Value Investing: Tools and Techniques for Intelligent Investment

Chapter 23. Grimm's Fairy Tales of Investing^[23]

Stories are great before bed, but are disastrous as a stock selection technique. Defining story stocks can be tricky, but stocks with a high price to sales are a good candidate. After all, if something is expensive against its own revenues you had better believe its story as that is all you have. However, such stocks are doomed to underperform massively, and thus should be avoided like the plague!

• Of the plethora of valuation measures that are available, price to sales is one that makes little sense to me. It has always struck me that those who use price to sales are drifting up the income statement in a desperate effort to find something that makes a stock look cheap. But a measure that ignores any concept of profitability has always seemed very dangerous to me.

• I'm not alone (for once). In April 2002, Scott McNealy, CEO of Sun Microsystems, lambasted the absurdity of investors who were willing to buy his stock at $64 – which was 10 times sales. He ridiculed the implicit assumptions that investors were backing, such as his having no employees to pay, and no taxes to pay. He concluded, 'Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?'

• Despite these frank words, investors appear to continue to regularly fall for story stocks. For instance, in the USA the highest decile ranked by price to sales has a median price to sales ratio of over 10×! ...