Kenneth Fisher is a high profile investment manager and one of the richest people in America. He is credited with establishing the price-to-sales ratio as a hugely influential indicator in the valuation of stocks. His extensive research, numerous books, including the highly regarded Super Stocks, and the success of his investment firm Fisher Investments, have made him among the most widely-followed and respected professional investors in the world.
Fisher was born in 1950 and after graduating in 1972 he worked for his father, the notable investment analyst, Philip Fisher. He founded Fisher Investments in 1979 and has gone on to produce seven book, numerous research papers and articles and continues to write a long-running portfolio strategy column for Forbes magazine.
In Super Stocks, Fisher set out his views on how individual investors should approach and value stocks. Since then, his views have broadened in line with the expansion of his investment firm, which now manages $42 billion of client money. However, the success of his price-to-sales ratio approach, combined with other quantitative and qualitative factors, continues to appeal to value investors.
The investment formula proposed in Super Stocks is a value-based approach that aims to invest in good quality companies (Super Companies) at an attractive price. The result is what Fisher describes as Super Stocks – stocks that increase 3 to 10 times in value in three to five years from their purchase.
His initial screening of the market involves looking for companies that are suffering from “glitches”, which he says frequently occur in young companies as they grow. He cites temporary setbacks in earnings performance, often caused by management teams that make mistakes during the growth cycle. He says the damage to share valuations caused by glitches can represent buying opportunities for investors.
He explains: “Very few investors have a rational basis for valuing growth stocks in the face of a lack of earnings. The stock loses supporters and falls, in time, much too far. The best managements react to difficulties and overcome them. In time, sales pick up. Later, profits begin to pick up. Simultaneously with the profit resurgence, the stock price begins to rebound.”
Like his father, Fisher is sceptical of using earnings or asset-based metrics such as the P/E ratio to value stocks. He believes that earnings are not accurate enough to predict the future and that P/E-based strategies generally offer limited upside. He prefers instead to focus on the price-to-sales ratio (PSR) as well as actual and potential profit margins. He believes these metrics offer an insight into how much business a company does; the basic cost structure associated with that business and the way in which a private owner would think about the business.
As opposed to the P/E, the PSR uses corporate sales instead of corporate earnings. It is calculated by taking the total market value of a company (share price divided by shares in issue) divided by the last 12 months’ corporate sales. Typically, Fisher would seek out stocks with a PSR of 0.75 or less.
Because many Super Companies are technology businesses, Fisher also uses a metric known as the Price Research Ratio (PRR), which analyses the value of R&D. The PRR is the market value of the company divided by the corporate research expenses for the last 12 months. The ratio helps to spot apparently cheap PSR stocks that look like Super Companies but are not. It can also identify Super Companies that may appear expensive on a PSR basis but are in reality cheap. You can read more about R&D screening here.
Beyond the PSR, Fisher seeks to avoid risk with a toolkit of other quantitative indicators. He wants to see companies able to generate internally funded future long-term average growth of approximately 15 to 20 percent. He also wants long-term average after-tax profit margins above 5 percent. In addition, a Super Stock should have:
- Free working capital sufficient to support at least five years of the worst losses imaginable for the company
- Less than 40% of its total assets financed by debt
- Sufficient net free working capital to cover at least three years of negative cashflow
It is important to note that Fisher’s Super Stock criteria are applied to what he calls Super Companies. These are companies that not only meet his fundamental criteria but also display robust qualitative characteristics. The emphasis is on avoiding investments in “living dead” stocks but instead targeting companies with management that can recognise mistakes, correct them, and move on. His criteria, which in many respects reflect his father’s 15-point checklist, include:
- Growth orientation
- Marketing excellence
- A competitive advantage
- Creative personnel relations
- The best in financial controls
- High margins, high market share, better management, leading product positioning and a quality image
Again like his father, Fisher believes that the ‘right’ time to sell a Super Stock is “almost never”. However, a stock would get sold if its PSR gets outrageously high or the company ceases to have those traits which qualified it as a Super Company.
How the Ken Fisher screen works
In Super Stocks Fisher set out three ways for investors to find potential candidates: scan for low PSRs, scan for money-losing companies and scan for qualitative assessments of superior companies (what his father called ‘scuttlebutt’).
At Stockopedia, we have developed a version of the screen that uses Fisher’s quant criteria, including PSRs of less than 0.75, average 5-year net margins greater than 5%, gearing of less than 40% and positive free cash flow. We have included a requirement for 5-year EPS CAGR of greater than 15% to seek out companies with a growth track record. We have also limited the number of brokers covering the stock to less than 10 in order to seek out young and potentially overlooked companies.
In the year-to-date the screen has had a rough ride against the market, delivering a -8.5% return. However, a long-term version of the low price-to-sales screen tracked by AAII between 1997 and 2003 produced a consistently strong performance, with no down year through a mixed market environment. On this point, it is worth noting that the PSR earned itself a bad name in the late 1990s because it was misused to justify nosebleed valuations during the dotcom bubble. Proponents of the metric maintain that it still works and that low PSR stocks can bounce back very quickly. Indeed, for companies with no earnings (and hence no P/E ratio) the PSR can be a useful tool – and a handy starting point for more detailed research.
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