Returns when starting from a P/Sales multiple > 15
What follows is some light exploratory analysis on growth stocks. Prompted by this (h/t Fritz)
Bernstein tends to do great work, so I have no reason to doubt the accuracy of the analysis. Yet the potential growth of businesses seems to have accelerated over the last five years aided by much better distribution (software can be deployed much faster, new product growth explodes when it goes viral on social media etc). Therefore the question becomes whether P/Sales multiples indeed SHOULD be higher as potential growth rates have also accelerated.
Let's look at the 2016 cohort of US companies with a market cap > $100MM:
So medians roughly confirm Bernstein's analysis, averages look a little better due to large positive outliers offsetting large negatives outliers which are floored at -100%. The distribution is also interesting, with 62% of stocks having negative outcomes and 10% of stocks having outcomes where total returns were >200% (implying a >25% IRR, a fair compensation for fishing in such a risky pool).
For 2016 data pharmaceuticals (healthcare) completely dominate the pool. They make up 77% of the pool and 70% of companies with 5-year total returns >200%. Early-stage drug companies similarly dominate most pools ex-2000 (tech bubble). Hence a backtest for companies with P/S > 15 tends to be a backtest for the performance of early stage drug companies. Not particularly informative if we're looking for insights on whether the 2021 cohort of P/S > 15 companies will perform.
However in 2021, once again, the composition seems to have shifted! The share of consumer discretionary (think Tesla, Meli etc.) has doubled and many SaaS / Payments companies have entered the pool.
While in previous periods P/S > 15 was almost synonymous with pharmaceuticals, a new cohort of Payments, SaaS and consumer discretionary companies is now at the top (at least in terms of market cap):
The difference between P/S 2021 and P/S 2016 shows many of the companies that have entered the pool have done so thanks to heavy multiple expansion (only PSA was in the 2016 pool of companies with P/S multiples > 15).
An interesting case study from the 2016 set is Facebook which went from a 2016 P/S multiple of 16x to a 2021 P/S multiple of 10x. In order to achieve a 185% total return (or 22% annualized) FB had to achieve a 37% sales CAGR to offset the multiple compression in P/Sales.
Clearly, the bar is set much higher for today's leading growth companies. From this set only TSLA, MELI, TWLO and TTD have sales growth estimates that are similar to FB's historical 5 year CAGR of 37%. However TSLA and MELI have far lower gross margins (21% TSLA, 43% MELI vs 80% FB), TWLO starts at a 29x sales multiple (vs 16x for FB in 2016) and has lower gross margins at 50% and TTD starts at 37x sales...
Sell-side estimates, of course, are notoriously conservative and FB itself is a great example of that. Early 2016 consensus estimates of 2017 sales were off by -23.9%! Early 2017 consensus estimates underestimated 2018 sales by -22.9%! The underestimation error improved slightly in 2019 and 2020 but growth also came in. Maybe Cathie Wood and the team at ARK (as well as RVCapital) are onto something when they claim that the incentives both on the sell and buy-side these days is still to err towards conservatism as opposed to accuracy.
TSLA, MELI, TWLO and TTD may well beat estimates but still, to get to a similar 22% annualized return as FB starting from 2016 they would have to consistently beat them by a LOT. It seems more as if many of these stocks are being priced to a 10% return in a reasonably optimistic scenario.
Studying historical pools of companies that trade at P/S > 15 (2000, 2006, 2011, 2016) we find that there has been a steadily increasing pool of companies starting from P/S > 15 that generate greater than 10%, 15% and 20% annualized IRRs. At least some evidence that returns on pricey high growth companies are improving.
If we look at the pool of companies ex-pharma, base rates of success on average rise slightly:
What can we conclude from this exercise? Nothing definite but I would offer the following takeaways:
Historical backtests of companies with P/Sales ratios are dominated by the heavy overweighting of early stage drug development companies, which are an asset class of their own
Still, success rates from an already high starting multiple are relatively low, with about 22% of companies with a P/Sales multiple >15 offering a total return CAGR >10% (19% ex-pharma), 15% offering a CAGR >15% and only 12% offering a CAGR >20%. It's just very hard to get multiple expansion starting from P/Sales > 15 and compounding gets a lot harder when sales growth is offset by multiple contraction.
Be very careful in underwriting the durability of growth when you are buying a company with P/Sales > 15. In the case of FB this worked out and sales compounded at a sufficiently rapid rate to offset multiple expansion. Its a lot easier to make money when you have multiple expansion going your way. Companies that achieve this tend to look extremely dominant in their vertical (or at the top of a bubble) ex-post. Non-pharma examples from the 2016 pool are: RIOT, LBRDA, FB, WKHS. 2011 has TPL, ROIC, BIDU. 2006 features TCOM, OLED. 2000 has...JCOM
Many of today's high growth companies trading at high P/Sales (TSLA, MELI, TWLO, TTD) seem inferior to Facebook in 2016 at P/Sales of 16 due to a combination of lower gross margins or much higher starting multiples.
Personally I don't think this new generation of SaaS/Payments and consumer discretionary companies joining the P/Sales > 15 club is entirely unreasonable. However we can assume that their multiple expansion since 2016 at the very least represents the market getting a lot better at pricing them to a high single digit / low double digit annual return. I would be quite surprised if, more than say 15% of the cohort beat a 20% CAGR hurdle.