A Good Price to Sales Ratio is Tough to Find in Software Stocks

The Chart Below Shows:

the market cap of just software stocks valued at over 10x price to sales is over $6 trillion
that means that software stocks priced at preposterous levels are now worth ~30% of US GDP
KCR thanks Scott McNealy for using Sun Microsystems history to make investment decisions on stocks valued like this simple

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Summarily: when you have to move away from price to book or price to earnings ratios because they are negative or so high they don’t make sense, piling into a company at 10x price to sales based on grand promises in the future is probably a suboptimal decision. To see the mirror image of this, please see our research on what we believe are the outsized opportunities for GARP investors.

We would like to give our sincerest thanks to legendary investigative reporter Herb Greenberg for asking us to build this chart. Seeing that the market capitalization of software stocks floating on valuation metrics that have failed every historical sanity test is north of $6 trillion was eye-opening. Certainly, we would not have thought to do this.

We would also like to highlight the ever brilliant Lu Wang’s article on software stocks where she quotes Michael Purves of Tallbacken Capital as saying “To pretend that every stock is really exciting and is going to be the next Google is kind of absurd” – a sentiment we brought the empirical data to in our piece “Who is the Next Amazon?”

Please see the chart below to pound the point home just a tad further. The percentage of the market cap of software stocks trading over 10x price to sales has just hit 80%. A number last seen at the peak of the dot.com mania.

High Ratio vs. Low Ratio: Is it “different this time”?

As so many famous investors like Seth Klarman, Andrei Shleifer, Galbraith, and historical fiascos like Enron have documented and proven, every mania goes through a period where people start to say high valuation ratios don’t matter. There is always an excuse.

A stock’s share price is not, in our view, an accurate reflection of a company’s value. We believe market prices are wildly inefficient. There are over 100 software stocks that meet the manic criteria described above.

Let’s thin the list out and compare the most fragile companies. The first row in the table below is software stocks over 10x P/S that also burn cash. This cash burn is often after massive add-backs for stock compensation. The second row is the broad market.

The first row in the table below shows that these cash-burners are trading at 25x sales. Even more remarkable is their -4% Total Yield. Investors are subsidizing these stocks’ to the tune of -4% a year, which dwarfs the dilution we explained in our piece comparing ARKF’s negative yield to the XLF dividend.

A good price-to-sales ratio depends on the company’s underlying fundamentals. A low price-to-sale ratio does not mean a company is a bargain. For those looking for cheap stocks with dividends or high-quality stocks with long histories of safely compounding wealth, or growth stocks trading at reasonable prices, the bubble today provides some terrific opportunities in our view.

In contrast, we believe the stocks below offer investors very weak risk/reward features going forward. A good price to sales ratio attached to a good company is, in our minds, a much better alternative!

Please view below our list of Software Stocks >10x Price to Sales that Burn Cash.

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Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

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