Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)

by Philip A. Fisher

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.

Even a casual glance at American stock market history will show that two very different methods have been used to amass spectacular fortunes. In the nineteenth century and in the early part of the twentieth century, a number of big fortunes and many small ones were made largely by betting on the business cycle. In a period when an unstable banking system caused recurring boom and bust, buying stocks in bad times and selling them in good had strong elements of value. This was particularly true for those with good financial connections who might have some advance information about when the banking system was becoming a bit strained. But perhaps the most significant fact to be realized is that even in the stock market era which started to end with the coming of the Federal Reserve System in 1913 and became history with the passage of the securities and exchange legislation in the early days of the Roosevelt administration, those who used a different method made far more money and took far less risk. Even in those earlier times, finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear.

Before going further, it might be well to summarize briefly the various investment clues that can be gleaned from a study of the past and from a comparison of the major differences, from an investment standpoint, between the past and the present. Such a study indicates that the greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole. It further shows that when we believe we have found such a company we had better stick with it for a long period of time. It gives us a strong hint that such companies need not necessarily be young and small. Instead, regardless of size, what really counts is a management having both a determination to attain further important growth and an ability to bring its plans to completion.

The business “grapevine” is a remarkable thing. It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company. Most people, particularly if they feel sure there is no danger of their being quoted, like to talk about the field of work in which they are engaged and will talk rather freely about their competitors. Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge.

However, competitors are only one and not necessarily the best source of informed opinion. It is equally astonishing how much can be learned from both vendors and customers about the real nature of the people with whom they deal.

There is still one further group which can be of immense help to the prospective investor in search of a bonanza company. This group, however, can be harmful rather than helpful if the investor does not use good judgment and does not do plenty of cross-checking with others to verify his own judgment as to the reliability of what is told him. This group consists of former employees. Such people frequently have a real inside view in regard to their former employer's strengths and weaknesses.

POINT 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?

Not even the most outstanding growth companies need necessarily be expected to show sales for every single year larger than those of the year before. In another chapter I will attempt to show why the normal intricacies of commercial research and the problems of marketing new products tend to cause such sales increases to come in an irregular series of uneven spurts rather than in a smooth year-by-year progression. The vagaries of the business cycle will also have a major influence on year-to-year comparisons. Therefore growth should not be judged on an annual basis but, say, by taking units of several years each. Certain companies give promise of greater than normal growth not only for the next several-year period, but also for a considerable time beyond that.

No company grows for a long period of years just because it is lucky. It must have and continue to keep a high order of business skill, otherwise it will not be able to capitalize on its good fortune and to defend its competitive position from the inroads of others.

The investment novice taking his first look at the chemical industry might think it is a fortunate coincidence that the companies which usually have the highest investment rating on many other aspects of their business are also the ones producing so many of the industry's most attractive growth products. Such an investor is confusing cause and effect to about the same degree as the unsophisticated young lady who returned from her first trip to Europe and told her friends what a nice coincidence it was that wide rivers often happened to flow right through the heart of so many of the large cities.

POINT 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?

The investor usually obtains the best results in companies whose engineering or research is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities.

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

For a large number of publicly-owned companies it is not too difficult to get a figure showing the number of dollars being spent each year on research and development. Since virtually all such companies report their annual sales total, it is only a matter of the simplest mathematics to divide the research figure by total sales and so learn the per cent of each sales dollar that a company is devoting to this type of activity.

how does the careful investor obtain this information? Once again it is surprising what the “scuttlebutt” method will produce. Until the average investor tries it, he probably will not believe how complete a picture will emerge if he asks intelligent questions about a company's research activities of a diversified group of research people, some from within the company and others engaged in related lines in competitive industries, in universities, and in government.

A simpler and often worthwhile method is to make a close study of how much in dollar sales or net profits has been contributed to a company by the results of its research organization during a particular span, such as the prior ten years.

POINT 5. Does the company have a worthwhile profit margin?

From the standpoint of the investor, sales are only of value when and if they lead to increased profits. All the sales growth in the world won't produce the right type of investment vehicle if, over the years, profits do not grow correspondingly.

For this reason I believe that the greatest long-range investment profits are never obtained by investing in marginal companies. The only reason for considering a long-range investment in a company with an abnormally low profit margin is that there might be strong indications that a fundamental change is taking place within the company. This would be such that the improvement in profit margins would be occurring for reasons other than a temporarily expanded volume of business.

In regard to young companies, and occasionally older ones, there is one important deviation from this rule—a deviation, however, that is generally more apparent than real. Such companies will at times deliberately elect to speed up growth by spending all or a very large part of the profits they would otherwise have earned on even more research or on even more sales promotion than they would otherwise be doing. What is important in such instances is to make 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 profit margin.

However, with the exception of companies of this type in which the low profit margin is being deliberately engineered in order to further accelerate the growth rate, investors desiring maximum gains over the years had best stay away from low-profit-margin or marginal companies.

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

The success of a stock purchase does not depend on what is generally known about a company at the time the purchase is made. Rather it depends upon what gets to be k...

Some companies are in the seemingly fortunate position that they can maintain profit margins simply by raising prices. This is usually because they are in industries in which the demand for their products is abnormally strong or because the selling prices of competitive products have gone up even more than their own. In our economy, however, maintaining or improving profit margins in this way usually proves a relatively temporary matter. This is because additional competitive production capacity is created. This new capacity sufficiently outbalances the increased gain so that, in time, cost increases can no longer be passed on as price increases. Profit margins then start to shrink.

When profit margins of a whole industry rise because of repeated price increases, the indication is not a good one for the long-range investor.

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

POINT 8. Does the company have outstanding executive relations?

POINT 9. Does the company have depth to its management?

A small corporation can do extremely well and, if other factors are right, provide a magnificent investment for a number of years under really able one-man management. However, all humans are finite, so even for smaller companies the investor should have some idea of what can be done to prevent corporate disaster if the key man should no longer be available.

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

POINT 11. Are there 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?

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

The investor wanting maximum results should favor companies with a truly long-range outlook concerning profits.

POINT 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?

If equity financing will be occurring within several years of the time of common stock purchase, and if this equity financing will leave common stockholders with only a small increase in subsequent per-share earnings, only one conclusion is justifiable. This is that the company has a management with sufficiently poor financial judgment to make the common stock undesirable for worthwhile investment.

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

It is the nature of business that in even the best-run companies unexpected difficulties, profit squeezes, and unfavorable shifts in demand for their products will at times occur.

Furthermore, the companies into which the investor should be buying if greatest gains are to occur are companies which over the years will constantly, through the efforts of technical research, be trying to produce and sell new products and new processes. By the law of averages, some of these are bound to be costly failures. Others will have unexpected delays and heartbreaking expenses during the early period of plant shake-down. For months on end, such extra and unbudgeted costs will spoil the most carefully laid profit forecasts for the business as a whole. Such disappointments are an inevitable part of even the most successful business. If m...

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

Probably most costly of all to the investor is the abuse by insiders of their power of issuing common stock options. They can pervert this legitimate method of compensating able management by issuing to themselves amounts of stock far beyond what an unbiased outsider might judge to represent a fair reward for services performed.

So far as I have been able to observe, 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 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

The young growth stock offers by far the greatest possibility of gain. Sometimes this can mount up to several thousand per cent in a decade. But making at least an occasional investment mistake is inevitable even for the most skilled investor.

The long-range gain in value of this class of big company growth stock will, over the years, be considerably less than that of the small and usually younger enterprise. Nevertheless it will mount to thoroughly worthwhile totals. Even in the most conservative of the growth stocks it should run to at least several times the original investment.

Therefore, for anyone risking a stake big enough to be of real significance to himself or his family, the rule to follow should be rather obvious. It is to put “most” of his funds into the type of company which, while perhaps not as large as a Dow, a Du Pont, or an International Business Machines, at least comes closer to that type of stock than to the small young company. Whether this “most” be 60 per cent or 100 per cent of total investments varies with the needs or requirements of each individual.

In other words, if the right stocks are bought and held long enough they will always produce some profit. Usually they will produce a handsome profit. However, to produce close to the maximum profit, the kind of spectacular profit defined earlier, some consideration must be given to timing.

In short, the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.

But now, either because he believes one of his securities should be sold or because some new funds have come his way, such an investor has funds to purchase something new. Unless it is one of those rare years when speculative buying is running riot in the stock market and major economic storm signals are virtually screaming their warnings (as happened in 1928 and 1929), I believe this class of investor should ignore any guesses on the coming trend of general business or the stock market. Instead he should invest the appropriate funds as soon as the suitable buying opportunity arises.

In contrast to guessing which way general business or the stock market may go, he should be able to judge with only a small probability of error what the company into which he wants to buy is going to do in relation to business in general. Therefore he starts off with two advantages. He is making his bet upon something which he knows to be the case, rather than upon something about which he is largely guessing. Furthermore, since by definition he is only buying into a situation which for one reason or another is about to have a worthwhile increase in its earning power in the near- or medium-term future, he has a second element of support. Just as his stock would have risen more than the average stock when this new source of earning power became recognized in the market place if business had remained good, so if by bad fortune he has made his new purchase just prior to a general market break this same new source of earnings should prevent these shares from declining quite as much as other stocks of the same general type.

I believe there are three reasons, and three reasons only, for the sale of any common stock which has been originally selected according to the investment principles already discussed. The first of these reasons should be obvious to anyone. This is when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed.