Using PRRs can help you stay out of trouble. To buy a Super Stock, consider these rules:
RULE 1:Don’t ever buy a Super Company selling at a PRR greater than 15. There are always plenty that can be bought at lower valuations.
RULE 2: Find Super Companies with a PRR of 5 to 10. You are unlikely to find them at PRRs much below 5. (Some other company already may have acquired them at these low levels.)
PRRs indicate how much the market values a company’s R&D. Since we know there isn’t any real magic in engineering and most research success is really just a function of good marketing, it becomes
obviously silly to pay too much for research. Most initial public equity offerings of the early 1980s were at 15 times research or more—often much more. The really hot ones were at 50 to 200 times research. With these, the PRR and the PSR are exactly what they should be—they are relatively perfect reflections of each other. They indicate the stock is way too high. Perhaps money can be made in these stocks. But they don’t qualify as Super Stocks because, starting at these prices, people aren’t likely to make 3 to 10 times their money in three to five years. People are more apt to lose money buying these high-PRR initial offerings.
Looking beyond initial offerings, the same rules apply. In Chapter 3, Verbatim is shown having a high Price Sales Ratio. It also had a very high PRR in 1983 at just over 100. This is scary. First, the market places a very high value on sales. Then, if research is low rel- ative to the market value, from where are enough new products to come to make sales grow enough to push up the stock? Avoid these high-priced companies. (If other people make money on them, who are you to begrudge them that? At least make sure that you won’t be losing money. Be sure that you are making it instead.)
If the PRR is a reflection of the PSR, why bother with it? Because the two are not always reflections of each other. In the instances where they are not, some interesting questions need to be answered before money is invested. They are perfect reflections of each other if the PSR and PRR for that company are either both low or both high. But what if the PSR is low while the PRR is high? What if the PSR is high while the PRR is low? Consider some cases.
The PRR helps when a Super Company seems high priced (based on PSRs) but is really rather cheap. Consider a Super Company with a marginally high PSR like 1.0. Suppose it has a very low PRR like 5.0. The implication is that current research expenditures, on perceived market opportunities, will soon give birth to a new set of products (or even product lines) which will boost sales and profits. Check it out (spelled
m-a-r-k-e-t-i-n-g). If true, this Super Company may be worth the mar-
ginally high PSR because of the events that caused the very low PRR. If it’s not true, it is probably because marketing is bad. Then the research expense won’t bear fruit so that it isn’t really a Super Company.
Using PRRs in conjunction with PSRs may force serious consideration of a Super Stock that you otherwise would overlook. The PRR helps an investor find opportunities that otherwise might be missed.
Recently, I bought stock in Finnigan Corporation (San Jose, California). It is the world’s leading producer of mass spectrometers, a sophisticated form of analytical instruments. The stock seemed somewhat high for me on a PSR basis at 1.0. Yet on a PRR basis, it seemed inexpensive. This prompted me to look further, where— sure enough—a lot of new-product development that could have significant future benefit was brewing. Time will tell if this investment will be successful. But without the PRR, I would have shied away from the PSR and missed what may be an exciting opportunity, worthy of time and effort.
Consider a company portrayed by others as a Super Stock (a rather bad sign if people are touting it). Suppose it is selling at a PSR of only 0.75. On a price sales basis, it seems to meet our requirements. (Notice that absolutely no mention whatsoever is made here of earnings.) But suppose the PRR is 25. This is too high. It implies that the company isn’t spending what it should to maximize its future. Research is being conducted at a low level. Apparently, marketing is not making the effort or else just not finding opportunities.
Since there isn’t any magic, the company’s research efforts may produce results, but not at a level from which dramatic sales improvements are likely to flow—hence the low PSR. Perhaps the company is making acquisitions because it can’t find enough internal opportunities. Management may understand its market perfectly. Seeing low potential for growth, it has chosen this low R&D/high-acquisition effort.
Using PRRs in conjunction with PSRs in this case resulted in avoiding an investment which, on the surface, appears to be a Super Stock but certainly isn’t. It isn’t even a Super Company. The low PSR was just bad bait. The PRR in this case helped avoid buying a probable loser.