In Super Stocks the author describes his investment approach based on the price/sales ratio: buying stocks of high-growth companies with low price/sales ratios due to temporary problems.
I found Super Stocks an informative book and I liked its emphasis on the price/sales ratio. A ratio I ignored so far because I focused on ratios based on earnings. A lot of the content, however, was a repetition of things I already read elsewhere. And as the book was written more than thirty years ago, a few things are outdated.
A Super Stock is defined to be both: A stock which increases 3 to 10 times in value in three to five years from its initial purchase. The stock of a Super Company bought at a price appropriate to an inferior company.
The Anatomy of a Super Stock
Get Rich with the "Glitch"
The most profitable common stock investments come in the form of young, rapidly growing companies that are currently out of favor with Wall Street. The stock becomes worth more because the company becomes bigger and the financial community finally comes to appreciate its true value and, along the way, bids up its price.
Few companies grow at rapid rates year after year without suffering some irregularity or "glitch" resulting in unfavorable earnings or even losses.
Young companies frequently suffer glitches as they mature. The best young managements improve with their mistakes. Some years later, these exciting little companies are likely to be much, much larger than at the time of their first troubles.
If the company successfully introduces new products on time, the stock price may continue to grow for years at about the rate of sales and profit growth. If the company suffers a glitch – which most companies do at some time, the stock price is apt to plummet. Most of those who previously thought the company so wonderful now become disenchanted with management and their apparent lack of ability to foresee and act on the future.
Time and again, stocks are bid up to unrealistic levels as investors set their sights on excessively high expectations. As the company encounters a glitch in its growth, the stock comes crashing back down.
The stock of a company that grows at above-average rates is a Super Stock when bought right after a glitch. The glitch phenomenon pushes the stock price down. It is this depressed price which allows for the abnormal returns of a Super Stock.
What Makes the Glitch Twitch?
Conventional Approaches to Stock Valuation
The most popular ways to value stocks are by using conventional yardsticks of earnings or asset values [...]. While there is nothing inherently wrong with earnings or assets, they are the results of other things. Profits are a result, not a cause. Stocks move off the same causes that cause the earnings. Stocks move because of something. Earnings and assets fluctuate because of something. The emphasis should be on the cause in because.
The "Low P/E" school says the current low price-earnings ratio of the stock is supported by earnings that will not go down significantly. The low price of the stock in relation to earnings seems to indicate Wall Street thinks the earnings will fall. The low P/E school believes that in time Wall Street will realize the earnings won't fall. At that time, they expect the stock to rise.
The limitation here is threefold. First, forecasting specific earnings per share is extraordinarily difficult to do for any period. [...] Second, numerous arbitrary factors are involved in how earnings are calculated. Some of these are merely accounting variables which may change over time. [...] Third, even if you do a perfect job of forecasting earnings – which no one does – you are likely to make only a small amount on your money with this approach. Successfully applied, it can make 100 percent on your money, but it won't make 10 times your money. It just won't work. The markets may not be efficient, but they aren't so inefficient as to allow for that kind of variation between consensus opinion on earnings, reality, and stock prices.
The "Growth Stock" school of thought believes that as a company grows, the stock responds – perhaps irregularly – to rising earnings that accompany growth. Given enough growth, this school envisions a rising price for the stock virtually regardless of the price initially paid.
This philosophy suffers from two limitations. The first is the same as with the low P/E school – it's just very hard to forecast earnings, even one or two quarters in advance. [...] The second limitation to this school of thought [...] is that, again, even if your earnings estimates are right, the stock may not perform well. Why? The stock market discounts the future. The price is likely to already have compensated for future growth.
The weakness of earnings-based valuation techniques becomes all the more obvious by considering what happens if you don't allow for their use. If you take away earnings, how do you value a company?
Don't think in terms of buying stock – forget the stock aspect. [...] The more fundamental notion should be that you are buying a business. What would someone pay to buy the whole business – lock, stock, and barrel?
Pricing Is Everything
Just as the market reaches high levels, people forget that stocks go down. Based on hopes and dreams, they pay prices that have little resemblance to what a private buyer would pay for the whole business. A stock can rise 70 percent from an already high level in a Bull Market but fall just as much, or more, in a Bear Market.
A perfect Super Stock is the stock of a business which:
- Can generate internally funded future long-term average growth of approximately 15 to 20 percent.
- Will generate future long-term average after-tax profit margins above 5 percent.
- Is bought at a Price Sales Ratio of 0.75 or less.
The Price Sales Ratio is just like a price-earnings ratio that uses corporate sales instead of corporate earnings. It is the total market value of a company divided by the last 12 months' corporate sales.
Price Sales Ratios are of value because the sales portion of the relationship is inherently more stable than most other variables in the corporate world.
A company's worth to a private buyer should be a function of the volume of future sales and average future profit margins – how much future business it will have and how much money it will make doing that business.
To buy stocks successfully, you need to price them based on causes, not results. The causes are business conditions – products with a cost structure allowing for sales. The results flow from there – profits, profit margins, and finally earnings per share.
- Rule 1: Avoid stocks with PSRs greater than 1.5. Never ever buy any stock with a PSR greater than 3. A stock selling at a PSR this high can increase rapidly, but only based on "hype". Stay away – unless you want small short-term profits at the risk of large long-term losses. [...]
- Rule 2: Aggressively seek Super Companies at PSRs of 0.75 or less. There are always some around. There is no shortage. Hold them for a long time [...].
- Rule 3: Sell stock in any Super Company when the PSR rises to between 3.0 and 6.0. If you don't want to take much risk – sell at 3.0. If you are willing to take slightly more risk – hoping excessive optimism will continue to sweep the stock price up, hang on hoping for 6.0 – maybe higher if you like gambling.
Don't buy stocks simply because they have low PSRs: You need quality as well.
Price Research Ratios
Price Research Ratios provide an analysis of the value of research. Technology companies make up a significant portion of the universe of Super Companies. Therefore, PRRs play an important role in the analysis of Super Stocks.
PRRs help avoid mistakes in two ways:
- They help avoid buying companies which are cheap on a Price Sales Ratio basis and are thought to be Super Companies but in reality aren't.
- They give a clue when a Super Company with a seemingly high Price Sales Ratio is in reality quite cheap.
The Price Research Ratio (PRR) is the market value of the company divided by the corporate research expenses for the last 12 months. The PRR is a simple arithmetic relationship between the stock price and the research budget of the company. Note that it is not a relationship between the stock price and the productivity or output of research.
If a company isn't good at marketing, it isn't good. A technology company that isn't good at marketing, isn't good at technology. A Super Company is competent (not necessarily perfect) at marketing.
Most of the variance in results boils down to finding what to develop in the first place. What should the product be like? How should it perform? Why will the customer prefer it over other alternatives? What is the motivation that generates the sale? These kinds of marketing factors determine up to 80 percent of the effectiveness of research. The other 20 percent varies with the capability of management.
Simply don't pay too much for research. To buy a Super Stock, you need to buy a Super Company at a low price. Avoid the lure of supposed research magic. There's no magic in engineering. The real key to what a company will get out of its research lies in marketing. Once you determine marketing capability, valuing research becomes a relatively easy thing to do.
To buy a Super Stock, consider these rules:
- Rule 1: Don't ever buy a Super Company selling at a PRR greater than 15. There are always plenty that can be bought at lower valuations.
- Rule 2: Find Super Companies with a PRR of 5 to 10. You are unlikely to find them at PRRs much below 5.
The PRR helps when a Super Company seems high priced (based on PSRs) but is really rather cheap. Consider a Super Company with a marginally high PSR like 1.0. Suppose it has a very low PRR like 5.0. The implication is that current research expenditures, on perceived market opportunities, will soon give birth to a new set of products (or even product lines) which will boost sales and profits. [...] If true, this Super Company may be worth the marginally high PSR because of the events that caused the very low PRR. If it's not true, it is probably because marketing is bad. Then the research expense won't bear fruit so that it isn't really a Super Company.
It is a mistake to be too precise with PRRs. They should be used as a broad gauge of value. Don't try to fine tune them. Instead, use the PRR to point out the rare instance where the Price Sales Ratio fails to give an accurate interpretation of value. Think first in terms of Price Sales Ratios.
The highest value of the PRR is not in seeking out cheap stocks but in helping avoid mistakes.
Applying Price Sales Ratios to Nonsuper Stocks
PSRs have value in the analysis of most stocks. The basic theme is similar to the application of PSRs to Super Companies:
- Avoid buying any stock at a high PSR.
- Seek opportunities among stocks with low PSRs.
As a general rule, buy stocks of huge companies at PSRs of 0.4 or less. In even the strongest of Bull Markets, most should be sold at 2.0 or less. Even the greatest should be sold as their PSR approaches 3.0.
Even the greatest of growth rates does not offer a superior stock return when coupled with a high initial PSR.
Fortunes from Failures
Super Companies: The Business Aspects
A Super Company is a business which distinguishes itself because it can generate internally funded growth at well above average rates.
A Super Company should be able to grow an average of at least 15 "real" (after inflation) percent per year.
In their most abbreviated form, the business aspects of a Super Company must include:
- Growth orientation: A burning desire in all senior personnel [...] for growth. This need manifest itself not only in growth markets but, more importantly, throughout the daily lives of the employees that make growth happen.
- Marketing excellence: A broad understanding of changes in the nature of its market – at least as soon as the customer first perceives them – along with an organization capable of attaining and continuing to maintain customer satisfaction.
- An unfair advantage: A competitive superiority over all current or potential competitors – usually being the lowest-cost producer – and/or having established a unique or semiproprietary position in at least a major portion of its product lines.
- Creative personnel relations: A company "culture" that makes employees feel that they are treated with dignity, that they have been and will be offered fair promotion opportunities, and that they exist in an atmosphere where constructive ideas from subordinates are encouraged and financially rewarded.
- The best in financial controls: Financial controls which learn quickly if results are not as planned. This must be coupled with a constant desire to seek continual creative evolutionary improvements in financial controls relative to the competition.
Marketing is an absolute key – perhaps the single most important aspect to success. More companies fail, or exist at a lackluster level, for lack of marketing excellence than for any other single reason. Superb marketing is so important because it satisfies one of business's only reasons for existence: its customers.
Marketing in its simplest and best form is helping people. And it is hard to do a good job if you don't understand them. This ability to understand the customer is what makes good marketing so unique.
Be skeptical of firms hiring third-party sources to act as their servicing agents.
A company with $50 million a year of sales is usually much better off in a $150 million market which is rapidly growing than it is in a much bigger and faster growing market.
Don't be concerned about investing in a company that is losing money if it has a bright future. But be very concerned about investing in a company that is losing money if the losses are significant in relation to its war chest – it may not have a future at all.
As a general principle, it is safest to consider how much money a company might lose in the period ahead [...] and then make sure the balance sheet is strong enough to support these losses and more. A Super Company should have free working capital sufficient to support at least five years of the worst losses imaginable for the company.
Temporarily losing money in an accounting sense is acceptable, but beware of a negative cash flow.
If management owns substantial amounts of stock, they are the stockholder's partners. They have every incentive to make the shares become more valuable.
Management should get a reasonable salary – but small in relation to the value of the stock it owns. Be skeptical when management owns an amount of stock not much larger than their salary. They may be more interested in their salary than in the value of their stockholders' company. It is best if management's stock ownership is at least 10 times its combined annual salary.
Be skeptical when one or two individuals own controlling interest in a company – the results may be anything from fantastic to terrible. It all depends on the people.
What is margin analysis all about? It is being able to project approximately how much money a business should earn in the future. It is being able to do so even if there may be little or no profitability at present.
Margin analysis is critical to Super-Stock analysis as it gives a rational basis to valuing businesses suffering an earnings glitch.
The most enduring way to raise profitability is to raise gross margins. This usually requires doing something fundamentally different than in the past. Products may be designed with lower production costs. Products may be designed with unique features that support a higher sales price in relation to production costs. Pinching pennies in overhead, selling expense, and R&D is not likely to have enduring effects because competition too easily can do the same things.
Margin Analysis Continued
If something is already well touted, it isn't apt to be worthwhile. If someone wants you to buy something, someone wants to sell it to you. The "sure thing" that everyone knows is a sure-fire money-maker is usually a sure-fire money-loser.
Opportunities are seldom labeled.
Bringing It All Back Home
When is the "right" time to sell a Super Stock? Almost never. The time to sell is when one of two things happens:
- Its PSRs get outrageously high.
- The company ceases to have those traits which qualified it as a Super Company.