Sunday, July 21, 2013

Philip Fisher's 15 Points to Look for in a Common Stock

After reading Peter Lynch's Beating the Street a few weeks ago, I decided to read another investing classic: Philip Fisher's Common Stocks and Uncommon Profits. As one of the pioneers of the modern investing industry, Fisher is often credited with laying the groundwork for what we know as growth investing today.

First written in 1958 -- nearly 25 years after Graham and Dodd's Security Analysis established the framework for value investing --  Common Stocks and Uncommon Profits is cut from a very different cloth than Graham and Dodd. For instance, at many points in the book, Fisher says a high price-to-earnings ratio should not be an automatic turn-off for investors.

Here's one such example:
If the company is deliberately and consistently developing new sources of earning power, and if the industry is one promising to afford equal growth spurts in the future, the price-earnings ratio five or ten years in the future is rather sure to be as much above that of the average stock as it is today...This is why some of the stocks that at first glance appear highest priced may, upon analysis, be the biggest bargains. 
This approach is clearly different from traditional value investing. No "net-nets" or "cigar butts" here -- Fisher is more interested in finding and investing in the few excellent companies in the market. Valuation may matter, but it's secondary to identifying top-notch businesses.

In the book, Fisher lays out "15 Points to Look for in a Common Stock" that can help investors do just that.

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 splits outstanding companies into two camps: "fortunate and able" and "fortunate because they are able". The former group consists of well-run companies that also benefit from a secular tailwind. Modern examples might be Amazon and eBay, both of whom have benefited mightily from the Internet revolution. As the Internet has grown, so have these companies' fortunes. Some of their success can certainly be attributable to excellent execution, but these companies' long-range sales curves extended as more and more people embraced online shopping.

The latter group consists of companies that create their own luck by reinventing the business by introducing new products or shifting strategy. In the book, Fisher uses the example of DuPont, which expanded its chemical offerings well beyond blasting powder and consequently lengthened its long-range sales curve.

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?

This may sound a lot like the previous point, but as Fisher says, this point is "a matter of management attitude." Consider Apple: Steve Jobs could have stopped with the iPod and would have been long remembered for revolutionizing the way we listen to music. Early investors would have made good money riding only the iPod's success. But what really made Apple a top-performing stock for the past decade was Jobs' drive to make sure that the iPod was followed by the equally-revolutionary iPhone and iPad products.

Few companies will match Apple's success, but the example does show how identifying companies with management teams intent on staying on the offensive with new products/processes can reward shareholders by having an extended long-range sales curve.

3. How effective are the company's research and development efforts in relation to its size?

Most R&D analysis begins and ends with the tried-and-true "R&D spending as a percentage of sales" metric. Though this ratio can reveal how current R&D spending compares with the past, it tells us very little about what kind of returns the company is getting on each R&D dollar. Admittedly a difficult figure to determine, you can look at the success of recent product launches as a sign of R&D productivity. Ideally, you want a company's R&D spending to be dedicated to creating or enhancing its economic moat. Firms that not only create new products but also create unique production methods will benefit more than companies that just create new products that can be quickly replicated by existing techniques in the industry.

4. Does the company have an above-average sales organization?

This is an often overlooked area of research -- indeed, one that I've under-appreciated over the years. The reason for this common oversight, as Fisher rightly notes, is that there's no accounting measure or ratio -- as there is for research and development, for example -- that captures marketing spending and effectiveness.

But the quality of a sales force matters. Think about it this way: Ever been to a restaurant with crappy service? Even if the food is good, because of a bad service experience you're much less likely to go back or recommend the place to friends. The same thing occurs in business all the time.

Analyzing the quality of a company's sales force requires a more qualitative approach. If you can, ask customers, suppliers, competitors who has the best sales force in the industry. If you can get the company on the phone, ask them how their sales force is rewarded. If you don't have access to those parties, a Google search may reveal something helpful.

5. Does the company have a worthwhile profit margin?

As Fisher puts it, "the greatest long-range investment profits are never obtained by investing in marginal companies." That is, if the company isn't doing anything remarkable, nothing is changing, and its margins are razor-thin, there's no point buying it. In most cases, I look for companies able to consistently generate 10%+ margins. There are exceptions -- for example, firms can have low profit margins and high asset turnover and generate good returns on equity (see: Costco, Wal-Mart, etc.).

6. What is the company doing to maintain or improve profit margins?

The investing community often falls into the trap of extrapolating present trends. If a company's margins have averaged 8% over the last five years, for example, many forecasts will assume about 8% margins over the next five years, too. As such, the market price for the stock has a good chance of implying about 8% margins going forward. So when a company is able to break away from historical trends and boost margins to, say 15%, that will have a profound impact on the stock price and investors who anticipated that move will be rewarded.

7. Does the company have outstanding labor and personnel relations?

Put another way, "Are rank-and-file employees passionate about working for the company?" Though this is rare, when employees are enthusiastic the productivity levels can be extraordinary. It's precisely these companies that can truly deliver better-than-expected profit margins and returns on capital even if the market is skeptical. When doing your research on this point, reach out to people in your network who may work for the company or industry to find out who has passionate employees. LinkedIn, Glassdoor, and other websites may also provide some quality information about employee morale.

8. Does the company have outstanding executive relations?

Similar to Point #7, but more focused on executive motivation and passion for the job. Excessive management pay packages is certainly cause for concern, but you also want the executives to be appropriately compensated. Otherwise, they'll likely have one eye on the business and one eye on the door.

9. Does the company have depth to its management? 

I've debated this point with others in the investment industry and I've heard good counterarguments, but there is something to be said for a company that can retain employees -- especially in this day and age -- for 10+ years and promote them to senior positions.That is usually a sign that highly-skilled people like working for the company (see Point 7) and have bought into the culture and mission. Conversely, a company that needs to frequently hire from the outside might have trouble retaining key employees or might be looking to change the corporate culture. Hiring outside executives to repair a defective corporate culture is often necessary, but it can also disrupt operations for a few years and you may want to put your investing dollars elsewhere unless you know a lot about the specific situation.

10. How good are the company's cost analysis and accounting controls?

Financial sleuths can examine the consistency of a company's assumptions for pension accounting, depreciation, revenue recognition, etc. Firms that frequently change these assumptions to make the numbers "work" each year should be avoided. Also consider management incentives (found on the annual proxy statement) to see if executives have moving targets each year or lowered hurdles that have enabled management to earn a healthy bonus regardless of performance.

11. Are the 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?

This question can be rephrased as "Does the company have an economic moat?" By doing a competitive analysis of the firm against its peers, we can begin to figure out if the company is relatively advantaged and, more importantly, if that advantage is sustainable or unsustainable. (Here's a video about understanding economic moats.)

12. Does the company have a short-range or long-range outlook in regard to profits?

Long-term shareholders naturally want a management team with an eye toward building long-term value rather than just managing for short-term results. While it's true that the long-term is made up of many short-terms, you also don't want companies to consistently forgo value-enhancing projects or squeeze important suppliers/customers just because it might hurt the quarterly EPS.

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?

Basically, you want to find companies that are financially healthy enough to fund their growth investments with internally-generated cash or with reasonable amounts of debt. Firms that consistently need to issue equity (and dilute current shareholders' stake in the process) should be avoided.

14. Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?

Take a look through the company's reports and conference call transcripts following a particularly poor quarter or year. Is management forthcoming about mistakes they've made or is everything sugar-coated or blamed on the economy/weather/markets? If management takes ownership for the company's underperformance and thoroughly explains the steps they're taking to improve the business, you might just have a winner.

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

The key word here is unquestionable. A management team that has any history of dishonesty, fraud, or ignoring shareholder interests will likely repeat this behavior and you don't want to be in their way when they do. I've made this mistake fairly recently, actually, and even though the company checked off a lot of boxes on the good side of the ledger, management's lack of integrity should have outweighed all those points.

Thanks to the Internet and company filings, we have plenty of ways to analyze management track records and behavior at current and former companies. The key here is when in doubt about a management's integrity, just walk away.

More to come

Common Stocks and Uncommon Profits is a must-read for serious investors, but I wouldn't recommend it as a book that new investors should read first. It was written for experienced professional investors, has some dated company examples, and assumes the reader has a certain level of access to the company that most retail investors don't have. Most of Fisher's lessons, however, are evergreen and the book is full of great quotes that I'll list in a subsequent post.

For a list of other good investing books, click here.

Thanks for reading!


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