Low price-to-sales ratio might be a buy indicator

Advisers looking for a signal that the time to jump into the market has arrived can follow the Dow Jones Industrial Average price-to-sales ratio, which last month dropped to its lowest level in 12 years.

The price-to-sales ratio for the 30 companies that make up the Dow was at 71 cents as of Dec. 1, which means investors can purchase $1 of revenue in a company for that price. That’s down from a five-year reading of $1.18 and a 10-year ratio of $1.31. The ratio is calculated by dividing a stock’s current price by its revenue per share for the previous 12 months.

The last time the market touched these low levels was in November 1996, after which the market moved up significantly until Jan. 14, 2000. The Dow returned 23.92% annually during that stretch in the late 1990s, indicating that the current low ratio may mark good time for investors to buy into the market, according to Neil Hennessy, chief investment officer and portfolio manager for Hennessy Mutual Funds Inc.

“Typically, what happens in the past tends to come to fruition in the future,” said Mr. Hennessy, whose Novato, Calif.-based firm had $1.1 billion in mutual fund assets under management as of June 30. “We’re not going to go the rest of our lives in a bear market.”

In addition to the 12-year-low price-to-sales ratio, another reason to believe that the market is in for a turnaround is the estimated $4 trillion to $6 trillion that institutional and retail investors have at their disposal to spend in the market. “At some point in time, people are going to figure out that there is plenty of cash sitting on the sidelines,” said Mr. Hennessy. “I’m trying to interject rational and common sense into an irrational market.”

While the price-to-sales ratio can serve as a sign for buying opportunities in the market, it should not be used as the sole indicator, according to Dick Bellmer, a partner at Indianapolis-based Deerfield Financial Advisors Inc., which manages around $350 million in assets.

Some of his wealthier clients have decided to take a more aggressive stance in the market in response to bargain prices, but many others are opting for a safer route because they’re not certain whether the economy has hit bottom yet. Overall, Mr. Bellmer sees a lot of opportunities in the market because of low prices.

“This should be an active manager’s paradise when it comes to beating the market,” said Mr. Bellmer, who formerly was chairman of the Arlington Heights, Ill.-based National Association of Personal Financial Advisors. “As it relates to sectors, pick one. They are all good right now.”

Using the decade-low price-to-sales ratio as a sole indicator for jumping into the market should be approached with caution because it does not take into account likely revenue decreases at many companies next year, said Scott Kays, president of Kays Financial Advisory Group.

However, he does see great investment opportunities in the market.

“Price-to-sale is just confirming a lot of other indicators that shows the market is cheap,” said Mr. Kays, whose Atlanta-based firm has around $125 million in assets under management. “If you don’t take some sort of advantage of these stock prices, you’re missing the boat.”

Mr. Kays is very bullish on technology next year because he believes software companies will thrive. His view is that numerous firms will want to upgrade their computer capabilities to increase productivity and cut down on paper in a down economy. Mr. Kays’ clients are allocated mainly into mutual funds and exchange traded funds, along with some individual stocks.

Some advisers, such as Geoffrey VanderPal, a certified financial planner at Elite Financial Planning Group of America Inc. in Las Vegas, are more pessimistic about a market turnaround in the near future. [The low price-to-sales ratio] is irrelevant if there is no profitability,” said Mr. VanderPal, whose firm manages a little over $100 million in assets. “It needs to be used in conjunction with other indicators to be applicable.”

For the time being, most of Mr. VanderPal’s clients are being kept in cash positions since he cannot definitively say any sector is in for a strong rebound in 2009. “To speculate that any one sector is going to do well in the next 12 months is a bit premature,” he said.

While he acknowledges that the price-to-sales ratio could drop even lower in the short term, Mr. Hennessy is confident that market conditions will improve sooner rather than later. “How many times have we looked at history just repeating itself?” he said. “This is a traders’ market.”

E-mail Andrew Coen at [email protected].