In this next chapter of Mosaic, Mohnish Pabrai examines the price to sales ratio and the financial shenanigans of Computer Associates (CA). Pabrai begins “Computer Associates – A Good Business Model Gone Awry” with a discussion of James O’Shaughnessy’s book What Works on Wall Street.
Using a 40 backtest of S&P Compustat’s, O’Shaughnessy’s found that all stocks as a group returned an average annualized return of 12.45% from 1954-1994. However, he found that if you only invest in stocks with a price to sales ratio less than 1 and rebalancing annually that annualized average returns increased to 18.14%. The P/S ratio might be have been better than using the P/E ratio, because earnings are often manipulated, but sales numbers are harder to fudge.
However, Computer Associates (CA) found a way to fudge both of these value ratios. The company manipulated its software sales numbers by recording part of it as license fees and part as maintenance fees. There was a huge gap between revenues booked and cash received.
Pabrai asks the following questions when looking at companies:
- What are its revenues and market cap?
- What is its expected future free cash flows?
Computer Associates’ 10-Ks and 10-Qs gave Pabrai a headache when he tried to understand them. As you might remember from “On Avoiding Enron-itis!” not being able to understand a financial statement is a serious red flag.
On its face, CA had a simple and effective business model. It bought up software companies, removed expensive senior management, and then milked the software maintenance fees. This is a vulture business model and it can be effective.
It is extremely hard for large companies to change vendors quickly, so many were locked into the maintenance fees. After a while, a Fortune 500 company figured out a way to prevent getting caught in the CA maintenance trap by requiring cheap software keys to include a clause that would require the reimbursement of all investment in the software if the vendor ever gets acquired by CA.
I’m a bit surprised that Pabrai likes the price to sales ratio. I’ve read several studies that indicate that the price to sales ratio is that that effective anymore since O’Shaughnessy’s book was written. I found this to be one of the weaker chapters of Mosaic. I recommend reading many of the earlier chapters however. You can read most of them for free online by visiting my collection of links called Poor Man’s Mosaic.