The Speculator's
Corner
The New New Ratio
By Laurel
Kenner and Victor Niederhoffer
Special to
TheStreet.com
2/15/00 3:58 PM ET
URL: http://www.thestreet.com/comment/thespeculatorscorner/884451.html
After many failed attempts to discover the formula for achieving superior returns in the market, we have found the secret elixir: the price-to-letter ratio.
Two serendipitous events led to our discovery. The first was the purchase of the book "Funky Business" at Heathrow Airport in London. "We are moving from a world of atoms to a world of bits," write authors James Ridderstrale and Kjell Nordstrom, two professors who call themselves "funksters."
According to the duo, "If you can touch something, it is probably not worth a great deal." Take a cardboard box, a small booklet and a CD-ROM; together, they're worth $20. But, "Write Lotus Notes on it and you can charge $499."
The book knocked our collective hats off when we read it, but it required one other revelation to spark our discovery.
While in the bath one day, Vic overheard Roger Longman, managing partner of Windhover Information, a Norwalk, Conn.-based research firm, discussing a formulation of his that received much favorable notice at the recent Chase-Hambrecht & Quist biotechnology conference. Roger floated the idea of a price-to-weight ratio, or P/W ratio as a new measure of value. The lower the delivery cost of a product, the greater the potential for profit. Think molecules, not machines.
When we heard Roger talking about the high P/W ratios of biotechnology companies, we knew we had stumbled onto something big. Price-to-earnings ratios, price-to-book ratios and price-to-sales ratios are about to become historical curiosities.
Not only have investors been putting the wrong thing in their denominators, they've been making a mistake by looking for lots of stuff at low prices. The failure of low P/E ratios as an indicator of high returns is apparent from last year's relative performance of the Nasdaq 100 and the Standard & Poor's 500 index. In January, the Nasdaq 100's P/E was 100; and the index returned 100% for the year. The S&P 500, with a P/E of 32, returned only 21%.
Under this new system, the P/W of a company delivering molecules could be in the billions. In contrast, Amazon.com (AMZN:Nasdaq), which sells at 80 and ships an average package of say five pounds, has a P/W of merely 8.
Like all great discoverers, Roger quickly found applications for his theory. He is bullish on Celera (CRA:Nasdaq) and Incyte (INCY:Nasdaq), two companies longer on ideas than actual products. Conversely, he is relatively bearish on Chemdex (CMDX:Nasdaq) and SciQuest.com (SQST:Nasdaq), because those companies distribute weighty reagents and other chemicals whose denominators in the calculation tend to weigh the ratio down.
Unlike Archimedes, Vic didn't jump out of the bathtub shouting "Eureka!" when he connected the funksters with Longman. Eight young kids were in the vicinity, and hip trouble keeps him from jumping much these days.
Nevertheless, he immediately realized that the price-to-weight ratio was a vast improvement over the measures of value that had their heydays in the 20th century: The price-dividend ratio favored by our coupon-clipping ancestors, the now hopelessly outmoded price/earnings ratio, and the price/book ratio that came into popularity during the depressed 1930s and the recessed 1970s. As the century ended and Internet companies with great prospects and no profits ascended, the price/sales ratio became fashionable.
Now, we have the price-weight ratio. But why stop there? We live in a world of bits, not matter, and why shouldn't we value companies based on ideas? Or even better, symbols. The price-to-letter ratio fits the bill. Just divide the price of a stock by the letters in a company's name. Yahoo!(YHOO:Nasdaq), with five letters in its name, sells at 166. Thus, its P/L ratio is 33.
While the P/L ratio might be seen as a subset of P/W since the amount of print on the label could be a major weight factor, it is so much more. Consider the membership of the Nasdaq 100. Of the six companies that showed average returns of 1,000% or more over the past three years, four -- CMGI (CMGI:Nasdaq), Yahoo!, Qlogic (QLGC:Nasdaq) and SDL (SDLI:Nasdaq) -- have P/L ratios above 13.
The bottom performers of the Nasdaq 100, on the other hand, represent companies with lots of letters in their names, P/Ls in the 1-2 range and negative returns. These include Northwest Airlines (NWAC:Nasdaq), PacifiCare Health Systems (PHSY:Nasdaq) and Quintiles Transportation (QTRN:Nasdaq). In the past 12 months, Dell Computer (DELL:Nasdaq) -- an overly descriptive name if ever there was one --joined the losers' list.
Some may complain that companies with high current P/L ratios earned them by rising in price, and that those with low P/Ls reached that unfortunate condition by falling. Others may object that we didn't exclude companies not in the index three years ago or include those that went bankrupt or were kicked out. However, since these biases invalidate 99% of the studies of ratios and returns that we know of, we can hardly be expected to apply them here.
We cannot conceive what advances will occur in future developments of valuation measures. For now, we offer the list of the 10 companies with the highest P/L ratios, as of Feb. 9, 2000. (But don't go out and buy them unless you're ready to run down the street naked to your broker's office shouting "Eureka!")
SDL (SDLI:Nasdaq)
eBay (EBAY:Nasdaq)
Ciena (CIEN:Nasdaq)
Biogen (BGEN:Nasdaq)
Yahoo! (YHOO:Nasdaq)
CMGI (CMGI:Nasdaq)
Qlogic (QLGC:Nasdaq)
NTL (NTLI:Nasdaq)
Intel (INTC:Nasdaq)
3Com (COMS:Nasdaq)
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Laurel Kenner is a former markets editor of Bloomberg, and a trader. Former hedge fund manager Victor Niederhoffer is currently a private investor and author of Education of a Speculator. At time of publication, Kenner was not long any of the issues in this column, while Niederhoffer owned shares of Quintiles Transportation and held a net long position in S&P 500 futures and options, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While they cannot provide investment advice or recommendations, they invite you to comment on this column at mailto:%20commentarymail@thestreet.com.
