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Philip Fisher Articles: Conservative Investors Sleep Well

Sunday, August 31, 2008

Posted on Wallstraits: Conservative Investors Sleep Well

Today's Lesson: Philip Fisher
Conservative Investors Sleep Well

In 1975, growth investing pioneer Philip Fisher published a short investing manual called: Conservative Investors Sleep Well. It contained Fisher's ideas about selecting a focused portfolio of high growth potential businesses-- which, along with Fisher's 1958 book, Common Stocks and Uncommon Profits, is credited with influencing Warren Buffett and Charlie Munger as they moved from a pure Benjamin Graham net asset valuation method to include softer analysis of management quality, branding and franchise value, and earnings growth potential.

Conservative Investors Sleep Well gives equity investors an overview of Fisher's stock selection methods, which include the following business characteristics:

  • 1. Superiority in production, marketing, research and financial skills
  • 2. The people factor, outstanding managerial competence
  • 3. Inherent characteristics of the business itself that offer above-average profitability
  • 4. Price earnings ratios

How Does One Act Conservatively?

Philip Fisher defines 'conservative', as applied to stock investing as follows:

  • 1. A conservative investment is one most likely to conserve (i.e., maintain) purchasing power at a minimum of 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.

Consequently, to be a conservative investor, not one but two things are required either of the investor or of those whose recommendations he is following. The qualities desired in a conservative investment must be understood. Then a course of inquiry must be made to see if a particular investment so qualifies. Without both conditions being present the buyer of common stocks may be fortunate or unfortunate, conventional in his approach or unconventional, but he is not being conservative.

SUPERIOR PRODUCTION, MARKETING, RESEARCH, AND FINANCIAL SKILLS

Low Cost Production

To be a truly conservative investment a company--for a majority if not for all of its product lines--must be the lowest-cost producer or about as low a cost producer as any competitor. It must also give promise of of continuing to be so in the future.

Strong Marketing Organization

A strong marketer must be constantly alert to the changing desires of its customers so that the company is supplying what is desired today, not what used to be desired. In a competitive world of commerce it is vital to make the potential customer aware of the advantages of a product or service. This awareness can be created only by understanding what the potential buyer really wants (sometimes when the customer himself doesn't clearly recognize why these advantages appeal to him) and explaining it to him not in the seller's terms but in his terms.

Outstanding Research & Technical Effort

Previously, outstanding technical ability was vital only to highly scientific industries like electronics, pharmaceutical, aerospace and chemical manufacturing. However, today technological ability is as important to a shoe manufacturer, a bank, a retail, and even an insurance company. Technological efforts are now channeled in two directions: to produce new and better products, and to perform services in a better or lower-cost way. In research and technology, there is as much variation between efficiency of one company and another as there is in marketing.

Financial Skill

Companies with above-average financial talent have several significant advantages. Knowing accurately how much they make on each product, they can make their greatest efforts where these will produce maximum gains. Skillful budgeting and accounting can allow a truly outstanding company to create an early-warning system to detect threats to profitability.

THE PEOPLE FACTOR

Briefly summarized, the first dimension of a conservative investment consists of outstanding managerial competence in the basic areas of production, marketing, research, and financial controls. This first dimension describes a business as it is today, being essentially a matter of results. The second dimension deals with what produced these results and, more importantly, will continue to produce them in the future. The force that causes such things to happen, that creates one company in an industry that is an outstanding investment vehicle and another that is average, mediocre, or worse, is essentially people.

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. These people must be engaged not in an endless internal struggle for power but instead should be working together toward clearly outlined corporate goals. One of these goals, which is absolutely essential if the investment is to be a truly successful one, is that top management take the time to identify and train qualified and motivated juniors to succeed senior management whenever a replacement is necessary. Whenever possible the company should promote from within, not recruit from outside, except where special skills and diversity is required.

Fisher shares two examples of how companies can involve employees at all levels in both operations and managerial decision-making with great success-- Texas Instruments and Motorola. Each company designed systems to motivate and reward employees for contributions to efficiency and productivity. Fisher believed that companies able to perfect people-oriented policies and techniques--these special ways of approaching problems and solving them--are in a sense proprietary. For this reason they are of great importance to long range investors.

INVESTMENT CHARACTERISTICS OF BUSINESSES

The first dimension of a conservative stock investment is the degree of excellence in the company's activities that are most important to present and future profitability. The second dimension is the quality of the people controlling these activities and the policies they create. The third dimension deals with something quite different: the degree to which there does or does not exist within the nature of the business itself certain inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future.

Fisher seeks above-average profitability as a conservative investor, not only as a source of further gain but as a protection for what he already has. Sales growth has a cost attached, and without high profit margins growth is risky. A company with a high sales growth rate in relation to assets may be a more profitable company than one with higher profit margins but slow sales growth. For example, 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 sales.

However, while from the standpoint of profitability return on investment must be considered as well as profit margin on sales, from the standpoint of safety of investment all the emphasis is on profit margin on sales. Thus if two companies were each to experience a 2 percent increase in operating costs and were unable to raise prices, the one with a 1 percent margin of profit would be running at a loss and might be wiped out, while, if the other had a 10 percent margin, the increased costs would wipe out only one fifth of its profits.

Fisher compares high profit margins to an open jar of honey. The honey will inevitably attract a swarm of hungry insects bent on devouring it. In the business world, he points out, there are only two ways a company can protect the contents of its honey jar from being consumed by the insects of competition. One is by monopoly, and the other is efficiency. Efficiency is preferable, and is driven by economies of scale and establishing a leadership position.

Fisher uses the examples of IBM, General Electric and Sears to show how tough it is to topple the industry leader. He states how Montgomery Ward could never surpass Sears, Westinghouse could never catch GE, and dozens of computer companies always trailed far behind IBM. Today, Fisher may be having second thoughts as Dell has crushed IBM's PC dominance with a better distribution system, Wal-Mart blew away Sears with low prices and superior logistics systems, and, well, GE has just kept chugging along as a leader in several global markets for over 100 years.

Fisher looked for businesses that had created a perception in its customers minds that their product or service was the safe bet, and a competitive product or service was risky. He saw two sets of conditions necessary for this to happen. First, the company must build up a reputation for quality and reliability in a product (1) that the customer recognizes is very important for the proper conduct of his activities, (b) where an inferior or malfunctioning product would cause serious problems, (c) where no competitor is serving more than a minor segment of the market so that the dominant company is nearly synonymous in the public mind with the source of supply, and yet (d) the cost of product is only a quite small part of the customer's total cost of operations.

Second, it must have a product sold to many small customers rather than a few large ones. These customers must be sufficiently specialized in their nature that it would be unlikely for a potential competitor to feel they could be reached through advertising media. They constitute a market in which, as long as the dominant company maintains the quality and adequacy of its service, it can be displaced only by informed salesmen making individual calls, which is considered prohibitively expensive by competition. This sort of sustainable competitive advantage, in Fisher's mind, was to be most likely found in the high technology fields.

Fisher summarizes this ability to sustain above-average profit margins by saying a company should ask itself, "What can the particular company do that others would not be able to do about as well?" This sounds quite similar to Jim Collins (Good To Great) 'hedgehog concept', where companies that have transitioned from just good to really great were able to focus on simple business concepts or niche markets where they were capable of becoming the very best in the world.

PRICE EARNINGS RATIO

The fourth dimension of any stock investment involves the price-earnings ratio-- that is, the current share price divided by the earnings per share. When investors try to associate this ratio to the value of a business, trouble arises. Fisher believed, the common denominator among successful investors was their refusal to sell certain unusual high-quality stocks simply because each has had such a sharp fast rise that its price-earnings ratio suddenly looks high in relation to that which the investment community had become accustomed.

In view of the importance of all this, it is truly remarkable that so few have looked beneath the surface to understand exactly what causes these sharp price changes. Yet the law that governs them can be stated reasonably simple: 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.

Fisher uses the example of a company with earnings of $1 per share trading at $10, thus a PE of 10. During the last 2 years most companies in its industry have been suffering, but this company has introduced innovative new products and earnings have grown to $1.40 and then to $1.82 during these 2 years, with promise of more strong growth ahead. Although the development of these new products was in the works for many years, the financial community had not appraised them well, but as results were observed the company was reappraised and the PE rose from 10 to 22, this the current stock price (22 X $1.82) of $40, a 400% gain in 2 years. Even moderate 15% annual growth from here will likely result in returns of thousands of percent over the next decade to early investors.

For Fisher, the matter of "appraisal" is the heart of understanding the seeming vagaries of PE ratios. But "appraisal" is a subjective thing, and may have more to do with what the appraiser thinks is going on that what is really going on. Thus, the current PE reflects not reality, but the consensus of the financial community's appraisals. Opportunity arises when the financial community is slow to make accurate appraisals, or is playing "follow-the-leader" down the wrong path.

Fisher advises against switching out of good stocks to chase better ones. The risk of making a mistake and switching into one that seems to meet all of the first three dimensions but actually does now is probably considerably greater for the average investor than the temporary risk of staying with a thoroughly sound but currently overvalued situation until genuine value catches up with current prices. Investors who agree with Fisher on this particular point must be prepared for occasional sharp contractions in the market value of these temporarily overvalued stocks.

On the other hand, it is Fisher's observation is that those who sell such stocks to wait for a more suitable time to buy back these same shares seldom attain their objective. They usually wait for a decline to be bigger than it actually turns out to be. The result is that some years later when this fundamentally strong stock has reached peaks of value considerably higher than the point at which they sold, they have missed all of this later move and may have gone into a situation of considerably inferior intrinsic quality.

In order of risk, Fisher advises staying away from stocks that may be appraised below or about at their proper value, but score low on the first three dimensions. But, most risky of all for investors, is chasing companies that are appraised far above what is currently justified by the immediate situation, regardless of scores on the first three dimensions. The patient investor seeking low risk (wanting to sleep well) must learn to discern between facts and appraisals.

Previous Philip Fisher articles

1.
Philip Fisher Articles: Finding Growth Stock
2. Philip Fisher Articles: Investing in Growth



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Urban Street Survivor

Okay, so the title may sound a bit like a spin-off video game from the Street Fighter series but this low budget film has got my attention. Mainly because I got to go on set while they were shooting the promo on the Gold Coast yesterday but still . . .
Here’s the low down on Urban Street Survivor:
The film centres around a 15-year-old street kid called Mouth who ran away from an orphanage at the age of 11. Using his cunning Mouth manages to survive on the rough streets and avoid attention from several of the racial gangs which rule the surrounding area. Eventually he’s taken in by a reformed gang leader who offers him and other street kids an alternative to the violent gang life through channelling their anger in to self defence classes. But a music concert on the border of several rival gang territories brings tensions to a head and threatens the future of the boys. Brisbane lad Hamish Irvin plays Mouth and was discovered by the writer/director/producer Stuart Freeman at the Australian Academy of Acting when he was working there last month. Freeman has got Hamish to do a cockney accent for the role (just because he can) and apparently the young up and comer is so good, he’s going to be a ‘massive international star in the future’. Freeman and long time writing buddy Nick Pendragon penned the script for Urban Street Survivor which is one of five they are presenting to studio executives in America later this month. For those of you who are not familiar with Freeman’s work he was the first assistant director on Aussie films The Adventures of Priscilla, Queen of the Desert and Mad Max III. Originally hailing from the UK, he now lives on the Gold Coast and has been busy trying to boost the profile of the local film industry. Freeman just finished shooting a short film for the annual In The Bin Short Film Festival about the devastating affects land mines can have on communities long after a war is over. The film is called `Red Ribbon’ and was shot at the West Burleigh quarry in a bid to make the set look like somewhere in Iraq or Afghanistan. If any where on the Gold Coast could look like a dusty, war ravaged, deserty hole then it’s West Burleigh quarry so mission accomplished. Freeman is also shooting majority of Urban Street Survivor on the Gold Coast too like yesterday, for example, when he used Benowa skater Max Morphett to shoot some of the skate board scenes at Pizzey Park. Miami state primary school also let Freeman use the grounds to film eight leather-clad women on Harley’s fangin' it through the school. Meow. Stay posted for more Urban Street Survivor updates and news on what Stuart Freeman and the gang are up to next.

Director Stuart Freeman shooting scenes for Urban Street Survivor at Pizzey Park skate park, Miami yesterday.



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Philip Fisher Articles: Investing in Growth

Saturday, August 30, 2008

Here is another version of Philip Fisher Articles: Finding Growth Stock

And like the earlier posting, I cannot recall the source of this article. Sigh!

~~~~~~~~~~~~~~

Investing Styles Thru History
Philip Fisher: Investing in Growth

Philip Fisher was a pioneer of growth investing. But more unique among growth investors, Fisher looked for growth companies only when they were selling at reasonable valuations. Even high earnings growth stocks fall out of favor, become overlooked and sell for less than their underlying worth from time to time. He was looking for low price relative to long-term prospects. Fisher's genius was to identify the fundamental factors behind a company's strength that led to above average earnings growth with the discipline to invest only in those showing extraordinary value.

Fisher learned about investing from Professor Boris Emmett at Stanford University's Graduate School of Business in the late 1920s. As a first-year student in 1927, Fisher was assigned to drive the Professor to the San Francisco Bay area once per week to visit real businesses. This assignment offered tremendous insights for Fisher, both from learning about real businesses, and from listening to Professor Emmett's insights during the weekly trips.

Fisher developed an ability to identify well-managed companies with a potential to grow beyond their current size, a concept of "growth investing" not yet formalized in the late 1920s. He also learned to focus on the importance of the sales and marketing role in these businesses. Previous investment focus had dwelled on inventions and manufacturing efficiency, but Fisher saw the need for good sales & marketing people to convince others of the value of their product and control its own growth destiny.

Fisher's first job was as a securities analyst with an independent San Francisco bank. He disliked selling securities to customers based on superficial analysis to increase bank commissions, and asked for a new assignment. Fisher was finally allowed to do some hands-on analysis of US radio stocks. He visited the radio departments of several retail outlets and sought opinions on the three major competitors in the industry. He was surprised by the high degree of consensus.

The radio maker favored by the stock market was viewed as the worst company in the eyes of radio company's customers (the retail store owners). Another popular company, RCA was just about holding its own. Philco, however was the clear winner. It had superior models, was winning market share and was highly efficient. He searched for a negative comment from a Wall Street analyst on the first company, the worst performer in retailers' eyes, but was unable to find any. It was his first lesson in what became his evolving investment philosophy: reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them.

Learn From Mistakes

In August 1929, Fisher wrote a report that predicted within the next 6 months a great bear market would start, the greatest in a quarter-century. He actually underestimated their fierceness of the Great Crash and following Great American Depression of the early 1930s. Unfortunately, Fisher failed to take his own advice. He was entrapped by the lure of the market with rising prices. He invested his life's savings of a few thousand dollars into stocks bought on the basis they were cheap versus other more overpriced stocks. In choosing investments, he did not bother making inquiries from people who either knew their products or employees. By 1932, he lost almost all his money.

Fisher was determined to learn from his experience: "The chief difference between a fool and a wise man is that the wise man learns from his mistakes, while the fool never does." One lesson was that a low price to historical earnings ratio was no guarantor of value. What the investor needs is a stock with a low price relative to earnings in a few years ahead. He started to think of ways to predict accurately (within fairly broad limits) the earnings of firms a few years from now.

Fisher began to search for companies with these qualities:

  • 1. The people are outstanding;
  • 2. A strong competitive position;
  • 3. Operations and long-term planning were handled well;
  • 4. Enough high-potential new products to continue growth for many years.

From Fisher's description of why he invested in Dow Chemical Company helps us understand his methodology more thoroughly:

As I began to know various people in the Dow organization, I found that the growth that had already occurred was in turn creating a very real sense of excitement at many levels of management. One of my favorite questions in talking to any top business executive for the first time is what he considers to be the most important long-range problem facing his company. When I asked this of the president of Dow, I was tremendously impressed with his answer: 'It is to resist the strong pressures to become a more military-like organization as we grow very much larger, and to maintain the informal relationship whereby people at quite different levels and in various departments continue to communicate with each other in a completely unstructured way and, at the same time, not create administrative chaos. I found myself in complete agreement with certain other basic company policies. Dow limited its involvement to those chemical product lines where it either was or had a reasonable chance of becoming the most efficient producer in the field as the result of greater volume, better chemical engineering and deeper understanding of the product or for some other reason. Dow was deeply aware of the need for creative research not just to be in front, but also to stay in front. There was also a strong appreciation of the 'people factor' at Dow. There was in particular a sense of need to identify people of unusual ability early, to indoctrinate them into policies and procedures unique to Dow, and to make real efforts to see if seemingly bright people were not doing well at one job, they be given a reasonable chance to try something else that might be more suitable to their characteristics.

A Technology Focus

Fisher held relatively few companies in his portfolio at any one time, and was not afraid to concentrate his wealth on a few obscure businesses. In 1955, for example, he bought two stocks that were generally regarded as highly speculative. They were small companies and were technologically oriented; they were beneath the notice of conservative investors or big institutions. "A number of people criticized me for risking funds in a small speculative company which they felt was bound to suffer from the competition of the corporate giants." Both stocks eventually turned in spectacular returns. Their names? Texas Instruments and Motorola.

Fisher's view of the stock market was very rational. In reflecting on a lifetime of investing in 1980, Fisher noted that, with the exception of the 1960s, there has not been a decade in which the prevailing view was that common stock investment was foolhardy, because factors outside the control of corporate managers were too strong for them to control the destiny of their corporations. However, in every decade there were wonderful opportunities to buy stocks yielding returns of hundreds of percent. On the downside, in each of these decades there were also periods in which the 'speculative darlings' of the time became disastrous traps for the unwary, 'for those who blindly follow the crowd rather than who really knew what they were doing'. The next ten years will also present magnificent opportunities for those who know what to look for. They will also be littered with the same old traps for those unaware of the vital principles for good investing. Those who look for an intellectually cheap and easy way to fortune will find their path strewn with dangerous temptations.

Fisher chose to devote himself to the study of technology based companies. However, followers of Fisher do not have to confine themselves to this area-- as Warren Buffett so adeptly demonstrated with a Fisher-like quality focus outside technology industries, which he lacked the confidence for depth of understanding. Fisher intended to hold his investments for many years, if not decades. A great company, with highly motivated and able managers can continue to grow way beyond the investment horizon of conventional investors.

Selection Of Stocks

The most important elements of Fisher's analysis were:


  • 1. Research and Development

  • 2. Quality of People

  • 3. The firm's competitive position

  • 4. Marketing

  • 5. Financial state and control

  • 6. Scuttlebut

  • 7. Price paid

Scuttlebut is a factor which surrounds all the others. It is through scuttlebut that Fisher discovered the vital facts about a firm, from the character of its managers to the effectiveness of its research. Scuttlebut is the use of the business grapevine to research companies. It is scavenging for information by obtaining the views and opinions of anybody associated with a company: customers, employees, x-employees, rivals, suppliers, academics, trade association officers, industry observers, etc.

The business 'grapevine' is a remarkable thing. 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. Most people, particularly if they feel sure there is no danger of being quoted, like to talk about the field they are engaged and will talk rather freely about their competitors. Go to five companies in an industry, ask each of them intelligent questions about the points of strengths and weaknesses of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.

Suppliers and customers can provide an opinion that is as well informed and illuminating as that of competitors. They also provide a means of cross checking. The character of the people managing the firms should emerge. The impression formed can be reinforced by talking to former employees. However, when seeking opinions here, great care is needed to ensure allowance is made for the fact that views from this source may be tainted by feelings of resentment. It is very important that the person providing the information is reassured that their identity will never be revealed. The analyst must scrupulously observe this policy. Trade association personnel, especially, will need this reassurance, as will current employees. If there is the slightest doubt as to analyst's ability to observe the rules of confidentiality he or she will simply not get to hear unfavorable opinions.

In the case of really outstanding companies, the preponderant information is so crystal-clear that even a moderately experienced investor who knows what he is seeking will be able to tell which companies are likely to be of enough interest to him to warrant taking the next step in his investigation. This next step is to contact the officers of the company to try to fill out some of the gaps still existing in the investor's picture of the situation being studied.


Previous Philip Fisher articles

1.
Philip Fisher Articles: Finding Growth Stock


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