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Could price-to-sales be the key to identifying blue-chips on the recovery trail?

Since the "bombed out" virtual portfolio bit the dust, we've lacked a stock filter that identifies recovery stocks; once again drawing on the simple ideas of Michael O'Higgins ("Dogs of the Dow"), John Harrington takes a look at the price-to-sales ratio as a means of identifying comeback kings.

Gas man
Has there ever been a less-loved blue-chip stock than Centrica?

Having had success with a UK version of Michael O’Higgins’s “Dogs of the Dow” methodology I thought I would check out his other ideas.

In his book, “Beating the Dow”, O’Higgins comes up with several stock screen filters, most of which are contrarian in nature.

O’Higgins makes it clear that his flagship “Dogs of the Dow” system is the pick of the bunch when it comes to investment ideas – though for the last few years he has been championing “Michael O’Higgins Absolute Return” (MOAR), a diversified contrarian portfolio of global indices.

One of his other ideas caught my eye, if only from an academic viewpoint, and it pertains to bombed out blue-chips trading on low valuations that have a low price-to-sales ratio (PSR).

Profits come and go but sales tend to stay relatively stable

Conventional wisdom has it that the PSR is a good way of valuing growth stocks that have yet to make any profits; that's definitely not O'Higgins's bag (man), as he likes the highly-liquid, well-research big beasts of the equity world - the sort of companies a professional Yorkshireman could hang his flat cap on.

It’s also a useful indicator for stocks in cyclical sectors, as the good times (in terms of profits) come and go but the sales remain relatively stable.

O’Higgins is not the only investment guru who is high on this particular ratio: James O’Shaughnessy, in his book “What Works on Wall Street”, did a lot of research on it and found that companies with a PSR of less than one tended to perform better than those with a value of more than one.

He was also a big fan of companies with above-average cash flow, high levels of share liquidity and generous dividends.

That sounds right up our street, but today we are looking at O’Higgins and his thoughts.

O’Higgins’s supplementary criteria to PSR are slightly different to O’Shaugnessy’s but he was on the same page in terms of going with highly liquid shares, hence the universe of stocks we’ll be trawling will be restricted to the FTSE 100.

O’Higgins also advised ranking the blue-chips in order of price/earnings (P/E) ratio and percentage change over the last year.

The percentage change filter plays into another perceived benefit of focusing on the PSR: it is said to be good for identifying recovery stocks.

A fistful of defensive stocks is the likely outcome

The drawback to PSR, perhaps, is the strong likelihood that it will generate companies that have little scope, other than through cost management, to rev up earnings; in the UK, this particularly applies to utilities, so it should not be a surprise that a stock filter focused on PSR would generate quite a few utility companies as prime candidates for investment.

Be that as it may, let’s put together a mish-mash filter of O’Higgins’s three indicators, and see what we get.

Giving the highest ranked stock (e.g. the stock with the lowest P/E ratio) a value of 1 and the lowest FTSE 100 stock a ranking of 100, and then aggregating the score for each blue-chip stock over the three categories, we end up with the following 10 stocks that score highest – well, lowest, but you get the idea.

Ticker

Name

PE

Price to Turnover

% change -1Yr

PE Rank

PSR Rank

% change Rank

Combined Score

LON:CNA

Centrica PLC

4.1

0.3

-35

1

3

1

5

LON:SSE

SSE plc

7.4

0.4

-10

5

6

7

18

LON:MKS

Marks & Spencer Group PLC

7.9

0.5

-4.3

8

9

14

31

LON:BT.

BT Group plc

9

0.9

-21

10

24

3

37

LON:WPP

WPP group PLC

7.8

1.3

-23

7

36

2

45

LON:SBRY

Sainsbury (J) PLC

13.4

0.2

0.64

24

2

24

50

LON:IMB

Imperial Brands PLC

14

0.8

-6.2

26

20

11

57

LON:PSON

Pearson plc

10.5

1.2

-5.5

13

35

12

60

LON:JMAT

Johnson Matthey PLC

15.5

0.5

-1.2

31

10

20

61

LON:SHP

Shire Plc

6.7

2.5

-16

4

57

4

65

It is, perhaps, interesting to note that there is very little overlap between the above stocks – the PSR 10 – and the 10 “Dogs of the Footsie”; only BT, Marks & Spencer and WPP make both lists, although Legal & General missed doubling up by a whisker.

The above list almost reads like a who’s who of defensive stocks, with utilities, supermarkets and cigarette companies in there, but there are a few stocks that seem to be coming back into fashion; I’ve been keeping an eye on marketing giant WPP and academic and scientific publishing group Pearson for a while, and both seem to be returning from the wilderness.

In contrast, Marks & Spencer’s current direction of travel seems to be taking it further into the wilderness, but ours is not to reason why when it comes to mechanical investment strategies; perhaps that pie-in-the-sky merger of the middle-class favourites M&S and Sainsbury will finally come to pass and we’ll have the joy of seeing the abject horror of M&S shoppers seeing a branch of Argos opening in what used to be the corduroy jackets section of the menswear department.

As with our other virtual portfolios, we’ll start with a virtual £10,000, and as per the “Dogs of the Footsie” system we’ll invest equally in all 10 stocks, let the portfolio do its thing for a year and then review the constituents in a year’s time. Naturally, we'll check in from time to time to see how the portfolio is doing.

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