THE PE INVESTOR

Philip Fisher

Philip Fisher (1907-2004) is widely considered to be one of the pioneers of growth investing (see Philip Fisher Wikipedia profile). His investing career lasted for more than 70 years, during which he found the time to author several groundbreaking books, including Common Stocks and Uncommon Profits and Paths to Wealth Through Common Stocks, along with articles, brought together in his Collected Works.

Legendary investor Warren Buffett, the most famous disciple of value investor Benjamin Graham, was introduced to the investment philosophy of Philip Fisher by his partner Charlie Munger. His influence was such that Buffett ultimately admitted to being equally influenced by both (see Buffett and Munger on Graham and Fisher).

Philip Fisher’s writings contain sharp insights on:

• How to find outstanding stocks, when to buy and when to sell.
• Economics (notably inflation).
• Stock market history.

Below are some of the key lessons from Philip Fisher’s books:

1. Two different methods have been used in the past to amass fortunes in the stock market: (a) betting on the business cycle and (b) finding outstanding companies.
   • Betting on the business cycle. This involves buying stocks in bad times (e.g. at the bottom of a great panic) and selling them in good times. Fortunes were made this way in the 19th century and during the early 20th century.
   • Finding really outstanding companies which can grow their sales and profits at a faster pace than industry as a whole, and sticking with them for a long period of time. This does not involve buying on a particular day, and makes investors far more money with far less risk.
2. There are more opportunities for investors in the second category than in the past, due to (a) the development of corporate management, (b) rising R&D spend and (c) structural inflation.
   • The concept of corporate management brought about favorable changes in the handling of corporate affairs. In the past, heads of large firms tended to belong to the owning families, to view the firm as their personal possession, to ignore the interests of outside stockholders and, as they grew older, to refuse innovation, suggestions and criticism. Investors therefore ran the risk that companies would lose their standing or that the benefits would accrue to insiders. While these risks have not disappeared, today’s top management, by contrast, are engaged in continuous self-analysis and a never-ending search for improvement.
   • Private corporate R&D expenditures have grown significantly. While some companies will fail to keep pace (because of too little spend or inability to convert such spend into commercial success), others will generate substantial sales gains, driven by managers with the ambition to grow and the ability to organize R&D so as to bring economically worthwhile products to the market.
   • In an inflationary context, investors in outstanding growth companies will come out ahead.
3. Such outstanding companies need not be young and small. What matters more than size is managerial ability:
   • Determination to attain further growth.
   • Ability to bring plans to completion.
   • Knowing how to organize research.
   • Preoccupation for long-range planning.
   • Constant vigilance in day-to-day tasks.
4. Successful stock investing consists of (a) choosing stocks that will rise far more than the market, (b) knowing approximately when to buy them, and (c) knowing when, if ever, to sell.
5. Doing this requires significant background knowledge on the companies and some knowledge of the investment community’s psychological attitude towards them.
6. The greatest stock value increases come from a combination of rising earnings and a rising price-to-earnings ratio (“P/E”).
   • Assets. In the absence of prospects for selling or liquidating a company, having a lot of assets will not send the stock price up. However, having too little may send it down. If a company earns an abnormally high return on a small amount of assets, and there are no good reasons preventing competitors to enter, investors should view low asset value as a warning signal and keep away.
   • Earnings. The correlation between growth in per-share earnings (“EPS”) and major increases in market price of shares is very close. Outstanding management enable EPS to grow decade by decade at above-average rates.
   • Change in the P/E ratio. Temporary changes may come from investors getting exaggerated ideas on the prospects of a glamorous industry, or over (under) enthusiastic for stocks as a whole. But the biggest and longer-lasting changes happen because of fundamental changes brought about by outstanding management, which make the shares safer and more appealing to investors, until they reach the “institutional ceiling”. To benefit from a rising P/E, look for stocks on the edge of institutional acceptance (see below).
7. To find outstanding investments, decide which companies to investigate, examine basic figures, review printed information, use the scuttlebutt method aggressively, then and only then meet management.
   • Decide which companies to investigate. Respected investors can be a great source of ideas, businessmen and scientists to a lesser extent. Broker reports contain inaccuracies and/or common knowledge, while trade and financial periodicals do not cover many matters of interest.
   • Examine basic figures.
   • Review printed information.
     • Financial position (does it have the financial strength to grow without hurting present shareholders?).
     • Profit margins compared to competition.
     • Breakdown of sales and profits by division.
     • Record and compensation of key officers.
     • Degree of conservatism in accounting policies.
     • Income statement: Historic trend of sales or of profit margins, R&D spend, Depreciation, Non-recurring costs.
     • Competition.
     • Ownership.
     • CEO’s comments to shareholders.
     • Analyst reports to assess the financial image of the firm.
   • Use the “scuttlebutt” method aggressively.
     • A first logical but impractical method to determine whether a company is outstanding would be to examine each facet of the organization in detail to establish an informed conclusion on the potential for growth and development.
     • A more practical approach (coined “scuttlebutt”) is to tap the business grapevine. The idea is to get a picture of the relative strengths and weaknesses of each company in an industry from a representative cross-section of the opinions of those concerned with the company: (a) competitors, (b) vendors, (c) customers, (d) research scientists, (e) trade associations, (f) former employees, (g) trade show attendees, etc.
     • In so doing, (i) it must be made clear that the source of information will not be revealed, (ii) investors must show sufficient interest in business problems to arouse the interest of those they are seeking data from, (iii) must have good judgment, and (iv) when dealing with former employees, must perform a lot of cross-checking to verify the reliability of their opinions and check carefully why they left the company.
     • So make sure to see or call every key customer, supplier, competitor, ex-employee, or scientist in a related field that you know or can approach through mutual friends.
     • If you are not getting enough evidence or if the evidence piles up that the company is “run of the mill”, give up the investigation and go on to something else.
     • If you need access to a few more people, ask your commercial bank for an introduction.
     • There is no need for each bit of data to agree with each other bit of data. For really outstanding companies, the preponderant information will be compelling enough to warrant taking the next step in the investigation.
   • Once you have obtained more than 50% of the knowledge you need to make the investment, contact management. The amount of time management will dedicate to an investor and the degree of willingness to furnish information depends on management’s estimate of the investor’s competence. Fill the missing gaps: How good are the business policies of the company? Is management avoiding elementary mistakes? Being sure that mechanical equipment is not sold to customers in any location where quick servicing is not readily available. Rapid settling of labor grievances so that disputes are not allowed to smolder and grow. Pricing of proprietary and semi-proprietary products on a scale related to their benefit to customers rather than in relation to cost. Is the firm unusually well run? Is the sales force trained and supported with back-up specialists? What steps are taken to assure research efforts are expended in the most profitable area? Unique means the company has adopted to assure continued greater-than-average loyalty from its customers or employees? How well are these policies carried out? Check with former associates and others who have had dealings with management. What is the degree of competency of the people involved? Size them up and look for desired traits: (a) Trustworthiness, (b) Perseverance, (c) Ability to communicate ideas, (d) Ingenuity, (e) Determination, (f) Smart decision-making.
   • If after meeting with management you find your prior hopes confirmed and some of your previous fears eased by answers that make sense, then proceed.
8. Buy companies that have disciplined plans for achieving long-range growth in profits and inherent qualities making it difficult for newcomers to share in that growth.
   1. The four dimensions of a conservative investment
      1. Functional factors
         • Low-cost production. The firm must be one of the lowest-cost producers of its products or services and must promise to remain so. A comparatively low breakeven will enable it to survive depressed market conditions and to strengthen its market and pricing position when weaker competitors are driven out of the market. A higher than average profit margin enables it to generate more funds internally to sustain growth without as much equity dilution or borrowing strain.
         • Strong marketing organization. The firm must (a) be alert to changes in public tastes, (b) generate a flow of new products that more than offset maturing or obsolete lines, (c) understand what the buyer really wants, (d) explain the advantages of the product or service in the buyer’s terms, (e) measure the cost effectiveness of the marketing means used (advertising, sales calls, etc.).
         • Outstanding research and technical effort. Even nontechnical firms require a strong and well-directed research capability to (a) produce newer and better products, and (b) perform services in a more effective or efficient way. Research effectiveness is enhanced by (a) market/profit consciousness, and (b) the ability to pool the necessary talent into an effective team.
         • Financial skill. A good financial team (a) provides cost information enabling management to direct its energy towards the most profitable products, (b) has a cost system which pinpoints where production, marketing, and research costs are inefficient, (c) enables capital conservation through tight control of fixed and working capital investments, (d) provides an early warning system that identifies threats to the profit plan sufficiently ahead of time to devise remedial plans.
      2. People factors
         • Leader with a determined entrepreneurial personality combining drive, original ideas, and skills.
         • Extremely competent team with considerable authority to run the activities of the firm.
         • Attracting competent managers at lower levels and training them for larger responsibilities. Succession should largely be from the available talent pool.
         • Entrepreneurial spirit permeating the organization.
         • Adaptation to change. Every accepted way of doing things must be reexamined periodically, and new, better ways sought. Changes in managerial approaches involve risks, which must be recognized, minimized and taken.
         • Genuine effort to have employees at every level feel that their company is a good place to work: (a) employees treated with dignity and decency, (b) work environment and benefits programs supportive of motivation, (c) ability to express grievances without fear and with expectation of appropriate attention and action, (d) participatory programs to generate new ideas.
         • Management must be willing to sacrifice current profits to lay the foundation for future improvement.
      3. Business characteristics.
         • Above-average profit margins. 2-3% of sales higher than the next best competitor is sufficient. If margins are too spectacular, it can attract competition and be a source of danger. While from the standpoint of profitability return on investment must be considered as well as profit margin, from the standpoint of safety of investment all the emphasis is on profit margin.
         • Reasons for sustained high profit margins. “What can the particular company do that others would not be able to do about as well?”
           • Advantage of scale. (a) lower production and advertising unit costs, (b) greater ability to attract new customers because of a well-recognized trade name, (c) enough volumes to integrate backwards and establish plants in strategic locations, (d) prominent shelf space granted by retailers. These advantages are often offset by inefficiencies: (i) bureaucratic layers of middle management, (ii) delays in making decisions, (iii) inability to know what needs corrective attention.
           • Technology at the interplay of various disciplines.
           • Reputation for quality and reliability in a product: (a) that is sold to many small, difficult to reach customers, (b) that is very important for the proper conduct of the customer’s activities, (c) where an inferior or malfunctioning product would cause serious problems, (d) where no competitor is serving more than a minor segment of the market (so the dominant company is synonymous with the product), (e) the cost of which is only a small part of the customer’s total cost of operations.
      4. The price.
         • The price of a stock is determined by the current financial-community appraisal of the particular company, of the industry it is in, and to some degree of the general level of stock prices.
         • Determining whether the price is attractive, unattractive or somewhere in between depends for the most part on the degree these appraisals vary from reality.
         • Because of an appraisal at variance with the facts, a stock may sell for a considerable period for much more or much less than it is intrinsically worth.
         • On a scale of ascending risks are:
           • High quality firms with a lower P/E than warranted.
           • High quality firms with a P/E in line with fundamentals.
           • High quality firms with a higher P/E than warranted because their qualities have become legendary.
           • Average or low-quality firms with a P/E lower than or in line with fundamentals.
           • Companies with a P/E far above what is justified.
         • Investors must be aware of the financial-community appraisal of the industries in which they are interested, and see if such appraisal is significantly more or less favorable than the fundamentals warrant.
         • In determining the relative attractiveness of two stocks, simply comparing their expected four year growth prospects and P/E could be misleading; (a) the odds of seeing growth rates interrupted can be different due to leverage or business reasons, (b) their growth prospects beyond four years may be different, thus warranting a different P/E then.
         • The level of stocks as a whole depends on: (a) the financial community’s appraisal of the degree of attractiveness of common stocks, (b) interest rates, (c) to a much smaller degree, the propensity to save.
         • Fluctuations in the supply of new issues are more a result of stock price levels than an influence.
   2. The fifteen points to look for in a stock.
      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? This consists of appraising the degree of potential sales growth that now exists for a company’s product. It is not impossible to make a one-time profit from companies (i) with stable sales and operating economies or (ii) with a large increase in sales but only for a few years. Companies posting spectacular growth over several decades (i) need not show smooth progressions year over year, (ii) must have a high business ability to defend their competitive position, (iii) either find themselves in a more attractive industry than originally envisaged (“fortunate and able”) or take advantage of their skills to go into unrelated lines of business with growth potential (“fortunate because they are able”). The investor must be alert as to whether the management is and continues to be of the highest order of ability: without this, sales growth will not continue. Correctly judging the long-range sales curve of a company is of extreme importance to the investor. Superficial judgment can lead to wrong conclusions.
      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? Does the company recognize that, in time, it will have grown up to the potential of its present market and that to continue to grow it may have to develop further new markets? Companies with significant growth prospects for the next few years because of new demand for existing lines, but which do not have policies nor plans to provide for further developments, may provide one-time profits for investors, but not consistent gains over 10 or 25 years.
      3. How effective are the company’s research and development efforts in relation to its size? Companies vary in the % of sales they dedicate to R&D, but also in the efficiency of this spend. To attain maximum efficiency, there is need for (1) coordination (a) among experts of various backgrounds, (b) between research, production and sales, and (2) for top management to understand the nature of successful commercial research: (a) only select tasks with the potential to generate many times the cost of research, (b) once a project is started, do not curtail it for budget reasons or accelerate it with crash programs. Government-sponsored defense research may not enable to build a steady repeat business, but the related know-how may be profitably transferred to non-defense fields. The strength of market research, which is a bridge between developmental research and sales, must also be evaluated. To evaluate whether a company has an outstanding research organization: (a) use the scuttlebutt method, (b) assess the amount of sales and profits generated by new products in the past 10 years.
      4. Does the company have an above-average sales organization? Without sales, survival is not possible. The making of repeat sales to satisfied customers is the first benchmark of success. In a competitive world, expert merchandising is needed for most products and services to attain their full potential. Outstanding companies have both aggressive distribution and a constantly improving sales force, via a thorough selection and training of their sales personnel, and the constant seeking of more efficient ways to solicit from, service, and deliver to the customer. Yet the relative efficiency of a company’s sales, advertising, and distributive organizations does not receive sufficient attention from investors. To assess sales efficiency, use the scuttlebutt method.
      5. Does the company have a worthwhile profit margin? For investors, sales growth is only of value if it leads to profit growth. The study of profit margins should be made not at a single point in time but for a series of years. The greatest long-term investments are never made in marginal companies or low-profit companies, but rather in companies with broad profit margins, usually the best in their industry. Profits of marginal companies: (a) show a greater % increase in years of abnormally good business than stronger companies, (b) but decline more rapidly when the business tide turns. The only exceptions are companies: (a) which deliberately engineer low profit margins to further accelerate growth (make sure investment in research and sales promotion is the real reason), (b) where a fundamental change is taking place (e.g. efficiency or new products) to take them out of the marginal category.
      6. What is the company doing to maintain or improve its profit margins? The success of a stock purchase does not depend on what is generally known about a company at the time of purchase, but upon what gets to be known after the stock has been bought. Therefore, it is not the profit margins of the past but those of the future that are important to the investor. Profit margins seem to be under constant threat: rising labor, raw material and supplies costs, riding taxes. In this context, companies can maintain profit margins (a) by increasing prices: this often proves temporary as demand subsides and/or new competitive capacity gets added, (b) by more ingenious ways: review procedures and methods, and design equipment to reduce costs.
      7. Does the company have outstanding labor and personnel relations? Companies with bad labor relations experience unnecessary expenses (production disruptions related to strikes, training of new hires related to employee turnover). If workers feel they have been fairly treated, leadership can accomplish more in terms of productivity. Indicators of the quality of labor relations include: (a) relative labor turnover vs companies in the same area, (b) relative size of waiting list of applicants vs companies in the same area, (c) methods to settle grievances, (d) wage scales, (e) attitude of top management towards rank-and-file employees.
      8. Does the company have outstanding executive relations? Creating the right atmosphere among executive personnel is vital as these are the people whose judgment, ingenuity, and teamwork will in time make or break any venture. The following are indicators of the quality of executive relations: (a) executives have confidence in their president, (b) promotions are based on ability, not factionalism or family ties, (c) salaries are at least in line with the standard of the industry and the locality, (d) salary adjustments are reviewed regularly so that merited increases come without having to be demanded, (e) management bring outsiders into anything other than starting jobs only if there is no possibility of finding internal candidates, (f) top management does not tolerate those who do not cooperate in team play.
      9. Does the company have depth to its management? Small outstanding corporations can do well for investors under really able one-man management. But unless they are swallowed by bigger firms with management talent, something must be done to avoid corporate disaster if the key man is no longer available. But companies worthy of investment interest are those that will continue to grow. Sooner or later, they will reach a size where they will not be able to take advantage of further opportunities unless they start developing executive talent in some depth. Policies needed to develop management depth include (a) delegation of authority to executives (vs interference of top brass with routine operating matters), and (b) welcoming and evaluation of suggestions from personnel (even those criticizing current practices).
      10. How good are the company’s cost analysis and accounting controls? The true cost of each small operating step and of each product should be known (a) to assess what needs attention, (b) to establish optimal pricing (i.e. maximize profit while discouraging undue competition), (c) to determine which products are worthy of special sales effort and promotion, and (d) to avoid running seemingly successful but actually unprofitable activities.
      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? In retail, skills in handling real estate matters are of great significance. Credit management and insurance costs are important in some industries. Broad patent protection is important for young companies to prevent large competitors from putting them out of business (though it is constant leadership in engineering that is the real protection).
      12. Does the company have a short-range or long-range outlook in regard to profits? Some companies will conduct their affairs so as to gain the greatest possible profit right now (e.g. negotiate the sharpest deals with their suppliers). Others will deliberately curtail maximum immediate profits to build up goodwill and thereby gain greater overall profits over a period of years (e.g. pay above contract prices for vendors incurring extra delivery costs, go to special trouble and expense to take care of a regular customer in trouble). The scuttlebutt method will reflect these differences in policies.
      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 the company’s cash plus borrowing capacity is not sufficient to exploit the prospects of the next few years, equity financing becomes necessary. If the resulting dilution results in a modest increase in EPS, it means management has a poor financial judgment and the investment is thus undesirable.
      14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur? Even in the best-run companies, unexpected difficulties, profit squeezes and reductions in demand occur at times. How a management reacts to such matters can be a valuable clue to the investor. Avoid those who clam up as they (a) may not have a program worked out to solve the unanticipated difficulty, (b) may be panicking, or (c) may not have an adequate sense of responsibility to their stockholders.
      15. Does the company have a management of unquestionable integrity? The management of a company is always far closer to its assets than is the stockholder. They can benefit themselves at the expense of shareholders by (a) paying themselves or their relatives at above-market wages, (b) selling or renting their properties to the company at above-market rates, (c) getting vendors to sell through brokerage firms controlled by insiders, or (d) issuing themselves stock options in unfair amounts. The only protection is to limit investments to companies run by managers with a high sense of trusteeship and of moral responsibility to their shareholders.
   3. Growth stocks vs. bargain hunting and dividend-yielding stocks.
      • The accounting / statistical bargain hunting approach may turn up some actual bargains, but may fail to uncover future business issues. In any case, the discount to fair value is generally limited and may take considerable time to narrow. Superbly managed growth stocks do better because they show gains of several hundred % each decade, whereas bargains as much as 50% undervalued are unusual.
      • Compared to dividend-yielding stocks, growth stocks tend to do better in terms of capital appreciation, but also on dividend yield itself after a while.
      • Young growth stocks offer the greatest possibility of gain (up to several thousand % in a decade), but occcasional mistakes are inevitable and every dollar can be lost.
      • Gains on more entrenched large growth stocks will be lower but still worthwhile (at least several times the original investment), and any losses should be temporary.
      • Small investors should only use truly surplus funds to invest in stocks, with an appropriate mix of conservative growth stocks and young growth stocks.
9. Focus on buying these companies when they are out of favor.
   • If the right stocks are bought and held long enough they will always produce some profit, but some consideration must be given to timing to produce close to the maximum profit. In the current state of human knowledge, the conventional method of trying to forecast business activity and money rates is too fallible, except maybe during highly speculative periods such as 1929. Experts disagree with each other to a surprising degree, and even some the most wrong forecasts seemed convincing at the time.
   • Nothing is more desirable for stockholders than the influence of an upward trend of earnings multiplied by a comparable upward trend in the way each dollar of such earnings is valued.
   • As a result, buying points arise when (a) a worthwhile improvement in earnings is coming in the right sort of company, but has not yet produced an upward move in the price (e.g. capital investment enabling extra output at high margins), (b) temporary corporate troubles have produced a significant decline in the stock price but give promise of being solved in a matter of months (e.g. introduction of new products, start-up of complex plant, strike), or (c) a major market setback occurs, where all kinds of stocks go down sharply (but only the truly good ones recover to new all-time highs).
   • Investors without a backlog of well-chosen investments bought below present prices should start buying as soon as they have located an appropriate investment but stagger purchases over several years (a) to avoid committing all of their assets near the top, and (b) to ensure they master investment techniques.
10. Aside from personal motives, only sell (a) when a mistake has been made, (b) when there has been a fundamental weakening, (c) when the firm has grown to a point where it no longer will be growing faster than the economy as a whole or (d) when better opportunities are found.
    • Keep close tabs on your portfolio companies.
    • Be honest with yourself.
    • If management has deteriorated, sell at once.
    • If growth prospects are exhausted, selling may take place at a more leisurely pace.
    • Review mistakes with care to avoid repeating them.
11. Do not sell because of (a) a looming bear market, (b) the stock has become overpriced, or (c) the stock has had an advance.
    • Fear that a bear market is in the offing.
      • Depression forecasts cannot be used reliably in complex economies.
      • Modern business recessions are less severe than in the past. During depressions, most stocks see their price decline by 35-50%, and only a small fraction of companies fail, typically those highly indebted.
      • Outstanding companies will make new highs during the next bull market and can go up several 100% or 1,000% over a decade.
      • Capital gains tax will take its toll.
    • An outstanding stock has become overpriced.
      • A stock with an expanding earning power should sell at a higher P/E than a stock with a stable earning power.
      • An investor cannot pinpoint how much per share a company will earn in 2 years. The best one can do is assess if EPS will be about the same, up moderately, up a lot, or up tremendously.
      • If the growth rate is so good that the company will have quadrupled in 4 years, whether it sells at 25x or 35x earnings is not a great concern.
      • There are too many chances that (1) the expected price reaction will not occur, (2) if it does the investor will wait for still lower prices and will not get back until the stock has again climbed to even higher levels, or (3) by the time the reaction does come, the stock will have continued to climb so much that at its coming bottom it will still be above present prices.
    • The stock has had a huge advance.
      • Outstanding companies don’t work this way.
12. De-emphasize the importance of dividends.
    • The typical investor is confused into thinking that a company paying no dividend is doing nothing for its stockholders.
    • The reason is that retaining earnings may or may not benefit them, so that each time earnings are not passed out as dividends, such action must be examined on its own merit.
    • Stockholders get no benefit from retained earnings when:
      • Managements pile up cash and liquid assets far beyond any present or prospective needs of the business.
      • Substandard managements use retained earnings to enlarge inefficient operations earning subnormal returns on capital rather than to make them better.
      • A change in custom or public demand forces companies to spend money on assets which do not increase volumes, but merely avoid a loss of business.
      • Due to inflation not being properly captured by accounting standards, depreciation is not enough to replace existing assets.
    • Stockholders may benefit when earnings are plowed back:
      • To build new plants.
      • To build launch new products.
    • High dividends are not a factor of safety:
      • Bad performers come more often from the high dividend-paying group than from the low dividend-paying group.
      • Over a span of 5-10 years, the best dividend results come not from the high-yield stocks but from those with the relatively low yield.
      • Income tax takes a huge toll on dividend receipts.
    • Wise companies set a dividend policy (e.g. set amount approximating a given percentage payout), let shareholders know what it is, and do not change it.
13. Don’t buy into young unprofitable (“promotional”) companies.
    • They may appear attractive as a chance to get in on the ground floor…
    • … but the batting average is lower…
      • In an established company (with at least 3 years of commercial operations and 1 year of operating profit), all the major aspects of the business (production, sales, cost accounting, management teamwork) can be observed.
      • In a promotional company, all an investor can do is look at a blueprint and guess what the problems and the strong points may be. This is so difficult to do that wrong conclusions are much more likely.
    • … and their financing should be left to specialists.
      • Young promotional companies are often dominated by one or two individuals who have great talent for certain phases of business procedure but are lacking in other equally essential talents.
      • Contrary to specialized groups, investors usually are not able to convince them to bolster weak spots and do not have readily available management talent to help them.
14. Don’t ignore a good stock just because it is traded over the counter (“OTC”). The better OTC stocks are frequently more liquid than many listed shares. Be sure that (i) you have picked the right security and (ii) you have selected an able and conscientious broker.
15. Don’t buy a stock just because you like the “tone” of its annual report. Like any other sales tool, annual reports are prone to put a corporation’s “best foot forward.”. Avoid companies whose reports fail to give proper information on matters of real significance to the investor.
16. Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price. If an outstanding company is selling at twice P/E of the market, and its earnings are expected to double in the next 5 years, it does not mean that the price is discounting earnings 5 years ahead, unless the earnings spurt is a one-time matter. If the industry promises to afford equal growth, and management continues to develop new sources of earnings power, why shouldn’t this stock sell for twice the market P/E ratio in 5 years as it has done in the past?
17. Don’t quibble over eighths and quarters. For small investors: if the stock seems the right one and the price seems reasonably attractive at current levels, buy “at the market”. For large investors: go to your broker or securities dealer, disclose how much stock you want to buy, give them a free hand on price up to a point somewhat above the most recent sale.
18. Don’t overstress diversification. Funds should be concentrated in the most desirable opportunities.
    • Investors have been so oversold on diversification that the fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.
    • Buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.
    • How much diversification is needed depends on:
      • The degree of diversification within the company itself (segments, end-markets, customers).
      • The breadth and depth of the company’s management (i.e. how far it has progressed away from one-man management).
      • Whether the industry is highly cyclical or not.
      • The maturity of the growth stock:
        • Large entrenched growth stocks: < 20% each.
        • Midway companies: < 10% each.
        • Young risky growth companies: < 5% each.
    • Investors should have sufficient diversification so that an occasional mistake will not prove crippling.
    • Beyond this point, they should take extreme care to own not the most, but the best stocks.
19. Don’t be afraid of buying on a war scare. When major wars break out, the stock market usually plunges sharply downward, but by the end of the war, most stocks sell at levels vastly higher than before. Wars cause governments to spend more than they can collect from taxpayers, thus resulting in a vast increase in the amount of money. As the value of money depreciates, stock prices, expressed in units of money, go up. On just a threat of war, the thing to do is to buy, but buy slowly. If war occurs, then increase the tempo of buying significantly.
20. Don’t be influenced by what doesn’t matter. There is a strong temptation to fill up as much space as possible with indisputable facts, whether or not the facts are significant: (a) the price at which the stock sold four years ago may have little or no real relationship to the price at which it sells today, (b) the fact that a stock has or has not risen in the last several years is of no significance whatsoever in determining whether it should be bought now, (c) detailed accounting descriptions of what happened last year may not give a true picture of what will happen next year. Past earnings and price ranges should not be completely ignored however: past EPS may shed light on how cyclical the company might be, while past P/E ratios may serve as a base to assess future P/E ratios.
21. Don’t fail to consider time as well as price in buying a true growth stock. What is important is to find a way to buy the stock at a price close to the low point at which it will sell from here on in. One way is to buy once the stock reaches a conservative fair value. An alternative is to buy the shares not at a certain price, but at a certain date, i.e. at a particular point in the company’s development (e.g. one month before the pilot-plant goes live).
22. Don’t follow the crowd. Investors must examine factually and analytically the prevailing financial sentiment about both the industry and the specific company they are considering. An industry or a company where the prevailing style or mode of financial thinking is considerably less favorable than the actual facts warrant can provide rewards. They should be extra careful when buying into companies and industries that are the current darlings of the financial community, to be sure that these purchases are actually warranted.
23. Stocks that are going to have a big rise regardless of inflationary conditions are the only type of stocks that will safeguard investors’ assets against inflation.But in the short range, inflation moves sufficiently slowly so that investors should take their time waiting for an outstanding opportunity.
    • More inflation is sure to come during depressions given the widely held opinion that the duty of government is to maintain prosperity. Federal revenues used to come from custom duties, which were fairly stable. The bulk of federal revenues now come from personal and corporate income tax. Sharp declines in the level of business thus cause corresponding federal revenue declines. Since the Great Depression, farm price supports, unemployment compensations, public work spending, tax cuts, and loans to corporations have become acceptable tools to counter unfavorable business trends, running counter to the previous balanced budget discipline.
    • But leisurely inflation must not necessarily break loose into a galloping inflation, due to costs of carrying inventory and to quality and cost improvements. There are so many costs to carrying inventory (opportunity cost on funds tied up, interest if the inventory is purchased with borrowed money, warehousing, storing and insurance costs, spoilage, and obsolescence because of style or technical changes) that it does not pay – contrary to what economists believe – to stock up just because the general price level will rise further. Advance buying has occasionally occurred because of fear of physical scarcity or fear of a price rise in a particular commodity. A speed-up in prices is not impossible, but would happen at a time of depression, when investment bargains usually abound. Researchers are working to make things cheaper or better, acting as a countervailing force to expanding money supply and labor unions.
    • The widely accepted cure for inflation of raising interest rates (“tight money”) actually sets in motion forces that are sure to speed up inflation in time: This inadequate “cure” stems from a misguided theory that people would engage in advance buying, using borrowed money, and that raising the cost of borrowed money would thus stop such advance buying. It is illogical to claim that raising wages and raw material prices is inflationary while raising the cost of money (which is also a cost of doing business) is deflationary. This could work if the economy was operating at full capacity. But most industries operate between 70-90% of capacity, and most projects that would be curtailed in times of high interest rates are not for new capacity, but for modernization of old capacity, which would bring about a lower cost per unit. Whenever the Fed tightens money, industry curtails capital spending, and home building and other industries in which financing costs play a big part in final prices to the consumer usually become equally affected. The decline in these “swing” industries begins to hurt other lines, and a general decline is on its way. What should be done is to help industry borrow at low rates to carry modernization programs, which will lower costs. These lower costs will be passed on to customers, and increase the volume of orders.
    • With inflation around 2-3% per annum, any investment which does not have the means of increasing its value by at least 20-30% every ten years is a poor one in the long range.
    • While high-grade bonds may outperform in the short run, they will not be suitable for the long-term investor due to inflation. A business recession will cause an easing of money rates and a corresponding rise in bond prices, thus making this asset class appealing for short-term traders with a good sense of timing. But the rate of monetary depreciation will make real returns on high-grade bonds low or negative, thus making bonds unattractive for the long-term investor.
    • But in the short range, inflation moves sufficiently slowly so that the investor should take his time waiting for an outstanding opportunity rather than rush to grab anything that might be a hedge against rising prices. Also, money set aside for short-term needs should be left in cash.
    • The belief that all stocks, because they represent ownership in tangible assets, are an inflation hedge is wrong.
      • Many such stocks have shown no increase in their price over 15 years of steadily rising prices.
      • Within the general price level, some things go up in price while others go down.
      • Except when a company is about to be liquidated, the value of its assets has very little to do with its stock price.
      • There is no full built-in protection against inflation in stocks. As prices rise, it takes more and more money to do the same physical amount of business (inventories, accounts receivable, cost to replace plant and equipment).
      • The stock of a company with a mediocre management is not likely to prove much protection against inflation. With the surge in inflation, the business cycle may hurt investors in financially weak or marginal companies even more than in the past.
      • Well-capitalized growth companies with the ability to withstand a year or two of hard times will only see a temporary decline in their market value rather than a threat to their existence.
    • The conventional wisdom on which stocks to buy in times of inflation is not always right.
      • Capital-intensive industries. Prior to WW2, oversupply in the cement industry kept profits at meager levels. After WW2, demand increased and new plants were needed. The cost of building such plants had increased so much that cement prices had to rise significantly to provide the needed return. Profit margins of pre-war low-cost plants were spectacular.
      • Pricing power. Companies unable to pass increased costs to customers may struggle to protect their stockholders from inflation, but that is not the case for low-cost producers. By the time a low-cost producer’s margins are threatened by rising costs pressing against non-rising selling prices, the extreme pains of its higher-cost competitors will have forced industry-wide price adjustments that relieve the situation.
      • Utilities. Public utilities are guaranteed a fair rate of return. But most are always at least one step behind, as government commissions take a long time to hold meetings and increase prices. All the while, they must borrow to build additional plants, at more expensive terms due to lower margins. This affects the quality of service.
    • Stocks that are going to have a big rise regardless of inflationary conditions are the only type of stocks that will safeguard the investors’ assets against inflation.
      • Find a company with a highly competent management that has found a way to increase its per-share earnings year after year (after allowing each year for the temporary ups and downs of the business cycle).
        • Such increasing profits usually come from increasing the size of existing activities or starting new activities in related lines.
        • To be great enough to nourish a business in inflationary times, this growth must be truly large; in addition to supplying the capital needed by the older parts of the business, there is the problem of supplying the capital for the newer lines as well.
        • This requires management of great capability and judgment in selecting the right spot for expansion.
      • Be sure that management is determined to continue this growth and safeguard it through the build-up of younger executives trained in the same general policies.
      • Then, if you can buy these shares before most of the financial community fully appreciates the situation, get them and hang on to them, regardless of how high they go, for as long as these policies continue.
24. Stocks vs. bonds, gold, and real estate.
    • The attractiveness of an investment depends on the profit that investment may be expected to make and on the degree of risk involved in attempting to make it.
    • How much risk a particular investor is ready to face in any particular investment should be determined by their personal circumstances and temperament. For the degree of risk they chooses to face, they should pick the investment with the lowest risk-to-reward ratio.
    • Purchase of a home should have first call on investible funds. Beyond that, the opportunities afforded by real estate are less attractive in relation to the risks involved than those available through common stocks.
    • Residential real estate:
      • Loss of income due to vacancies.
      • Troublemaking tenants.
      • Maintenance and repairs.
      • Overbuilding due to tax advantages.
      • Inflation trap: rent ceilings in times of inflation, while maintenance and repair go up, eroding net income.
    • Commercial real estate:
      • While government price ceilings were placed on almost everything else, commercial property with percentage-of-sales leases was left completely undisturbed, offering strong protection to real income.
      • General-purpose store buildings that were prime property if located on one of the best blocks of the main shopping district have lost value as an ever-larger % of total retail business passes to the shopping centers.
      • Even more than handling apartment houses, operating a shopping center is a highly specialized activity.
    • Specialized real estate:
      • Gas stations leased to oil companies had monthly rents, percentage-of-sales leases and gallonage leases.
      • But they were not protected against (i) the energy crisis which caused the oil company to close them as the leases ran out and (ii) the fact that no one else was willing to take them over, leaving real estate owners with no tenants.
    • Capital-intensive activities (orchard growing, livestock raising, prospecting for oil and minerals, leasing airplanes and tankers):
      • Interest driven largely by their tax shelter features.
      • Risk of disappearance of the tax advantage.
      • Risk of losing money due to unskilled operators.
    • Gold and gold stocks:
      • Interest driven by instability in FX markets, depreciation of many currencies and industrial uses.
      • Negative returns due to handling charges.
      • Uncertainty on the future price of gold.
    • Fixed-income securities:
      • Less difficult to analyze but less attractive than properly selected stocks (low post-tax real rate of return, one-time moderate profit at best).
      • Short-term fixed-income securities can be an excellent place for temporarily parking funds.
25. Institutional buying has a large influence on the stock market. Stocks which gained institutional acceptance will continue to sell at above-average P/E ratios as long as they retain their qualities. To benefit from rising P/E, look for stocks on the edge of institutional acceptance.
    • Institutional buying in the stock market comes largely from: (1) pension and profit-sharing funds, (2) trustees for the benefit of private individuals, represented mainly by the trust departments of large banks, (3) investment trusts, (4) insurance companies, and (5) educational and charitable organizations.
    • A relatively low level of common stock prices prevailed over most of the 1930’s, due to (i) the low level of general business, (ii) the uneasy feeling of investors about the Roosevelt administration, (iii) high estate taxes forcing the liquidation of sizable blocks of shares when wealthy stockholders died, and (iv) high income taxes cutting into wealthier classes’ ability to save.
    • During the 1950s, institutional buying acted as a countervailing force, with an even greater impact as these fresh purchases of stocks would remain long-term investments, thus reducing the supply of stocks. An important part came from switching into common stocks a proportion of funds previously invested in other media.
    • Careful study can be made of stocks just on the edge of institutional acceptance, which will benefit from rising earnings trend and a rising P/E ratio.
      • Medium-sized corporations, with an adequate size to appeal eventually to institutional investors.
      • Steady upward trend in earnings.
      • Management of outstanding ability.
      • Relatively wide profit margin for their industry.
    • The best institutional stocks will continue to sell at much higher P/E ratios than stocks as a whole. Long accepted stocks take as long to disappear from the approved institutional groups as new ones are slow to be added. They will stay at this high price-earnings ratio and will continue to go up in price about in proportion to how their earnings expand so long as they retain their unusual qualities.
    • If they lose these qualities, then they become extremely dangerous. They will decline not alone in proportion to the decrease in their profits but a great deal more. As institutions eventually sell them, they lose their premium value.
    • If a stock enjoys a major upward revision of its P/E ratio:
      • Determine whether this change is due to institutions starting to hold his stock or to some completely different set of factors.
      • Determine whether its management, its prospects, its inherent risks, and all the other factors on which its true investment status will depend justify the increased price in relation to each dollar of earnings.
      • If that is the case, the investor can be rather certain that this will continue and that the gain is just as “real” (i.e., permanent) as though it had come solely from improvement in earning power.
      • Beware when a particular industry becomes the momentary darling of the marketplace: even when the industry’s prospects are sound, the stocks of secondary and less well-run companies in that industry can be carried up to P/E ratios which do not represent sound values.
26. First-tier stocks included in the institutional club may get carried to unduly high multiples, while overlooked ones can be rewarding.
    • In the early 1970s, as in the late 1920s, some first-tier stocks, especially those with a past record of improved earnings every year, were believed to be resistant to cyclical and other adverse influences. As more and more purchasing power became available to some institutions (e.g. trust departments of large city banks), they kept on buying such stocks regardless of price. As the first-tier stocks sold at higher and higher P/E ratios in relation to the rest of the market, they too started to topple.
    • Such institutions ignored a fundamental investment rule: Whenever the price of a stock reflects the promise of a magnificent future, but several years must elapse before that future can materialize, there is a probability that an important though temporary decline will occur sometime in the intervening period.
    • They also excluded many fundamentally worthy stocks from the first-tier group. Examining the reasons why they were not included can be quite rewarding for the investor: if those reasons are not valid, then these stocks should be worthwhile opportunities.
      • Stocks with some degree of cyclical variation. The logical time span in which to measure results may have been one year when the biggest activity was growing crops, but it is usually much longer for technological firms. Paying a hefty premium to avoid (i) the probability of holding an otherwise outstanding stock through an occasional poor year and (ii) having to explain this bad year to their boss or customers does not make sense, provided the more cyclical company is a sufficiently low-cost operator so that, at the bottom of the cycle, there are sufficient earnings to finance the needs of the company. The premium paid for steady annual increases also tempts companies to “manage” earnings.
      • Smaller capitalization stocks ruled out for liquidity concerns. If properly selected, such stocks would by their very nature grow to a point where eventually they would have a broad resale market.
27. To protect against low-cost imports, investors can invest in firms based abroad, active abroad or which maintain technical leadership, the latter being less risky.
    • Invest in foreign companies: they are more difficult to investigate (language barriers, sources of information are also abroad, different accounting principles, less basic information disclosed, lower liquidity).
    • Invest in companies with major investments abroad; foreign investors are made welcome until money stops pouring in and profits flow back toward home, and regimes favorable to foreign investors may be overturned in times of depression.
    • Invest in companies attaining and maintaining technical leadership in a field of a rapidly advancing technology. The thing to do is to find the management with technical teams capable of staying in front.
    • It is the run-of-the-mill company making products the foreigner can easily copy which can be in danger.
28. Increased population does not have a major impact.
    • The increase in the total business produced by population changes is less significant for investors as it might appear.
    • This is because the investor does not hold common stock in the economy as a whole but in individual companies.
      • While the potential market for these companies’ products will expand with the growing workforce, so will the competition.
      • Many families will need to make changes in their budget, so there will be many shifts in overall demand between one type of product and another. Some will gain, others will be fighting a declining trend, but it is extremely complex to judge how, under the pressure of increased demands on the budget, family decisions will shift from one product to another.
29. Mergers and acquisitions, if executed successfully, can speed growth, but carry significant risks.
    • If executed successfully, mergers and acquisitions may cause a business to progress with far above average speed.
      • General improvement in the entire operation when a highly efficient management takes over a company that has been nearly so well run.
      • Redesign one or more major products of the acquired concern so as spectacularly to broaden the available market.
      • If a larger company is already selling a number of other products to the same customers, it can handle this additional line, too, at almost no extra cost.
      • Reduction in the cost of debt if the acquirer has a better credit rating.
    • The very nature of M&A, however, carries sizable risks.
      • They can result in less earnings rather than more.
      • They can so weaken a corporation that in the years ahead it will prove a less rather than a more attractive long-range investment.
    • Some savings look nice in theory but rarely occur.
      • Running the acquired operation with the top management of the buyer without expanding it.
      • Reduction in manufacturing costs by combining production facilities.
    • There are various sources of danger to investors:
      • Personnel issues. When mergers take place between two companies of about equal size, the struggle for occupying the top job degenerates into internal infighting. Even when one is dominant, executives may experience unease when the center of gravity passes to someone they hardly know, causing loss of talent or efficiency.
      • Management distraction. Top management get involved in so many problems in unfamiliar fields that it is unable to carry on with its former efficiency.
      • Undetected flaws. Because the seller knows more about his business than the buyer, the acquired business has faults far worse than allowed for in the acquisition price (“It is only after you have married the girl that you find out about the false teeth and wooden leg.”).
    • Risks to investors are usually limited in:
      • Backward integration deals.
      • Forward integration deals, save when a management makes the mistake of acquiring one company that competes with a number of its other customers and fails to allow for the loss of most of its sales to what were formerly customers but are now competitors.
      • Acquisitions of smaller companies.
      • Deals between companies in similar lines of business that have been aware of each other’s activities for years and that thoroughly understand each other’s problems.
      • Acquisitions made by companies in closely related fields, when all factors seem overwhelmingly propitious.
      • Acquisitions where a high price has been paid for something that thoroughly fits into the needs of a business.
    • Risks to investors are usually higher in:
      • Companies aggressively trying to grow by acquisitions, especially (i) in unrelated lines, (ii) when the CEO spends a sizable amount of his time on M&A, or (iii) when a top official is assigned to M&A as one of his principal duties.
      • Deals where a not particularly attractive business is acquired at a very low price in relation to existing assets and past earnings.
      • Deals in which the number of completely different industries in which a company is engaged causes strain on management.
    • Joint ventures have proven successful in many instances but their profits are given less weight by investors. A solution would be to list their shares.
30. Thoughtful investors should either support management completely or sell their shares.
    • If management is sincere and able, should stockholders not consider the possibility that their own views, when at odds with that of management, may be ill founded?
    • Is it wise for shareholders to throw around their weight in minor matters to curb the desires of a management that has been doing an outstanding job for them? No large company ever built up an outstanding management team which did not delegate authority to those who were performing well.
    • Where the proposal is highly undesirable, the stockholder should ask himself two questions: (1) Is there any significant chance of defeating the proposal? (2) If management is supporting something this bad, is it not probable that its judgment or its morals have deteriorated enough, so that even if this plan is defeated, other highly undesirable propositions will be initiated in the future?
    • When a proxy fight results from clear evidence of something less than outstanding management, the investor usually fares best who does not get himself involved but sells his shares and looks around for a well above-average situation.
31. Methods of investment evaluation have become more sophisticated.
    • Pre-1930s: Examine financial statements in great detail, with only a basic idea about the nature of the business.
    • After 1930s: Contact corporate officials to keep tabs on the company, visit plants, attend return visits of management in financial centers, read reports of security analyst bureaus.
    • After WW2: Scuttlebutt, to get a well-rounded picture, detect weak points which would not be volunteered, get answers (Are steps being taken to correct this situation? If so, what are they?) and help judge the efficiency of management.
    • In the future: Teamwork in investment research, to enable quicker, more thorough and more accurate scuttlebutt than the lone expert.
32. Do your homework before picking a financial advisor.
    • Be certain of their complete honesty and that their advice is not driven by the immediate fee.
    • Understand their investment philosophy, i.e. what they are going to try to do for you and how.
    • Ask for specific details of how they get the data, and how they keep in touch with what is going on at their portfolio companies.
    • Ask their opinion on stocks you know about.
    • Ask for a fair cross-section of results obtained for others, compare them to a record of security prices for the same period, and analyze whether the outperformance comes (i) from skill, (ii) from allocation to bonds in a period of falling prices or to risky marginal companies in a period of rising prices, or (iii) from trying to anticipate market moves. Eliminate advisors with less than 3 years of track record.
33. The short-term investment focus of mutual funds is damaging.
    • Salesmen for mutual funds use last 3 months performance as a selling tool.
    • Many institutions have led or become engulfed in this striving for consistent above-average gains each quarter, and were influenced by brokers.
    • This leads to:
      • End-of-period window dressing: selling losers to avoid showing them and selling the best stocks at a profit to compensate losses. When the next bear market comes, the absence of these stocks will be noticed.
      • Increased turbulence, with enormous buying or selling at the same time.
      • Speculation.
    • Consistently good short-term results are impossible to attain.
    • Until it is generally recognized that time and patience are two of the basic ingredients of true investment success, the cost to all concerned is painfully high.
34. The efficient market theory is a fallacy
    • It is indeed difficult to identify technical trading strategies that work well enough after transactions costs to provide an attractive profit relative to the risks taken.
    • But the belief that stocks automatically and instantly adjust to whatever is known about a company is not accurate.
    • While some dispersions may come as a result of surprises, most differences can be anticipated at least roughly both in terms of direction and general magnitude of gains and losses relative to the market.
    • Prices are not efficient for the diligent, knowledgeable, long-term investor.

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