A Kenneth Fisher price-to-sales portfolio

by John Reese, editor Validea

In ouf Validea newsletter, we maintain numerous model portfolios based on the strategies of leading investors, such as Warren Buffett, Ben Graham and Peter Lynch.

Our Kenneth Fisher-based Portfolio has shown a 7-year annualized return of 11.9%; this approach focuses on a metric Fisher pioneered: the price/sales ratio.

While investors for decades relied heavily on the P/E ratio, Fisher found that earnings -- even the earnings of good companies -- can fluctuate greatly from year to year.

These fluctuations could occur as firms replace equipment or facilities in one year rather than in another, use money for new research that will help the company reap profits later on, or change accounting methods.

Sales, however, are much more consistent, and the PSR can thus find strong firms that are going through earnings "glitches" that have driven their stocks down to bargain levels.

Fisher also looked at a variety of other metrics, including the debt/equity ratio, profit margins, and earnings growth.

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 and become the darlings of Wall Street, raising expectations to unrealistic levels.

Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.

But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again.

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.

According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock.

To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.

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.

That 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.

Now, here's a look at several of the stocks that currently make up my Fisher-based portfolio.

Raytheon Company (RTN)
General Dynamics Corporation (GD)
Ross Stores, Inc. (ROST)
Aeropostale, Inc. (ARO)
Apollo Group (APOL)
Jos. A. Bank Clothiers (JOSB)
Lincoln Educational Services (LINC)

Learn more about this financial newsletter at John Reese's Validea.