October 02, 2003,
If you're skeptical of what businesses report as "earnings" their official profits you have a right to be. Earnings are an artifice of what are called generally accepted accounting principles, and, while GAAP earnings are universally admired, almost worshiped, by accountants, they're also based on a lot of guesswork such as reserves against possible losses on what people owe the company or projections of how expensive shutting down a plant will be.
We've also learned in recent years that some companies cheat.
WorldCom, for example, booked operating expenses as if they were capital investments. Under GAAP accrual rules, operating expenses get deducted from profits immediately while capital investments are depreciated over many years, a little at a time.
But even for honest companies, GAAP earnings may not be particularly meaningful. This month I moderated a panel discussion at which Baruch Lev of New York University, one of the top accounting scholars in the world, said that "extensive research shows that accruals [the GAAP earnings reported in the press each quarter] are widely manipulated, and investors are systematically deceived."
The reason is that "most accruals are based on managers' estimates, which are never publicly verified," he said. "This is an invitation to manipulation."
So what's an investor to do? First, examine a company's cash flows essentially the amount of money that actually comes in and out the door. Cash flow, according to the academic literature, is a better predictor of a firm's future health and true value than accrual earnings. "Earnings are an opinion," goes the saying. "Cash is a fact."
Cash flows are reported to the Securities and Exchange Commission just like earnings, but most investors ignore them. One problem is that cash-flow statements are not easy to understand, and they can be distorted by, say, a huge one-year investment. Still, they are a better yardstick than earnings.
The second approach is holistic. Yes, look at earnings and cash flow, but don't get carried away by them. Look at simpler things. Consider the business the firm is in, its advantages and its competition. Also look at the single most important number on the earnings or the cash-flow statement: sales.
If sales are rising, a business is usually doing pretty well, even if its earnings aren't. A business that isn't increasing its sales won't continue to increase its earnings, or its cash flow, for very long.
Most sophisticated investors ignore sales because the number is too brutishly uncomplicated. They should think again. Kenneth L. Fisher brought the indicator to the public's attention about 20 years ago, and James P. O'Shaughnessy resurrected it in his important 1996 book, What Works on Wall Street (McGraw-Hill). O'Shaughnessy used a massive database to test how dozens of stock-picking strategies worked over a period of more than 40 years (1952 to 1994). One of the best: Find stocks with low price-to-sales ratios.
You've heard of the price-to-earnings ratio, I hope. A P/E tells you the number of dollars it costs to buy a dollar's worth of a company's annual earnings. Well, a P/S tells you the number of dollars it costs to buy a dollar's worth of a company's revenue, or sales.
The P/S ratio tends to vary across industries, but low numbers (especially below 1.0) often indicate bargains. You calculate the P/S ratio by dividing the price per share by the sales per share. And you calculate sales per share by dividing total revenue for the year (achieved or expected) by the number of shares outstanding. Many online financial data banks, including Yahoo and Morningstar, provide P/S ratios along with P/Es.
Here's what O'Shaughnessy found: Over the period he studied, the 50 stocks with the lowest P/S ratio produced average annual returns of 18.9 percent, compared with 14.6 percent for all stocks. That's a huge difference over time. During the 42 years he studied, an investment of $10,000 became $5.9 million using the low-P/S strategy but just $1.8 million for an investment in the market as a whole.
By contrast, low-P/E stocks beat the market as a whole by only six one-hundredths of a percentage point.
The reason that the low-P/S gambit works is that it is a value play. As with low-P/E stocks, you are buying a lot for a little, so you may be getting a bargain. But since earnings aren't as solid as revenue, P/Es can deceive.
Still, merely buying low-P/S stocks is a crude, almost mindless strategy. You have to apply holistic analysis, too; that is, use your head. After all, automobile stocks and airlines always have super-low P/S ratios. General Motors (GM) currently weighs in at 0.1. Huge, competitive telecom companies also have low P/S ratios, as do retailers, especially grocery chains.
To see why P/S ratios alone can be misleading, look at airline stocks. Delta (DAL) has had a low P/S ratio for years (currently, it's 0.13), but the stock has gone almost straight down since 1998, from more than $70 to $13.07. Revenue has declined, so disappointed investors have marked down the shares. The numerator of the ratio has fallen much faster than the denominator; the result is a lower and lower P/S and an unattractive stock though one that may be so detested it's a good buy.
Southwest Airlines (LUV), on the other hand, has a P/S of 2.47. Unlike Delta, which has lost money three years in a row, Southwest has always been profitable, and its sales per share are up substantially nearly 50 percent since 1998. Investors like the stock, but it's still trading at the same price as three years ago. In historical terms, Southwest's P/S is fairly low. In 1997, it was more than 10.0; in 2000, it was as high as 7.0. Southwest may, in fact, be cheap today. (I hasten to say I am a longtime owner, and I am not telling you to rush out and buy it.) The moral: Don't take P/S at face value.
The American Association of Individual Investors has worked out a more complicated and more logical way to search for good low-P/S companies. John M. Bajkowski, the group's vice president for financial analysis, uses a computerized "screen" that seeks companies whose P/S ratios are not merely low in an absolute sense but also low compared with their own P/S history and with the P/S levels in their industry.
Also, as a way to keep clunkers off the list, he insists that the company's "relative strength index" (that is, its return compared with that of other companies) over the past year be greater than the industry median.
All the excruciating details are on Page 3 of the September issue of the AAII Journal, but you don't need to look them up. I am not selling Bajkowski's strategy as foolproof. I just want you to start taking P/S ratios at least as seriously as you take P/Es.
The results of the AAII technique, however, have been dazzling. Back-tested to 1998, the strategy produced positive returns every year and beat the benchmark Standard & Poor's 500-stock index each year since 1999. So far in 2003, the strategy has returned 32 percent (about twice the S&P), and its cumulative return for the past 5 3/4 years is 225 percent, compared with 10 percent for the S&P.
The average P/S ratio for the stocks that qualified was 0.5, compared with 1.4 for all listed stocks and at relatively low volatility (price swings). And here's a surprise: The average P/E ratio of these low P/S stocks was actually higher than for all listed stocks.
I have made brief mention of the AAII screen before and cited some of the stocks that passed it, including a "favorite find" called AO Tatneft (TNT), one of Russia's largest integrated energy companies, trading as an American depositary receipt, or ADR. Tatneft has since gone from $15.35 to $21.62. That big increase knocked it off the current P/S recommended list of the AAII, but Audiovox (VOXX), a maker of wireless phone handsets that I also mentioned, remains. It's gone from $9.25 to $13.15.
Other stocks on the current list include Restoration Hardware (RSTO), the trendy home-furnishings chain; AutoNation (AN), car retailer; Vans (VANS), sporty footwear and apparel; American Dental Partners (ADPI); and Corn Products International (CPO), food processing. In all, there are 39 names, and it's a delightfully varied group, both in size and sector.
Eleven months ago, I introduced readers to what I believe is the only mutual fund that uses P/S in determining which stocks to put in its portfolio. The fund is Hennessy Cornerstone Growth (HFCGX), and it probably comes as no surprise that the fund grew out of O'Shaughnessy's research. O'Shaughnessy himself launched the fund late in 1996, then sold it to Neil Hennessy, a money manager from Novato, Calif. (www.hennessyfunds.com).
The fund uses several criteria to screen stocks by computer, but the general idea is to find companies that have both value and growth characteristics. The value part comes mainly from a low P/S ratio, growth from price momentum.
The fund rocks.
I'm not telling you to buy it, but feel free to kick yourself for ignoring my enthusiastic column of last year. So far in 2003, it has returned 28.9 percent. Its average annual return over the past five years is 19.5 percent, compared with the low single digits for the S&P. And all this at risk levels slightly below those of the market as a whole.
Still, the fund gets no respect. Morningstar analyst Kerry O'Boyle seems positively infuriated at how well the fund has done: "Neil Hennessy ... calls his approach passionless investing, but another word one could use is mindless. ... Once a year sometime in the first quarter the computer spits out 50 new stocks for the fund to invest in over the next 12 months. The stocks are selected based on price/sales ratios and several relative-strength criteria. ... There's no research, no analysis, and no due diligence on Hennessy's part as to the quality of the underlying business. ...
"The fund's trailing five-year record is impressive. It's just hard to understand why."
Why is it so hard? The fund uses an indicator that hardly anyone else uses, and it seems to work as long as it's leavened with other intelligent information (either in hard data, as in this case, or human analysis).
Currently, the Cornerstone Growth portfolio includes such stocks as Aetna (AET), with a P/S of 0.5; Chicago Bridge & Iron (CBI), 1.0; Western Digital (WDC), 1.0; and J.B. Hunt Transport Services (JBHT), 0.9.
Last week, I calculated the P/S ratios of all 30 stocks in the Dow Jones industrial average, using their prices at Tuesday's close and sales-per-share projections for this year from the Value Line Investment Survey. The range was wide from less than 1.0 for GM, AT&T (T), Boeing (BA), International Paper (IP), and Hewlett-Packard (HPQ) to more than 5 for Coca-Cola (KO), Intel (INTC), and Microsoft (MSFT).
Do any potential bargains leap out? Perhaps HP, at a P/S of 0.9, but it's in a tough competitive environment and still hasn't digested its merger. Perhaps Altria Group (MO), the tobacco company, at 1.1, but it's got continuing legal troubles. More compelling may be International Paper, at 0.8; Honeywell (HON), at 1.0; and Caterpillar (CAT), at 1.2.
These aren't recommendations. They are suggestions for further study. The price-to-sales ratio may sound big, clumsy, and mindless, but it may be a lot more revealing than the lithe, sophisticated, trendy P/E.
James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned, he owns Microsoft and Southwest. This article originally appeared in the Washington Post.