Price & Sales Education Series
What separates the best investors from the rest? How can we emulate the greatest investors in the world like Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio)?
It is not using some complicated algorithm. It is not having the highest IQ. It is not being part of a secret society. It is simply being a good shopper.
They know what they are buying and they do their homework. This is something we all do before buying a car. This is something we all should do before buying investments. It is the habit of doing it that is the hard part.
Since we are shoppers of publicly traded companies, we will do our homework on a company's financials. Just like a car shopper is going to start the search by looking at the outside of the car, we will start our search at the top of the income statement. After the car shopper identifies the looks of the outside of a car, only then will she look inside and eventually under the hood to view the engine. We as investment securities shoppers should start simple and study sales.
Ingrain this number in your memory. Have a picture in your mind of its past levels. Know how low and high it went in past business cycles. Be able to identify what cycle it is in currently and where it might be in the future. Understanding you are buying revenue is essential. Studying the price the market has historically bid for a company’s sales is your homework.
Identifying the price the market has paid for a company’s sales will help us identify when revenue was on sale.
The Interactive Chart GuruFocus.com offers makes it easy.
We begin by studying Oshkosh Corporation (OSK), a company held in the portfolio of Third Avenue Management, a company found by Martin Whitman (Trades, Portfolio), a legend in value investing.
In order to master this concept, it is best to start with predictable companies. Being ranked 1-Star in GuruFocus' Predictability measure does not make it difficult to study, as seen below.
This chart depicts OSK's price in green and revenue in blue.
Price is what we pay to buy one share of Oshkosh Corp.. Similar to when purchasing that new car, the price may be higher in the beginning of the month and lower towards the end when the sales people are trying to make quota.
A car is what we buy at the auto dealer; revenue is what we buy in the stock market. For Oshkosh Corp, we are buying the sales of, "specialty vehicles and vehicle bodies." This blue sales line is less volatile; however, it does move due to economic conditions. This is the key for investors.
Notice how OSK's price in 1997 was far below the blue line but by 2006 was above. Fast forward one year to 2009 and notice how price decreased below the blue revenue line.
What might explain why the investing public bid so little for sales in 2009 but so much in 2006?
These trends are often due to investor psychology. As a shopper of securities, we must know why, by how much and how often it occurs. Ignoring it will lead you down a path to financial ruin, as happened to many after the Panic of 1837.
As Warren Buffett (Trades, Portfolio) stated on the way to get rich on Wall Street is, to "try to be greedy when others are fearful. And you try to be fearful when others are greedy.”
Having the character to not let greed overtake you will lead you on a path to wealth.
Gurufocus interactive charts help identify when to be fearful and when to be greedy.
Below is a chart of OSK's price-to-sales ratio starting in 1996. This chart is created by taking the price and dividing it by revenue. It includes the same numbers as the chart above, but depicts it in an easy to understand chart. Click the “P/S Ratio” tab in Interactive Chart to enable this feature.
To interpret why this chart is important, compare the current level to the past. The range is from a low of 0.08 in 2009 to a high of 1.4 in 2006. It can be seen as a temperature gauge measuring the investing public's willingness to buy revenue. Next, examine what happened to price after it reached near P/S ratio extremes.
Below is a chart depicting OSK's price increase after the market bid 0.17 times the level of sales in 1997.
Those buying near historical P/S lows experienced price gains.
Price gains also occurred after the P/S ratio lows of 2009.
Below is a chart of the price decrease after 2006 when OSK was above the 1.4x sales level. Those buying near historical high P/S levels experienced major price declines.
Understanding how market euphoria or despair affect price is important.
One way we can understand the P/S ratio is by looking at it from a business owner’s perspective. From every $1.00 received in revenue, the company deducts money to pay for employee salaries, materials supplied, interest on loans, and taxes to the government. Only after paying these expenses come earnings and dividends.
In Oshkosh Corp’s case, for every $1.00 in revenue OSK has on average $0.97 of expenses. What's remaining, $.03, is profit. Thus, $0.03 out of $1.00 is a 3% profit margin.
When we buy a company's stock, we pay a multiple of sales. Market conditions are often reflected in profit margins. During good times, witnessed by high profit margins, the market often demands a premium for each $1.00 of sales. In bad times, when margins are low, the market may offer a discount on each $1.00 of revenue.
In 2006, when the P/S was 1.4, the market was charging $1.40 for every $1.00 in sales. If we predict Oshkosh Corp can maintain a profit margin of 3%, as a part owner, we estimate we will receive $0.03 on every $1.00 of sales.
Putting these numbers together, we calculate an estimated owner's yield. This "Owner's Yield" is revenue remaining after all expenses, divided by the price we pay for sales. For Oshkosh Corp in 2006, that yield was 2.1%. This return was calculated by dividing the $0.03 earned on every $1.00 of sales and dividing it by the price we paid for sales, $1.40, ($0.03/$1.40).
However, if we purchased Oshkosh Corp sales at a lower price to sales multiple, as the market offered in 2009, then our “owner’s earning yield” would be more. Had we purchased those same sales for only $0.08, as was offered in 2009, our return would have been about 38% ($0.03/$0.08).
Of course, this is a very rough calculation of owner’s earnings. Actual profit margins or revenue change may substantially differ from our estimates.
At today’s level, the market is bidding .6x sales for Oshkosh Corp revenue. This is higher than the average reading after 1998. If we estimate 3% profit margins into the future and we are currently paying .6x sales, then our “owner’s earnings” yield is about 5% ($0.03/$0.60).
Perhaps 5% sounds good compared to BB-rated corporate bonds. Remember, however, buying common stock provides no guarantee of yield. There is also no guarantee bonds will stay at these levels either. The important thing is to compare this yield to its own historical levels. Within those ranges we may identify a margin of safety where institutional investors support price
In addition, ask yourself these questions: What were past growth rates? What are growth rate estimates? Will competition depress current high profit margins? How will a capital intensive business fair if interest rates rise?
Do your homework. Study the company. Study its history in good times and bad. Become familiar with the numbers backward and forward. Recite the historical bargain levels. Have fun with the numbers. Make it a habit and create good-looking charts.
We must put the odds in our favor by being our own investment analyst. And never forget: Revenue is what you buy and price is what you pay.
Thanks to GuruFocusfor providing the Interactive Charts.
