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

Investment Analysis Clubs Saul’s Investing Discussions
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Locke and Duma,

In modern history, the only time “new era” stocks at the cutting edge of technology traded at 25 or 30 times revenue were in early 2000 (Cisco, Microsoft etc) and in the subsequent bear market, they dropped by 60-90%.

During last year’s pullback, the S&P500 declined roughly 20% and the average Saas stock declined 35%.

I don’t wish to argue over this topic, the historical data is all there in James’ book and if you want to ignore or dismiss it, that is entirely your decision.

Whether Jsmes is a value investor or not, is irrelevsnt. The data he has presented in his book is objective : if you think that these Saas stocks are somehow not subject to the laws of economics and they will keep rising forever, then we can agree to disagree.

Best,

GM

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Whether Jsmes is a value investor or not, is irrelevsnt. The data he has presented in his book is objective : if you think that these Saas stocks are somehow not subject to the laws of economics and they will keep rising forever, then we can agree to disagree.

GM:

This is not a test of wills and there is no reason to get irritable. You are arguing a point I have made numerous times as you know because you do lurk at the NPI. I have been at this game long enough to know that, given time, one day you will be right :wink:

But your point is taken, you have concerns about irrational exuberance about stocks with high P/S. We have explored this issue in detail at the NPI as you know.

But you cannot just summarily dismiss the facts of the past year that the lower end P/S NPI type stocks did NOT perform as well as the middle range or even higher end. And it is NOT statistically irrelevant as you claim…there was selection bias to those stocks that these two boards believed had the best TA, SAM, Revenue growth rates, etc. They were all bought on the same day at the then price in equal dollar amounts.

We cannot imagine the results weren’t what they were…the lower P/S didn’t do as well…says nothing about why…just was.

I would appreciate if you would show us the results of the O’Shaughnessy mutual funds vs the market and Saul’s results. That could be worthy of discussion.

But it is also important to point out that I suspect by the time you are right about the P/S issue, Saul will have been long gone form many of these stocks. He is his own “quant”…trading hard on rules (witness the “massive” slowdown in SHOP revenue growth that was imperceptible to most) and his style has morphed with the times and no doubt will morph again.

I half jokingly suggested on the NPI that it would be a great exercise to take Saul’s knowledgebase and convert it into “quant” stock buy/sell decisions…now none of you try this at home or steal my idea :wink:

But the point is, he hasn’t stayed still and keeps finger on pulse of every stock as do so many here…and never falls in love with any story…ever.

Please let us know what the O’Shaughnessy mutual fund comparison shows and how you use his quant in your investments with examples.

Best:
Duma

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Duma,

I wasn’t irritated by any of the posts.

James studied stock market history and wrote a very detailed book about valuations - his data spanned 50 years. The subject of this thread is high EV/S which is why I presented the findings of his objective study.

I’m not an investor in his funds; neither do I use his quant style of investing and I don’t even know how his funds have performed - that is not the subject of THIS thread/discussion.

Even if his funds have under-performed, that doesn’t invalidate the findings of his 50+ year study.

Richly valued stocks can stay elevated for long periods of time (as stated in James’ book) but in the bear-market, they have always gotten creamed!

Perhaps, everyone on this board is smart enough to know when the next bear-market will come along and they’ll all exit these richly valued stocks close to the highs - but I’m not so smart.

If only investing was this easy and all one had to do was to just buy into the fastest growing companies at ANY valuation - unfortunately, it isn’t so simple or straightforward.

An investor’s long-term return (over the full stock market cycle) is determined by two factors -

  1. growth rate of the business
  2. Valuation at the time of buying into that business

Everyone keeps bringing up Saul’s remarkable track record to justify this way of investing. But, it may help to keep in mind that prior to 2017, Saul amassed this incredible track record of 20+ years by following Peter Lynch’s GARP strategy - Growth at a reasonable price - hence, his laser focus on PEG ratios. And now, he says that valuations don’t matter and he doesn’t even look at them!?

Anyways, each to their own, we are all responsible adults and don’t have to agree all the time.

Finally, since you brought it up, my own portfolio is invested in 22 growth stocks (35% China, India, Latin America and around 50% in the US) and without owning stocks trading at 20,25 or 30 times revenue, my portfolio is up 34% ytd (despite me being hedged from early November until 7 January) and losing out on the first week’s gains. And since I started investing this way (with hedges), my long-term CAGR is 21%.

In case you or others are interested, here are my holdings -

Tencent, Ping An Healthcare & Technology, Align, Amazon, Alibaba, Baozun, Docusign, Facebook, Farfetch, HDFC Bank, Huya, Iqiyi, Lyft, Mercadolibre, Netflix, ServiceNow, Paypal, Shopify, Square, StoneCo, Tencent Music and Weibo.

So, no - I don’t run my portfolio based on any quant strategy (although I do hedge my book by using a systematic trend following strategy) and like you and others on this board; I also invest in high growth stocks (but keep a close eye on valuations).

Best,

GM

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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.

Duma,

I get your point. However, we are talking about stock performance. Sometimes stocks fall below or don’t change much on IPO day. The public market decided that Elastic was worth nearly double the IPO price almost immediately. Tens of millions of share were purchased at IPO price. Tens of millions of more shares were bought in the first day at $70 vs $37. An IPO is by definition a public offering. Investors of the public did buy public shares of Elastic at $37 on 10/4/2018. All of us can participate in an IPO. We could have participated in the Elastic IPO if we did the work.

In general,the only requirements to participate in an IPO are a broker with a partnership with one of the underwriting agencies, a non annuity(401K type) account, and a minimum balance that is not unusually high.

If someone says SHOP is up 530% since IPO, for instance, they mean measured from IPO price. That’s the starting point.

So when measuring ESTC performance as a public company. It’s current price has risen 116% since IPO. The IPO occurred during the year of your observation report. The IPO price should be the starting point for measuring performance. If the market thought less of ESTC it would be closer to or perhaps even less than the IPO price. LYFT??

What do the buyers of the IPO shares whose shares are coming up for the lockup expiration view their performance as. 116% gain or 18%?

You did great work in your study and it is your work, so you get the final say as to what goes in. There should at least be a discussion though about measuring ESTC performance. A caveat or an asterisk or something.

Thanks again for putting that work together.

Darth

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During last year’s pullback, the S&P500 declined roughly 20% and the average Saas stock declined 35%.

Hi GM,
What a totally irrelevant thing to say!

When the S&P bottomed for 2018 after its 20% decline:
It had gone roughly from a gain of 9% to a loss of 13% for the year.

When my portfolio, with a lot of SaaS stocks, bottomed after its 26% decline (yes it dropped more than the S&P):
It had gone roughly from a gain of 96% to a gain of 45% for the year. Yes! That was its Bottom!

Oh, and the S&P finished with a loss of 6.6% on the year, and my portfolio finished with a gain of 71.2% on the year.

Last year’s decline not only was a correction, but briefly hit Bear Market territory for all the indexes ( defined as a loss of 20%). I can remember posting about clicking on an investing news site with 7 article headlines, and 6 had the words “Bear Market!” in the titles, and two also had “Bubble Bursting” in them. The Fool was running articles on how to survive the Bear Market. Seeking Alpha was running articles on how to survive the Bear Market. Zacks was…well, you get the idea, it was no fun and quite scary. But figure it out. Would you rather have been in the nice “safe” S&P, or those “risky” SaaS stocks?

I think a lot of people still have post-traumatic stress disorder from the 2008/2009 crash, and expect another just like it every 10 years. Well it was almost 80 years (79 to be exact) from 2008 to the last comparable crash, which was in 1929. None of us were even born then. It was three generations between them!

And, as Tinker said, there’s a lot of implied aggrieved morality going on, people waiting for the hand of the investing God to come down and smite us successful investors because we are not following the laws of investing as written in the value investors’ bibles.

As always, that’s just the way I see it…

Saul

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Saul,

In your post you’ve mentioned “what a totally irrelevant thing to say!”

How is it irrelevant?

Hundreds visit your board and perhaps many still don’t own SaaS stocks.

You and others on this board keep mentioning that the SaaS stocks are different and because of their recurring revenues, they are protected from the normal business and stock market cycle.

My last year’s stock market pullback example confirms that this just isn’t so - the S&P500 declined 20% and the SaaS stocks fell 35% - if they truly are immune, why didn’t they hold steady at/near their highs; why did they go down almost twice as much as the broad market?

Last year’s stock market wobble was not a recession induced bear-market which are typically greater - 36% decline in the S&P500 over the past 8 cycles to be precise and during each of those, the high-growth/high-beta stocks have decline a lot more.

The topic of this thread was/is “Do high EV/S ratios hurt returns?”

The answer based on 50+ years of data/history is a resounding YES.

Thats all I have to say on this subject - perhaps it truly is different this time; time will tell.

Best,

GM

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I have read through this thread very thoroughly. The returns that this board had over the last 2 years are unbelievable, no doubt. But, GM’s warning was targeted towards new(er) investors (like me). I didn’t get into SHOP until it was $105, for example, and built it up on the way up. I also made other poor investment choices and while my accounts recovered plus some, I was at break-even point in December (attributed to some early purchases of AYX and TWLO, just wish I had the guts back them to take bigger stakes)

So “only time will tell” is very much will be true. And no one makes us stay in any of the stocks for 50 years.

Sincerely appreciate everyone’s contributions.

Natasha

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28

The P/S ratio study in O’Shaugnessy’s book was conducted over 50 years, revised annually. He didn’t break down the stocks in 1951 and use those same stocks for 50 years. The book has this passage:

The only time both Large Stock and All Stock high-PSR stocks beat the benchmarks was in the 1960s, an era dominated by performance-obsessed managers who would pay any price for a stock with a good story. Indeed, 1967 was the second-best year for high PSR stocks drawn from All Stocks. In his
book 101 Years on Wall Street, John Dennis Brown calls 1967: “…a vintage
year for speculators. About 45 percent of all issues listed at the NYSE would
gain 50 percent or more.” Thus, high-PSR stocks perform best in frothy, speculative markets but do poorly in all other years. Amazingly, during the speculative 1967 market, low-PSR stocks still did well.
The decile analysis confirms that of all the value ratios, PSR is the most
consistent and best guide for future performance

Another section of the study:
Unfortunately, such horrendous performance is not unique—the 50 stocks with
the highest PSRs routinely underperform the All Stocks universe, regardless of
what the market is doing. The only real exceptions are during extremely speculative markets. If you look at the annual data for the high-PSR stocks from All
Stocks at www.whatworksonwallstreet.com, you’ll see that their two best years
were at the peak of the stock market bubbles in 1999 and 1967.

This is definitely something to keep in mind. I don’t believe SaaS stocks have a different set of rules because they charge for software on a routine basis therefore are something that can be bid up into the stratosphere any more that I believe that consumer goods/food stocks can be bid up like crazy because people have to eat. Eventually this market will mature just like all that have preceded it.

The difference is, most of us won’t stick around. I certainly won’t. I’m not High P/S ratio investing so much as I am High RS investing. I would never choose a high priced stock over a low priced stock to be contrarian, but going for the best of the best tends to draw me to those stocks, when going for a growth stock, which is completely different than contrarian investing (ie buying banks after the dust settled in 2010, buying Restoration Hardware when it was low priced and had a lot of controversy, etc.) Here’s the section on high relative strength stocks, which, unsurprisingly, were found to give superior returns over the market as a whole.

The performance of those 50 stocks from All Stocks having the best one year price appreciation also had extraordinarily high risk. The standard deviation of return for the 50 best one-year price performers was 37.82 percent,
the highest we’ve seen for an individual factor. The enormous risk pushed the
Sharpe ratio to 35, well below All Stocks’ 46 (Figure 15-4). When examining
deciles, we’ll see that performance is increased and risk is reduced when
focusing on the top 10 percent of stocks by price appreciationusing on the top 10 percent of stocks by price appreciation.
I cannot overstate how difficult it can be to stick with volatile strategies
such as this one. Investors are drawn to these strategies by outstanding relative performance, as when the 50 stocks with the best relative strength from
All Stocks gained 101 percent in 1991 and an eye-popping 152 percent in
1999. And while people think they can cope with volatility when a strategy
is doing well, they have the wind knocked out of them when their volatile
strategy declines 30 percent in a bull market. The emotional toll this takes is
enormous, and you must understand it before embracing a highly volatile

The December crash was nothing for people in SaaS stocks. It was extremely unusual for the high beta/high return stocks to not fall more than the market as a whole.

People buying the SaaS stocks right now are also deploying the high RS strategy, which is proven to work. But there is a large amount of volatility associated with it.

I looked at O’Shaugnessy’s fund results. I certainly won’t be doing whatever his recommendations are in the book. The bottom line is there is more than one way to make money in the market. However, it seems there is no mechanical method for picking stocks that holds up over time. Quantitative analysis is very difficult to get or keep an edge in.

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29

In your post you’ve mentioned “what a totally irrelevant thing to say!” How is it irrelevant? You and others on this board keep mentioning that the SaaS stocks are different and because of their recurring revenues, they are protected from the normal business and stock market cycle. My last year’s stock market pullback example confirms that this just isn’t so - the S&P500 declined 20% and the SaaS stocks fell 35% - if they truly are immune, why didn’t they hold steady at/near their highs; why did they go down almost twice as much as the broad market?

Irrelevant : not mattering, immaterial, inconsequential, unimportant

Hi GM, I didn’t mean it as anything personal. It simply is the definition of the word. I already pointed out that at it’s 2018 bottom your S&P was at minus 13% for the year, while my portfolio had a gain of 45%, even though it fell 6% more. If that doesn’t make the increased 6% decline “not mattering, immaterial, inconsequential, unimportant and irrelevant”, what does?

Here’s another example: From the beginning of 2017 (2yrs, 3mo ago), when I started investing in SaaS companies, to last Friday:

My portfolio of largely SaaS companies was up 332% (more than quadrupled), while
The S&P was up 25%.

You wrote During last year’s pullback, the S&P 500 declined roughly 20% and the average Saas stock declined 35%.

If we have another pullback this month, and the S&P again declines 20% and my SaaS stocks decline 35%, your S&P will be flat, up zero, with no gain at all for the two years and four months, while our SaaS portfolios will have gains of 181% in the same time.

If that increased percentage fall for the SaaS stocks isn’t immaterial, inconsequential, unimportant, and irrelevant, what is?

But the comparison is even worse. We aren’t investing in “the average SaaS stock” (What’s that?), which you say declined 35%. We are investing in the “best SaaS stocks” which declined only 26%. If our portfolios again decline 26%, our SaaS stock portfolios would still have gains of 220%!!! while your S&P would be flat at zero.

Yes, the boogie man of SaaS stocks declining more than the S&P is immaterial, inconsequential, unimportant, irrelevant. Sorry, that is simply what the word means.

Saul

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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 of stocks for 50 years and never letting go?

What O’Shaughnessy actually did was to set up a stock screen, keep the top 50 stocks that passed the screen at the beginning of the calendar year, and sell them all at the end of 12 months. With the cash from the proceeds, he then bought the top 50 that passed the screen the next year, in equal amounts, held those for one year, and so on. He most certainly did not buy and hold the same stocks for half a century.

He created many different screens, and ran simulations of how each screen would do for 50+ consecutive years. He found that the best returns were from screens that used P/S ratios below 1.5, combined with price momentum (i.e., growth at a reasonable price) and the worst were those that used the highest P/S ratios.

I think that there is a time and a season for everything. The last 2 years have been the season of investing in enterprise software and cloud computing stocks, which have yielded vastly superior results to buying low P/S stocks. Which is why, over the last 18 months, I’ve invested the way Saul has, and pretended that I never read “What Works on Wall Street” :slight_smile:

Ron

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The trouble is that some have a fear of the unknown and look back to what could happen when what is most important is what is happening today and for some of us, tomorrow may never happen! So, what if’s and quoting history or facts from past performances is imo meaningless.
It’s actually quite simple, stick with your disrupters and when they fail to disrupt or for whatever reason you are unsure, sell, reduce exposure and don’t look back.
Not easy at times but not worth any stress. Fwiw.

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32

Saul,

The best Saas stocks didn’t just decline 26% during last year’s stock market pullback.

Here are the actual drawdowns for the stocks popular on this board -

Twilio (-)29%
Alteryx (-)33%
Okta (-)45%
MongoDB (-)27%
ZScaler (-)36%
Elastic (-)27%
Square (-)51%
Shopify (-)31%
Nutanix (-)45%
Wix (-)34%

So, average decline was 36% versus 20% decline for the S&P500 Index.

And its not ‘my’ S&P500 Index - I don’t invest in any index.

I’m not gaining anything by posting these facts here; but am only trying to highlight that (a) perhaps these SaaS stocks are not immune from the stock market/business cycle (b) historically, stocks trading at the highest P/S ratios have been the worst performers.

If you (and others on this board) don’t agree with me, then please ignore my posts; its nothing personal - we are all contributing our thoughts on this wonderful board which you started; and despite our difference of opinion on valuations, I deeply respect you as an investor!

Best,

GM

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They say no one can time the market - but they lie. If you watch Saul’s portfolio, for example. though he suggests he chooses stocks for the long term, there is substantial churn.

There have been numerous requests to find what system is used as a sell system, but simplistically it seems that (unless something specific breaks a business model) it is simply that a faster growing stock has been identified. While still quant-driven this supposes a better option rather than choosing stocks to weed out. In that context, there really isn’t a “sales” model per se.

I think it is unambiguous that in a downdraft the high growth stocks we are playing with tend to drop further (just as they climb faster) than the average issue.

We have been through a three month correction last year and Saul correctly pointed out that he had only given up a portion of his profit. That would not be true of someone who had not invested all year. The observation of the behavior of these stocks in the context of an environment of near zero interest rates when the equity market has been nearly steadily growing for a decade. GM brings up an important point - we do not need an inflection point as deep as in 1929 or 2008 to have a rotation of which stocks are in fashion - and which are out of fashion. Let the good times roll, but be aware markets sometimes act irrationally for an extended period of time - being forewarned is being forearmed.

Jeff

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34

Thank you GM, I appreciate the information.

Andy

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O’Shaughnessy himself cannot match the market. I don’t know how his followers can beat the market? :slight_smile:

His research is great. But it’s for the past. When the time and environment change, we have to adapt. Buffet is very successful in buying consumer staples decades ago. They were the growth stocks then. Lots of Buffet followers still buying the same kind of stocks that Buffet bought decades ago and never realize that they need to adapt.

So success always go to those small group of people with forward vision.

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and the SaaS stocks fell 35%

Which SaaS stocks? Some index? Some bucket of yours? No one here has ever suggested investing in any and all SaaS stocks. Every company here is investigated as an individual and pluses and minuses evaluated. Many of the favored ones are SaaS at the moment, for reasons which have been elucidated, but there is no sense at all of blanket investing in every company which can claim SaaS.

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Growth Monkey,

Could you do us a simple favor to make sure we are all analyzing the same problem

If we invested $10,000 in each of the SaaS stocks on Jan 1 2018, how much would those stocks be worth today?

If we invested $10,000 in the SP500 how much would that be worth today?

At its low in December, what would those values be?

Sauls point is this, even though they fell by greater percentages at the top, their rapid gains had raised their floor well beyond even the peak of the SP500

You have to speak of the whole investment and entire story. It is simply not fair to new investors to only focus on the headlines.

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What Buffett practices is not buying consumer staples but businesses in stable industries that do not change rapidly. He has so much money to manage now he doesn’t have s way to deploy it effectively. Something that did not happen as a result of getting lucky in consumer staples. The guy is a genius. I was really impressed when I read his interview in “the money masters”. He forgets more in one year than I’ll ever know in my lifetime. Another good interview in that book was T Rowe Price who I would say Is the father of growth investing and better then Philip Fisher who is often given that title.

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That’s interesting GM. I had to think about it. I finally figured out that those are the maximum downs for 10 companies, but they all hit those maximum downs on different days spread out over weeks or months so that while the “average” maximum down for the individual stocks was 36%, the maximum decline for the group on any one day (at least for the group I was holding) was 26%. For example I hit my low of a gain of 45% in October. My November low was a gain of 50%, and my December low on Dec 24, when the markets hit their bottom (as I remember), was a gain of 48.5%. And one time one stock was down, and the next week it was another, etc, depending on news, earnings reports, and all that stuff. (I hope that I’m clear about this).

As a side note, Nutanix is not a SaaS company, and had its own issues, not related to the market decline, and Square is not a SaaS company for the most part, and lost its charismatic CFO, Sarah Friar, in December, which shocked everyone, and led to a decline not particularly related to what the market was doing. Since they are not SaaS companies, and were by far the largest decliners on your list, you might want to revisit it.

Best

Saul

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GM,

This fact is absolutely pointless.

“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.”

This sample is 50 stocks with the highest p/s regardless of any underlying fundamentals, management, etc.

The stocks we talk about here are high p/s, but that’s not why we invest in them.

We invest in them because they are executing wonderfully and often have some of the best founders and leadership teams managing them.

Using general statistics like that example is absolutely pointless.

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