Common Stocks and Uncommon Profits – Phil Fisher and fifteen points for investing

AuthorAthenarium / Posted on

Common Stocks Uncommon Profits - Phil Fisher - Fifteen Points

Phil Fisher’s fifteen points and investment checklist

Investors can avoid disasters such as Enron, Tyco and WorldCom if they focus on Main Street’s verification of each business’ strengths and not the gossip of Wall Street Opinion. In his book, Common Stocks and Uncommon Profits, investor Phil Fisher identified fifteen points that characterise an attractive investment opportunity. According to Fisher, these are fifteen fundamental business features that companies cannot fake. While much of the fifteen points are self-explanatory, it has great utility as a checklist for what to buy and what to avoid. In this post, we will review Fisher’s fifteen points, which we categorise into five themes:

Attractive growth prospects

1. Does the company have significant sales growth potential for at least the next several years?

Fisher advises readers to consider both the growth potential and its likelihood of realisation. The quality of management, industry trends and business cycles are important considerations here. Similarly, Fisher recommends we focus on the quality of growth, looking across several years of growth as opposed to year-to-year comparisons.

2. Does management have the determination to continue development of products and processes to increase total sales when the existing growth potential have been exhausted?

While the first point is a matter of fact to Fisher, this second point is a matter of management attitude. Managers need to recognise whe existing opportunities have reached its potential and when new developments need to be explored. However, Additionally, Fisher believes that new engineering and research must have some business relationship with existing operations. Unsurprisngly, companies are better placed to succeed in new industries that are related to existing business than in totally unrelated industries.

3. Does the company take a long-range view to profits?

Some companies for example will forgo near term profits to look after their customers, partners and/or suppliers during unusual or difficult circumstances to improve relationships and profits in the long run. Fisher believes, like many other value investors, that companies with a genuinely long-term outlook with regards to profits are more likely to deliver sustainable results. This point is of course no different to Warren Buffett’s investment philosophy.

4. Will future company growth require new equity financing such that expected benefits to existing shareholders are offset by the dilution in their claim?

This point focuses on the company’s reinvestment requirements for growth. Fisher believes that it is important that a company can rely on existing cash, profits and prudent borrowing to finance future growth. If not, the attractiveness of the investment depends as well on the expected dilution to existing shareholders that comes with subsequent equity financing. Hence, the expected growth in earnings needs to be sufficiently large to make the cost of dilution acceptable.

Strong profit margins

5. Does the company have an attractive profit margin?

Fisher believes that the best long-run investments are unlikely to be in marginal companies. Investors should look for healthy margins across a series of years. These companies should ideally have the best margins in their industry. However, Fisher believes an exception might be made for young companies that forgo profits today to accelerate their growth over the next few years. It is critical here that increased spending is allocated to further research, sales promotion or related activities that will improve the company’s future. This is distinct from a company that must reinvest all profits in capital projects just to stay afloat.

6. What is the company undertaking to protect or grow profit margins?

Fisher likes companies that actively review their operations for improvement and opportunities for growth. The author warns readers to watch for industries whose profit margins rise purely as a result of simple price increases. This is not neccessarily an attractive indication to the long-range investor. Pat Dorsey shared a similar sentiment in his book The Little Book that Builds Wealth.

7. Are there characteristics unique to the business and/or industry that provide useful clues on the position of the company relative to its competitors?

This is a catch-all inquiry for the investor to remember because company matters are likely to differ on a case by case basis. Examples here might include manufacturing know-how, sales and service quality, customer goodwill, or patents. Professor Bruce Greenwald has suggested investors think about demand advantages (e.g. customer captivity), supply advantages (e.g. technologies) and economies of scale advantage that a business may have over its competitors. He provides a great dissection on competitive advantages and barriers to entry in his book Competition Demystified.

Effective research, sales and accounting

8. Is the company’s research and development efforts effective relative to its size?

While research and development (R&D) expenses to sales ratios can provide a crude comparison of company research relative to competitors, it is not always meaningful. Fisher suggests that such figures are potentially misleading because companies can account for R&D and capital expenses in very different ways.

Furthermore, the level of investment and degree of skill is necessary but not sufficient for outstanding results. Leaders must coordinate people of diverse skills and backgrounds to common goals. The coordination and link between research, production, sales and top management are also very important. This was also an important message in Fisher’s prior work, Conservative Investors Sleep Well.

Similarly, R&D efficiency curtails when projects expand during growth years and contract during slow years. Fisher dislikes crash programs for example, where research people are moved in and out of projects frequently. He suggests such work models are likely to increase the total cost to benefit ratio of research.

Taken collectively, Fisher believes it is worthwhile to understand the flow in sales and net profits from new products or services that is attributable to company R&D.

9. Does the company have an above average sales team?

Company survival is impossible without sales. Fisher believes that the relative efficiency of company sales, advertising and distributive organisation tend to receive insufficient attention from investors. However, it is outstanding research, production and sales that company success is based.

10. Does the company have good cost analysis and accounting controls?

To develop and priorities good strategies, companies need a sufficiently accurate and detailed breakdown of their cost and revenue drivers. Otherwise, management may or may not be solving problems that need the most attention.

Strong managerial relations and depth

11. Does the company have outstanding labour and personnel relations?

Fisher notes that the difference in profitability between a company with good personnel relations and one with poor personnel relations is greater than just the potential cost of workforce strikes. That is, effective leadership and working conditions can improve the productivity of each worker. Training and recruitment of staff is expensive, and high workforce turnover introduces unnecessary expenses that better-managed companies can avoid.

Fisher suggests comparing the workforce turnover rate and size of waiting list for job applications against competitors in the same locality. The author believes it is a useful indicator of the underlying quality of labour and personnel policies. Similarly, companies that make above-average profits and pay above-average wages relative to its locality may be another positive indicator. Conversely, companies that pay below average wages may be a red flag.

Furthermore, the absence of conflict does not imply a healthy relationship. For some companies, it might imply a culture of fear. Companies with good labour relations should make the effort to resolve grievances and disputes quickly and fairly. Investors should be sensitive to top management’s attitude to employees at all levels. Managers who exhibit little responsibility for their ordinary workers are less likely to make the company a desirable investment for the long term.

Red flags include mass staff hirings and firings at the slight swing in the company’s outlook, or when little is done to make ordinary employees feel valued. Similarly, in her book Investing Between the Lines, author LJ Rittenhouse recommends that investors review executive communications to determine how important employee relations are to the company and management.

12. Does the company have outstanding executive relations?

The judgement, ingenuity and teamwork among executive personnel is vital to the success of a company. Executives should have confidence in their president and/or board chairman. Promotions should be based on ability and not factionalism. Salaries should be at least in line with the industry and locality average, and adjustments are reviewed for merit increases. Outsiders should only be recruited if there is no one internally to promote or fill that role.

13. Does the company exhibit depth in its management?

Fisher believes that even small companies should have a succession plan if their key leaders and talent are no longer available. Companies with attractive investment prospects need to grow over time. To pursue growth opportunities, the executives of such companies will often need to develop depth in skills and experience over time. Fisher notes that companies that do not provide enough delegation of authority will limit the potential of future executive material since middle management staff today will not receive the opportunities to develop. Likewise, insufficient delegation means that there is too much detail to handle effectively and efficiently at the top. Capable managers should welcome and evaluate suggestions and ideas from across the organization, even if they invite criticism.

Honesty and integrity

14. Is management candid with shareholders during good and bad news?

Disappointments are an inevitable part of both successful and unsuccessful businesses. Management that do not report openly during bad situations may indicate that they do not have a solution to a problem, and lack a sense of responsibility to its shareholders. Fisher believes it is a red flag when managers are not candid during both good and bad times.

15. Does the company have a management of unquestionable integrity?

Fisher believes that investors should confine investments to companies with management that exhibit a strong sense trusteeship and moral responsibility to its shareholders. Bad management will find many ways to derive benefits at the expense of shareholders. One common mechanism is managerial abuse of stock options. Other symptoms include inclusion of relatives with irrelevant experience on the payroll at above fair value; renting or selling personal assets to the corporation above market rates; and selection of vendors or suppliers that benefit friends or cross-holdings. Again, point fourteen and fifteen shares common ground with Warren Buffett. The Oracle of Omaha liked to invest in rational, intelligent and honest managers with strong integrity.

Further reading

References

  • Fisher, P. (1960). Common Stocks and Uncommon Profits, Harper & Brothers. Revised Edition.
  • Fisher, P. (1975). Conservative Investors Sleep Well, Harper & Row. Chapters 1-3.