Do high EV/S ratios hurt returns? - a study

Investment Analysis Clubs Saul’s Investing Discussions
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Do high EV/S ratios hurt returns? - a study

Duma did an interesting little trial test on the NPI board a year ago. He divided up the stocks that they (and we) were talking about most into three groups by EV/S.

The three groups (each with roughly 10 stocks) were:

EV less than 10
EV between 10 and 14
EV over 14

The idea was to take a look a year later and see if high EV/S (“overvalued” stocks) really led to less return after a year.

His results were very interesting:

The low EV/S had by far the worst results with an average gain of 37%

The medium EV/S group had the highest results with an average gain of 77%

The high EV/S group was right behind with a return of 68%. However this one had a negative-ringer in it, that didn’t really belong. It was the only one that included a biopharma, NKTR, which it was a huge outlier from the beginning, being a biopharma in the first place, and having a EV/S of 47 (next highest out of ALL the stocks was EV of 21). It lost 67% of its value in the course of the year, and the high EV group STILL managed to gain 68%. Without NKTR, with a more homogeneous tech group like the other two groups, it was up 82%, with the best score.

So much for high EV/S killing results.

And it further turned out that the overall BEST determinant of future results was starting revenue growth rate… Well, what do you know? What a surprise…duh.

The stocks starting out with the highest revenue growth rates were the nine companies with revenue growth rates of 55% to 75%. Their average return for the year was 138% !!! There were only two outliers that didn’t do well, Elastic and Shopify who grew at only 24% and 35%, and the group grew at 138% anyway!!! These two (Elastic and Shopify, happen to be the two that I exited (well, exited Shopify and just-about exited Elastic). I still own all the others : Alteryx, Twilio, Smartsheets, Zscaler, Okta, Mongo, and The Trade Desk.

Remember that Duma, made this experiment a year ago, on the NPI board, and I didn’t know anything about it until now. The results however seemed pretty clear, highest revenue growth rate stocks and stocks with EV/S over 10 had VERY substantially better returns than slow growing and low EV/S stocks.

Here’s a link if anyone is interested in following further. https://discussion.fool.com/tinker-modern-portfolio-theory-34169…

And a big thanks to Duma.

Saul

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I had the same issue, in that NKTR (as well as CELG in the low P/S group) didn’t seem like they really fit. But as he says it was included because it was being discussed at the time which is fine.

As Tinker likes to say, cheap is cheap for a reason. Absent FUD like TWLO losing Uber’s business the high growth stocks worth pursuing are expensive and stay expensive until they no longer fit the high growth category. Obviously there is some extreme where it doesn’t make sense. But until the stocks starts irrationally growing absent actual results I wouldn’t consider selling just because of valuation. It’s not clear to me that the lower P/S high revenue growth stocks are any better than the higher priced ones. Differences in P/S will come from other metrics (actual growth and acceleration, business plan, net retention), any FUD, perceived competitive advantage/moat/competition, TAM, profit margins, share dilution/lockup, etc.

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So much for high EV/S killing results.

Someone else here just posted about high beta stocks, that is, stocks that move at an accelerated rate relative to the market as a whole. (https://www.investopedia.com/investing/beta-know-risk/ )

So, it makes sense that stocks with high EV/S have a high beta, and that in a overall rising market such as we’ve been having for a decade now those stocks would indeed do better.

The idea was to take a look a year later and see if high EV/S (“overvalued” stocks) really led to less return after a year.

It would be interesting to look over a much longer period of time, especially one that had a significant market “correction.”

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Smorg,

I’ll take the bait…

Since when does a 20% correction in something like a month which happened in Q4 2018 not count as a significant “correction”?

Or are you only talking about things like the Great Recession which on average happen every…50 years?

Yeah we should probably just stay on the sidelinesm

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Since when does a 20% correction in something like a month which happened in Q4 2018 not count as a significant “correction”?

I would postulate when it bounces back a couple of months later. The Dow is already back to the level it was at the start of Dec 2018, the S&P 500 is higher.

Yeah we should probably just stay on the sidelines

I’m certainly not proposing that, nor am I saying that the stocks discussed on this board aren’t ones in which to invest. I’ve talked before about how agile Saul is in terms of getting out of stocks, and I realizing that that’s a key element when investing in high beta stocks. Ride the wave up and get out before you get too burned. If you linger, the high beta stocks take more of a beating than the market in general.

And if you’re also looking at high quality companies that actually have a market advantage, which is what is discussed here, that can also help you survive downsides. But, that’s different than saying all EV/S ratios are good or bad (not that anyone here was saying that, btw).

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It would be interesting to look over a much longer period of time, especially one that had a significant market “correction.”

And, better yet, would be a more systematic study rather than one based on “stocks we have been talking about”. My suspicion is that in the combination of any given metric and the evaluation of the individual company that the former has a trivial significance compared to the latter. Any given screen might be useful in bringing previously unrecognized to the fore, but I suspect that the analysis of the specific company, its market, its position, etc., etc. dwarf whatever metric might have brought it to out attention in the first place.

To actually validate this study one would need both a much larger universe of stocks, some consideration of which companies to include or exclude and the evaluation of the consequences of doing so, evaluation over multiple time lines, etc., i.e., not just a hodge-podge sample for a limited period of time. Not to mention that the crude division into three categories and the lack of reclassification are both likely to impact the results significantly.

It is fine to ask oneself “X, Y, and Z have been big winners so what might they have in common that I should look for in potential future winners?” It is another thing to believe that one has derived some magic formula.

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For evaluating ESTC in this example I think it’s noteworthy that ESTC IPOd in October and has had right about 6 months.

Also, the IPO price was $37. And it nearly doubled the first day of trading to $70. And that is the starting point that Duma used here.

I’ll be interested to see where it is at the 1 year point 6 months from now in October, with lockup firmly behind them.

Darth

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https://discussion.fool.com/every-time-i-do-this-the-results-are…

Smorg,

I am referring you to this post. It talks about when to sell. Seems the time to sell coincides with the reason not to buy something. Go figure. But anyways, read the linked to post discussing the most profound Seeking Alpha article ever written. This author has apparently decided not enough evidence yet exists to buy Shopify. I will let it speak for itself.

Tinker

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Elastic is worth at least 85 million shares, thus its enterprise value is greater than the $5.5 billion or so listed on Yahoo!

This said, (you can read the prior post I referred Smorg to, which explains why a multiple is not how you value something), if the enterprise value is anything close to what Yahoo! lists, it is substantially undervalued even at 20x this year’s revenues. All depending of course, as always, on business fundamentals continuing to skip along. We would not invest anyways if we did not believe this to be the case.

A case of an outrageously overvalued stock being quite undervalued. Try to find an investor (not on the Fool) who you can even have a conversation with that construct. But yet it is quite the contrarian circumstance that does get the hairs up, at least a bit, with at least a smidgen of enthusiasms.

Tinker

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Lieberman,

Since when does a 20% correction in something like a month which happened in Q4 2018 not count as a significant “correction”?

20% is not a significant correction. If you think a 20% correction is significant then you probably shouldn’t be investing in Saul’s stocks. 20% corrections are just a time to start getting excited, they will happen all the time in these type of stocks. Heck after any quarterly report these stocks could drop close to 20%. When you have lost 50% or more, then things are starting to get significant.

Andy

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Andy,

Show me one of the higher multiple stocks that have fell 50%. I can show you Nvidia, Pivotal, Pure, Talend, Nutanix not quite, and I am sure many others that were considered more “reasonably” valued.

In fact during the October and December crashes Mongo - so extremely overvalued - actually reach a 52 week high.

It almost appears as if there is an implicit moral issue here instead of an investment discussion. It is too good to be true. Market “darlings”, whatever.

When business fundamentals turn sure. But during market crashes the stocks with the highest multiples and commensurate highest business fundamentals have overperformed going down and going back up.

When, at some point, a dominant hyper growth company that is extremely overvalued is no longer dominant, or its a ceiling in its market without finding tangential markets to grow in, then there may be an incident. But even VEEV, with 20% growth, has maintained its very high multiple and still given excellent returns. Why? Because it has an extremely high CAP, as does ISRG, growing at 13% and yet a multiple not much less than Abiomed.

Tinker

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I am done with this topic. I am investing in the best growth companies in the world with the strongest fundamentals, which include long-term competitive advantage, enormous markets to spread into, and incredible recurring business models.

If you wish to invest in stocks that don’t have these things, then by all means do so. You can feel more comfortable investing in “reasonable” valued or undervalued stocks. Each to their own.

Tinker

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Andy,

Apologies if it sounded like I was personally attacking you. I was not, just frustrated with the topic. When was the last 50% correction?

If 2018 was not a crash then https://www.cnn.com/2018/12/31/investing/dow-stock-market-to… why was 2018 the worse year for stocks since 2009?

Here are the historic stock market bears of all time:

http://www.nbcnews.com/id/37740147/ns/business-stocks_and_ec…

Only 2 fell 50% or more, and one was 1929. How many here were wiped out in 2009, the second largest stock market loss in history? Not most of us.

Either you invest and remain flexible in the most maximum way possible, or you invest using sub-par tactics because they appear to be reasonable. I find investing in the best fundamental growth companies is the best way to go. If they happen to have much higher multiples that is because they deserve them.

And yes, Oct and Dec 2018 were blow out crashes. However, even if they had held, how much were you still up over the last several years even at the bottom of these crashes? Saul I am sure way up, so was I, and I would wager so were most of us.

Stocks go up, stocks go down, but having the historic stock market crashes as one’s guide as to how to invest during normal times simply does not make sense to me. But as I said, if it works for people, they should do what works for them and makes them feel comfortable. This board’s investment strategies may make them feel uncomfortable. But that is called contrarian investing.

David Gardner’s techniques for investing scare the living bejeesuz out of most of the population.

Tinker

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Tinker,

Show me one of the higher multiple stocks that have fell 50%. I can show you Nvidia, Pivotal, Pure, Talend, Nutanix not quite, and I am sure many others that were considered more “reasonably” valued.

Tinker I think your time frame is to short. You are only thinking within the last year. In fact what does a year mean in anybody’s time frame? Do you really think a year means anything? Also I can show you posts of people that thought NVDA was to high before it crashed and we both saw what happened to it although it is starting to work its way back up.

It almost appears as if there is an implicit moral issue here instead of an investment discussion. It is too good to be true. Market “darlings”, whatever.

I am not sure where you got this from my post. I didn’t mention market darlings or anything to do with a specific stock. I think you are trying to read something into my post that was never there. I was talking about when stocks fall. It could happen to anyone of them when their growth drops. You were surprised by NVDA as much as the next guy when it dropped. We both thought it was going to keep going up but when it dropped we shrugged our shoulders, it happens. Also Twlo was sold out on this board because of Uber, it dropped, but it came back after it was realized that it was not that big a deal. Shop was a darling on this board for awhile, we saw everyone getting out of it because it’s growth was slowing, look at where it’s at now. It dropped almost 30% before starting it’s climb back. So let’s not act like these things do not happen. Instead of trying to cheer lead, let’s try to be more sensible and acknowledge the good and the bad.

When business fundamentals turn sure. But during market crashes the stocks with the highest multiples and commensurate highest business fundamentals have overperformed going down and going back up.

Now you are getting back to what my post was about. You know as well as I do that when the market crashes the highest multiples will drop most likely the farthest, but if you hang onto them they will come back as long as fundamentals are the same. I am not trying to scare anyone but I am being realistic. A 20% drop is something to laugh about, we will see a lot bigger drops than that.

Andy

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Tinker,

Apologies if it sounded like I was personally attacking you. I was not, just frustrated with the topic. When was the last 50% correction?

Apology accepted. Sorry about that Tinker. Ok the last 50% correction I had was in 2015. I lost half my portfolio. It didn’t scare me Tinker because I knew I was going to make it back. Some of them were some bad choices I made so I sold them, and some of them were good companies that I held. Sometimes the Market doesn’t have to crash for you to have a big drop.

That is why I say a 20% drop is nothing, in fact if you look at my posts in December you will see me posting that I was getting excited when the market was down 20%. I happen to like it when the market drops because I see it as a buying opportunity.

Andy

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This post won’t be very popular but in order to give the newbies on the board the correct picture, I’ll say it anyway.

A study done with a small sample size over a 12-month period has no meaning. It doesn’t prove or disprove anything - it is statistically meaningless.

If anybody is interested in knowing what type of stocks have performed well over the past several decades (and what hasn’t worked), you can read “What works on Wall Street” by James O’Shaughnessy.

You can obtain the PDF copy from the following link -

http://csinvesting.org/wp-content/uploads/2015/02/What-Works…

Your attention is drawn to the following chapters -

Chapter 3 (Page 32) - Short Periods are Valuless

Chapter 8 (Page 134) - High Price to Sales Ratio stocks are toxic

Here is the conclusion from the book -

“The dubious honor of worst performance to date goes to those 50 stocks having the highest Price to Sales ratio from the All Stocks Universe; $100,000 invested on December 31, 1951, was worth just $19,118 at the end of 2003. You’d be vastly better off with T-Bills, where the same $10,000 grows to $135,185! The Sharpe Ratio is 6, the bottom of the barrel.”

James O’Shaughnessy runs a very successful quant. asset management firm and his updated work also shows that stocks with the highest Price to Sales Ratio produce the worst returns over the full stock market cycle (i.e. economic expansion/bull-market and recession/bear-market).

So far since 2009, we have only witnessed economic expansion/stock bull-market and the cycle will complete during the next recession, when the stock bear-market will end.

Then, and only then will one truly know how the stocks with the highest Price to Sales ratios fared over the complete stock market/business cycle.

Again, some of the posters on this board may not like this post and they may claim that this book’s conclusions are wrong or that this time is different. Perhaps, it is different this time; but there is no way of knowing that now - we’ll only find out at the end of the next recession-induced bear-market.

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Ummm, since 1951 is vastly older than me, and vastly longer than I will invest, and vastly longer than anyone here has ever held a stock, at all…how is that study even relevant at all?

I mean, what company still exists that one might have invested in back then that one can invest in now…GE, IBM, Ford, Caterpillar, General Mills perhaps.

In that time period, and I’m sure this is now just a fluke, came and went Polaroid, Microsoft, Oracle, Intel, ISRG, Qualcomm, Amazon, Google, ARMHY, Salesforce, and a whole herd of other companies. What, having held on to them, all of them considered the most expensive of their lot, your returns would equal or be beaten by t-bills? REally? And what if you made timely buys and then held and bought monthly?

I seriously do not see how that study has an ounce of applicability to anything we do as investors. It is not just the times being vastly different, and the economics vastly different, but also the method of investing. Who here is investing to hold a portfolio fo stocks for 50 years and never letting go?

What disruptive technologies did his study include? When did he decide to buy them? When did he decide to sell them? Never?

I cannot even take this seriously if your opinion is that this is representative of the manner in which we invest.

Shopify is up 530% or so since its IPO. According to this study you agree with the most profound SA article ever written where the author still does not find SHOP inexpensive enough to buy - even after watching rise more than 500%. Should SHOP investors just give back all the gains because it si upsetting the rules of this study?

Pretty legitimate criticisms. In fact I am not finding a single point in this entire study that has any tangible learnings for us today, in the context of what we do, at all.

You will need to fill in the applicability of how these findings relate, SPECIFICALLY, to what we do here.

Perhaps we steal things, or defraud people…or, or, or…well it must be something because the study says it is so.

Tinker

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And… just as I stated in my post; the angry posts have started coming in!

All the investors who lived through the different periods had some ‘new era’ industries which were really cutting edge at that time.

Instead of getting upset with my post or the findings of the book Tinker, perhaps you may want to read the book. And if you already know that you are right and 60-years of history, valuations etc don’t matter, then simply ignore the post and after the end of the next recession/bear market, you’ll find out whether this time truly is/was different.

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And… just as I stated in my post; the angry posts have started coming in!

That’s not a productive comment, GrowthMonkey.

As Tinker said, “I seriously do not see how that study has an ounce of applicability to anything we do as investors.”

I agree with Tinker.

So, instead of just saying you are right because you anticipated that people would disagree with you, why don’t you instead give us your thoughts on which (if any) practical applications from the 1950-study could be of use in today’s investing environment from a growth investor’s perspective.

That would indeed be more meaningful instead of just citing “conventional wisdom” that may or may not fit the investment style we follow here.

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GM:

If you had actually read the original post on the 3 P/S portfolios, you would see it contained many provisos including that this was taken from the popular stocks discussed on this and the NPI board, was during a market bull, didn’t rebase expansion of multiples, etc. It was never meant to be a scientific study, just observational and as you may know, most studies are spawned first from observations.

Why were these specific stocks chosen vs a huge landscape of stocks?? Because these were the best and brightest selections that were chosen from the heap of all stocks as having best prospects…these selections were by design a selection bias…and should have been.

I have read James O’Shaughnessy many times over the years…he is largely a value investor and longer term holder. I know he is a quant also and we all know that 70% of stocks trade by software algorithms.

But I think you too readily dismiss this thread in an attempt to be provocative…and I am saying this from the perspective of someone who also believes that there is too high a price to pay for a stock. We had a great thread at the NPI were we challenged everyone to come up with stocks that reached a P/S of > 20 and what the returns had been in the subsequent 3 years. That exercise was very telling IMO.

But you are dismissing the momentum style investing by claiming that it doesn’t hold water to a completely different style of investing in stocks that were long term buy and holds. Tell me what the average hold time is for a stock at the NPI or Saul’s? These are actively traded stocks and far different from James O’Shaughnessy’s brain dead long term buy and hold stocks…apples and orange comparisons.

BTW, have you looked at the results of his funds in comparison? https://www.osfunds.com/

The quants are really in vogue right now…how are you using them in your investments specifically??

Darth:

The ESTC (not in the original portfolio) price was taken properly…one cannot get the IPO price pre-market…the average investor had to wait until it hit the market, it is proper to take what a routine investor could first get the stock at and not preremarket IPO price IMO.

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