Thursday, 30 September 2010

Common Stocks and Uncommon Profits by Philip Fisher (Summary)

Common Stocks and Uncommon Profits
by Philip Fisher
By Kenneth L. Fisher (Philip Fisher’s Son)
Ken Fisher credits his father for teaching him the "craft" of investing. He writes that, "It’s the difference between learning to play the piano (craft) and then composing (art)." Indeed Ken’s own investment practice—his art— deviates from his father’s preference for growth stocks; Ken prefers value-oriented investments. But the process Ken uses to arrive upon investment decisions is largely based on his father’s tenets of "scuttlebutt" and "the fifteen points." As the son now runs a large investment management company he uses these principles en mass. He also believes his father’s ideas about undue diversification, in particular, influenced Buffett.
Phil Fisher went to Stanford and started work as a security analyst in San Francisco in 1928. He formed his own firm, Fisher & Co., in 1931. After some years in the game he decided to write this book, "In studying the investment record of both myself and others, two matters were significant influences in causing this book to be written. One, which I mention several times elsewhere, is the need for patience if big profits are to be made from investment. Put another way, it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens. The other is the inherently deceptive nature of the stock market. Doing what everybody else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all."

Fisher summarizes his conclusions from the past in the following paragraph, "Such a study indicates that the greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole. It further shows that when we believe we have found such a company we had better stick with it for a long period of time. It gives us a strong hint that such companies need not necessarily be young and small. Instead, regardless of size, what really counts is a management having both a determination to attain further important growth and an ability to bring its plans to completion…It makes clear to us that a general characteristic of such companies is a management that does not let its preoccupation with long-range planning prevent it from exerting constant vigilance in performing the day-to-day tasks of ordinary business outstandingly well."

Merriam-Webster defines "scuttlebutt" as:
1, a : a cask on shipboard to contain freshwater for a day's use, b : a drinking fountain on a ship or at a naval or marine installation
Fisher makes use of definition 2 here in the second chapter. "It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company." Though he writes only three pages about scuttlebutt here, Fisher assures us the concept will be discussed in great detail all throughout the book.

Below you will find "The Fifteen points to look for in a common stock," Fisher’s famous checklist for the inquiring investor.
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
4. Does the company have an above average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company’s cost analysis and accounting methods?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regards to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the large number of shares then outstanding will largely cancel the existing benefit from this anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?

"The typical investor has usually gathered a good deal of the half-truths, misconceptions, and just plain bunk that the general public has gradually accumulated about successful investing." Fisher posits that the average investor believes only a bookish genius is capable of superior returns. He doesn’t agree with this mean mentality. "The most skilled statistical bargain hunter ends up with a profit which is but a small part of the profit attained by those using reasonable intelligence in appraising the business characteristics of superbly managed growth companies," he further expounds upon his view of apparent expertise, "Even among some of the so-called authorities on investment, there is still enough lack of agreement on the basic principles involved that it is as yet impossible to have schools for training investment experts…"

Contrary to Buffett, Fisher is looking for companies that "will have spectacular growth in their per-share earnings." (Buffett is primarily concerned with consistent and handsome returns on equity.) Buffett and Fisher do agree on the worthlessness of macroeconomic forecasting. Fisher writes, "The conventional method of timing when to buy stocks is, I believe, just as silly as it appears on the surface to be sensible. This method is to marshal a vast mass of economic data…I believe that the economics which deal with the forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages." Fisher prefers to buy into outstanding companies when their earnings are temporarily depressed, and so consequently is the share price, because of a new product or process launch. "In contrast to guessing which way general business or the stock market may go, he should be able to judge with only a small probability of error what the company into which he wants to buy is going to do in relation to business in general."

Fisher is very precise about when to sell. "I believe there are three reasons, and three reasons only, for the sale of any common stock which has been originally selected according to the investment principles already discussed." They are: 
1.) Upon realizing a mistake, 
2.) When a stock no longer meets the 15 points, and
3.) If a substantially attractive investment arises and stock needs to be sold to finance that investment.
Interestingly, Buffett’s commonly told parable about investing in your classmates seems to have originated out of this chapter. Both describe a hypothetical scenario of buying a percentage of the future earnings of a classmate. The point being that we should rationally select people on the basis of their character rather than purely on their intellect. Fisher notes how foolish it would be to sell your lucrative future contract on classmate’s earnings for the sake of buying another, less proven, classmate’s earnings, simply because somebody offered to buy your original classmate investment at a high price.

Fisher warns us to be wary of two scenarios when earnings are retained and no dividends are paid. 
  • The first is when executives pile up liquid assets for a sense of security. 
  • The second occurs when "substandard managements can get only a subnormal return on the capital already in the business, yet use the retained earnings merely to enlarge the inefficient operation rather than to make it better."
Fisher posits that "regularity or dependability" is the most important characteristic of dividends. He illustrates his claim using the restaurant parable that Buffett so often cites. "There is perhaps a close parallel between setting policy in regard to dividends and setting policy on opening a restaurant. A good restaurant man might build up a splendid business with a high priced venture. He might also build up a splendid business with an attractive place selling the best possible meals at the lowest possible prices. Or he could make a success of Hungarian, Chinese, or Italian cuisine. Each would attract a following. People would come there expecting a certain kind of meal. However, with all his skill, he could not possibly build up a clientele if one day he served the costliest meals, the next day low-priced ones, and then without warning served nothing but exotic dishes. The corporation that keeps shifting its dividend policies becomes as unsuccessful in attracting a permanent shareholder following. Its shares do not make the best long-range investments."

"1. Don’t buy into promotional companies."
"When a company is in a promotional stage…all an investor or anyone else can do is look at a blueprint and guess what the problems and strong points may be."
"There are enough spectacular opportunities among established companies that ordinary individual investors should make it a rule never to buy into a promotional enterprise."
Fisher wants to see a firm with at least one year of operational profit and two to the three years of business before investing.
"2. Don’t ignore a good stock just because it is traded ‘over the counter.’"
"3. Don’t buy a stock just because you like the ‘tone’ of its annual report."
"The annual report may…reflect little more than the skill of the company’s public relations department in creating an impression about the company in the public mind."

"4. Don’t assume that the high price at which a stock my be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been discounted already in the price."
"…why shouldn’t this stock sell five years from now for twice the price-earnings ratio of these more ordinary stocks just as it is doing now and has done for many years past?"

"5. Don’t quibble over eights and quarters."
"If the stock seems the right one and the price seems reasonably attractive at current levels, buy ‘at the market.’"

Given the recent terror and talk of war, we will focus on point two in this chapter.
"2. Don’t be afraid of buying on a war scare."
"At the conclusion of all actual fighting—regardless of whether it was World War I, World War II, or Korea—most stocks were selling at levels vastly higher than prevailed before there was any thought of war at all. Furthermore, at least ten times in the last twenty-two years, news has come of other international crises which gave threat of major war. In every instance, stocks dipped sharply on the fear of war and rebounded sharply as the war scare subsided."
"War is always bearish on money. To sell a stock at the threatened or actual outbreak of hostilities so as to get into cash is extreme financial lunacy. Actually just the opposite should be done. If an investor has about decided to buy a particular common stock and the arrival of a full-blown war scare starts knocking down the price, he should ignore the scare psychology of the moment and definitely begin buying."

The other four points…
1. Don’t overstress diversification.
3. Don’t forget your Gilbert and Sullivan.
4. Don’t fail to consider time as well as price in buying a true growth stock.
5. Don’t follow the crowd.

"Possibly one-fifth of my first investigations start from ideas gleaned from friends in industry and four-fifths from culling what I believe are the more attractive selections of a small number of able investment men. These decisions are frankly a fast snap judgment on which companies I should spend my time investigating and which I should ignore. Then after a brief scrutiny of a few key points in an SEC prospectus, I will seek ‘scuttlebutt’ aggressively, constantly working toward how close to our fifteen-point standard the company comes. I will discard one respective investment after another along the way. Some because the evidence piles up that they are just run of the mill. Others because I cannot get enough evidence to be reasonably sure one way or the other. Only in the occasional case when I have a great amount of favorable data do I then go to the final step of contacting the management. Then if after meeting with management I find my prior hopes pretty well confirmed and some of my previous fears eased by answers that to me make sense, at last I am ready to feel I may be rewarded for all my efforts."
Fisher also notes that he’ll invest in one stock out of two hundred fifty that he initially considers. For every two to two and a half visits he’ll buy into the company—this points to the fact that most of his work is done beforehand.

Chapter eleven concludes the first part of Fisher’s book; it and the chapters leading to it comprise a book within a book. "This book has attempted to show what these basic principles are, what type of stock to buy, when to buy it, and most particularly, never to sell it—as long as the company behind the common stock maintains the characteristics of an unusually successful enterprise."

Part two is of the book is entitled, "Conservative Investors Sleep Well."
Fisher begins by defining two terms:
"1. A conservative *investment* is one most likely to conserve (i.e. maintain) purchasing power at a minimum risk.
2. Conservative *investing* is understanding of what a conservative investment consists and then, in regard to specific investments, following a procedural course of action needed properly to determine whether specific investment vehicles are, in fact, conservative investments."
At the time of writing, in mid-1974, Fisher noted that the morale of the investor was the lowest it had been in history since the Depression. Consequently there existed, "a magnificent opportunity for those with the ability and the self-discipline to think for themselves and to act independently of the popular emotions of the moment."

"The company that qualifies well in this first dimension of a conservative investment is a very low cost producer or operator in its field, has outstanding marketing and financial ability and a demonstrated above-average skill on the complex managerial problem of attaining worthwhile results for its research or technological organization. In a world where change is occurring at an ever increasing pace, it is 
(1) a company capable of developing a flow of new and profitable products or product lines that will more than balance older lines that maybe become obsolete by the technological innovations of the others; 
(2) a company able now and in the future to make these lines at costs sufficiently low so as to generate a profit stream that will grow at least as fast as sales and that even in the worst years of general business will not diminish to a point that threatens the safety of an investment in the business; and 
(3) a company able to sell its newer products and those which it may develop in the future at least as profitably as those with which it is involved today." - Fisher.

The second dimension is the most important of the qualitative aspects of sound investing: the people factor. "Here is an indication of the heart of the second dimension of a truly conservative investment: a corporate chief executive dedicated to long-range growth who has surrounded himself with and delegated considerable authority to an extremely competent team in charge of the various divisions and functions of the company."
Fisher warns us of one-man shows and provides an insight into determining the managerial balance of an investment, "If the salary of the number-one man is very much larger than that of the next two or three, a warning flag is flying."
Fisher concludes with three points about the second dimension:
"1. The company must recognize that the world in which it is operating is changing at an ever increasing rate." Dow Chemical is looked at as an example.
"2. There must always be a conscious and continuous effort, based on fact, not propaganda, to have employees at every level, from the most newly hired blue-collar or white-collar worker to the highest levels of management, feel that their company is a good place to work." Texas Instruments is looked at as an example.
"3. Management must be willing to submit itself to the disciplines required for sound growth."

Investment Characteristics of Some Businesses
Fisher’s third degree deals with "the degree to which there does or does not exist within the nature of the business itself certain inherent characteristics that make possible can above-average profitability for as log as can be foreseen into the future." Fisher’s views on profitability jibe with Buffett’s concerns about inflation, indeed Fisher may have influenced Buffett in this regard. "A company that has annual sales three times its assets can have a lower profit margin but make a lot more money than one that needs to employ a dollar of assets in order to obtain each dollar of annual sales."
Fisher sides with industry leaders rather than number two and three players. "It has been our observation, that in many years of trying, Westinghouse has not surpassed General Electric, Montgomery Ward has not overtaken Sears, and---once IBM established early dominance in its areas of the computer market—even the extreme efforts of some of the largest companies in the country, including General Electric, did not succeed in displacing IBM from it’s overwhelming share of that market."
In short, along with good leadership, a company needs great economics for it to be truly a conservative investment.

Price of a Conservative Investment
Fisher posits that many fortunes have been made when investors have refused to sell their position in a rapidly appreciating equity. If the company is of a high quality then selling it is rather foolish, at almost any price, because of the scarcity of high-quality investments. What will you do with the money?
"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," writes Fisher. He warns us about the vagaries of these "appraisals", emphasizing that they are not snapshots of true company performance but only opinions of fallible human minds—minds prone to herd behavior at that.

To illustrate the willy-nilly stances common to analysts Fisher looks their views chemical industry from the 1950s to the 1970s. In the 50s chemical concerns were golden synthesizing wonder products like DDT and nylon. In the 60s they appeared to be commodity producers with seemingly the same business characteristics of steel mills. Then in the 70s, for whatever reason, chemical stocks became expensive again.

"The fourth dimension to stock investing might be summarized in this way: The price of any particular stock at any particular moment is determined by the current-financial community appraisal of the particular company, of the industry it is in, and to some degree of the general level of stock prices. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between depends for the most part on the degree these appraisals vary from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in certain purely financial factors, of which interest rates are by far the most important."

--Part III is entitled "Developing an Investment Philosophy"--
This chapter reviews Fisher’s early hard-luck experiences and how they forged his philosophy. His interest in investing bubbled up as grammar school kid when he overheard his uncle explaining stocks to Fisher’s grandmother. Fifteen years or so later he had completed his first year at Stanford and went to work for a bank "writing" reports on companies which the bank was issuing high-yield debt for. (He noted that he wasn’t really originating the reports, as the standard practice was to paraphrase whatever was in Moody’s.) Encouraged by a supporting boss, Fisher began seeking out the management of the debt issuing companies and incorporating his inquiries into his reports.
In performing his due diligence Fisher came to a first principle, "Reading the printed financial records about a company is never enough to justify an investment."
Fisher went on to loose money during this period of time. He wasn’t alone: it was 1929. Another principle learned – "what really counts in determining whether a stock is cheap or overpriced is not the ratio to the current year’s earnings, but its ratio to the earnings a few years ahead"--, and one more job completed at an investment firm, Fisher struck out on his own. In 1933 he managed a monthly profit of $29 (rent was $25), but soon (1935) his practice was "extremely profitable."

Fisher begins by recounting his intrigue with Food Machinery Corporation; he started pay attention to the operations of this firm in 1928. Food Machinery Corporation was the product of a merger between three agricultural machinery companies. The company appealed to Fisher for three business reasons: it was a "world leader in size," it had cornered some pockets of the market, and it enjoyed the fruits of a "superbly creative research or engineering department." In addition to these favorable business economics Fisher trusted and admired the company’s management. There was a shotgun burst of IPOs in 1928, including that of Food Machinery Corporation. "Food Machinery was thought to be just another of the many ‘flaky’ which were sold to the public at the height of a speculative orgy…it was possible to buy these shares in quantity at the ridiculous price to which they had sunk." And that was what Fisher did for his clients. Unfortunately, Fisher doesn’t disclose the success of this investment in this chapter. He does gives us another principle, namely, "I established what I called my three-year rule. I have repeated again and again to my clients that when I purchase something for them, not to judge the results in a matter of a month or a year, but allow me a three year period." Fisher broke this rule one time, when he sold Rogers Corporation in the mid 1970s.

Fisher’s entrepreneurial efforts stalled when he served in the Air Force for three years starting in 1942. His assignments occasionally gave him time to plot his return to investing. Upon returning he decided to earnestly investigate the chemical industry, as Fisher was convinced of its post-war growth potential. His research culminated when, in 1947, he invested in Dow Chemical. Dow appealed to Fisher because of its efforts to become the lowest cost producer in each of its markets and because of its emphasis on the "people factor." When Fisher asked the president of Dow what he foresaw as Dow’s biggest problem in the future the president confessed that he worried about Dow becoming a more "military-like organization" – such concern for people sold Fisher.
One of Fisher’s key principles is repeated in this chapter: "Even if the stock of a particular company seems at or near a temporary peak and that a sizable decline may strike in the near future, I will not sell the firm’s shares provided I believe that its longer term future is sufficiently attractive."

According to Fisher, the market is not efficient. "Efficient market theory grew out of the academic School of Random Walkers. These people found that it was difficult to identify technical trading strategies that worked well enough after transactions [sic] costs to provide an attractive profit an attractive profit relative to the risks taken. I don’t disagree with this. As you have seen, I believe it is very, very tough to make money with in and out trading based on short-term market forecasts. Perhaps the market is efficient in this narrow sense of the word…I do not believe that prices are efficient for the diligent, knowledgeable, long-term investor."
Fisher points out that the prevailing view, that is the fully informed professional perspective, has often been incorrect or inefficient. "With the possible exception of the 1960’s, there has not been a single decade in which there was not some period of time when the prevailing view was that external influences were so great and so much beyond the control of individual corporate managements that even the wisest common stock investments were foolhardy and not perhaps for the prudent…Yet everyone of these periods created investment opportunities that seemed almost incredible with all the advantages of hindsight."

Here are the points, abbreviated, Fisher gives as his conclusion:
1. Buy into companies that have disciplined plans for achieving dramatic long-range growth in profits and that have inherent qualities making it difficult for newcomers to share in that growth.
2. Focus on buying these companies when they are out of favor.
3. Hold the stock until either (a) there has been a fundamental change in its nature (such as a weakening of management through changed personal), or (b) it has grown to a point where it no longer will be growing faster than the economy as a whole.
4. For those primarily seeking major appreciation of their capital, de-emphasize the importance of dividends.
5. Taking small profits in good investments and letting losses grow in bad ones is a sign of abominable investment judgment. A profit should never be taken just for the satisfaction of taking it.
6. There are a relatively small number of truly outstanding companies. Their shares frequently can’t be bought at attractive prices. Therefore, when favorable prices exist, full advantage should be taken of the situation.
7. A basic ingredient of outstanding common stock management is the ability to neither accept blindly whatever may be the dominant opinion in the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary.
8. In handling common stocks, as in most other fields of human activity, success depends greatly on a combination of hard work, intelligence, and honesty.


"Investing is simple, but not easy." - Warren Buffet

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