(Image: Zen Buddha Silence by Marilyn Barbone.)
July 9, 2017
Philip A. Fisher is a legendary growth investor. He is the author of Common Stocks and Uncommon Profits (Wiley, 1996; originally published by Harper & Brothers, 1958). Growth only creates value when the return on invested capital (ROIC) is higher than the cost of capital. Fisher focuses on value-creating growth.
Warren Buffett – partly through the influences of both Charlie Munger and Phil Fisher – went from buying statistically cheap stocks to buying stocks where the business could maintain a high ROIC for many years. Buffett also learned from Fisher the value of scuttlebutt research – interviewing competitors, suppliers, customers, industry experts, and others who might have special insight into the company or industry. Finally, Buffett learned from Fisher that you should concentrate the investment portfolio on your best ideas. Buffett once remarked:
I’m 15% Fisher and 85% Benjamin Graham.
Typically, Buffett only buys a stock (or an entire company) when he feels certain about the future earnings. This means the business in question must have a sustainable competitive advantage in order to keep the ROIC above the cost of capital. Buffett then looks at the current price and determines if it’s at a discount relative to future earnings power. Because Buffett is still trying to buy at a discount to intrinsic value (in terms of future earnings power), he’s 85% Graham.
- That’s not to say Buffett does a precise calculation. Only that there must be an obvious discount present. At the 1996 Berkshire Hathaway annual meeting, Munger said: “Warren talks about these discounted cash flows… I’ve never seen him do one.” Buffett replied: “That’s true. If [the value of the company] doesn’t just scream at you, it’s too close.” (Janet Lowe, page 145, Warren Buffett Speaks (Wiley, 2007))
Phil Fisher doesn’t think about buying at a discount to future earnings power. He just knows that if a company can maintain a relatively high ROIC for many years into the future, then all else equal, earnings will march higher over the years and the stock will follow. So Fisher simply looks for these rare companies that can maintain a high ROIC many years into the future. Fisher doesn’t try to calculate whether the current price is at a discount to some specific level of future earnings.
THE FIFTEEN POINTS
Fisher highlights fifteen points that an investor should investigate in order to determine if a prospective investment is worthwhile. A worthwhile investment can, over a few years, increase several hundred percent, or it can increase proportionately more over a longer period of time.
Point 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?
Fisher writes that sales growth is often uneven on an annual basis. So the important question is whether the company can grow over several years. Ideally, a company should be able to grow for decades. This generally only happens when management is highly capable.
Point 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?
To grow beyond the next few years, ongoing scientific research and development engineering are required. Usually such research is most effective when it is clearly related to new products bearing some similarity to existing products. The main point is that management has to be farsighted enough to develop new products that, if successful, will produce growth many years from today.
Point 3. How effective are the company’s research and development efforts in relation to its size?
Some well-run companies get twice (or more) the ultimate gains for each research dollar than other companies. A good company has technically skilled engineers and scientists, but also leaders who can coordinate the research efforts of people with diverse backgrounds.
Moreover, company leaders have to integrate research, production, and sales. Otherwise, costs may not be minimized or products may not sell as well as they could. Non-optimal products are usually vulnerable to more efficient competition.
Point 4. Does the company have an above-average sales organization?
It is the making of a sale that is the most basic single activity of any business. Without sales, survival is impossible. It is the making of repeat sales to satisfied customers that is the first benchmark of success. Yet, strange as it seems, the relative efficiency of a company’s sales, advertising, and distributive organizations receives far less attention from most investors, even the careful ones, than do production, research, finance, or other major subdivisions of corporate activity. (page 31)
In some successful companies, a large chunk of a salesperson’s time – often over the course of many years – is devoted to training.
Point 5. Does the company have a worthwhile profit margin?
Marginal companies typically increase their earnings more during good periods, but they also experience more rapid declines during bad periods. The best long-term investments usually have the best profit margins and the best ROIC in the industry. Marginal companies are very rarely good long-term investments.
Point 6. What is the company doing to maintain or improve profit margins?
Some companies achieve great success by maintaining capital-improvement or product-engineering departments. The sole function of such departments is to design new equipment that will reduce costs and thus offset or partially offset the rising trend of wages. Many companies are constantly reviewing procedures and methods to see where economies can be brought about. (page 37)
Point 7. Does the company have outstanding labor and personnel relations?
A company that has above-average profits and that pays above-average wages is likely to have good labor relations. Furthermore, management should treat employees well in other ways. Ideally, employees will feel that they are a crucial part of the business mission.
Point 8. Does the company have outstanding executive relations?
Executives should feel that promotions are based solely on merit. Some degree of friction is natural, but such friction should be kept to a minimum in order to ensure that executives work together.
Point 9. Does the company have depth to its management?
…companies worthy of investment interest are those that will continue to grow. Sooner or later a company will reach a size where it just will not be able to take advantage of further opportunities unless it starts developing some executive talent in some depth. (page 41)
Fisher also points out that executives must be given real authority in order for them to develop. As well, top executives should be open to suggestions from developing executives.
Point 10. How good are the company’s cost analysis and accounting controls?
No company is going to continue to have outstanding success for a long period of time if it cannot break down its over-all costs with sufficient accuracy and detail to show the cost of each small step in its operation. Only in this way will a management know what most needs its attention. Only in this way can management judge whether it is properly solving each problem that does need its attention. (page 42)
Point 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?
Typically it is leadership in engineering or in business processes – rather in than patents – that allows a company to maintain its competitive position.
Point 12. Does the company have a short-range or long-range outlook in regard to profits?
One company will constantly make the sharpest possible deals with suppliers. Another will at times pay above contract price to a vendor who has had unexpected expense in making delivery, because it wants to be sure of having a dependable source of needed raw materials or high quality components available when the market has turned and supplies may be desperately needed. The difference in treatment of customers is equally noticeable. The company that will go to special trouble and expense to take care of the needs of a regular customer caught in an unexpected jam may show lower profits on the particular transaction, but far greater profits over the years. (page 46)
Point 13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
If the company is well-run and profitable, then a reasonable amount of equity financing need not deter you as an investor. A stock offering creates cash for the company. If the ROIC on this cash is high enough, and the price at which the stock offering is made is not too low, then future earnings per share will not suffer.
Point 14. Does the management talk freely to investors about its affairs when things are going well but ‘clam up’ when troubles and disappointments occur?
Even the best-run companies will encounter unexpected difficulties at times. Also, companies that will grow their earnings far into the future will constantly be pursuing technical research projects, some of which won’t work:
By the law of averages, some of these are bound to be costly failures. Others will have unexpected delays and heartbreaking expenses during the early period of plant shake-down. For months on end, such extra and unbudgeted costs will spoil the most carefully laid profit forecasts for the business as a whole. Such disappointments are an inevitable part of even the most successful business. If met forthrightly and with good judgment, they are merely one of the costs of eventual success. They are frequently a sign of strength rather than weakness in a company. (page 48)
It’s crucial when failures or setbacks do occur that management is candid in reporting the bad news.
Point 15. Does the company have a management of unquestionable integrity?
There are countless ways management could enrich itself at the expense of shareholders. This includes issuing stock options far beyond what is reasonable and fair.
Managers with high integrity always keep the interests of outside shareholders ahead of their own interests. Good managers tend to produce positive surprises, while bad managers tend to produce negative surprises. Over a long period of time, it’s simply not worth investing when you can’t trust management.
WHAT TO BUY
Fisher argues that a superbly managed growth company will generally see its stock increase hundreds of percent each decade. By contrast, a stock that is merely statistically undervalued by 50 percent will generally only double.
You should invest part of your portfolio in larger, more conservative growth companies, and the rest in smaller growth companies. How much to invest in each category depends on your circumstances and temperament. If you can leave the investment alone for a long time and you don’t mind shorter term volatility, then it makes sense to invest more in smaller growth companies.
WHEN TO BUY
Fisher writes that forecasting business trends is not far enough along to be dependable for investing purposes. This is still true. I wrote last week about why you shouldn’t try market timing: http://boolefund.com/shouldnt-try-market-timing/
Yet, says Fisher, often when a new full-scale plant is about to begin production, there will be a buying opportunity. First, it takes many weeks at least to get the plant running. And if it’s a revolutionary process, it can take far longer than even the most pessimistic engineer estimates.
Even after the new plant is operating, generally there are difficulties and unexpected expenses. Often word spreads that the new plant is in trouble, which causes some investors to sell the stock. A few months later, the company might report a drop in net income due to the unexpected expenses. Fisher:
Word passes all through the financial community that the management has blundered.
At this point the stock might well prove a sensational buy. Once the extra sales effort has produced enough volume to make the first production scale plant pay, normal sales effort is frequently enough to continue the upward movement of the sales curve for many years. Since the same techniques are used, the placing in operation of a second, third, fourth, and fifth plant can nearly always be done without the delays and special expenses that occurred during the prolonged shake-down period of the first plant. By the time plant Number Five is running at capacity, the company has grown so big and prosperous that the whole cycle can be repeated on another brand new product without the same drain on earnings percentage-wise or the same downward effect on the price of the company’s shares. The investor has acquired at the right time an investment which can grow for him for many years. (page 65)
Fisher reiterates that it’s possible to learn how an individual company will perform. But it’s not possible to forecast the stock market with any useful degree of consistency. There are too many variables, including the business cycle, interest rates, government policy, and technological innovation.
WHEN TO SELL
For an investor, mistakes are inevitable. Generally speaking, a careful investor may be right as much as 70% of the time. But that means being wrong 30% of the time. The important thing is to learn to identify mistakes as quickly as possible. This is not easy, as Fisher explains:
…there is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.
Furthermore this dislike of taking a loss, even a small loss, is just as illogical as it is natural. If the real object of common stock investment is the making of a gain of a great many hundreds of per cent over a period of years, the difference between, say, a 20 per cent loss or a 5 per cent profit becomes a comparatively insignificant matter…
While losses should never cause strong self-disgust or emotional upset, neither should they be passed over lightly. They should always be reviewed with care so that a lesson is learned from each of them. If the particular elements which caused a misjudgment on a common stock purchase are thoroughly understood, it is unlikely that another poor purchase will be made through misjudging the same investment factors. (page 78)
The second reason for selling is if the company no longer qualifies with respect to the fifteen points. Usually this is either because there has been a deterioration of management or because the company no longer has the same growth prospects.
Deterioration of management, writes Fisher, is sometimes due to complacency, but it usually is because new top executives are not as good as their predecessors.
A third reason for selling is that a much better investment opportunity has been found. Attractive investments are extremely hard to find, observes Fisher. When you do find one, it’s often worth switching (including paying capital gains taxes) if the new opportunity appears to have much more upside than some current investment.
Once you have found a good company, you should rarely sell. Even if you knew a bear market was about to occur – which can very rarely, if ever, be known – if your stock will probably reach a new high in the next bull market, then trying to sell and then re-buy is risky and time-consuming.
You can’t know how far a specific stock will decline – if at all – and thus you won’t know when to buy the stock back. Also, the stock may not necessarily decline at the same rate, or even at the same time, as the general market. In other words, if your stock is likely to increase at least 400% eventually, say from a price of $20 a share to $100+ a share, then it’s risky and time-consuming to try to sell at $20 and buy it back at $16 or $12. Many investors who try to do this end up not buying the stock back below where they sold it. Fisher sums it up:
That which really matters is not to disturb a position that is going to be worth a great deal more later. (page 83)
This is even more true when you factor in capital gains taxes.
Some argue that if a stock has increased a great deal, you should sell it. This makes no sense, says Fisher. If the stock is a long-term winner of the sort you’re looking for, then by definition it’s going to increase significantly and frequently be hitting new all-time highs. Fisher concludes:
If the job has been correctly done when a common stock is purchased, the time to sell it is—almost never. (page 85)
THE HULLABALOO ABOUT DIVIDENDS
If you’ve found an excellently managed growth company – a company that can maintain a relatively high ROIC, including on reinvested earnings – then you should prefer low dividends or no dividends. Fisher:
Actually dividend considerations should be given the least, not the most, weight by those desiring to select outstanding stocks. Perhaps the most peculiar aspect of this much-discussed subject of dividends is that those giving them the least consideration usually end up getting the best dividend return. Worthy of repetition here is that over a span of five to ten years, the best dividend results will come not from the high-yield stocks but from those with the relatively low yield. So profitable are the results of the ventures opened up by exceptional managements that while they still continue the policy of paying out a low proportion of current earnings, the actual number of dollars paid out progressively exceed what could have been obtained from high-yield shares. Why shouldn’t this natural and logical trend continue in the future? (pages 94-95)
At the extreme, for an outstanding company that will grow for decades, it may be best if the company paid no dividends at all. If you bought Berkshire Hathaway at the beginning of 1965 and held it through the end of 2015, you would have gotten 20.8% annual returns versus 9.7% for the S&P 500 (including dividends). Your cumulative return for holding Berkshire stock would come to 1,598,284% versus 11,335% for the S&P 500 (including dividends). Berkshire has never paid a dividend because Buffett and Munger have always been able to find better uses for the cash over the years.
FIVE DON’TS FOR INVESTORS
Don’t buy into promotional companies.
All too often, young promotional companies are dominated by one or two individuals who have great talent for certain phases of business procedure but are lacking in other equally essential talents. They may be superb salesmen but lack other types of business ability. More often they are inventors or production men, totally unaware that even the best products need skillful marketing as well as manufacture. The investor is seldom in a position to convince such individuals of the skills missing in themselves or their young organizations. Usually he is even less in a position to point out to such individuals where such talents may be found. (page 97)
Don’t ignore a good stock just because it is traded ‘over the counter.’
The key point here is just to be sure you are investing in the right company.
Don’t buy a stock just because you like the ‘tone’ of its annual report.
Often annual reports are either overly optimistic or they fail to disclose material information needed by the investor. Very often you need to look beyond the annual report in order to find all important information.
Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.
If a company can grow profitably in the future like it has in the past, then even with a high P/E, the stock may still be a good buy. Fisher:
This is why some of the stocks that at first glance appear highest priced may, upon analysis, be the biggest bargains. (page 105)
Don’t quibble over eighths and quarters.
If you’ve found a well-managed growth company whose stock is likely to increase at least several hundreds of percent in the future, then obviously it would be a big mistake to miss it just because the price is slightly higher than what you want.
FIVE MORE DON’TS FOR INVESTORS
Don’t overstress diversification.
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them… that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification. (pages 108-109)
When Buffett was managing the Buffett Partnerships (1957 to 1970), in the mid 1960’s he put 40% of the portfolio in American Express when the stock fell due to the salad oil scandal. Buffett and Munger have always believed in concentrating on their best ideas. Buffett:
We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.
Buffett again in a 1998 lecture at the University of Florida:
If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake. Very few people have gotten rich on their seventh best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best.
In the field of common stocks, a little bit of a great many can never be more than a poor substitute for a few of the outstanding. (page 118)
Don’t be afraid of buying on a war scare.
Through the entire twentieth century, with a single exception, every time major war has broken out anywhere in the world or whenever American forces have become involved in any fighting whatever, the American stock market has always plunged sharply downward. This one exception was the outbreak of World War II in September 1939. At that time, after an abortive rally on thoughts of fat war contracts to a neutral nation, the market soon was following the typical downward course, a course which some months later resembled panic as news of German victories began piling up. Nevertheless, 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. (page 118)
Whether stocks end up higher due to inflationary government policies, or whether stocks actually are worth more, depends on circumstances, writes Fisher. Yet either way, buying stocks after the initial war scare has been the right move.
Don’t forget your Gilbert and Sullivan.
Some investors look at the highest and lowest price at which a stock has traded in each of the past five years. This is illogical and dangerous, writes Fisher, because what really matters is how the company – and stock – will perform for many years into the future. A good growth stock will increase at least several hundred percent from its current price as a result of the company’s future economic performance. Past stock prices are largely irrelevant.
Don’t fail to consider time as well as price in buying a true growth stock.
Occasionally if you’ve followed a company for some time, you may notice that certain ventures have consistently been followed by stock price increases. Although it won’t always work, you could use this information as a guide to when to buy the stock.
Don’t follow the crowd.
Psychology can cause a stock to be priced almost anywhere in the short term, as the value investor Howard Marks has noted. Fisher:
These great shifts in the way the financial community appraises the same set of facts at different times are by no means confined to stocks as a whole. Particular industries and individual companies within those industries constantly change in financial favor, due as often to altered ways of looking at the same facts as to actual background occurrences themselves. (page 131)
HOW TO GO ABOUT FINDING A GROWTH STOCK
It’s difficult to find good investment ideas. In your search, you may accidentally exclude a few of the best ideas, while spending a great deal of time on many stocks that won’t turn out to be good ideas.
Note: Fisher is talking about growth stocks. If you’re a value investor, then a quantitative investment strategy can work well over time.
One way to find good investment ideas is to see what top investors are doing.
Fisher offers some details about how he approaches potential investment ideas. In the first stage, he does not seek to talk with anyone in management. He does not go over old annual reports. Fisher:
I will, however, glance over the balance sheet to determine the general nature of the capitalization and financial position. If there is an SEC prospectus I will read with care those parts covering breakdown of total sales by product lines, competition, degree of officer or other major ownership of common stock (this can also usually be obtained from the proxy statement) and all earning statement figures throwing light on depreciation (and depletion, if any), profit margins, extent of research activity, and abnormal or non-recurring costs in prior years’ operations.
Now I am ready really to go to work. I will use the ‘scuttlebutt’ method I have already described just as much as I possibly can… I will try to see (or reach by telephone) every key customer, supplier, competitor, ex-employee, or scientist in a related field that I know or whom I can approach through mutual friends. However, suppose I still do not know enough people or do not have a friend of a friend who knows enough of the people who can supply me with the required background? What do I do then?
Frankly, if I am not even close to getting much of the information I need, I will give up the investigation and go on to something else. To make big money on investments it is unnecessary to get some answer to every investment that might be considered. What is necessary is to get the right answer a large proportion of the very small number of times actual purchases are made. For this reason, if way too little background is forthcoming and the prospects for a great deal more is bleak, I believe the intelligent thing to do is to put the matter aside and go on to something else. (pages 140-141)
If you’ve finished ‘scuttlebutt’ research with regard to the fifteen points, then the next step is to approach management. Only ‘scuttlebutt’ can give you enough knowledge to approach management with intelligent questions.
Fisher writes that he may find one worthwhile stock out of every 250 stocks he considers as possibilities. He finds one good stock out of every 50 he looks at in some detail. And Fisher invests about one time of out every 2 or 2.5 company visits. By the time Fisher visits a company, he has already uncovered via ‘scuttlebutt’ nearly all the important information. If Fisher can confirm his investment thesis when he meets with management, as well as ease some of his concerns, then he is ready to make the investment.
TEMPERAMENT MORE IMPORTANT THAN IQ
Fisher concludes Common Stocks and Uncommon Profits by noting the importance of temperament:
One of the ablest investment men I have ever known told me many years ago that in the stock market a good nervous system is even more important than a good head. (page 148)
Or as Buffett put it:
Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.