As a value and growth at a reasonable price manager we are challenged by markets that have stretched valuations. One measure that is at all time extremes (for the S&P 500) is the price of the market relative to sales. The following is an excerpt from the quarterly investment letter of GMO, a large global value manager. They look back at the dot com bubble for a dose of reality.

Scott McNealy, co-founder and CEO of Sun Microsystems, made the now famous statement to Bloomberg in 2002:

“…2 years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

The percentage of US stocks trading at a 10X sales ratio is not as extreme as the dot com peak in 2000, but it’s never been closer. Timing when this spike peaks is a mugs game, but is likely has a linked to Fed policy, inflation expectations and the overall level of interest rates. If you believe rates will rise, value should perform much better than growth in the coming cycle. If you believe deflation is the longer-term outcome, then growth stocks should continue to maintain the lead.

Percentage of US stocks trading at a 10X sales ratio

Source: GMO, Compustat

It is not strictly impossible for a stock trading at 10x sales or more to give a good return. Amazon was trading at well over 10x sales in the fall of 1999, and the return from then has been a very healthy 18% annualized, or 38x total gain over 22 years. On the other hand, Amazon did fall by almost 93% from that peak to the low 2 years later, and an investor who had held off and only bought when its price/sales fell below 10 in late 2000 would have made 89x his initial investment and saved himself a good deal of initial pain.

Looking back, it’s clear that buying a growth stock that trades at 10x sales on average provides significantly lower than average returns than the broad market. The probability that value out performs growth going forward is material.

Source: GMO, Compustat, Standard & Poor’s

The over 10x P/S portfolio is a market capitalization weighted portfolio of all stocks trading above 10x trailing 12-month sales, rebalanced monthly.

The argument here is that value stocks should outperform growth stocks for the next market cycle. Value stocks are currently trading at a 40% discount to their historical average relationship to growth stocks. Consider selling some exposure to the growth weighted S&P 500 and adding some value exposure. Here are two ETFs to consider. The pure Russell 1000 value ETF (IWD) if you are still very bullish on overall market growth but want to own value stocks. There is a newer ETF (RWVG) that is long the IWD, but it’s relative to how IWD (Russell 1000 value) does compared to IWF (Russell 1000 growth). At a time of higher risk and higher valuation, what would you rather own? If we look back in 2 years, Scott McNealy’s reflection in 2002 should resonate. What were you thinking?

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