Conservative Investors Sleep Well - Phil Fisher

Investing like Phil Fisher

The philosophy of legendary investor Phil Fisher is to concentrate long-term investments in a small number of unusually promising companies. In his book Common Stocks and Uncommon Profits, he specifies fifteen things for conservative investors to keep in mind when searching for companies with promising long-term investment prospects. To summarise these points in brief, Fisher likes companies with:

Strong profit margins and growth prospects
Great research, sales and accounting divisions
First-in-class managerial relations and depth
A culture for honesty and integrity

This philosophy is not disimilar to other great investors like Warren Buffett and Peter Lynch. The challenge however is in verifying the quality of prospective companies. Not only that, the investor must understand the durability of such advantages, if they even exist at all. In his other book, Conservative Investors Sleep Well, Phil Fisher offers some guidance on identifying the growth potential, managerial capability and defensiveness of the company in question. While far from a magic formula, it offers some helpful considerations to keep in my when investing like Philip Fisher.

In this post, we will review a few of the ideas we took from Fisher’s book, focusing particularly on the functional, people and business factors that he believes make for sound investments. They can serve as an additional checklist to keep in mind when we evaluate the prospects and nature of a company.

Jump ahead:

Functional factors that make good investments
People factors matter in good business
Business characteristics to grow and defend
Further reading

Functional factors that make good investments

While other investors like to focus more on the competive landscape and dynamics of a company, Fisher paid very close attention to the inner workings of the companies he studied. Fisher believed that high quality companies with good long term prospects will get many functional practices right. This includes low-cost operatings, customer centricity, strong marketing, effective research and good accounting practices.

Lowest-cost

The firm is and can remain the lowest-cost producer relative to its competition. A low break-even mark will allow the company to navigate depressed markets and improve its market share and price position when weaker competitors fall out. Furthermore, an above average profit margin allows the company to sustain growth at lower dilution risk to existing shareholders.

Customer focused

The firm is customer orientated and able to recognise and react to changes in customer needs. This should lead to new products that can offset maturing or obsolete lines. One great example of this today is Amazon (NASDAQ: AMZN) and its founder Jeff Bezos. Those who read all of his annual letter to shareholders will observed how focused Bezos was on creating value for his customers.

Effective research

Even nontechnical firms should have effective research capability to develop new products, improve existing products, and help services be performed in more effective and efficient ways. The research capability is productive when it is market / profit conscious and can bring talent together to work as an effective team.

Strong marketing

Effective marketing should understand what customers want and help them to understand the company’s products, all while being cost-effective in implementation. There’s little value in having the best product if customers are unable to find and engage with it. Likewise, effective marketing, gleaned from consumer research, will serve as an input into product development and research.

Good accounting

The firm has a strong financial team and financial practices in place. Good cost information and cost systems will enable management, production, marketing and research to identify priority opportunities and allocate resources appropriately. Good control of fixed and working capital investments can conserve capital. Finance should provide early warnings to management about potential threats to profit and enable them to navigate risks and implement remedial plans as soon as possible.

People factors matter in good business

The quality of the management team and its workforce were very important considerations to Phil Fisher. He looked for evidence of managerial competence, teamwork, internal development, entrepreneurial spirit, investment discipline and a genuine and conscious culture.

Determination, competence and teamwork

Fisher liked companies with founders or leaders that combine determined entrepreneurial personality with the skills necessary for building the firm profitably. The CEO must have a competent team, which he/she delegates significant authority to them. Fisher looks for an ethos built on teamwork. By contrast, he sees managerial dysfunction or micromanagement as a redflag.

Internal development and promotion

The company attracts high quality managers in-house from lower levels by training them for bigger responsibilities. Companies that recruit executives from outside is another red flag to Fisher.

Entrepreneurial and disciplined

The managers recognise and value the need for change, introspection and discipline. They are willing to undertake risk, and forgo current profits, to pursue worthwhile future improvements. The entrepreneurial spirit should be a feature at all levels of the company.

Genuine and conscious culture

Fisher prefers companies that foster an environment where all employees at all levels of the firm feel that their workplace is a good place to work. Companies should treat all employees with dignity and decency, and create an enviornment and benefit scheme that supports and motivates them. Furthermore, staff should feel comfortable to express grievances without fear. They should also expect appropriate attention and action from management. Fisher believes that companies with genuine and conscious cultures will achieve greater productivity and innovation over the long-term.

Business characteristics to grow and defend

In addition to high quality operations and management, Phil Fisher looks for businesses with traits that can deliver and sustain growth and earnings over a long period of time. Here, Fisher will consider the impact of factors such as profit margins, differentiation and indirect competition.

Profit margins

While return on assets is useful for analysing new investments, historic assets stated at historic costs might distort comparisons of firm performance. Fisher believes that profit to sale ratios can offer a complementary indicator of an investment’s safety, particularly during periods of high inflation.

Barriers to entry

High margins tend to attract competition. The company should endeavour to operate so efficiently, whether by scale or some supply advantage, to eliminate any incentive for newcomers to enter. However, Fisher notes that efficiencies from scale are often offset by the inefficiencies of bureaucracy in middle management. Companies with leading market share and fantastic management is an attractive but rare competitive advantage.

First mover advantage

The growth narrative of companies with the latest fad, technology or ‘next big thing’ are often quite exciting to many investors. However, Fisher warns that being first, particularly in a new product market, is often just the first of many steps towards a dominant leadership position. Not many firms have the right mix of management and product to succeed with their first mover advantage.

Competition and substitution

Similarly, it is difficult to introduce new products into markets with dominant competitors. As new entrants develop their business models, we should expect competent incumbents to take defensive action as well. More generally, Fisher advises investors to avoid studying products and companies in isolation. There are many layers of indirect competition such as a consumer’s budget constraint. As in any Economics 101 class will tell us, demand for most products will change when its price or relative price of direct and indirect substitutes change.

Economic moats

It is not always easy to understand the source of a company’s competitive advantage, whether it is durable or whether it even exists at all. Nevertheless, great companies will need some edge to defend itself against competitives over the long run. Fisher suggests a plethora of possible sources, ranging from strong franchises to superior services.

For readers that want more detail on analysing competitive advantages, Fisher’s work shares similarities with Bruce Greenwald’s book, Competition Demystified. Like Fisher, Greenwald likes to focus on company and industry barriers to entry. These barriers may present themselves in one or more demand advantages (e.g. customer captivity), supply advantages (e.g. patents) and economies of scale.

Another brief but accessible text is Pat Dorsey’s The Little Book That Builds Wealth. Like Fisher and Greenwald, Dorsey likes to focus on intangible assets (e.g. brand), switching costs, network effects and cost advantages to determine the durability of a company’s competitive edge.

Conservative Investors Sleep Well – Philip Fisher on investment characteristics