Heard about Kenneth L. Fisher pioneering the Price/Sales ratio a couple of times, so decided to pick up his book “Super Stocks” (Reissued Edition of the 1984 Investing Classic).
This is an interesting book, in the camp of ‘growth stock investing’. I think there are growth companies, and there are growth stocks. Everyone wants to find the next growth company Microsoft, Starbucks, etc. when they are young and ride them all the way up. As what Fred Kobrick, author of The Big Money wrote, growth companies has repeatability that allows it to grow and grow. Companies that latch onto a fad and sizzle later, can be growth stocks but not growth companies.
Fisher’s research showing that the P/S tends to drop as companies get larger, is consistent with the fact that as a company grows bigger and bigger, its margins drop and its growth slows, leading to lower P/E and P/S.
Fisher also focuses on the market share of the companies as a gauge on whether a company is a super company. This is similar to what Kobrick advocated as well.
Other good points in this book includes tips on how to get in touch with management, and also on time management of our lives to be as productive as possible.
Main Idea for Young, Rapidly Growing Companies
- Each product released by a company will go through the product lifecycle of introduction, growth, maturity, decline.
- For a company’s sales and profits to keep growing, a company needs to keep introducing each new product before sales for the current one declines.
- When a company suffers a ‘glitch’ due to lack of experience, sales temporarily flatten out and profits plummet for the following reasons:
- A company spent costs in anticipation of greater sales that did not materialise.
- Assets may need to be written down, e.g. useless equipment, bad inventory.
- Unanticipated money needs to be spent to correct the problem, e.g. fix the root cause, placate customers, spend on marketing
- The stock price also plummets. 30% of the stock value can be wiped out in a few days. Investors don’t know how to value growth stocks without earnings so it falls even further.
- Good companies overcome these difficulties. The glitch makes Super Stocks out of Super Companies. It is rare for a Super Company to have a truly substantial sales decline.
- Buying the stock right after the glitch but before the recovery, would result in phenomenal returns.
Super Stock Definition
- Potential to make 3-10x your money in 3-5 years.
- Can generate internally funded future long-term average growth of 15-20%.
- Will generate future long-term average after-tax profit margins above 5%.
- Is bought at a P/S of 0.75 or less.
Benefits of P/S and P/R Over Other Methods
- P/E valuation doesn’t work when there are no, or negative, earnings.
- P/B valuation cannot be applied to tech companies.
Price/Sales (P/S) Ratio
- The highest P/S decreases as the company size increases. In Nov 1982, for companies with annual revenue less than $100M, $200M, $300M, $400M, $800M, and $800M+, the highest P/S is around 6+, 6, 5, 4, 3, and 2 respectively. Companies less than $100M revenues typically have P/S of 1-3, for other revenue sizes, P/S is typically 1-2.
- As a company increases in size, its P/S will eventually be no higher than the highest P/S for other companies of its future size.
- For a range of P/S, you can draw up a table of corresponding P/Es for different profit margins.
How to use P/S ratios
- Rule 1: Avoid stocks with P/S > 1.5. Never ever buy any stock with P/S > 3.
- Rule 2: Aggressively seek Super Companies at P/S of 0.75 or less.
- Rule 3: Sell stock in any Super Company when the P/S rises to between 3-6.
- Rules for specific types of companies
- Buy stocks of huge companies at P/S of 0.4 or less, and sell at P/S of 2 or less.
- For industrial companies, their P/S should be lower because of low margins. Buy them at P/S under 0.4 and sell them as P/S approaches 0.8 (can be sold at 0.5-0.8 for lesser quality companies).
Price/Research (P/R) Ratio
- Defined as the market value of the company (using fully diluted shares) divided by the corporate research expenses for the last 12 months.
- Pertains only to technology companies.
- Technology research is a commodity. Market research determines the success of the product.
- If R&D spending is not detailed, find out what percentage of the company’s total labour force is devoted to engineering. Take two-thirds of this percentage. This should approximate the company’s R&D expenses as a percentage of sales. E.g. 12% of labour force is devoted to engineering, so ~8% of sales should be R&D expenses.
How to use P/R ratios
- Rule 1: Don’t ever buy a Super Company selling at a P/R > 15.
- Rule 2: Find Super Companies with P/R of 5-10.
- Must have a competitive superiority over all current or potential competitors.
- Have better margins than its competitors.
- Ought to gain or keep market share.
- Have good labor relations, seldom face labor unions or disputes.
- The Japanese does well in fields requiring mass consumer marketing or price marketing, and relatively poorly in markets intensive in direct selling to sophisticated customers or markets that require significant strategic market planning. E.g. selling of lasers require intensive marketing, which is hard for a non-local company to do.
- A small company does best in markets that are rapidly growing but too small to attract the big guys at the moment.
- The relative market share is more important than the absolute market share. A company with a 30% market share in a fragmented market with 10 competitors at 7% each is great.
- Most good companies have operating expenses being of at least 20% of sales, and gross margins above 30%.
- Average long-term potential margin = 0.13 * (market share)^2 * (1+ industry growth rate) / market share of largest competitor
- Rule 1: If the actual margin falls short of the potential margin, and no competitor appears to have an unfair advantage, it is due to the lack of general management ability.
- Rule 2: If potential margin is high but the competition is likely to have an unfair advantage, then the industry growth rate should be reduced as the competition will grab more of the industry growth.
- Rule 3: If potential margin is low, and it does not have any unfair advantage, it is unlikely to be a Super Company.
- Rule 4: If potential margin is low, and it does have clear unfair advantage, the estimated industry growth rate can be increased.
- Rule 5: If historically good actual margin has fallen temporarily, and industry conditions and the management has not changed, then good margins will likely return within 3 years.
- Low P/S and P/R among the industries in which he is knowledgeable.
- Money-losing companies with which he is not already familiar.
- Qualitative assessments by others, of outstanding businesses with strong future prospects.
- The F&S Index catalogs information from all kinds of publications, and is useful to find everything in print about a company.
Getting Hold of Management
- Write a letter to the CEO (about 95% successful response rate), explain the following
- Why you want to see him
- Potential financial interest
- That you have already put effort into studying his company
- Explain about yourself and your firm
- Mention some companies you are invested in
- Offer references
- Volunteer to meet with someone else if he thinks it is more appropriate or if he is going to be out of town.
- Offer 5 alternative dates to go to his HQ and suggest that he picks a date/time most convenient to him.
- If all the dates are bad, suggest that he picks an alternate date which you will try to make.
- Suggest he have his secretary call to set up the date and time.
- Thank him in advance for his time.
Management Interview Questions
- Who follows your company from the financial community, and what do you see as their attitude toward the company?
- Please draw a basic organisation chart showing how the business is organised and what functional responsibilities report to each key officer
- Please break down your markets by product type.
- Why do customers buy your products over those of your competitors?
- What level of technology exists in your products — what is the technology employed at your company?
- How is the selling effort conducted — how are the sales made?
- From the time an initial customer prospect is identified, how long does it take to close the sale?
- Are there any important sectors of your market which you don’t address?
- What is your market share by product area, and what are the shares of your leading competitor — and who do you view as your strongest competitors?
- How does your market share compare now with several years ago?
- Are there any new entrants into your market in the last 2 years?
- How does pricing vary by product — has price cutting been a significant factor in the past?
- Is there any significant amount of revenues derived from servicing your customer base other than as shown in the income statement?
- What is the quarterly history of orders and backlog (only asked if not disclosed in publicly available information)?
- Is there any seasonality to the business other than as reflected in orders and backlog?
- Please list the approximate level of sales in the top five foreign countries in which you do business and among your top five customers.
- Is the marketing effort conducted any differently overseas?
- Describe the process at your company through which a product idea passes as it moves from initial inception to initial shipments.
- How much do your typical salespeople earn, and how much of that is based on sales commission?
- How long has your typical salesperson been with the firm, and where did he or she come to you from? How did you recruit this person?
- Overview / Strategic
- What is the long-term objective of the company?
- What are your long-term objectives for profit margins, and how do you intend to achieve those goals?
- Over the next few years, how would you expect the components of your income statement to change in relation to each other?
- Should I expect to see major acquisitions or divestitures as part of your plan for the next several years?
- Do you envision any major functional additions to the senior management staff?
- Pleas review each member of senior management, indicating what things they are strongest and weakest in. For instance, if Joe Blow, the president, is strongest in marketing, which area is he next strongest in and which area is he weak in?
- What are your plans for capital expenditures for the next few years, and what specific product areas do you plan to stress?
- If any of your top officers have left the company in the last few years (check by looking in 10-K), why did they leave and where did they go?
- Which are your most active members of the board of directors and which are the least active? (While you may think managements would be hesitant to answer this, he has seldom found it to be so).
- Please review the number of employees by each functional area, for this year and last year (R&D, marketing, field sales, service, production, finance, other).
- Miscellaneous but important
- Will research expense as a percentage of sales be greater or less than it currently is in future quarters and years?
- What areas are you currently spending your money on in R&D?
- How much of cost of goods sold represents purchases of finished goods and how much represents in-house fabrication and assembly?
- Is there any crucial part or component with only one or two vendors which could become in short supply?
- What questions should I have asked that I didn’t? (If they can’t come up with one or more, they are either not bright or not forthright).
Pre-Buy Valuation Projection
- Fully diluted number of shares, market price per share, market cap.
- Last 12 months’ sales, P/S.
- Last 12 months’ R&D, P/R.
- Which market is the stock trading, which brokers to use to buy.
- Factors that might make the stock decline.
- Rate you predict sales to grow at over the next 5 years.
- Reasonable future margin in 3-5 years.
- Reasonable and conservative valuation the market will give when it attains the future margin, using a projected P/S.
- What P/E will that translate to, in 3-5 years, using the projected P/S and profit margin.
- To buy the total amount of stock that you want, how much money is needed and what percentage of the target business is that? consider that the stock price might be rising while you buy.
- The CAGR you expect to earn over 3-5 years.
- There are 1,440 minutes per day, excluding 8 hours of sleep, you have 1,000 minutes left.
- Each hour you spend on something is 6% of your day.
- Don’t waste time on looking into interesting things that you would likely not pursue further.