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Business

Price/earnings ratio has a flaw

Some investors prefer the price/sales ratio over the price/earnings ratio.

Mark Lennihan /Associated Press

Some investors prefer the price/sales ratio over the price/earnings ratio.

The trusty price/earnings ratio, which holds a place of honor in many investors’ tool kits, has a small flaw. If a company is manipulating earnings to look better than they are, the ratio gives a deceptive signal.

Sales are a more basic measure than earnings, and harder to manipulate. For that reason, some investors prefer to use the price/sales ratio (stock price divided by the past four quarters’ sales per share) as their main stock-selection metric.

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Ten times from 1998 on, I have written columns recommending a handful of stocks that look attractive based on the price/sales ratio. The average one-year total return for these 10 lists has been 48.4 percent, compared with 6.2 percent for the Standard & Poor’s 500 index.

The most recent column in this series showed a 52.2 percent gain, against 24.6 percent for the S&P 500 from July 31, 2012, through July 12, 2013. GameStop Corp was mainly responsible for the good performance: It jumped 181 percent.

My other selections from last July had mixed results. Marathon Petroleum Corp. advanced 58 percent, and Encore Wire Corp. gained 35 percent. But World Fuel Services Corp. managed only a feeble 1.1 percent gain, while GT Advanced Technologies Inc. fell 14 percent.

Of the 10 columns on the price/sales ratio, seven beat the S&P 500, and all 10 were profitable.

Bear in mind that past performance doesn’t predict future results. Performance of my column picks is hypothetical and doesn’t take into account transaction costs or taxes. And results of my column recommendations should never be confused with the performance of portfolios I manage for clients.

At the moment, an average price/sales ratio is 1.55. I consider a ratio of 1.0 or less to be low, and 0.5 or less to be very low.

Stocks in some industries — autos for example — usually sell for a small multiple of sales. So in deciding what’s low, it helps to compare a stock with its industry peers.

The price/sales ratio is particularly good at identifying turnaround candidates — companies that have robust sales but need to organize themselves better in order to achieve strong profits.

Here are five new picks with low price/sales ratios.

I’ll begin with Phillips 66, a refiner in Houston. I was tempted to recommend Marathon Petroleum again but Phillips is even cheaper: 0.23 times sales, as opposed to 0.31 for Marathon.

A little over a year ago, Phillips 66 was spun off by Conoco Phillips, an integrated oil company. On Wall Street, Phillips 66 is already followed by 21 analysts, 13 of whom recommend it. But in my opinion, Main Street investors are still unfamiliar with it, which is one reason the stock is cheap.

Next I suggest Stewart Information Services Corp., also Houston-based. Stewart is one of the largest issuers of title insurance in the United States. The company was hurt badly during the financial crisis and its aftermath, posting losses in 2007 through 2010.

It has been profitable the past two years, however, and looks attractive to me at 0.3 times sales and less than six times earnings.

I also favor Magellan Health Services Inc., of Avon, Conn. It provides psychiatric and psychological services. Publicly traded since 2004, Magellan has shown a profit every year and had record profit last year.

Magellan is debt-free. Its stock sells for 0.5 times sales, and I believe there will be increased demand for psychiatric and psychological services over the next few years.

Fourth, I want to try again with World Fuel Services Corp., despite its disappointing performance in the past 12 months. The Miami company provides fuel, flight plans, weather reports, and other services to ships, planes, and trucks.

World Fuel has been profitable in each of the past 10 years. It suffered a small earnings decline last year, but analysts expect it to post rising earnings this year and in the next two years.

My fifth and final pick is the most speculative, because of its location. Nam Tai Electronics Inc. has its headquarters in Shenzhen, China. Its stock trades on the New York Stock Exchange under the symbol NTE. The company makes calculators, mobile phones, and other electronic devices sold under other companies’ brand names.

Like many other Chinese stocks trading in the United States, this one looks very cheap on standard metrics. It sells for 0.2 times sales, four times earnings, and 0.8 times book value. What’s more, it currently yields more than 8 percent in dividends.

I have recommended Nam Tai from time to time over the years and have owned the stock in the past, but have no position currently.

John Dorfman is chairman of Thunderstorm Capital LLC in Boston.
His firm of its clients may own or trade securities discussed in this column.
He can be reached at jdorfman@thunderstormcapital.com.

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