(09/04/12) 5 Stocks Worthy of the Fisher King

Linking stock valuations not to earnings but to sales is a pretty well accepted practice now, but the man who built the case for price-to-sales ratios is still picking winners with his methodology today, writes John Reese of Validea Hot List.

In 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher—the son of Philip Fisher, who is known as the "Father of Growth Stock Investing"—thought there was a major hole in the P/E ratio's usefulness.

Part of the problem, he explained in his book Super Stocks, is that earnings—even earnings of good companies—can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term—how well or poorly the company's underlying business was performing.

While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies"—those that were capable of growing their stock price three to ten times in value in a period of three to five years—rarely decline significantly.

Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.

Fisher's findings—and his results—helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans," his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.)

The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.

While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.

The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios.

That well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul—all while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul.

These five stocks are currently in my Fisher-based portfolio: