Philip Fisher Articles: Conservative Investors Sleep Well

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