Library / Investment Classics
Date of review: April 2019
Book author: Philip A. Fisher
Вook published: 2003
Book author: Philip A. Fisher
Вook published: 2003
Common Stocks and Uncommon Profits by Philip A. Fisher (2003)
This is an excellent book that I think is underrated by the investment community, unlike The Intelligent Investor, which often comes to mind as the top classic book on investments. Perhaps, it was written in such a style that makes it a little more difficult to grasp the first time you read it. I re-read the book recently and was fascinated by how much wisdom, but also how relevant many concepts are. This is the first out of three main books written by Phil Fisher - I provided reviews of two other books in my Library.
If I had to summarise the message of the book in just one sentence, I would say
The quality of the company measured in the quality of its products, processes, management and personnel, as well as the market it operates in, determines the long-term growth potential of the company, which in turn is key for generating long-term investment results. Just like recently investors who have held big winners of the past two decades with all their ups and downs (e.g. Amazon, Netflix, Costco), Fisher advocates that the actual price paid for a great business is secondary to earnings growth. Clearly, from a math perspective, this statement is correct as long as the price is not unreasonable and growth is real and sustainable. The problem often has to do not that the price paid was high, but the quality of the company was not high enough to justify the price. Opportunities to find such exceptional companies are rare.
According to Fisher, the key to successfully identifying such companies is the 'Scuttlebutt' approach which is active discussion with the company's former employees, its vendors, customers, competitors. It reminds me of advice that Peter Lynch makes as well.
The book is well structured as there are 15 criteria to use for analysing opportunities as well as 10 practical pieces of advice and mistakes to be avoided as well as useful messages on when is best to buy or sell stocks.
Here are 15 points to look for in a common stock which Fisher considers as attributes of a company that can be a successful investment. He notes that a company does not have to score on all the points. Unfortunately, these points are almost all quantitative and, thus, require judgement rather than arithmetics, but perhaps this is why they can still be applied (anything easily quantifiable could be quickly calculated by computers). I have slightly rephrased them to make them sound simpler, I apologise if my version makes them worse. You are encouraged to read the original, of course.
According to Fisher, the key to successfully identifying such companies is the 'Scuttlebutt' approach which is active discussion with the company's former employees, its vendors, customers, competitors. It reminds me of advice that Peter Lynch makes as well.
The book is well structured as there are 15 criteria to use for analysing opportunities as well as 10 practical pieces of advice and mistakes to be avoided as well as useful messages on when is best to buy or sell stocks.
Here are 15 points to look for in a common stock which Fisher considers as attributes of a company that can be a successful investment. He notes that a company does not have to score on all the points. Unfortunately, these points are almost all quantitative and, thus, require judgement rather than arithmetics, but perhaps this is why they can still be applied (anything easily quantifiable could be quickly calculated by computers). I have slightly rephrased them to make them sound simpler, I apologise if my version makes them worse. You are encouraged to read the original, of course.
15 points to look for in a common stock
1. Company should have products or services with sufficient market potential that should help the company to deliver significant sales growth over at least several years.
Fisher specifically points out that sales growth are necessary for long-term profits growth, while cost-cutting can also deliver a short-term effect.
2. Management's determination to develop products or processes that will increase total sales potentials further when the growth potential of currently attractive product lines is fully achieved.
To me, this point is best seen in companies like Amazon, where management keeps looking for new opportunities often adjacent to its core services, taking 3-5 year views.
3. How effective are the company's R&D efforts in relation to its size.
Fisher points out that a simple dollar amount of spending on R&D or relative to sales may not be enough, as different companies have different policies on what they include in R&D, besides, companies differ in how effective they are in R&D processes. He refers to large corporations where new ideas are often not supported for various reasons, which creates opportunities for smaller rivals to try a new product, approach to marketing, sales, production process etc. The author's practical advice on measuring this point is to try to assess the share of sales coming from products/services developed as a result of R&D processes over the past 10 years.
4. Exceptional sales team.
Fisher points out that product quality alone is not enough in a highly competitive market. Strong sales teams especially in B2B sectors are very important for long-term success.
5. Company should have an attractive profit margin.
One of the few indicators that can actually be measured, although it varies by industry quite widely. Fisher also mentions that even though low-margin companies can enjoy a faster growth rate in a recovery phase of an economic cycle, these profits can easily disappear during the next downturn, while higher-margin companies would easily overtake their competitors through the cycle. Fisher makes one important exception for younger companies that can have reduced profits due to active investment in R&D and sales of new products. Although according to the author, an investor should be 'absolutely certain that it is actually still further research, still further sales promotion, or still more of any other activity which is being financed today so as to build for the future, that is the real cause of the narrow or non-existent product margin'.
6. Company should be actively working on maintaining or improving profit margins.
Fisher brings up a few examples when companies saw their margins fall due to new or better products that were introduced by competitors. Most of these new products took years to be developed, which means that companies should be planning well in advance about improving quality, cutting costs or developing new products.
7. Relations between management and employees.
This is a very important point which I have only recently started to appreciate. Fisher mentions the well-known fact that a motivated employee can be several times more productive than an upset colleague even if they both receive the same salary. Hence, companies, where employees are happy, can achieve better margins, higher growth and stronger market positions with practically the same amount of labour costs. Netflix is one of those rare companies that took this principle further by paying up to attract exceptional talent to generate the best content and customer experience.
8. Relations between top managers should be outstanding.
A similar point suggests that unless executives have great working relations with each other, the company may eventually lose direction, focus and face other problems.
9. Company should have the depth for its management team.
10. Cost analysis and accounting control.
11. Other aspects of the business which will give the investor important clues as to how outstanding the company may be in relation to its competition.
Fisher brings an interesting example of insurance costs as an indication of how well the company manages its operation (a poorly run company would spend more on insurance relative to its better run competitors).
12. Does the company have a short-range or long-range outlook in regard to profits?
Fisher clearly advocates a long-term approach to customer relations as well as to relations with employees, suppliers, partners etc. '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. To me, Amazon is one of those companies that is ready to sacrifice near-term profits for a long-term opportunity.
13. Is the company likely to face the need to raise capital to fund its growth.
The important point is that shareholder value is often destroyed through growth that requires too much capital.
14. Does the company's management talk freely to investors when things are going well and in much more challenging situations?
Fisher means not just financial performance but also operations and product development.
15. Management's integrity.
Fisher provides cases when management's integrity could be questioned, such as putting relatives on a company's payroll (especially above-market rates), rents own property to the company, buys materials and equipment not directly but through intermediaries in which management has an interest, exceptionally high compensation to management especially in the form of stocks and options. Importantly, Fisher notes that while an attractive investment opportunity may not meet all the criteria, this issue of integrity is one that cannot be absolutely ignored in selecting stocks.
When to buy
Fisher discusses five major top-down drivers that can impact a company's performance and its stock price, but most often, they pull the business and the stock in opposite directions and also depend on other people's reactions and expectations making it very difficult for an individual investor to make use of them. Fisher's advice is thus quite unsurprising - an investor should act when key fundamentals are in place.
On a question about price vs quality (which factor to put more weight on when deciding which stock to buy), Fisher makes an important point. Fisher says '…the degree by which a company is undervalued is usually somewhat limited. The time it takes to get adjusted to its value is frequently considerable…This means that over a time sufficient to give a fair comparison - say five years - 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… The reason why the growth stocks do so much better is that they seem to show gains in value in the hundreds of per cent each decade. In contrast, it is an unusual bargain that is as much as 50% undervalued'.
This point on much higher returns potential generated by companies able to grow earnings for many years compared to simply cheap stocks was made a few times by Buffett, especially when he described how his investment approach changed after he met Munger.
On a question about price vs quality (which factor to put more weight on when deciding which stock to buy), Fisher makes an important point. Fisher says '…the degree by which a company is undervalued is usually somewhat limited. The time it takes to get adjusted to its value is frequently considerable…This means that over a time sufficient to give a fair comparison - say five years - 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… The reason why the growth stocks do so much better is that they seem to show gains in value in the hundreds of per cent each decade. In contrast, it is an unusual bargain that is as much as 50% undervalued'.
This point on much higher returns potential generated by companies able to grow earnings for many years compared to simply cheap stocks was made a few times by Buffett, especially when he described how his investment approach changed after he met Munger.
3 reasons to Sell
- Mistake in the investment thesis. Important to have the humility to accept mistakes and control your ego to be able to correct them.
- Company no longer meets most of 15 points above as over time industry and corporate conditions change. Many reasons could be explained by deterioration in management or growth prospect (see the next point).
- Growth prospects for the business are not better than for the overall industry, the company has exhausted its exceptional growth potential.
He also argues against selling just because this company appears somewhat overvalued as this is 'trying to measure something with a greater degree of preciseness than is possible'. Finally, Fisher calls the ridiculous reason to sell a stock just because 'it had a great run'.
5 Don'ts
- Don't buy into promotional companies. Here, Fisher means early-stage business without even a year of profits and just 1-3 years since launch.
- Don't ignore a good stock just because it is traded 'over the counter'.
- Don't buy a stock just because you like the 'tone' of its annual report. As Fisher puts it 'there is no way of telling whether the president has actually written the remarks in an annual report, or whether a public relations officer has written them for his signature'.
- 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. Fisher notes that if a company has strong growth prospects after 3 years during which its sales also increased, its multiple would likely remain close to current levels, and investor's returns would match high growth during a 3-year period. It is thus important to understand whether growth in the next 3 years is just a one-off, temporary issue or early stage of a long development trajectory.
- Don't quibble over eighths and quarters. The point is that if the company's characteristics match most of 15 points, there is no point trying to buy its stock at the bottom as you run the risk of missing huge returns.
5 more Don'ts
- Don't overstress diversification. Apart from well-known points that large companies can be well-diversified geographically, Fisher suggests the optimal number of stocks in a portfolio. His advice is to focus on A. large and fast-growing companies (20% of the portfolio could be allocated to each such stock), B. Smaller companies with faster growth (5% of portfolio), and C. Young businesses with tremendous potential but also with a risk of a complete loss of investment (5% of portfolio).
- Don't be afraid of buying on a war scare.
- Don't be influenced by what doesn't matter.
- Don't fail to consider time as well as price in buying a true growth stock. Quite surprisingly, at least for me, is Fisher's comments that if you manage to buy a growth stock at a very attractive price, your total return would be much better. I am personally not convinced it is so easy to time your purchase, although Fisher brings examples of when such growth companies may see their shares slide.
- Don't follow the crowd.
Notable quotes
- Two matters were significant influences in causing this book to be written. One, which I mentioned several times elsewhere, is the need for patience if big profits are to be made from an 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.
- It would be nice if there were some easy, quick ways of selecting bonanza stocks. I strongly doubt that such a way exists.
- War is always bearish on money. To sell 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 the job has been correctly done when a common stock is purchased, the time to see it is - almost never.
- There is an 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 being foolish.
- 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 reason.