Sunday, February 7, 2010

Conservative Investors Sleep Well: Chapter 3

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 the expanded version of this book, which includes 2 other works by Fisher including "Conservative Investors Sleep Well" and "Developing an Investment Philosophy".

Having covered the essential elements of a conservative investment, along with a discussion of the people required to achieve those elements, Fisher now discusses a third dimension of a conservative investment: is the company in an industry with economics that are favourable to its firms? If the company cannot do anything that others cannot quickly and easily copy, the company will see its profits erode.

High profit margins attract competition. To protect itself from competition, a company must operate so much more efficiently than others that there are no incentives for current or potential competition to upset the situation. Some industries lend themselves to making this a possibility far more than do others.

One characteristic that can help a business stay number one is an economy of scale. In some lines of business, producing more units can lower the average cost per unit, whereas in others higher production rates can make little difference in average cost. Since larger companies are more difficult to manage efficiently, the advantage of scale will only exist if the larger company is exceedingly well-run.

In certain industries, companies can also have advantages if they are first to the market. Once this is done, it becomes very difficult for a competitor to displace the innovator. The first to market can thus end up with a disproportionately large share even when competitors exist. Fisher uses the pharmaceutical industry as an example of where this advantage can exist.

There are other more unusual ways for companies in certain industries to sustain advantages. For example, a company may have products that are difficult/uneconomical for the customer to switch from, resulting in a consistent stream of re-orders. Fisher discusses the criteria required for this to occur with an example in the electronics industry.

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