Valuing companies in a black hole

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The Independent Online
Afew months ago, a friend of mine recommended an American book, Super Stocks by Kenneth Fisher, first published in 1983. The message on the front cover of the paperback, published by Business One Irwin, reads: 'The book that's changing the way investors think.' Certainly it lived up to its promise and did that for me.

The essence of Fisher's approach is to seek out young, rapidly growing companies that are suffering from a 'glitch' - a happening that results in unfavourable earnings results or even losses. The glitch could be the result of an unexpected gap between old products being phased out and new and better products being ready to take their place. Other possibilities are teething troubles with a new product or an unfortunate acquisition.

Growth companies are often over- rated, but during a glitch the market usually over-reacts the other way, forcing the shares down to previously undreamt-of levels.

Meanwhile, companies that encounter these kinds of difficulty usually enter into a period of internal reappraisal. As a result, overheads are cut, new products developed and the sales organisation streamlined. Managements also tend to take the view that if they are going to have a break in the company's earnings record, they might as well be thorough and write off everything else in sight. If the company then manages to recover, it often emerges very much stronger than before.

While a business is in the middle of a glitch, conventional measures of valuation such as yields and p/e ratios can be useless. When a company is making losses it can fall into a kind of black hole in the stock market. Whoever knows a way of measuring the value of a company while it is in that hole operates at a considerable advantage to other investors, who can only play guessing games.

Fisher's first measure is the price-to- sales ratio (PSR): the total market value of the company divided by the last 12 months' corporate sales. Fisher recommends avoiding stocks on a PSR of over 1.5 and aggressively seeking out companies on a PSR of under 0.75. He clearly demonstrates in his book that high PSRs are dangerous and low ones are potentially very attractive.

Fisher's second measure is the price-to- research ratio (PRR), which is the market value of the company divided by corporate research and development expenditure over the last 12 months. He suggests buying companies on a PRR of five to 10 and avoiding companies with PRRs of greater than 15.

He points out that the PSR is a far more powerful measure, but he uses the PRR to cross-check it. For example, a technology company that seems a little expensive on a sales basis could still be a buy if its PRR is exceptionally attractive. Conversely, a company with a very attractive PSR might not be spending enough on research, which would give cause for concern.

Fisher's methods work best with companies that have a distinct advantage over their competitors. In his book he also makes a very detailed study of profit margins, which are the essential ingredient that transforms sales into bottom-line earnings. When and if a company recovers from a glitch, those earnings form the basis for calculating p/e ratios again. As the company comes out of the market's black hole, the share price then begins to improve, often dramatically.

What I like about Fisher's approach is the courage his key ratios (PSR, PRR and profit margins) give an investor during a period when a company has had a glitch and is in a black hole. Obviously, there will be a failure rate but when the approach works it often produces what Peter Lynch so aptly describes as 'a tenbagger'. A few losses can then easily be offset against the occasional spectacular gain.

Although the PRR applies mainly to technology growth shares, the PSR and profit margins can, of course, be used as measures for investing in most quoted companies. A dramatic UK example was Next at 30p, just after disposing of Grattan in March 1991. Sales were forecast at pounds 450m against a market capitalisation of only pounds 110m, so the PSR was a very attractive 0.25. Today Next shares are 191p.

I will be doing some detailed research on PSRs, PRRs and profit margins as applied to different sectors of the UK market. I hope as a result to find some interesting anomalies, which I will tell you about soon.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.