It's Quality That Counts: The Fisher Approach to Stock Investing
By Maria Crawford Scott
Judging the qualitative factors of a growth company when selecting stocks: The Philip
A. Fisher approach to investing.
Successful investing is
often called a mix between science and art. Despite many attempts to find winning
combinations of measurable factors that can be used to predict stock market winners,
investment decisions often boil down to judgment calls that take qualitative factors into
consideration.
One of the first investment "philosophers" to focus almost exclusively on
qualitative factors was Philip A. Fisher, who began as a securities analyst in 1928 and
three years later founded the investment counseling firm, Fisher & Co.
At a time when many investment professionals attempted to make money in stocks by
betting on the business cycle, Fisher instead favored buying and holding the stocks of
companies that were well-positioned for long-term growth in sales and profits. And this
positioning could best be determined by examining factors that are difficult to measure
through ratios and other mathematical formulationsthe quality of management, the
potential for future long-term sales growth, and the firm's competitive edge.
Fisher outlined his philosophy for the lay investor in his book "Common Stocks and
Uncommon Profits," which was published in 1958. He later expanded upon his work in
"Conservative Investors Sleep Well" and "Developing an Investment
Philosophy." All three works have been republished by John Wiley & Sons in
"Common Stocks and Uncommon Profits and Other Writings by Philip A. Fisher,"
($19.95, John Wiley & Sons Inc., 605 Third Ave., New York, NY 10158). These writings
are the primary source for this article.
Growth Stocks: The Overall Philosophy
Fisher first and foremost was a growth stock investor. He felt the greatest investment
returns did not come from the purchase of stocks that were undervalued, since even a stock
that is undervalued by as much as 50% would only double in price once it reached fair
market value. Instead, he sought much higher returns from those companies that could
achieve growth in sales and profits greater than the overall market over a long period of
time. On the other hand, once those companies were found, he favored buying them
opportunistically, either when the market temporarily undervalues the company due to
unexpected bad news, or when the overall markets are depressed.
Fisher did not seek companies that showed promise of short-term growth due to cyclical
events or one-time factors, feeling that the timing was too risky and the promised returns
too small. Instead, he focused on long-term growth, which he felt could only come from
companies that were strong in three "dimensions":
- The company is producing goods or services with the potential for future long-term
sales,
- The company has special characteristics that will allow it to retain a favorable
competitive edge over existing competitors and newcomers, and
- The company has excellent management with both a determination to grow the company, and
the ability to implement its plans.
True long-term growth companies, he felt, were not necessarily small and relatively
young firms, although he did not exclude these companies (as long as they had some
operating history upon which he could judgehe did not favor new firms). On the other
hand, he noted that the qualities that constitute excellent management vary considerably
based on firm size.
Finding Companies Worthy of Consideration
Although Fisher wrote for the average individual investor, his approach is not one that
is easy to implement.
To begin with, Fisher did not begin his search through any methodical screening system.
Instead, he maintained that most of his original ideas came from "key investment
men" (other investment advisers) whom he had come to respect in terms of their
knowledge of the kinds of stocks he preferred. Other sources included trade and financial
periodicals.
The primary type of company he saw as a potential for further investigation was one
that was either in or entering into an area with opportunities for unusual sales growth,
but in which other newcomers or competitors would have a more difficult time entering.
Once a prospective firm is found, Fisher said his next step was to determine whether the
company measured up to his 15-point criteria. To determine this, he first examined the
financial statements for a thorough understanding of the nature of the business,
including: its capitalization and financial position, profit margins, a breakdown of total
sales by product lines, the extent of research activity, earning statement figures that
throw light on depreciation and abnormal or non-recurring costs in prior years'
operations, and the major owners of the stock including the degree of ownership by
management. Then, he used what he terms the "scuttlebutt" approach to help
answer his 15 points, talking to competitors, analysts, and anyone who may have knowledge
of the company. Lastly, he sought information to analyze his 15 points through a
discussion with management.
The 15 Points
What are the 15 points?
In his first book, Fisher described a 15-point system he used to rate a prospective
company, and he limited his investments to firms that fulfilled most of those 15 points.
In later writings, he restated these points in terms of the three dimensions he felt were
necessary for strong long-term growth; they are presented here not in the original order,
but in reorganized form:
Functional factors:
- Is the company providing a product or service that has sufficient market potential for a
sizable increase in sales for several years? In this instance, Fisher is discussing sales
over the long-term, and warns against firms that may show spurts due to one-time factors.
On the other hand, he notes that the problems of marketing new products often causes sales
increases to come in a series of uneven spurts rather than a smooth progression, and
suggests judging sales growth over a series of years rather than single years.
- Does the company have superiority in productionis it the lowest-cost producer (for
manufacturing firms) or have the lowest-cost operations (for service firms or retailers)?
Low production costs will allow a company to survive during hard times when higher-cost
competitors are weeded out, he notes. In addition, low-cost producers are better able to
build funds internally for future growth.
- Does the company have a strong marketing organization? Fisher's definition of a strong
market organization is broad, and includes the ability to recognize changes in public
tastes, an effective advertising effort, and an efficient product distribution system.
- Does the company have outstanding research and development efforts? Fisher was a strong
believer in research efforts to produce new and better products in a better way or at
lower cost. Sometimes, he noted, these efforts would even lead to new lines of business.
He suggested examining the amount expended on research relative to its size, but warned
against simple comparisons among companies because of differences in what is included in
reported research and development figures. Fisher was also concerned about the
effectiveness of a firm's research effort indicated by its ability to bring research ideas
to production and eventually to marketthat is, its teamwork with the other parts of
the firm. The most important question, he said, is how much in net profits over the past
10 years has been a result of research efforts? Firms that have done well in this regard
in the past, he said, will most likely do so in the future.
- How effective is the company's cost analysis and accounting controls? Good management
and the efficient use of resources can only come from good information, according to
Fisher. In addition, the finance function should provide an early-warning system for
problems that could affect profitability.
- Does the company have financial strength? Fisher was concerned here with a firm's
ability to finance growth without the need to use equity financing, since increasing the
number of shares outstanding would dilute an existing shareholder's benefits of investing
in the firm.
Excellence in management and labor relations:
- Does management have the determination, leadership and skills necessary to continue to
develop products or services that will further increase sales? Fisher strongly believed
that good management was key to long-term growthby spotting new opportunities,
adapting to changing market environments, developing plans, and coordinating the efforts
of the organization to carry out those plans.
- Is there a good working relationship among the management team? Fisher felt that good
teamwork was crucial among the major divisions, and that this was best fostered by a
strong effort to develop and promote its managers from within the organization.
- Does the company have enough depth to its management? Even smaller firms, Fisher noted,
need enough depth in management to prevent a "corporate disaster" should
something happen to the key person.
- Does the company have good labor relations? Fisher felt that the entrepreneurial
atmosphere and teamwork within a firm should permeate through all aspects of a company,
including rank and file workers. Mediocre relations, he stated, tend to produce high labor
turnover and greater costs in training new workers.
- Does management have a sufficiently long-range outlook? Fisher noted that long-term
growth sometimes comes at the expense of short-term profits, and managements that are
unwilling to forego current profits can hurt the future growth of a firm.
- Does the firm practice good investor relations? To Fisher, good investor relations mean
a management that is willing to be honest and forthcoming when troubles and
disappointments arise. Evasions, he stated, tend to be a sign of weak managementeither
they do not have a plan to deal with an unexpected difficulty, or they do not have a sense
of responsibility toward shareholders.
- Does the management have unquestionable integrity? "The management of a company is
always far closer to its assets than is the stockholder," Fisher states. And managers
can benefit themselves at the expense of shareholders in an "infinite" number of
ways, including salaries and perks high above the norm. The only protection shareholders
have against management abuses of position is to invest in companies whose managers have
unquestioned integrity.
Business characteristics:
- Does the firm have above-average profitability? In a rare instance, Fisher actually
suggests a mathematical comparisonprofit margins per dollar of sales, compared
against similar firms in the same industry. Older and larger firms should have among the
best figures in their industry, he states. On the other hand, younger firms may elect to
speed up growth by spending all or a large part of profits on research or sales; for these
firms, Fisher suggested that investors make sure that narrow profit margins are due to
spending in these areas alone. Firms operating in areas with high profits will attract
competition, but operating at extremely high efficiency levels will reduce the incentive
for competitors to enter the market.
- Is there some aspect to the business that will allow the company to keep its relative
competitive edge? Innovations, special skills or services, patent protections and similar
advantages give companies a strong ability to fend off competitors or newcomers to the
area.
Secondary Factors: When to Buy
Fisher did not necessarily favor the purchase of an "outstanding company" at
any price. Instead, he suggested that investors exploit buying opportunities, which can
take several forms:
- Short-term troubles: Even companies that are under the guidance of exceptionally able
managers are bound to have troubles, plans that fail to unfold or new products with
"kinks" that need to be worked out, and once that trouble produces a price
decline, investors can purchase the stock.
- Market blindness: Earnings increases that have not yet been reflected in price changes.
- Market declines: When the overall market drops and pulls the stock down with it,
investors are faced with a buying opportunity.
Fisher noted that investors can still make money if opportunities don't arise, but they
must have more patience with the chosen stock and recognize that their profits will be
smaller.
Although Fisher recognized opportunities in market declines, he suggested that
investors in general ignore business and economic trends, investing funds as soon as an
"appropriate buying opportunity" arises. For particularly conservative
investors, he recommended dollar cost averaging.
Stock Monitoring and When to Sell
Fisher provided a number of helpful rules both for purchasing and selling.
For stock purchases, Fisher warned against agonizing over eighths and quarters when
placing a trade. Attempting to shave points off the price, he noted, often results in a
trade not going through, and the investor loses out on investing long term in an
outstanding firm. And any savings, he pointed out, will be insignificant compared to
long-term returns.
Fisher was a strong advocate of long-term investing, advising investors to hold onto
their stocks until there is a fundamental change in the firm's nature, or it has grown to
a point where it will no longer be growing faster than the overall economy. He warned,
however, that when companies grow, managements need to change and adapt, and investors may
need to sell if management doesn't keep pace. Fisher recommended against selling for
short-term reasonsfor example, to take profits if a temporary downturn is expected.
Fisher suggested that investors use a three-year rule for judging results if a stock is
underperforming the market but nothing else has happened to change the investor's original
view. If after three years it is still underperforming, he recommended that investors sell
the stock.
On the other hand, Fisher advised selling "mistakes" quickly, once they are
recognized.
Lastly, Fisher warned against overdiversification, which he felt caused investors to
lower their standards and to put money in companies in which they do not thoroughly
understand. Sufficient diversification, he said, would be an investment in 10 or 12 larger
companies in a variety of industries with different characteristics, and any holding of
over 20 companies is probably too much.
Fisher in Summary
While Fisher does not provide an easy-to-follow methodical approach for individual
investors to implement, his discussion of the qualitative factors within "outstanding
companies" serves as a useful outline that adds some color to the strict mathematical
approaches. Becoming acquainted with all of a company's financial statementsthe 10-k
and annual reportsas well as gaining an understanding of the industry in which a
company is operating and knowledge of the firm's competitiors are all necessary components
of Fisher's approach.
Fisher wrote of the complaints he received concerning the amount of time and effort
necessary to implement his approach. However, he was unsympathetic:
"Is it either logical or reasonable that anyone could [achieve the kind of reward
gained from selecting growth stocks successfully] with an effort no harder than reading a
few simply worded brokers' free circulars in the comfort of an armchair one evening a
week? . . .So far as I know, no other fields of endeavor offer these huge rewards this
easily."
Philip Fisher's Approach in Brief
Philosophy and style
Investment in "outstanding" companies that over the years can grow in
sales and profits more than industry as a whole. The key features of
"outstanding" companies are: strong management that has a disciplined approach
designed to achieve dramatic long-term growth in profits, with products or services that
have the potential for sizable sales long term, and with other inherent qualities that
would make it difficult for competitors and newcomers to share in that potential growth.
Universe of stocks
No restrictions on universe of stocks from which to select. Over-the-counter
stocks should not be overlooked, but "outstanding" companies are not necessarily
young and small.
Criteria for initial consideration
Prospective companies should pass most of the following 15 points, which can be
divided into three main dimensions: Functional factors:
- Products or services with sufficient market potential for sizable increase in sales for
several years. Major sales growth, judged over series of years.
- Superiority in productionlowest-cost production (for manufacturing firms) or
lowest-cost operation (for service firms or retailers).
- Strong marketing organizationefficiency of sales, advertising, and distributive
organizations.
- Outstanding research and development effortsamount expended relative to its size,
effectiveness of effort as indicated by ability to bring research ideas to production and
to market and by how much research contributed to net profits.
- Effectiveness of company's cost analysis and accounting controls, and choice of capital
investments that will bring the highest return.
- Financial strength or cash positionsufficient capital to take care of needs to
exploit prospects for next several years without the need to raise equity capital.
Excellence in Management
- Attitude of management to continue to develop products or services that will further
increase sales.
- Development of good in-house management and teamwork.
- Management depth.
- Good labor and personnel relations: Affiliation with an international union may be an
indication of bad relations; labor turnover relative to competitors.
- Long-range outlook by management even at the expense of short-term profits.
- Good investor relations, and willingness to talk freely about problems.
- Management of unquestionable integritysalaries and perks in line with those of
other managers.
Business characteristics
Above-average profitability: Compare profit margins per dollar of salescompare
within industry and examine for several years, not just single years. Older and larger
firms are usually the best in their industry. Younger firms may elect to speed up growth
by spending all or a large part of profits on research or sales; for these, make sure a
narrow profit margin is due to spending in these areas alone.
Ability to maintain good profit margins: Good position relative to competitionfor
instance, skill in a particular line of business, or patent protection for a small
business.
Secondary factors
Once an "outstanding" company is found, purchase stock when it is
out-of-favor either because the market has temporarily misjudged the true value of the
company, or because of general market conditions. "Outstanding" companies can
also be purchased at fair value, but investor should expect a lower (but respectable)
return.
Stock monitoring and when to sell
Use a three-year rule for judging results if a stock is underperforming but no
fundamental changes have occurred.
Hold stock until there is a fundamental change in its nature or it has grown to a point
where it will no longer be growing faster than the overall economy.
Don't sell for short-term reasons.
Sell mistakes quickly, once they are recognized.
Don't overdiversify10 or 12 larger companies is sufficient, investing in a variety
of industries with different characteristics.
© AAII Journal September 1996, Volume XVIII, No. 8