Sunday, February 14, 2010

Conservative Investors Sleep Well: Chapter 5

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".

Fisher continues with his discussion of what he calls the fourth dimension of a conservative investment: its price.

So far, Fisher has only discussed company-specific factors in determining the financial community's appraisal of an investment. However, Fisher notes that there are two other appraisals that can have a strong effect on a company's price: the financial community's appraisal of both the industry and of stocks in general.

Of course, as an industry matures, the P/E ratios of companies within it are expected to fall. But Wall Street's industry appraisals often overreact; at times, the financial community is overly positive, while at other times it is too negative.

Industry conditions do not change so quickly, but the financial community's appraisal does! Since the conditions prevailing in the industry do not change, Fisher believes it is the conditions that are emphasized that change, and thus the P/E ratios for industries can move dramatically.

To illustrate this point, Fisher discusses a few examples in the chemical and electronics industries, where Wall Street's emphasis shifted once and then back again, offering the investor opportunities to profit. In the chemical industry, for example, innovation can result in cheaper or higher quality materials or substances that can result in new and larger markets. At the same time, however, many chemical components can be replicated, and bouts of overcapacity can thus result in price wars and margin erosion. These properties of the industry don't change considerably over time, but the appraisal of the industry can change dramatically.

The challenge for investors is to determine whether Wall Street's appraisal of an industry is on the money, or too low or too high. Only then can the investor accurately predict the future direction of the market price.

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