Saturday, January 16, 2010

Common Stocks And Uncommon Profits: Chapter 6

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

Now that Fisher has discussed when a stock should be bought, he now discusses when it should be sold. There can be good personal reasons for selling a stock (purchasing a home, financing a business etc.), but Fisher focuses on the financial reasons for selling, of which he claims there are but three.

First, an investor should sell if he has made a mistake. Unfortunately, it is difficult for the investor to admit a mistake to himself. Furthermore, the investor is often willing to sell a mistake at a small gain, but he is loathe to do so even for the smallest of losses. Illogical behaviour of this sort can cost the investor dearly, for small losses remove little from a portfolio which should gain hundreds of percent over many years, but they can prevent an investor from allocating his capital to the stocks which will perform best in the future.

The second reason an investor should sell is if the company no longer exhibits the factors that made it a buy in the first place - namely, the fifteen items listed in Chapter 3. This can happen because management has become complacent, management has changed (and the new management no longer or is incapable of following the policies of the previous management), or the company is so large that it has run out of growth prospects. No matter how large the capital gain tax may be or how great the outlook for the company is, Fisher advises the investor to sell in such a circumstance.

The final reason the investor should sell is if there is a better opportunity in which to invest. A company that will grow earnings 15% annually for several years is great, but pales in comparison to the potential returns from a company that will grow earnings 20% annually for several years, even after taking into account the capital gains tax.

Fisher also warns investors not to sell simply because the price has advanced, or because it appears overvalued (when a company its growing earnings quickly, why pay the tax when its earnings will catch up to its premium in just a couple of years?), or because a bear market is expected (as these are impossible to predict).

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