Common Stocks and Uncommon Profits by Philip A. Fisher

       Renowned growth investor Philip Fisher wrote a seminal book on investments called "Common Stocks and Uncommon Profits". In the days when Ben Graham’s approach of "Value investing" was gaining widespread appreciation, Fisher brought a new dimension to long term investment which was later called as “Growth Investing”.

       Prior to 1950s the companies were mainly family owned and managed. These resisted change and hence such companies grew at a much slower rate. These companies would not spend money on R&D. However as years passed by they realized that they would go out of business and hence, now, they spend more money on R&D. Prior to the great depression of 1920s, the government never bothered about private companies as they were not a source of revenue. Government never collected corporate tax or income tax from companies. But in the early 1930s, government started to collect corporate tax. But it soon realized that if it wants higher tax revenues it will have to support the companies so that they don’t go kaput.

       Fisher is a big believer in common stocks compared to debt instruments like bonds. He believes that prior to 1950s bonds were a great investment option. Nowadays inflation negates the earnings of bonds as the inflation adjusted returns are much less. Bonds are good for large institutions like banks, insurance companies or for people with short term objectives. For long term investors, bonds may not be a good option.

       When one wants to evaluate a company, he or she would be puzzled as to how one can go about doing this. Fisher believes that scuttlebutt is a good method to evaluate a company. Scuttlebutt is the method of gathering information about a company by asking people about the company. You can scuttlebutt employees, former employees, competitors, vendors, customers, research scientists, government officials. They can provide more information about the company. However, personally, I am not too sure if scuttlebutt is really necessary in these days when GOOD companies are more open and information is readily available from various sources (like the internet). Moreover, small investors may not have time and resources to approach employees or competitors, vendors etc.

What to Buy?

When one sets out to look for companies to buy, fisher suggests fifteen point formula to evaluate a company. Applying these fifteen points (at least some of them) to the evaluation process will help investors to separate the wheat from the chaff.

The existing products or services of the company play a major role in generating revenues and profits of any company.  The first point deals with evaluating the existing products or services and analyzing if these products and services have sufficient market potential to generate sizeable increase in sales for the foreseeable future. One time profits from operational efficiencies like controlling the costs or even one time opportunities like selling radios/TVs may not be sustainable. One should measure the performance of companies over multiple years. Companies that have performed well for decades are generally of two types: "fortunate and able" and "fortunate because they are able". In both cases management played a key role. If the company management is excellent and the particular industry is subject to technology change and development research, sales are bound to increase. Fisher gives an example from his era i.e. Motorola. Motorola started as a television company and moved to 2-way radio, semiconductor development that resulted in huge profits. This was possible because of excellent management.

The second evaluation parameter deals with the future products of the company, i.e., does the management support new product or process development so that the company can enhance its sales in future when the existing products have exhausted their sales edge. There is a caveat here though, and the caveat is that the new products should be related to old products i.e. existing products are like root and the new products shall be new branches rather than new trees. Management should not unnecessary branch to new unrelated products.

Research and development (R&D) plays a major role in the success of any company. The third point deals with the effectiveness of the R&D operation of the company. An investor should assess the effectiveness of R&D effort in relation to the size of the company. Fisher believes that it is tough to gauge as different companies treat different things as research expenses. The best run companies extract twice the gain from every dollar spent on research. Fisher is a big believer is marketing. He says that some amount of R&D expense should be set aside for market research. What is the point in spending R&D efforts on a product that does not have a sizeable market opportunity? So market research is important. He believes that numbers like "R&D expense" or "Number of employees engaged in R&D" are not the true indicator of the impact of this R&D effort on company's bottom line. Fisher suggests a scuttlebutt to gauge the impact.

Fisher believes that sales teams play a vital role in the revenue generation capability of a company. The fourth point delves with the size and effectiveness of the sales organization. Sales does not generally get the attention because there is no good way to measure it the way costs (ex: input costs) can be measured. Fisher again suggests scuttlebutt method to measure effectiveness of the sales team on revenue. Fisher cites example of Dow chemical and IBM and describes how they have successfully institutionalized the sales process and how they train and hire the sales team. Some companies in India, for example, Ajanta Pharma provide details on their sales organization within India as well as in their export markets. However it is tough to get such information for all the companies.

All the sales, marketing, revenue generation leads to one important point i.e. profits. To increase profits, a company should have higher profit margin. The fifth point deals with the evaluation of the profit margins of a prospective company, i.e. does the company have a worthwhile profit margin? For each dollar of sales how much cents profits does the company get? When the times are good even smaller profit margin companies do well. But when the tide turns they come back to lower profit state. Hence check profit margin for multiple years. I believe that one should check the profit margin on standalone as well as consolidated basis. Fisher warns investors to never invest for long term in companies with abnormally low profit margin unless the abnormal low margin is because the company is investing in future growth.

The details on the profit margins of the past are a good indicator about any company’s efficiency, however an investor is interested in the future of a company. So it is essential to look at the future profit margins of the company. The sixth point deals evaluating the activities that the company is undertaking to maintain or improve the profit margins. Some overheads/expenses like salaries, hike in salary, taxes have a major impact on profits. Is the company doing something to optimize these aspects? Some companies can raise prices to maintain margins but this could make competitor's products cheaper. Some companies go for long range methods to improve profits. Ex: Reduce costs by designing new equipment. Improve efficiency in operations. These measures are healthy for the company. One should keep an eye on management statements on such topics.

A company does not have a life of its own. It is a conglomeration of people. Hence employee relations play a major part in the success of any organization. The sixth point deals with the labor and personal relation. If the company has excellent relationship with labor then there may not be an employee union existing in the company (though having a union does not mean the relations are bad). Too many strikes in the company means the relation is bad (though no strikes does not necessarily mean the relations are good. It can also mean company, out of fear, accepts all the demands of the union). Companies that have good relations have a quick grievance handling mechanism. Such companies would pay above average salaries for that locality if they have above average profit. Fisher also stresses on sentimental aspects like does the company feel responsible and treat employees with respect. Does it readily fire people when there is a small drop in profits? Does it care about their hardship? Does it feel that it should make the employees feel wanted by company?

Fisher talks about some points that are tough for investors to guage, for example the relation among the higher management personal or the depth of management are tough to evaluate. Things like a company’s cost analysis and accounting controls (i.e. does the management breakdown the cost to a details such that it figures out which products are profitable or not) is tough to evaluate.

Some aspects of a business are generally peculiar to the industry. For example, for a pharma research based pharma company, patents are important. To judge a company one should look at such industry specific differentiators and see if the company is better than its competitors. The eleventh point deals with this aspect. If real estate is a major cost for a company, does the company show competence to ensure that it can lower the cost. Same way if insurance is a major cost, then does the company holistically look at all its operations to ensure that accidents are less and hence insurance cost is low. Does the company treat patents only as enablers and not as a way to earn money? If patents are its main bread and butter then be careful. Patents help but the patent should be so foolproof that no one should be able to circumvent and produce the same product.

The twelfth point deals with the outlook of the company towards its short range and long range profits. For example, does the company conduct affairs so as to gain maximum profit right now or is it ready to forgo immediate gain so as to get a long term gain. If its supplier is facing a temporary issue is the company ready to accommodate to earn a goodwill so that in bad days the supplier will provide good quality components to you. Similar situation could happen with customers. Is the company ready to accommodate a regular customer caught in a jam to forgo a small profit in return of customer loyalty? For a lay investor it is tough to find this out. Fisher suggests scuttlebutt method for this.

Financing the growth ambition of a company is very important. Does the company do equity dilution to raise cash for its expansion? This dilution could be because it has hit its debt limit and cannot borrow more or it could be because the company does not like debt.  In any case if equity dilution leads to a situation where the growth brought about from the money earned from dilution does not increase EPS for existing shareholders then it is not a good situation to hold on to the sticks of such a company. i.e. gain from equity dilution should result in substantial increase in EPS for existing shareholders also.

The fourteenth point deals with the openness of the management during say disappointing quarters. Does it open up or does it clam up? Companies could face hurdles, unfavorable circumstances, and disappointments. The reaction of the management to such matters can be a valuable clue. Does it report freely or does it withhold information. Does it panic? If information is not forthcoming then it is a red flag. The final point deals with the management integrity. Does the management demonstrate an unquestionably integrity? Compared to shareholder, the management is nearest to the company's assets. Without breaking any law, the company could still be taken for a ride by the management. Some examples that show a dubious management are: Example 1: To put themselves or their family members on company's payroll and pay them high salaries. Example 2: Management sells/leases its personal property to the company at a very high rate compared to market rate. Example 3: Forcing vendors to sell material to it via agents controlled by the management etc.

Fisher believes that People who analyze all statistics go through all annual reports, minutely analyze each point may gain few additional percentage point gain compared to one who does not. But over a longer period of time such gains are immaterial and insignificant. So even a small time investor with reasonable intelligence can gain with little effort. I believe he makes an excellent point here. From my own experience I can safely say that if your time horizon is 1 day then you have to do a lot of meaningless technical analysis that leads you nowhere. If your time horizon is 1 year then you need to keep track of sales every quarter check Q-o-Q growth. Compare year-on-year growth for each quarter. Listen to management every quarter predict what would be the EPS growth by the end of the year and then decide whether to stay on or leave. However if your time horizon is 10 years then a bad quarter here and there would not matter as long as overall trend is positive. You may listen to management to confirm if they are on track with respect to EPS growth and do they foresee any issues.

If one does not have required knowledge, one should seek knowledge or hire an investment advisor. However, unlike a doctor or a lawyer there is no fixed/known way to judge the competency of a financial advisory. Fisher advises to choose an advisor who has at least, say, 5 years of experience. Whomever you chose as an advisor, he should meet two more critera: He or she should be completely honest and his or her thought process should match yours.

In the book I felt that Fisher laid more emphasis on companies with smaller market capitalization. He believes that young growth stocks offer by far the greatest possibility of gain. These stocks can also ruin your capital sometimes. However chances of such a thing happening are less if you choose stocks based on the fifteen points that were elaborated above. Also, It has been historically proven that growth stocks are better than dividend paying stocks in amassing wealth. He believes that even growth stocks pay dividend and over years generally this keeps increasing, so growth stocks can also become immediate money earner to some extent.

Fisher adds a whiff of caution to stock market investing. He believes that only surplus money should be used for investing in young growth stock. Investors should keep aside some money for critical illness, college education for kids. This money should not be put in stocks.

 When you Buy?

When to buy is as important a decision on what to buy. People generally go through vast amount of economic data to come to a conclusion on the near and medium term outlook of general business. Based on this, the purchase/hold decisions are made if no major worsening of background conditions are seen. If dark clouds are seen at the horizon then purchasing decisions are postponed. Fisher believes that economic forecast is akin to alchemy of the previous centuries. People predict based on their own interpretation and most analysts contradict each other.

The first scenario that warrants a buy decision is as described. When a company is trying to establish a new factory it faces some snags and takes time to come up. In the meantime the company tries to hide this by pumping up sales of older products. Then suddenly the new product clicks and the word spreads. People come flocking and buy its shares and the price goes up. Then a successful pilot operation is done and price of the stock goes even higher and people assume things are fine. After this every month news keeps coming that the plant is facing some difficulties and hence the earnings start to drop. Then the plant starts to function properly and a relief rally follows. Again news is received that the company is running some discount sale that might put pressure on the bottom line. This is when investors might panic and the stock hits the 52-week low. Fisher believes that this the perfect time to buy the stock because the company has successfully learnt the entire cycle for the first plant. Now when 2nd, 3rd, 4th or 5th plant comes up the successful learnings are applied to quickly get on feet and the company becomes a large company.

A second scenario is when say a company has reached a stage wherein if it say invests 15% money and can generate 40% revenue, the company is in great state! If the stock price does not reflect the gain that is going to come then it is a good time to buy.

If suppose this is a year where you don't notice excessive speculation in the market and major economic indicators are not showing warnings and you have money to invest then you can invest in a mature manner. Fisher also has some investment advice for first time investors. He believes that if someone is buying for the first time then it is better to buy in a staggered fashion over a few years than in a lump sum fashion. He will ride ups and downs, understand & experience cycles.

When to sell and when not to?

Selling a stock that one owns is generally an emotional moment. People sell stocks for various reasons. Some people sell stocks to meet some personal commitments like buying a house or car. Fisher empathizes with such situations. However his focus is more towards market related reason for selling stocks.

The first reason why an investor should think of selling in stock is when he comes to realize that there was a mistake done during initial purchase. Careful analysis has revealed that the fundamentals of the company are not what was initially assumed. Hence the stock should be sold. However human ego blocks them from selling. They want to wait till at least they reach a breakeven before selling. This is not the right approach. Such stocks that were bought on faulty analysis/presumption should be sold immediately.

The second reason to sell a stock could be that with passage of time it has become clear that the stock no longer qualifies based on the 15 points made out in the "when to buy" section. This deviation could have happened for two reasons. Management has lost its track because of complacency or the new management is not as good as the old one. Or the products of the company have had a spectacular run over the past few years and in future the company can at best be a market performer. This is not because of management issues. It is just that the company does not see growth opportunities in its area and diversifying is not an answer for the company. So it will grow at industry rate. In such a scenario it is good to sell the stock.

A third reason could be that an investor had temporarily parked his money in another stock and he has found a much better stock.

Fisher cautions investors to be careful of reason why they are selling. People generally sell because overall market condition might deteriorate in future. By selling with such an assumption means you are selling something about which you have very good knowledge (i.e. your stock) got information that is uncertain and you have less knowledge of (market correcting in future). Moreover if you sell and the event occurs or partially occurs you keep postponing the buyback hoping for price to further fall and if the stock starts moving up you miss out completely on the stock.

Sometimes people sell because the stock is overpriced. We arrive at this overpriced logic by comparing this company's PE with other companies of similar nature. On this point fisher differs from value investors and reveals that his is a growth investor. He says that probably the company is trading at 35 PE instead of 25 this could be because it is working on a new product that will come out in future. Even if new products are not in offing, the growth rate could be so good that it might quadruple in 10 years. This justifies high PE and such stocks need not be sold.

Another reason people sell is that it has gone up so much that it has used up its potential. So why not sell it and enter a stock that has not moved up so much. This is ridiculous way of thinking. Fisher gives a real life example where you have given money (loan) to three of your classmates and they will replay you based on their human capital. After 10 years one of them has grown really well and is being groomed as future vice president or CEO. So essentially you are sitting on say 600% returns. In such a case will you sell this asset and invest in another classmate who has not performed will hoping that you will get better results from this non-performing friend in future?

Fisher ends this topic with the golden quote: "If the job has been correctly done when a common stock is purchased, the time to sell is almost never."

 Dividends

Fisher is not a big believer in Dividends. He is of the opinion that companies should give some dividend and use most of the cash to build the company (new plants, optimize factories etc). He believes that while selecting a stock, its dividend should be the least priority item. If you buy an extremely good company that has a dividend policy that says that it will pay "x%" of its profits as dividend and sticks to it, as the profits grow the dividend amount automatically grows. An investor should become cautious only when a company paying “%x” percent of dividend suddenly stops paying dividend. It warrants an analysis for the reason for this sudden stoppage.

 Some don’ts for an investor

Fisher cautions investors to stay away from companies that have been launched just now with a lot of promise about a breakthrough product. One should buy a company which has had at least 2-3 years of commercial operations and one year of operating profits. When a company is in promotional stage it is tough to get information about company's production, sales, cost accounting, management teamwork and all other aspects of its operation. Generally young companies would have great technical minds. But that does not guarantee sales or they could have great sales people but may lag other business capability. Hence, however good the prospects of such a company look like, investment in such companies should be left to specialized people like venture capitalists or Private Equity investors who provide management guidelines as well.

Fisher also cautions investors not to buy a stocks just because its annual report looks attractive. An annual report is the best foot forward of a company and the colorful charts and tables in the annual report could be the work of select few creative minds within the company.

Fishes reminds users that a high priced stock need not discount future earnings now itself. If there is scope for future growth then current high price may be justified. To support this argument fisher gives an example of a company that commands a PE between 25-30 and this is twice that of index valuation (so index could be at a valuation of 12.5 to 15). If this company says that it is planning to double revenues in 5 years. It might appear as if the stock is discounting the growth of the company by 5 years (as its PE is currently twice that of index and earnings will doubly only after 5 years). So investors sell the stock forgetting that after 5 years if the stock may still be priced twice the index because it has further growth plans.

One should not be too picky about the exactly buy price of a stock. If a small investors have found the right stock and it is selling at say Rs. 100 and the optimum price is say Rs. 98, don't bother too much about the Rs. 2 difference. Just buy the stock. This Rs 2 makes a huge difference for institutions that buy hundreds of thousands of shares in one go.

One of the ills of Stock market investment is diversification. People go great lengths in explain the rationale for diversification. Fisher is not a big believer of diversification. People usually say "Don't put all your eggs in one basket". But people fail to notice the problem of putting eggs in too many baskets as they fail to keep track of all the eggs. They put less money in the stocks they know more about and in the name of diversification, channel more money into stocks about which they have very less idea. This brings us to the all-important question - How much stocks should one own? Fisher takes three cases to explain this. Large Cap: An investor can hold five large cap stocks with an upper limit of 20% corpus invested in each of the five stocks. When having such a portfolio investors should ensure that there is no overlap of products between the companies. This makes sense as we would be owning only five stocks so we better make sure they are truly diversified. Mid Cap: An investor can hold ten midcap stocks with an upper limit of 10% of corpus invested in each of these ten stocks. Small Cap: Fisher advises investors to own about twenty such companies with about an upper limit of 5% of corpus invested in each of these twenty companies. These companies are risky compared to midcap stocks. Sometimes the small cap companies turn into midcap companies in which case the allocation can be increased to say 10% of the corpus.

When Fisher wrote this book we were coming out of a big war. Hence he makes a point on war as well. He advises investors not be afraid of wars. Whenever there is a mention of a war (or an impending war) the stock market crashes with an assumption that war brings destruction. But war always leads to money supply as governments resort to money printing to fund the war. This leads to inflation which is good for stocks. Hence one should actually buy when there is a war. In case of an actual war, buy those companies that manufacture products that one would still be needed during a war. I believe food companies, drugs, utilities etc might still work.

When buying a stock investors sometimes look at the price four years ago and compare now and may find it much higher (or lower). Seeing this they might get put off and they might buy another stock that has not gone up as much. Therein lies the fallacy of investors that they believe all stocks move up by same amount and the ones that have not moved, will move in future. This the biggest mistake they make. The stocks that have gone up could be because of more sales or better management or higher profits. Hence expecting the same from all stocks that have not gone up is foolhardy.Before buying, investors should assess the future prospects of the company. The earnings capability of the next five years is more important than the earnings of the past 5 years. Analyst report generally emphasize past track record which is not worth it. Look at the future earnings potential not the past EPS.

Fisher advises investors not to fail to consider time as a factor while buying a stock. Let us assume a company currently quoting at a PE of 32 and ti has plans to grow really well over the next few years because of a new plant being planned by the management which will come to steam in say 8 months. Ideally the PE of the company should be 20 but because of past good and consistent performance people have pushed the prices higher and hence have unknowingly discounted this new plant that will come up in the future. In such a case should one invest now? Fisher suggests to wait for say 5 months to allow a time wise correction to the stock and buy it few months before the plant opens. This has two advantage: You can now buy with surety because you are buying just before the plant comes to steam. Hence unpredictability of plant not starting operations would no longer be there. Because you are buying just before the plant gets launched the current price (even though is higher) will become the base as the plant will add revenue and profit resulting in PE getting adjusted due to increase in profits. As an aside, in the waiting period of five months, I believe we can buy few stocks if PE comes closer to our estimate of 20.

Fisher also advises people not to follow the crowd. Price of stock going down because of revenue change, profit changes or higher/lower taxes is understandable and explainable. But sometimes price of stock goes up or down because of perception of people about the stock. Nothing has changed about the company or the economy at all. Some time ago, Fisher had talked with Dow chemical's management. Subsequently he told his friend about bright future prospects of Dow chemical and he felt it was worth buying. However his friend felt that the current price of Dow was not sustainable. Dow was doing well because of temporary post war boom. But his friend's analysis/conclusion did not consider the fact that company was developing new and interesting products. Now, when we look back at Dow chemicals it is clear that it did not fall and in fact it grew many hundred percent from that point. So, different people draw different conclusions looking at the same facts. Fisher also gives example of armament industry to drive home the point on not following the crowed. He says that armament industry always got a lower valuation in the past because government is the customer for these companies and in all government contracts order could be erratic and margins are always capped by government. Moreover if there are no wars/battles the business plummets. These seem acceptable reasons. However in the recent years the logic got reversed. Now there is a feeling that air borne defense equipment will be needed for many more years. Moreover, due to the technological advancements, older equipment are becoming redundant. Hence the same armory companies are being viewed differently. He also gives example of pharma and chemical industries. In America, over the years pharma and chemical companies have gone from being not favored to being favorite. This keeps ping-ponging every few years without any change in either the nature of business of the demand for their products. 

Common stocks and uncommon profits is an amazing book that covers all the aspects of stock market investment for a growth oriented long term investor. It is an essential book in the library of any investor.