perfect 100% score from my Fisher-inspired model. A few reasons: The $17-billion-market-cap firm has a PSR of 0.67, a reasonable 23% debt/equity ratio, $4.81 in free cash per share, and three-year average net profit margins of 9.0%.
Clearwater Paper Corp. (NYSE:CLW): This Spokane, Wash.-based firm makes a variety of tissue and paperboard products, as well as lumber products. It's a small-cap ($900 million), and it also gets a 100% score from the Fisher approach, which considers it a "smokestack" company. The stock sports a PSR of 0.67, a whopping $17.45 in free cash per share, and three-year average net profit margins of 5.8%. It's also reasonably financed, with a debt/equity ratio of 36%.
GameStop Corp. (NYSE:GME): Texas-based GameStop is the world's largest videogame retailer. The $3.4 billion market cap company gets a 90% from my Fisher-inspired model, thanks to its PSR of 0.37, debt/equity ratio of less than 9%, and long-term inflation-adjusted EPS growth rate of 28.8%. The lone blemish: Its three-year average net profit margins are 4.3%, falling just short of the model's 5% target.
Aeropostale, Inc. (NYSE:ARO): Headquartered in New York City, this mall-based teen clothing retailer ($2.2 billion market cap) gets a 90% score from the Fisher-based approach. Its PSR isn't low enough to make it a Super Stock, but at 0.91 it still indicates that the stock is a good value. The firm passes all of the other Fisher-based tests, sporting no long-term debt, a 31.3% long-term inflation-adjusted EPS growth rate, $2.78 in free cash per share, and three-year average net profit margins of 8.8%.
Ross Stores (NASDAQ:ROST): California-based Ross is the U.S.'s second-largest off-price retailer. The $7.5-billion-market-cap firm gets a 90% score form my Fisher-based model. Like Aeropostale, it has a solid but not-quite-Super-Stock-worthy PSR, which comes in at 0.98. Its other fundamentals are very strong, and include an 11.7% debt/equity ratio, $5.40 in free cash per share, and 24.4% long-term inflation-adjusted EPS growth rate.