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Joe Raedle

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds.

Intense fear at the time may have obscured the fact for many investors, but it's hard to argue that stocks weren't extremely cheap back at the end of March, 2009. U.S. equities were close to 50 per cent off their highs and selling at their lowest levels in more than a dozen years. Canadian stocks were at levels not seen since 2003. And on top of that, interest rates were at or near historic lows, making stocks even cheaper compared to bonds and fixed-income investments. Even well-known, long-time bears such as Jeremy Grantham and Steven Leuthold were calling equities cheap.

You wouldn't have known it by looking at the most-used stock valuation metric, however. At the end of March, the S&P 500 was selling at a whopping 116.3 times reported 12-month earnings. Using operating earnings, its price/earnings ratio was 18.6 - much more attractive, but not exactly dirt cheap.

That disconnect highlights the limitations of the P/E ratio. In major economic downturns, earnings can plummet to incredibly low, or negative, levels for brief periods, distorting the market's P/E.

The same can happen with individual stocks. Many times, a good company will go through a bad year or two - what Kenneth Fisher termed "the glitch" in his 1984 classic Super Stocks. Mr. Fisher, one of the investing greats upon whom I base my Guru Strategy computer models, said that many investors bail when a firm hits a glitch. But, he found, good companies are able to identify and fix their problems, and soon resume posting strong profits. If you can buy the stocks of such companies during a glitch, Mr. Fisher found, you can make a bundle when they get back on track and investors pile back in.

The trick comes in evaluating a company when its earnings have fallen sharply or have turned negative.

The solution, according to Mr. Fisher: the price/sales ratio (PSR). While earnings - even earnings of good companies - can fluctuate significantly from year to year due to business ups and downs, capital expenditures, or accounting changes, Mr. Fisher found that sales of good companies are much more stable. By comparing the amount of sales a company does to the price of its stock, he says investors can get a good idea of the real value of a stock.

Mr. Fisher is considered the PSR's pioneer, but other highly successful investors have followed his lead. One is James O'Shaughnessy, whose extensive study of historical stock market returns is one of the most in-depth of its kind. Mr. O'Shaughnessy, whose book What Works on Wall Street forms the basis for another of my Guru Strategies, found that the PSR was actually the single best determinant of a stock's future success or failure. He made the variable one of the key pieces of his growth stock selection strategy.

The PSR is no silver bullet - both Mr. O'Shaughnessy and Mr. Fisher used a variety of other variables in their stock selection processes - but it can be a very helpful tool in evaluating equities as a group or individually. (For the record, the S&P 500's PSR is currently a reasonable 1.1, according to Morningstar data; several sources had it below 1.0 last winter.)

Let's take a look at some stocks that pass my Fisher- or O'Shaughnessy-based models to get a better idea of how these two investing greats incorporated the PSR into their approaches.

Waste Services Inc.

Friday's close $9.56 U.S., down 38 cents

This Burlington, Ont.-based solid-waste management firm operates throughout Canada, as well as in Florida. It gets high marks from my O'Shaughnessy-based model, in large part because its 1.1 PSR (using trailing 12-month sales) easily comes in under this approach's 1.5 upper limit. In addition, the $460-million (U.S.) market capitalization firm has two other qualities the O'Shaughnessy growth approach likes: It has raised its EPS in each year of the past half decade, and it has a solid relative strength of 71.

Apogee Enterprises Inc.

Friday's close $15.54 U.S., up 19 cents

Based in Minnesota, this small-cap ($429-million) makes a variety of glass and acrylic products used in construction, picture frames and commercial optics, and it gets strong interest from my Fisher model. Mr. Fisher used a couple of different PSR standards depending on the company's industry, which my model reflects. For non-cyclicals, it targets stocks with PSRs below 1.5, and preferably below 0.75 (using trailing 12-month sales).

But for basic industry-type firms ("smokestacks"), Mr. Fisher looked for lower PSRs, since they tend to have lower margins and slower growth. This model wants smokestacks to have PSRs below 0.8, and preferably below 0.4. Apogee falls into this "smokestack" category, and its 0.57 PSR makes the grade.

My Fisher-based model also likes Apogee's 2.4 per cent debt/equity ratio, 38.7 per cent long-term inflation-adjusted growth rate, and $1.84 in free cash per share.

Dresser-Rand Group Inc.

Friday's close $32.94 U.S., down 18 cents

This Houston-based mid-cap ($2.7-billion) supplies products for the oil, gas, petrochemical and processing industries. It's another favourite of my O'Shaughnessy-based growth model, with a strong PSR of 1.1. It has also raised its EPS in each of the past five years, and has a solid relative strength of 73, two more reasons the O'Shaughnessy approach likes the stock.

Disclosure: I'm long Apogee Enterprises and Dresser-Rand Group.

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