Saturday, March 6, 2010

Developing An Investment Philosophy: 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".

This final chapter focuses on whether the market is efficient. Fisher is clearly in the "no" camp, though he notes that this philosophy has been gaining steam. He agrees that it is very difficult to make short-term profits and gain quickly from new, public information. However, for long-term investors he argues that the market is not even close to perfect.

To illustrate his point, Fisher points to the distribution of returns of various stock indexes. While the indexes themselves may move small amounts from day-to-day as the outlook for business conditions changes, individual stocks have far larger distributions of returns. Over five-year periods, the returns on an index may seem reasonable, but around 10% of stocks will show gains of thousands of percent. Fisher believes prudent investors can uncover at least some of these special stocks, leading to outsized profits in the long run.

As an example, Fisher takes the reader through a few years comparing the operations to the stock price of a company called Raychem Corporation. This was a company that only undertook projects if it could be the industry leader and if it possessed some knowledge or advantage that would make it difficult for competitors to copy. The company traded at 25 times forward earnings in 1975, as new products were expected to grow earnings in the years to come.

After a single major new product failure (resulting in a write-off that hurt earnings), followed by an unrelated restructuring meant to improve profitability, the stock dropped to one third of previous value over the course of a single year. Raychem management was upfront about both the positives and negatives facing the business, and yet the stock price stayed low, much to Fisher's bewilderment. Eventually, the price recovered. Fisher believes this to be a perfect example, though only one of many, of how the market is clearly inefficient.

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