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Why You Need To Be Careful Using Price-to-Sales To Value Stocks

When it comes to predicting stock prices, we all want convenient, easy-to-use metrics that will give us the answer to our question: Can I make money in this stock? Unfortunately, like many things in life, simple and quick short-cuts can lead us to the wrong conclusions. It's been a little over a year since I attempted to debunk one such valuation tool, the PEG Ratio, which I called "silly" (perhaps a bit too sensational!). That article, as old as it is, still gets hundreds of views a week, suggesting to me that these discussions of how to value stocks are of interest.

Today, I want to tackle another popular metric, known as "Price/Sales" (P/S). To calculate the value, and here is the simple part, all you need to do is divide the market cap (price of stock times number of shares outstanding) by the trailing sales (typically the last four quarters). The result is always a positive number. You can apply this to an individual stock or even to the whole market. The S&P 500, for instance, currently trades at 1.4X its trailing sales. This is pretty much the middle of the road for the past two decades, with a range of 0.7 (early 2009) to 2.3 (2000).

While there are many circumstances that are appropriate for using sales, like when there are no earnings, it can't be used without understanding how to use it properly. The bottom line is that you can't make money buying low P/S stocks (or shorting high P/S stocks) blindly.

What's Wrong with P/S?

 

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Is Speculating in the Stock Market "Bad"?

One of the great benefits of being a Seeking Alpha contributor or member is that we can all learn from one another. I just celebrated my sixth anniversary sharing my thoughts here, and I continue to believe one of the greatest perks authors receive is feedback from readers. I shared a perspective recently regarding what I perceived as a bubble in part of the market, a group of pink-sheet stocks involved in a speculative frenzy. My article, Reefer Madness: Pot Stocks in a Bubble, caught a lot of criticism, but it reinforced my views regarding the issue. I base this not only on the insane popularity of the article (based on page-views), but also the hundreds of comments I received (and friendly private messages too!).

While I can easily dismiss one criticism (that I must be "anti-cannabis") with a disclosure I perhaps should have included on the original article (that, as a Libertarian for the past 32 years, I am anti-prohibition), I believe that I need to make an effort to address another criticism that I am "anti-speculation". While it may be true that I tend to be a lot more conservative in my views regarding investments than many, I don't really believe in absolutes such as "speculation is bad". To me, this falls into the same camp as some of the greatest ongoing debates on Seeking Alpha, like the wisdom of share repurchases. There are two sides to most things in life, and this is the case as well when it comes to speculation.

What is Speculation

This is perhaps the most controversial part of this article, and I am sure many won't agree. 

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Six Simple but Super Investment Lessons

What a great ending to a phenomenal football season for the NFL! It seems so rare that a Super Bowl game goes down to the wire, and this was the third consecutive year that it could have gone either way. As is often the case, I find life lessons in sporting events, typically ones that apply to investing, and this year's Super Bowl offered no shortage.

As I mentioned last month, I am going to be sharing years of wisdom on a more frequent basis in what I am calling the KISS (Keep it short and simple) series. Not only do these articles have relatively few words, but they also lack charts and graphs, fancy math and even primary or secondary tickers. In case you missed the previous three, here they are in chronological order:

• Why PEG Ratio Analysis is Flawed
• 5 Tips for Becoming a Better Stock Picker
• 4 Ways to Become a Better Self-Directed Investor

So, with no further delay, here are the six big takeaways that I had from Super Bowl XLVII and the entire football season.

 

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4 Ways to Become a Better Investor

This is the time of year where many of us have already started to give up on our New Year's resolutions. Here's one that I haven't yet delivered in 2013 but I intend to keep with the Seeking Alpha community: Share more long-term oriented insight.

I was recently inspired by Chuck Carnvevale's discussion of the Shiller 10PE as the type of article that SA members will be continuing to read in the years to come. So much of what is on the website (including many of my own contributions) has the shelf-life of a Mayfly. So, my resolution is to try to step back from all the minute-by-minute or day-by-day action and share a little more perspective on occasion.

Over the last year or so, I shared two articles that I now consider the first two among my "Keep it Short and Simple" series, which is a win-win for everyone hopefully. For me, these are easy to write and don't require too much time, for they are the result of decades of observations. For you, they are easy to read and hopefully instructive too. The two I shared included a discussion of the flaws in PEG Analysis, which continues to get a significant number of readers every day, and five tips for becoming a better stock-picker.

So, in my first KISS attempt for 2013, I want to share some advice on how to be a better self-directed investor. 

 

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5 Ways to Become a Better Stock-picker

I believe that with a lot of time and effort, an individual can indeed beat the market. Unfortunately, it's not a "get rich quickly" endeavor. To succeed, one must know one's limitations as well as one's advantages. Lower commission costs, more information that is disseminated more broadly and more rapidly, and the democratization of analytical tools have made it easier for investors to have a shot at winning (delivering alpha), but these same tools have also made it easier for individuals to overtrade and to succumb to their own cognitive errors. Here, I mean professionals too.

I don't have the secret for how everybody can beat the market, because that, by definition, is impossible. I do have several suggestions for those who are willing to invest the significant time that I think it takes to excel at stock-picking. While larger institutions may have some advantages over plain old folks that go beyond just time, individuals have major advantages of their own: They won't move the market executing their trades, they aren't subject to institutional short-term pressures to perform (which can lead to selling at inopportune times), and they don't have to constantly fight "group-think".

So, while this list isn't exhaustive, here are five of the tips I would offer to someone who wants to excel at stock-picking:

 

 

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Thoughts on Buffet's Shareholder Letter

I am no expert on Warren Buffett, but I sure enjoy reading his letter every year.  This weekend's release was no different, though I had already read his perspective on gold (and other non-productive assets) relative to productive assets.

I don't think investing with Warren is likely to pay off these days - he has gotten too big, and he knows it.  Still, we can learn a lot from him, and this year's letter certainly bears this notion out.  Here are 4 things that caught my attention:

People Matter

Buffett has been thinking a lot about the future - without him.  He has appointed his brother as future chairman, he alludes to a new (unnamed) CEO to act as his eventual successor, and he has his two investment pros on board.  I honestly don't recall if he has spent as much time historically as he did this year naming all the names that he did, but it's clear that Warren invests in people.  

Everyone Makes Mistakes

Warren took himself to task over some bonds that are supported by the price of natural gas, suggesting that absent a miracle he will lose principal.  He also discussed his philosophy of sticking with losers under most conditions - he doesn't fire execs or shed businesses when the problems are industry-related.  

Share Repurchases Can Be Smart

There is a huge debate these days over share repurchases, with many people suggesting that they are inherently bad. Jim Cramer has certainly been rather critical.   I addressed this issue myself recently in November, when I asked the question:  Do Share Repurchases Destroy Value? Well, I think Warren and I see eye to eye on this one, as he lauded IBM's repurchase strategy.  I think it's the old adage:  Guns don't kill people, people do.  It's a tool that can be used smartly or stupidly.  Sadly, it's probably more the latter.  No need to take away the tool though!

The Worst Mistake:  Lack of Discipline

While Buffett didn't use these words, it's how I describe his criticism of his rivals in the insurance industry.  He says that the know better, but they still chase business when the returns aren't justified.  This is a lesson I learned back in my bond-trading days and have seen it play out over and over.  What I have observed, which is somewhat similar to insurance companies taking on too much risk for the reward, is that when someone spends their time and energy doing something, they usually can't step away.  Investors will buy bonds, for instance, at ridiculously narrow spreads to Treasuries because they are still positive.  Perhaps this is an even better example.  How often does your investment advisor tell you to get out of the market?  Most guys who buy stocks get caught holding stocks in adverse market conditions because it's all they know how to do.  While I don't always get it right, I was last very bearish in 2007 and early 2008.  When it comes to individual stocks, though, I use technical or valuation-driven parameters to trim or sell securities in my models at Invest By Model.  For instance, if my target for a stock suggests less than 20% return over the next year, it's an automatic sell.  I can do better!

So, these were my takeaways from the Oracle of Omaha's communique this year.  What a brilliant guy!  I hope you can learn something too.

Click here too read the letter (21 pages),