Common Stocks And Uncommon Profits: Chapter 10

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 this work by Philip Fisher, known as one of the greatest investors of all time.

In most of the letters Fisher receives, the public asks him how he goes about finding stocks that are worth investigation. As a result, in this the final chapter, Fisher discusses where his investment ideas come from.

Previously, Fisher used to believe that the best source for investment ideas came from his executive contacts. However, after doing a quick study, Fisher now realizes that only 1/5 of the ideas that he fully investigated and only 1/6 of his total investments came from this source. The rest of his ideas have mostly come from hearing about the investments of other investors whom Fisher respects. Very rarely will Fisher find ideas in the print media.

Once a company has been uncovered that is worth further investigation, Fisher applies the scuttlebutt method as discussed in Chapter 3. Fisher stresses that it is of the utmost importance to investigate the company in this manner before meeting with management. Since an investor will not get a useful reply, no matter how candid is the management, to the question "Is there anything else I should know about your company?", the investor must know what questions to ask about the company's weaknesses beforehand. Good managements will often speak candidly if the investor shows he has done his research and has judged the company well.

Fisher also argues that it is important to meet the key decision makers, but because the demands on the time of these people are so high, companies will only let investors who they feel are competent take up the time of these valued managers. Therefore, having done the research as per the previous paragraph, investors must approach management in a manner that makes them believe the investor is competent. An investor who shows up at the door unannounced, for example, is likely to meet a member of the investor relations department rather than a key decision maker. An introduction through the company's commercial bank, investment bank, or important customers or suppliers is a great way for the investor to ensure he will meet the right people.

Common Stocks And Uncommon Profits: Chapter 9

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 this work by Philip Fisher, known as one of the greatest investors of all time.

This chapter contains 5 more "don'ts" for investors:

1) Don't be too diversified

The benefits of diversification are overstressed, in Fisher's opinion. However, the drawbacks are not. Fisher recommends that the investor know his companies well, and having too many companies can prevent this from occurring. Large companies operating in several business lines are already diversified, and therefore if a portfolio is made up of only these types of businesses, where no product lines between the companies overlap, Fisher recommends investors need only 5 stocks to be diversified. At the other end of the spectrum, if the investor has a portfolio of only small stocks in single product lines, Fisher recommends putting no more than 5% of one's portfolio in any one stock.

2) Don't be afraid to buy on a war scare

The threat of war causes investors to ignore fundamental economics in forming their stock quotations. As such, investors should take advantage of such opportunities in order to buy stocks during these temporary dips.

3) Don't be influenced by what doesn't matter

Investors will frequently be influenced by a company's past share price, and its past P/E ratio, and make assumptions about the company's future valuation based on the past. Fisher argues that past valuation levels are not relevant, and the investor should always be forward looking in order to determine what a company is worth.

4) Don't fail to consider the right time to buy a growth stock

Fisher admits that the practice he recommends in this section may be controversial, but he believes timing, and not just price, should be used when purchasing a stock that is trading at a rich value. If a stock passes the 15 tests of Chapter 3, it may be at a price that, while not unattractive, commands quite a premium to the market. Fisher suggests that in this case the investor wait in order to buy at a later date.

5) Don't follow the crowd

This is not easy for the investor, since we are all influenced by the world around us. However, Fisher urges the investor to see through the waves of optimism and pessimism that take turns over the market and over specific industries. These waves will inflate and deflate P/E ratios, offering investors opportunities for profit.

Common Stocks And Uncommon Profits: Chapter 8

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 this work by Philip Fisher, known as one of the greatest investors of all time.

This chapter contains 5 "don'ts" for investors:

1) Don't buy unestablished companies

The temptation is there to buy brand new companies with little operating history, since investors who wait for these companies to become established will have to pay several times the price. Fisher argues that there are too many potential points of weakness for companies without a few years of sales and without at least one full year of operating profits.

2) Don't ignore a stock just because it is "over the counter"

Fisher argues that the rules for over-the-counter stocks are not too different from those on the exchange. If a great company can be found, the investor should not disregard it simply because it is not traded on an exchange.

3) Don't buy a stock because of the "tone" of its annual report

A company's annual report can appear upbeat simply because of the skill of its investor relations group. Investors are encouraged to see the facts that are often hidden between the colourful pictures and rosy language. When reports fail to give information on matters of real significance to the investor, the stock should not be considered for investment.

4) Don't assume that a stock's price already discounts high future earnings growth

In some cases, a stock may trade for twice the P/E of the market because earnings are expected to increase relative to the market. In such a case, analysts will often say the stock price discounts the future earnings growth. Fisher cautions the investor from this line of thinking. Because the investor is seeking out companies (as per Chapter 3) that continue to bring new products to market or find new markets for products, these companies should continue to grow. As such, there is no reason why these companies should always have a P/E that is much higher than the average company.

5) Don't quibble over the ask price

In some cases, investors will be unwilling to pay the market's asking price, and will therefore issue limit orders. In order to save a few bucks, the investor may cost himself dearly over the long term. If a company is a great company suitable as a long-term holding, the potential gains far outweigh the few dollars potentially saved by holding out for a better price. It is best not to take the chance that the issue will never be purchased.

Common Stocks And Uncommon Profits: Chapter 7

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 this work by Philip Fisher, known as one of the greatest investors of all time.

In this chapter, Fisher discusses whether dividends are important in stock selection. Fisher believes the public's thinking to be a little twisted and contain a number of half-truths when confronting the topic of dividends.

If managements are building up excess liquidity or generate sub-optimal returns on investment, Fisher absolutely believes that shareholders are better off if dividends are paid. However, the focus of the book has been on investing in the type of company that is generating excellent returns and with competent management; therefore, for the companies under consideration, these would not be issues.

Continuing with the assumption that this discussion is meant for holders of stocks which pass the 15 items listed in Chapter 3, for investors who are currently net buyers of common stock, Fisher finds it bewildering that they would find the idea of a dividend appealing. Presumably, they have invested in a great company, so it is strange that they would be willing to pay a tax, and then re-invest the lower proceeds, whether with the same company or elsewhere. Even pension funds, who do not pay tax, have to pay for the effort and transaction costs of investing the proceeds, when the funds could be utilized by the company with high rates of return.

Fisher recommends that management pay out a percentage of earnings, and stick to that, slowly and consistently raising it as earnings increase. In that way, they will attract the investors that are interested in that dividend rate and who can count on the income they require. For investors, however, Fisher believes that the dividend policy should be the least of their concerns.

Common Stocks And Uncommon Profits: Chapter 6

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 this work by Philip Fisher, known as one of the greatest investors of all time.

Now that Fisher has discussed when a stock should be bought, he now discusses when it should be sold. There can be good personal reasons for selling a stock (purchasing a home, financing a business etc.), but Fisher focuses on the financial reasons for selling, of which he claims there are but three.

First, an investor should sell if he has made a mistake. Unfortunately, it is difficult for the investor to admit a mistake to himself. Furthermore, the investor is often willing to sell a mistake at a small gain, but he is loathe to do so even for the smallest of losses. Illogical behaviour of this sort can cost the investor dearly, for small losses remove little from a portfolio which should gain hundreds of percent over many years, but they can prevent an investor from allocating his capital to the stocks which will perform best in the future.

The second reason an investor should sell is if the company no longer exhibits the factors that made it a buy in the first place - namely, the fifteen items listed in Chapter 3. This can happen because management has become complacent, management has changed (and the new management no longer or is incapable of following the policies of the previous management), or the company is so large that it has run out of growth prospects. No matter how large the capital gain tax may be or how great the outlook for the company is, Fisher advises the investor to sell in such a circumstance.

The final reason the investor should sell is if there is a better opportunity in which to invest. A company that will grow earnings 15% annually for several years is great, but pales in comparison to the potential returns from a company that will grow earnings 20% annually for several years, even after taking into account the capital gains tax.

Fisher also warns investors not to sell simply because the price has advanced, or because it appears overvalued (when a company its growing earnings quickly, why pay the tax when its earnings will catch up to its premium in just a couple of years?), or because a bear market is expected (as these are impossible to predict).

Common Stocks And Uncommon Profits: 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 this work by Philip Fisher, known as one of the greatest investors of all time.

This chapter is titled "When To Buy" as, having established that a stock is a winner (using the criteria from Chapter 3), the investor must now decide when to buy. Fisher notes that even purchases of extraordinary companies at the market heights of 1929 would have yielded handsome returns 25 years later, however, the largest returns are only possible when some thought is put into purchasing at the right time.

While many in the industry determine when to purchase stocks by studying economic conditions and trends and deriving forecasts from this data, Fisher does not believe this actually works. Economist opinions vary wildly from year to year, and even the most convincing of arguments often turn out to be wrong. As such, Fisher advises that investors should not time their purchases based on the economic outlook.

Instead, Fisher advises that investors tailor their timing to oppose market sentiment of the individual securities under consideration. For companies on the cutting edge, it is inevitable that there will be some failures: a new product may not produce strong sales, a new plant may be more expensive than expected or behind schedule. Often, the market will produce pullbacks in the price of the security. When the problem a company is encountering will take months to overcome (as opposed to years), the market price will often drop. It is at these points that Fisher advises the investor to jump in.

Common Stocks And Uncommon Profits: 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 this work by Philip Fisher, known as one of the greatest investors of all time.

In this chapter, Fisher discusses tailoring one's investment strategy to one's individual financial situation. There should be no doubt, however, that Fisher recommends growth stocks for all types of investors. While one can make good money investing in "bargains" rather than growth stocks, the relatively small upside of 50% does not give investors the triple-digit returns he enjoys from some of his growth stock investments.

Therefore, the decision the investor has to make has to do with the type of growth stock that should be bought. In this regard, Fisher comes up with two categories of growth companies. Those that are large and continue to grow (at the time of writing, these included stocks such as IBM, Dow and DuPont), and those that are as yet undiscovered by the institutional investors. Fisher notes that the undiscovered stocks have the most potential for excellent returns (on the order of thousands of percent), but at the same time he acknowledges that any one of them could turn out to be a dud and cost the investor his entire investment. Therefore, for those that have a stronger requirement to maintain their capital base, Fisher suggests the larger companies for their safety, and the fact that their upside should continue to be strong relative to the market. For those that can take more risks, Fisher advises a small-cap portfolio of the type of growth stocks that pass the tests of Chapter 3.

Fisher also recommends that investors who do not have the time to go through the steps outlined in Chapter 3 use a money manager. However, it is still important for such investors to understand the issues involved, so that they may ask the right questions of their manager. Noting that there are many incompetent managers, Fisher discusses some important aspects in choosing a strong manager, including a good track record, a comparison of this track record to the market, and a discussion of the manager's investing philosophy.

Common Stocks And Uncommon Profits: Chapter 3, Part 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 this work by Philip Fisher, known as one of the greatest investors of all time.

The following criteria conclude the list of items Fisher requires for stocks with outstanding returns:

13) Will substantial equity dilution be avoided to finance the business' growth?

A company that meets the tests of the other 14 criteria is one that will be able to borrow money to fund growth. However, debt levels will at some point hit a maximum level, which is determined by the type of business carried out. Therefore, if a company is already at a high debt level, equity financing might be employed. The investor should determine the attractiveness of the company after carefully calculating the results of dilution of the company's stock.

14) Does management continue to speak freely to investors when disappointments occur?

For even the best run companies, failures and disappointments occur. The firms showing the greatest gains are those which are always developing new products. Inevitably, some of these will not turn out as well as expected. How management reacts is what's important for the shareholder. If management "clams up" because it does not have a plan, or if management panics, the investor should exclude the company from investment.

15) Does management have unquestionable integrity?

Managements are always in a position such that they may enrich themselves at the expense of shareholders. They are closer to the assets than shareholders, and as a result are granted leeway that can be legally abused in an almost infinite number of ways. For example, they can put relatives on the payroll and pay them salaries above market value. Furthermore, they can lease assets to the corporation at above-market prices. Investors must confine investments to companies where managements are of the highest integrity. Fisher recommends the "scuttlebutt" technique (discussed in Chapter 2) for confirming that management has the necessary integrity.

Common Stocks And Uncommon Profits: Chapter 3, Part 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 this work by Philip Fisher, known as one of the greatest investors of all time.

The list of criteria to look out for in order to find home-run stocks continues:

10) How good is the company's cost analysis?

A company cannot have continued outstanding success unless it can accurately break down its costs by product and also at each step of its production process. If a company has weak product costing, products which the company thinks are wildly successful might actually be losing money. Fisher acknowledges that it is rather difficult for the investor to determine the efficiency of a company's costing, however. The "scuttlebutt" method (described in earlier chapters) will work only in identifying companies which are really deficient. Management will also sincerely believe the existing methodology is fine, and therefore little info can be gleaned on this subject from company personnel. Fisher suggests the best the investor can do is recognize the importance of this subject along with the limitations in making an accurate appraisal of the situation.

11) Are there other clues (perhaps industry related) which show the company to be outstanding relative to its peers?

This is a catch-all question, as items which are important in some industries are of no importance in others (e.g. for a retailer, real-estate management and/or leasing costs can make or break a company, but are of little importance in most industries). One useful barometer Fisher uses to compare companies within the same industry is insurance costs. Not only can lower insurance costs lead to larger profit margins in many industries, but they offer a clue as to how well management handles people, inventory and fixed assets in order to minimize waste, damage and accidents. The "scuttlebutt" method is useful in identifying such differences.

12) Does the company maximize long-term or short-term profits?

Some companies will try to gain the greatest possible profit right now, while others will build up good will and thereby gain more in the future. The "scuttlebutt" method is useful here in gleaning information from vendors and suppliers. Does the company force suppliers to offer the lowest possible price, or will it at times pay above contract in order to secure a strong partnership and a dependable source of future supply? Will it help out a customer in a jam, even when not required to do so? This may hurt current profits, but sets the company up for a strong future.

Common Stocks And Uncommon Profits: Chapter 3, Part 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 this work by Philip Fisher, known as one of the greatest investors of all time.

The list of criteria to look out for in order to find home-run stocks continues:

7) Does the company have outstanding labour relations?

Fisher believes that most investors do not fully appreciate the benefits of strong labour relations. While strikes clearly temporarily disrupt production, the benefit of excellent labour relations is far greater than the direct cost of strikes, for if workers feel fairly treated, the company is in a much better position to increase worker productivity.

Unfortunately, there is no easy way to identify whether a company has strong labour relations. But there are some insights an investor can gain. For example, if labour has not been unionized, this may be a clue that workers have not felt the need for union protection. Worker turnover, and the size of job applications relative to other firms can also be useful hints for the investor. The investor should also consider the behaviour of top management towards rank-and-file employees (e.g. are there mass layoffs whenever a small change in sales is anticipated?).

8) Does the company have outstanding executive relations?

The right atmosphere among executive personnel is vital, as the management team's ingenuity and judgement will make or break any venture. Executives should have confidence in their president and chairman. Promotions should be made on the basis of ability, not factionalism or family. Outsiders are brought in only if there is no possibility of finding someone who can be promoted into that position. The investor can usually learn about executive relations by chatting about the company with a few executives scattered across different levels of responsibility.

9) Does the company have management depth?

A one-man management can do very well for several years, but all humans are finite. A corporation with no plan in the event of a corporate disaster could find itself in trouble. Companies worthy of this type of investment are ones which will continue to grow for many years. To develop management depth, authority must be delegated so that managers down the line are given the real authority to apply themselves and grow as managers. Where top brass continually interfere in day-to-day operating matters, strong managers are unlikely to be developed.

Common Stocks And Uncommon Profits: Chapter 3, Part 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 this work by Philip Fisher, known as one of the greatest investors of all time.

Fisher continues to list off more of the 15 properties he believes investors should look for in order to identify the stocks with the potential for astronomical returns:

4) Does the company have an above-average sales organization?

Fisher calls the making of repeat sales to satisfied customers the first benchmark of success. But investors pay far less attention to whether a sales staff is efficient than they do to research, finance, production or other corporate activities. Fisher attributes the reason for this to the lack of financial ratios that can be applied in order to measure the quality of a sales staff. But the information is available in a qualitative sense using the "Scuttlebutt" method Fisher described earlier in the book. Competitors and customers know the efficiency of the sales staff, and they are often quite willing to express their views on the subject.

5) Does the company have a worthwhile profit margin?

Fisher believes that the greatest long-range investment profits are made by investing in the companies with the highest profit margins in the industry. There are some caveats to look out for though. Margins should be looked at over a period of many years, since temporary effects can abnormally lower or raise a company's margins. Furthermore, fundamental changes may be occurring in a company (new product, increase in efficiency) with low margins that will turn it into a company with high margins; these may be unusually attractive purchases. Finally, some companies have low margins because they plow a lot of their profits into research and sales, so they are actually building for the future. Investors counting on this to be the case must make absolutely certain that investing for the future is indeed the real reason for the low margins.

6) What is the company doing to improve margins?

Inflation will continue to increase the costs of most companies, but companies of different abilities will see varying results in their profit margins over time. Some companies have the ability to increase price in order to maintain or increase margins. Fisher argues that this only encourages new competitive capacity, and therefore only temporarily increases margins. But some companies use far more ingenious means to increase margins. Some corporations have departments whose sole function is to review procedures and methods in order to find savings. "Scuttlebutt" will not work as well as speaking to company personnel directly about the amount of work being done by the company in this area. Fisher argues that the investor is fortunate that most top executives are willing to talk in detail about such topics, however.

Common Stocks And Uncommon Profits: Chapter 3, Part 1

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 this work by Philip Fisher, known as one of the greatest investors of all time.

In this chapter, Fisher tells the reader how to determine if a company is one which will produce the outstanding returns alluded to in the previous two chapters. There are fifteen questions about each company under consideration that must be answered. If the answer is yes for most of them, the stock could very well be a super-performer. On the other hand, if the answer is no for many of them, Fisher considers it unlikely that the stock can generate the outstanding returns required. The idea is to separate the companies that are "able" from those that are fortunate, as the ones that are able will continue to prosper long after the ones that are fortunate have seen their growth stall.

The first three criteria are covered in this post, with the remaining twelve covered in subsequent posts:

1) Does the company have the market potential to grow sales for at least several years?

Here, Fisher is not interested in market conditions which offer the potential for a large surge in sales, even for years at a time. While he acknowledges that profits can be made from investing in such companies, these are not the home-run type companies he is looking for. For this to be possible, management must be skilled, and is always growing markets and product lines such that sales continue to increase even as its industries mature. An example of such a stock Fisher picked out in the 1950s is Motorola; he goes on to describe why Motorola fit this description and turned out to be the winner that it did.

2) Does management institute policies that that result in newly developed products?

Fisher stresses that this is not the same question as the one above. While the previous question has a factual answer, this question is related to management attitude. In other words, does management recognize that existing products will eventually reach their market potential?

3) How effective is the company's research and development?

Does management make the investments in R&D necessary to keep the company's growth trajectory high? Here, Fisher notes that it is not just the amount of R&D that is important (as a percentage of sales), but how well the processes are managed, how well the teams are motivated, and how well the research processes are integrated with the sales team. Fisher also believes that companies with research efforts in areas where the company already has a successful product have the most promise for future returns, as opposed to research in areas in which the company has no existing expertise. Furthermore, stability in funding research products is also important; companies that cut R&D at the bottom of the business cycle pay far more in the end than those who stay committed throughout, even if they need to use a business cash advance.

Common Stocks And Uncommon Profits: 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 this work by Philip Fisher, known as one of the greatest investors of all time.

Knowing that, as established in the first chapter of the book, the investor's goal is to find the incredible companies that will generate outstanding returns, Fisher describes two approaches for achieving this goal: the investor may hire someone to investigate potential companies, or he may follow what Fisher calls "Scuttlebutt".

Fisher strongly recommends the latter approach, as while the first approach sounds reasonable, in practice it does not work out well. For one reason, it takes an enormous amount of skill to find such companies, and those who have such skill will already have top managerial positions that pay well enough such that this venture would not interest them. Furthermore, it's doubtful that companies would allow anyone access to the information that is required to properly determine the company's potential position.

The "Scuttlebutt" method takes advantage of the business grapevine. Gathering a cross-section of opinions from various stakeholder groups of particular aspects of the company under study is immensely useful. Fisher recommends investors speak to competitors, suppliers, customers, researchers, trade associations, employees and former employees.

Fisher recognizes that most investors will have neither the time nor the inclination to go through the process described above. Nevertheless, he stresses that just knowing the relevant sources of information will be useful to the investor, so that at the very least he may ask the right questions of his financial advisor.

Common Stocks And Uncommon Profits: Chapter 1

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 this work by Philip Fisher, known as one of the greatest investors of all time.

Fisher starts the book with the results of some of his research. While investors put great effort into timing the business cycle, the best returns in the market come from finding the great companies and holding them for many years. These companies were available year after year at attractive prices; in other words, it was not necessary to buy these companies during wide market panics. But for every company that generated such phenomenal returns, there were several times as many with average or below-average returns. As such, what was required was to be able to identify which companies could generate the uncommonly outstanding profits.

Fisher then moves to a discussion of whether such stocks will continue to exist. On this point, Fisher argues that stock investors have reason to be even more optimistic in the future as compared to the past, and for more than one reason.

First, more than ever before, corporate managements conduct themselves in a manner that is positive for shareholders. Never before have managements been so willing to seek outside advice, institute succession plans, self-analyze, and implement the most up-to-date practices. In the past, companies were closely held and managers were entrenched, with insiders taking advantage of minority stockholders.

In addition, corporations plow more money into research than they ever have before. These investments have borne fruit in the fact that a larger percentage of sales continues to come from products that did not exist only three years ago.

Finally, as compared to the first several decades of the last century, governments have shown an increased willingness to ensure that depressions to do not occur. Governments will go into deficit, and even bail out industries to ensure that business conditions are satisfactory.

All of these points bode well for the future of stock investment. With this strong future, combined with the knowledge that the investor must, either by luck or skill, identify the stocks that will generate abnormally high returns, Fisher takes the reader into Chapter 2.