Ken Fisher's Price-to-Sales Strategy

08/05/2013 9:00 am EST

Focus: STRATEGIES

John Reese

Founder and CEO, Validea.com And Validea Capital Management

For decades, the price-to-earnings ratio has been the most widely used valuation measure for investors. But in 1984, Kenneth Fisher sent a shockwave through the investment world when he introduced the price-to-sales ratio strategy, notes John Reese of Validea.

Fisher thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings—even earnings of good companies—can fluctuate greatly from year to year.

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 three-to-ten times in value in a period of three-to-five 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—helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world.

Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 256.4%, or 13.5% annualized, while the S&P 500 gained just 68.2%, or 5.3% annualized. That makes it one of my most successful long-term strategies.

Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth, raising expectations to unrealistic levels. Then they have a setback, and their stocks can then plummet as investors overreact.

Fisher believed that these glitches are often simply a part of a firm's maturation. 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 it rights the ship and other investors jump on board.

The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings.). The answer: by looking at sales, and the PSR.

While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.

Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5%; the debt/equity ratio (this should be no greater than 40%, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15% per year.).

The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool.

While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth and cash flows, and low debt/equity ratios.

Here's a look at five of the stocks that I currently hold in up my Fisher-based portfolio.

Zagg Inc. (ZAGG)

HollyFrontier Corp. (HFC)

Telecom Argentina (TEO)

Royal Dutch Shell Plc (RDS-A)

USANA Health Sciences, Inc. (USNA)

This strategy's well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul—All while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul.

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