Saturday, February 27, 2010

Developing An Investment Philosophy: Chapter 2

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".

In this chapter, Fisher discusses how his investment philosophy has changed over time as he has learned from experience. Fisher shares some of his learnings, as well as some corollaries of those learnings which can be of use to investors.

First, Fisher has a three-year rule when it comes to selling investments. Unless he uncovers information which makes him doubt his original thesis, Fisher will not give up on a company before this time. However, if a company has not fulfilled its promise after three years, he will sell it immediately. Too often, he has seen companies underperform for a year or more, but when the gains do arrive, they come quickly and to a large extent. Rarely will it get to a point where Fisher has to sell after three years; this is not because all his investments pay off handsomely, but rather as a result of the fact that he will often uncover information that is not to his liking before that time is reached.

After a couple of early mistakes, Fisher vowed never to invest significantly in a company without getting to know its management first. There are two traits Fisher believes make for a top-notch management. The first is business skill. For superior business skill, management must not only be above-average handlers of the company's day-to-day tasks (e.g. finding more efficient ways to produce, managing receivables with sufficient diligence etc.), but must also have the ability to look ahead and make long-range plans that will produce future growth without taking huge financial risks. The second trait management must have is integrity, as they will always be closer to the business' affairs than stockholders.

Many are of the view that to make the most money in the market, one must be a contrarian, zigging when the market zags. However, this is not enough: the contrary opinion must also be correct. Simply going against the prevailing opinions will not result in outperformance, and can result in detriment. For example, as it became obvious that the automobile would replace the streetcar, shares in the latter sold at ever-lower P/E values; nevertheless, it would have been costly to buy these securities simply on the grounds that they were not favoured by the market. It is for this reason that Fisher came up with the three-year rule, as a quantitative check to stop him from continuing to be go against the market for too long.

Fisher has also played around with market timing. However, he found that the gains that were to be made (if there were any) were small relative to what could be made from trying to find the truly homerun stocks that are out there.

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