In 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Since the advent of securities analysis, the price-to-earnings ratio has sat right at the top of most investors' toolboxes. Benjamin Graham, perhaps the first great stock market investor, saw the ratio as a key way to value stocks, targeting those with P/Es below 15. Other greats, from Peter Lynch to David Dreman to John Neff, had differing takes on what P/E range was best, but all agreed that the ratio itself was a key to finding bargain-priced stocks. The P/E has become so popular, in fact, that it is usually the only valuation ratio that typical American newspapers include in their daily listings of individual stock quotes.
But Fisher, whose father, Phillip, was also a noted investor and author, thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his 1984 book Super Stocks, 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 Fisher thought was 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. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 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 to the sales the company generated.
Fisher's findings -- and his results -- rocked Wall Street, and were so influential that they formed the basis for one of my "Guru Strategies", computer models each based on the philosophy of a different investing great. In part thanks to his PSR focus, Fisher's firm, Fisher Investments, has become one of the world's most successful investment companies, and Fisher has become one of the world's richest men. (According to Forbes, his net worth is $1.3 billion today.) In addition, Fisher has become one of Forbes most popular columnists, writing both for the company's website and its magazine.
The test of time
Before we get into the specifics of my Fisher-based model, you should be aware of a couple things. First, while Super Stocks placed tremendous emphasis on the price/sales ratio and also included other quantitative aspects, there were also several qualitative parts to his approach. For example, he looked for companies that had an "unfair advantage" over their competition, such as strong name recognition or an important patent (much like the "economic moats" Warren Buffett seeks out).
Second, Fisher says his approach to investing has evolved quite a bit since Super Stocks, a point he stressed when I spoke to him a few years back while I was writing my book, The Market Gurus. The key to winning big on Wall Street is knowing something that other people don't, he believed, and when too many people became familiar with P/S investing, he needed to find other ways to exploit the market.
Still, there are a couple big reasons that I think the quantitative parts of the PSR-driven strategy Fisher laid out in Super Stocks is still quite relevant today. One is that his publisher reissued the book this year, with the same PSR focus. Another is that, frankly, the strategy still works. In July 2003, I began tracking a portfolio of stocks that score highest on my Fisher-based model. Since then, the portfolio has gained 165.7 percent -- more than tripling the 47.2 percent return of the S&P 500. And this year, even with the market struggling, it has more than quadrupled the S&P.
Price-to-Sales and "The Glitch"
Now, let's get down to business. To understand why Fisher focused so much on sales, it's important to understand part of his take on investor psychology. 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 believes that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's prices begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until the company rights the ship and other investors jump on board.
The trick is thus trying to evaluate a company during those periods when Wall Street is down on it because its earnings are in flux, or even negative, so that you can find good candidates for a rebound (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer, Fisher said, was the P/S ratio.
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 P/S values under 0.75 -- that's one of the signs of a Super Stock. As an example, let's take ConocoPhillips (NYSE:COP), the Texas-based giant that is the third-largest integrated energy company in the U.S. in terms of market capitalization and oil and natural gas reserves. To find the P/S ratio, 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. As of the market close on Monday, ConocoPhillips was selling at $80.25 per share, and had 1.644 billion shares outstanding, making for a market cap of just over $128 billion. When we divide that by its trailing 12-month sales of about $182.7 billion, we get a P/S ratio of 0.7, which falls into Super Stock territory.
One important note: Different industries often behave differently, and one distinction Fisher drew involved "basic industry" or "smokestack" stocks -- those that "plug along without much fanfare making the essential materials and parts we all need in our daily lives", like steel, auto, chemical, paper, mining, and machinery firms.
Because companies in these "smokestack" industries tend to grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street, and their P/S ratios tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusts his P/S target for these firms, and the model I base on his writings looks for smokestack firms with P/S ratios between 0.4 and 0.8; it is particularly high on those with P/S values under 0.4.
One "smokestack" company that makes the grade is Westlake Chemical Corporation, (WLK), a Texas-based firm that makes petrochemicals and fabricated products that are used in a number of everyday products, including tires, plastic wrap, piping, and window frames. The company, which has brought in more than $2.86 billion in sales in the past 12 months, has a P/S ratio of 0.45, falling nicely into the range that my Fisher-based model likes.
One last note on the P/S ratio: Fisher thought it was okay to hold stocks whose P/S figures rose above the limits he set for buying stocks -- a rising "P" in the P/S equation is, after all, a sign that the stock's price is rising and making you money. But if a noncyclical stock's PSR reached 3.0 or a cyclical stock's PSR approached 0.8, he said you should consider selling. After those points, returns tend to diminish and risk that the stock will fall increases.
Beyond the PSR
While the P/S ratio was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low P/S ratios simply because the investment world knows they are headed for financial ruin.
The other quantitative measures Fisher used include:
- Profit margins: Fisher believed stocks should be valued not on such things as earnings, which are results of other things, but instead on root causes that led to those results. Profit margins, like sales, are a cause, and to be a Super Company, Fisher said a firm should produce annual pre-tax margins of at least 5 percent over the past three years.
- The debt-to-equity ratio: Less debt equals less risk, and the model I base on Fisher's writings calls for debt/equity ratios no greater than 40 percent. (Financial companies are excluded, because the nature of their businesses causes them to carry a lot of debt.)
- Earnings growth: To be a Super Stock, a company had to be growing earnings by at least 15 percent more than inflation.
- Free cash per share: Firms should be generating positive free cash per share.
Let's take a look at how ConocoPhillips and Westlake stack up using these criteria. ConocoPhillips has three-year average pre-tax profit margins of 7.19 percent, a debt/equity ratio of 25.16 percent, long-term inflation-adjusted earnings growth of 51.73 percent, and $2.26 in free cash per share, passing all four tests.
Westlake also excels. Its three-year pre-tax profit margins have averaged an impressive 7.73 percent, its debt/equity ratio is 26.45 percent, it has grown earnings over the long-term at an inflation-adjusted rate of 25.67 percent, and it is generating $1.41 in free cash per share, passing all four tests.
Do your research
One more category Fisher looked at involves an interesting observation. For companies in certain industries, particularly tech and medical firms, Fisher saw research as a commodity. To measure how much Wall Street valued the research that a company did, he compares the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.
ConocoPhillips and Westlake are not technology or medical firms, so their PRRs don't apply here.
Two more oil picks
In addition to ConocoPhillips my Fisher-based strategy is high on a couple other energy stocks. Let's take a quick look at them:
Marathon Oil Corporation (MRO): Based in Houston, Texas, this integrated energy company has exploration and production activities in the U.S., several European countries, parts of Africa, and Indonesia. It is the fifth-largest refiner in the U.S., and has raked in more than $60 billion in sales over the last 12 months. Marathon's P/S ratio (0.65) is at Super Stock levels, and the company has averaged net profit margins of 5.11 percent over the past three years, two big reasons my Fisher-based model likes it. In addition, its inflation-adjusted EPS growth rate is 49.52 percent, while its debt/equity ratio is a manageable 36.57 percent.
Holly Corporation (HOC): Based in Dallas, this independent petroleum refiner is another Texas-based oil firm, making such products as gasoline, diesel fuel, and jet fuel. Holly has operations in and delivers its products to several states in the western portion of the United States, and its pipelines also serve northern Mexico.
Holly, which has taken in about $4.3 billion in sales over the past 12 months, boasts a strong 0.62 P/S ratio and has averaged 5.36 percent net profit margins over the last three years, both of which impress my Fisher-based model. In addition, it has been producing free cash per share of $1.88 and has an acceptable debt/equity ratio of just over 25 percent.
Different roads to success
After reading about Fisher's pioneering of the PSR, you may be scratching your head, Didn't I just write in my last column about John Neff, the renowned American mutual fund manager who focused first and foremost on stocks with below-average P/E ratios? And didn't Neff continually beat the market and earn his clients excellent returns using that P/E-driven approach? So who's right, Fisher or Neff?
In short, the answer is "both". One thing that has been clear as I've researched the gurus upon whom I base my models is that there is no one "right" way to win on Wall Street. There are numerous approaches, each of which has its own merits, and its own risk levels.
One similarity that runs across all of these gurus' approaches, however, is something I've touched on numerous times: their willingness to stick to their strategies even when they hit short-term or medium-term bumps.
Fisher's approach highlights another key similarity. As much as he believed in the PSR, as much as Neff believed in the P/E ratio, and as much as Peter Lynch believed in the P/E/Growth ratio, each of their methods still focused on a variety of fundamentals. That way, they identified stocks that were financially sound on a number of levels, and they also limited the losses they might suffer if their star variable ever went out of favor for a period of time. Whatever long-term strategy you decide on while building your own portfolio, you'd be wise to make sure it's one that is just as thorough and multi-layered.
Published by Globes [online], Israel business news - www.globes.co.il - on December 12, 2007