It's Not All About Earnings

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Includes: FL, LUV, SAFM, THO
by: John P. Reese

Summary

Stock market talk is often all about earnings, but sometimes earnings don't tell the whole story.

Successful investment strategists like Ken Fisher and James O'Shaughnessy have shown that the price/sales ratio can sometimes be a more effective measure of value.

Here's a look at how my Fisher- and O'Shaughnessy-based strategies work, and a few stocks they are high on right now.

Earnings, earnings, earnings: On Wall Street, profits are king. Headlines are filled with references to prominent companies' earnings - panic often ensues if a firm falls even a few pennies short of analysts' profit expectations. And when pundits talk about valuations, either of individual stocks or the market as a whole, they more often than not base their assessment on the price/earnings ratio.

But earnings don't always tell the whole story. In fact, oftentimes other metrics can provide an even better gauge of how a company or the market is doing. The Price/Sales Investor strategy I track on Validea.com is a good example. The key variable it looks at is the price/sales ratio - PSR - which compares a company's market capitalization to the amount of sales it has taken in over the past year.

The approach is inspired by the work of Kenneth Fisher, who in his 1984 investing classic Super Stocks pioneered the use of the PSR as a way to evaluate stocks. Fisher thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained, is that earnings - even earnings of good companies - can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what's truly important in the long term - how well or poorly the company's underlying business was performing. But while earnings can fluctuate, Fisher found that sales were far more stable, and a better gauge of a company's strength and prospects.

On Validea.com, I track a number of strategies I've developed based on the approaches of history's most successful investors. My 10-stock Price/Sales Investor portfolio is one of my best performers, averaging annualized returns of 10.5% since its mid-2003 inception vs. just 5.8% for the S&P 500.

How exactly does the Price/Sales Investor strategy work? It starts, of course, with the PSR, looking for companies with PSRs below 1.5, and really getting excited when a PSR is under 0.75. One caveat: Because companies in what Fisher called "smokestack" industries - that is, industrial or manufacturing type firms that make the everyday products we use - grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products. The Price/Sales Investor approach looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.

The Price/Sales Investor method also incorporates several other criteria based on Fisher's work. They include: average net profit margins of at least 5% over the past three years; debt/equity ratio of no higher than 40%; positive free cash flow; and inflation-adjusted earnings growth of at least 15% per year over the long term. For companies in the technology and medical industries, it also looks at the price/research ratio - the firm's market cap divided by the amount it spends on research. The more research spending the better (since good research can lead to future profits), with a price/research ratio under 5% the best case.

Fisher isn't the only investment guru whose research has pointed to the PSR as a great tool. James O'Shaughnessy, another of the strategists upon whom I base my investment models, made the metric a key part of his top growth strategy in his 1996 classic, What Works on Wall Street. O'Shaughnessy found that a combination of a high relative strength over the past year (relative strength is the percentage of stocks in the market that a particular stock has outperformed) and a low price/sales ratio (under 1.5) was a dynamic combination that could identify hot growth stocks that were still cheap.

As always, when using a quantitative screening model like my Fisher- or O'Shaughnessy-inspired models, you should invest in a basket of stocks to diversify away stock-specific risk. With that in mind, here are a handful of picks that these 2 approaches are high on right now.

Sanderson Farms (NASDAQ:SAFM): Mississippi-based Sanderson, founded in 1947, is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared food items. It employs more than 11,000 employees in operations spanning five states and 13 different cities, and is the third largest poultry producer in the United States.

Sanderson ($2 billion market cap) has a growth/value combo that impresses my Fisher-based model, which likes its 31.7% long-term inflation-adjusted EPS growth rate and 0.7 price/sales ratio. The strategy also likes that Sanderson's debt/equity ratio is less than 1%, and that it is producing nearly $5 in free cash per share.

Thor Industries, Inc. (NYSE:THO): Thor ($3.2 billion market cap) manufactures and sells a wide variety of recreational vehicles throughout the US and Canada, including the Airstream line of campers and trailers. Its products include conventional travel trailers, fifth wheels and park models. In addition, it also produces truck and folding campers and equestrian and other specialty towable vehicles.

Thor gets high marks from my Fisher-based model, in part because of its 0.76 PSR. The strategy also likes the RV-maker's 17% long-term inflation-adjusted growth rate, lack of any long-term debt, and $2.78 in free cash per share.

Foot Locker, Inc. (NYSE:FL): This specialty athletic retailer ($9 billion market cap) gets strong interest from my O'Shaughnessy-based model, which likes its 1.2 PSR. This approach also looks for firms that have upped earnings per share in each year of the past five-year period, which Foot Locker has done. And, as I mentioned above, it likes to see strong momentum behind its holdings, and Foot Locker's 12-month relative strength of 72 fits the bill.

Southwest Airlines Co. (NYSE:LUV): This one-time upstart has become a major player in the industry, taking in nearly $20 billion in annual revenues. The Dallas-based firm operates Southwest Airlines and AirTran Airways, and gets strong interest from my O'Shaughnessy-based model. A big reason: its 1.4 PSR. The strategy also likes its persistent earnings growth over the past five years and its solid 72 relative strength.

Disclosure: I am/we are long SAFM, THO, FL, LUV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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