No number or ratio in stock investing is more widely used than the P/E (price-to-earnings) ratio, but some think it has important limitations. Among the best known naysayers is Kenneth Fisher who wrote a book in 1984, Super Stocks, that made a case against the P/E and a case for the P/S (price-to-sales) ratio.
His thinking: earnings can be highly volatile -- much more so than sales -- which is why the P/S ratio is more reliable than the P/E. He is right in thinking that earnings movements can be deceptive. A move to expand a business, such as the opening of new factories or stores, can depress earnings in the short run, but lead to higher earnings in the longer term. Focusing on the P/E would cause you to miss this fact. Also, earnings are more easily manipulated than sales by management and accountants. This can affect their accuracy and volatility. Looking at the P/E, one can see earnings dip for any number of reasons and, as a result, cause the stock's price to go down, even though there is nothing wrong with the company, its operations or its growth strategy. A rise in commodity prices, as happened last year with oil and the airlines, and many other companies which use such metals as copper and steel, can dramatically hurt earnings, though these market conditions may be fleeting and not reflect on the company's underlying fundamentals.
Sales, on the other hand, typically are not nearly as volatile nor as subject to market conditions as earnings. During the current recession we have seen many companies whose sales dropped significantly, such as high-end retailers. Unless the current economic climate continues unabated for some time, these companies should recover. Others who have seen sharp sales drops, such as auto companies and home builders, are teetering near bankruptcy, and may not be around when the economy turns up. But Fisher's contention that, in general, sales are more revealing than profits seems to hold true.
What is the P/S? It is a number that lets you know how much you are paying for sales. A P/S of say 1.1:1, means you are paying $1.10 (as reflected in the price of the stock) for every $1.00 in sales. Fisher's rule of thumb for the P/S ratio is, don't buy a stock whose P/S is more than 1.5:1, and aggressively look for stocks with P/S ratios of 0.75:1 or less, where you are paying 75 cents for every dollar in sales. There is more to Fisher's strategy than this, of course, but this gives you a good idea of what is the strategy's most distinguishing variable.
Fisher has been in the money management business a long time. And the strategy I base on his writings has done relatively well. It was one of my original Guru Strategies. Since I have been using it, starting on July 15, 2003, it has handily beaten the market. From its inception to the present, it has produced an annualized positive rate of return of 5.8%, versus a negative 5.3% for the S&P 500.
I have revisited Fisher's ideas recently, as is true for all my Guru Strategies. This was a result of a book I wrote that was just published, The Guru Investor, which covers all of the strategists behind the Guru Strategies in detail (you can find a more thorough description and analysis of Fisher's strategy in the book than I was able to present here). As I looked anew at Fisher's ideas, I found them worth paying attention to, just as I did when I first decided to include them in my first book, The Market Gurus, and on my website, Validea.com.
I want to tell you about two stocks the Fisher strategy thinks are winners. One is a retailer of men's clothing, Jos A. Bank Clothiers (JOSB), headquartered in Maryland. The company, which was founded more than 100 years ago and caters to professionals, has about 450 stores, plus catalog and Internet sales. Of course, all retailers are suffering, and Bank's stock has tumbled like others. But, in fact, the company has done better than many other retailers. While such major national chains of women's and young people's clothing as Abercrombie & Fitch, Aeropostale, Chico's FAS, Gap, and Zumiez found their same-store sales dropping 12% or more last year, in its most recent reporting period, Bank had a 7% increase in same-store sales. Given this sales performance, it is no surprise that the Fisher strategy favors this company.
Let's look at some specific variables considered by the strategy. As noted above, the P/S should not be above 1.5:1, and preferably below 0.75:1. Bank's P/S is a very favorable 0.63:1. Put another way, you are paying relatively little for sales.
Also in its favor is its low amount of debt, with debt equaling just 19% of equity. Fisher does look at earnings (though not the P/E ratio). What he wants is an EPS growth rate in excess of 15%; Bank's EPS growth rate is 27.1%. The company also has free cash per share and a three-year average net profit margin of 7.94%, nicely above the 5% minimum required by the strategy.
Let me tell you about one more company favored by the Fisher strategy, Michigan-based Rofin-Sinar Technologies (RSI), which gets a majority of its sales from outside the US. The company manufacturers high performance lasers used in manufacturing processes to perform such functions as welding, cutting, drilling and marking.
Rofin's P/S ratio is 0.77:1, meaning you pay 77 cents for every dollar of sales. That's a very desirable price to pay for sales. Debt is low, just 11.2% of equity. In terms of growth of earnings, Rofin's is a solid 18.3%, while its three-year average net profit margin is a laser-sharp 11.5%.
Both Jos A. Bank and Rofin-Sinar are performing well, are well priced and receive the support of the Fisher strategy. Look closely at these two companies. I think they will pay off nicely in the medium- to long-term.
Published by Globes [online], Israel business news - www.globes.co.il - on March 12, 2009