John Reese is founder and CEO of Validea.com and its Canadian site Validea.ca, as well as Validea Capital Management, and is a portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
In the stock market, it's often all about earnings. Earnings reports, earnings growth rates, price-to-earnings ratios – when analyzing stocks, investors usually turn to these metrics as gauges of value.
But earnings don't always tell the whole story. In fact, other yardsticks often provide a better gauge of how a company is doing. The Price/Sales Investor strategy I track on my website 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.
Mr. Fisher thought there was a major hole in the usefulness of the standard price-to-earnings ratio. Part of the problem, he wrote, is that earnings – even earnings of good companies – can fluctuate from year to year.
A company's decision to replace equipment or spend money on research, as well as changes in accounting methods, can 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 is performing. But while earnings can fluctuate, Mr. Fisher found that sales were far more stable, and a better gauge of a company's strength and prospects.
At 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 in the U.S. market, averaging annualized returns of 12.1 per cent since its mid-2003 inception versus just 4.6 per cent for the S&P 500.
My Canadian 10-stock Price/Sales Investor portfolio, which I started tracking in 2010, got off to a slow start but has really come on since the start of 2012. It gained 17.2 per cent last year versus 4.0 per cent for the S&P/TSX composite, and this year it's been my best performer, gaining 11.1 per cent while the S&P/TSX has lost 0.1 per cent.
How does the Price/Sales Investor strategy work? It starts with the PSR, looking for companies with a ratio below 1.5, and really getting excited when a PSR is under 0.75.
One caveat: Because companies in what Mr. Fisher called "smokestack" industries, like heavy industry or manufacturing, grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement 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 Mr. Fisher's work. They include: average net profit margins of at least 5 per cent over the past three years; debt-to-equity ratio of no higher than 40 per cent; positive free cash flow; and inflation-adjusted earnings growth of at least 15 per cent a year over the long term.
For companies in the technology and medical industries, it also looks at the price-to-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).
To create actionable investment strategies on top of the Fisher strategy outlined above, I create 10- and 20-stock portfolios that hold the top-scoring stocks based on the strategy. Once a month, I rerun the strategy so that lower-scoring stocks are dropped from the portfolio and higher-scoring stocks are added.
As always, when using a quantitative screening model like this one, you should invest in a basket of stocks to diversify away risks. With that in mind, here are a handful of picks from both the United States and Canada that my Price/Sales Investor model is high on right now.
This general contracting firm has been active in Canada for nearly a century. The Toronto-based company is a small-cap stock ($550-million), but has taken in over $1.3-billion in sales in the past year. It has a 0.4 PSR, $1.22 in free cash per share, and three-year net average profit margins just over 5 per cent.
Ascena is a Suffern, N.Y.-based apparel retailer focused on women and tween girls. It operates under the brand names Justice, Lane Bryant, maurices, dressbarn and Catherines, with about 3,800 stores in the United States, Puerto Rico and Canada. Ascena has a 0.71 PSR, 18.8 per cent debt-equity ratio, and three-year average net profit margins of 5.44 per cent.
This Ontario-based auto supplier, with operations in 29 countries, has taken in nearly $31-billion (U.S.) in sales in the past year. It has a 0.44 PSR and a debt-equity ratio under 5 per cent. Its three-year average net profit margin (4.15 per cent) falls just short of this model's target, but the strategy still has interest in the stock.
Southfield, Mich.-based Lear supplies automotive seating and electrical power management systems. The $5.1-billion-market-cap firm has taken in more than $14.5-billion in sales in the past year, making for a 0.35 PSR. It also has a 20.6-per-cent long-term inflation-adjusted growth rate, and $2.17 in free cash per share.
Disclosure: I own shares in Ascena and Lear.