Saturday, February 13, 2010

Conservative Investors Sleep Well: Chapter 4

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".

After discussing the three essential dimensions that make a stock worthy of investment, Fisher now discusses Dimension #4: the investment's price. Fisher's explanation of why stock prices change is as follows:

"Every significant price move of any individual common stock in relation to stocks as a whole occurs because of a changed appraisal of that stock by the financial community."

For the companies in which Fisher is interested, the "appraisal" is most easily measured in the price to earnings ratio the market accords a particular stock. Fisher looks for price appreciation in two ways: first, from growth in the company's earnings, and second, from the increase in the stock's P/E ratio. Fisher offers that the latter source of appreciation can often play the larger role in a stock's price appreciation.

Fisher argues that there are wide variations between the financial community's appraisal of a stock and the true set of conditions surrounding it. Sometimes, this divergence can last for a few months, while at other times it can persist for years. When this divergence exists, the investor should take advantage of the situation.

The lowest risk investment opportunity exists when a company measures high in regard to the first three dimensions, but has a lower P/E than fundamentals warrant. Next risky, though still suitable for investment, are companies that again rate high on the first three dimensions, and have a P/E in line with these fundamentals. If a company truly has the desired attributes of the first three dimensions, the stock shall nevertheless appreciate in price.

The most dangerous group of stocks are those with a financial-community appraisal far higher than is justified by the fundamentals. Purchase of these shares cause sickening losses and can cause individuals to avoid stock ownership in droves. There are many such examples, and Fisher goes on to name a few.

Fisher continues his discussion of the right price at which to buy a stock in the next chapter.


Rayhaan said...

Hey saj, how does one determine the correct p/e ratio in line with the buisness s fundamentals? Are their certain conditions say like p/e below 2 and d/e below .4 and a stable industry like for eg food products which may unquestionably qualify as a gr8 investment? By the way just saw it right now u ve crossed the 1000 mark, cool!

Ankit Gupta said...

You made a good point that it might depend on the industry. Some industries are cyclical by nature and so they can easily become a value trap if their P/E ratio is low, 4-6, but is only possible due to something like large amounts of debt.

If I were you, I'd focus on the entire valuation, and study what affects the industry. The question isn't, would I buy Google at a 10 P/E ratio, or at $X/share, but rather, would I buy Google entirely for $170 Billion if I had the money?

If you want to learn about cyclicality, look at the auto industries and how they've used debt for so long... specifically, GM.

Saj Karsan said...

Hi Rayhaan,

In addition to Ankit's comments I would say that you can never tell if an investment is unquestionably a good investment based on P/E and D/E, because there are too many details that must be investigated.

Thanks for your note! Hopefully we'll cross 1100 soon!

Rayhaan said...

thx for the advice guys!
hey ankit do u too invest for a living?
(ps for purely selfish reasons i hope the growth is restricted otherwise i guess the individual advice might just fade away!lol)
by the way u dont tell us about arbitrage situations are they that risky or unworthy as investmenrs?

Saj Karsan said...

Hi Rayhaan,

I generally don't feel comfortable estimating a probability that a merger will go through. However, when both the target and the acquirer are potential value investments, I've found them to be worth discussing.