"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher
The above quote is over a half-century old, however every time I see Jim Cramer regaled in a ridiculous hat or pressing buttons which elicit sound effects that exhort a caller to buy or sell a stock, the quote pops into my mind. I guess the Cramers of the world have been around Wall Street for a long time, the only difference being now they conduct nightly forums.
If Benjamin Graham is considered as the "father of value investing", then Philip Fisher should be considered the "father of growth investing". Graham focused on quantitative analysis; Fisher focused upon qualitative analysis. Graham believed in selecting undervalued companies, holding them until they reached full value, then selling them when they no longer offered an analytical discount. Fisher also selected companies he deemed to be undervalued; however, he chose not to analyze them based upon Graham's metrics; rather, he evaluated them based upon his perception of their long-term growth potential. In other words, a high trailing earnings yield or a low price to book ratio was not the true source of their value. Instead, such things as having high quality of the management, being the leader in a evolving industry, having a long history of above-average profit margins, or being the low cost producers in an industry recognized as the source of long-term value.
Coincidentally, Ben Graham made a significant percentage of his long-term gains by holding a Fisher-type stock for decades, namely Geico. Graham admitted that he held the company long after he deemed it to be severely overvalued by his own metrics. In reality, Ben Graham employed the Fisher concept of buying and holding the low-cost provider of auto insurance; without that one big stock his long-term results would have appeared to be somewhat ordinary. See the postscript of "The Intelligent Investor".
A number of years ago, Warren Buffet described his investment philosophy as 85% Graham and 15% Fisher. As time has passed and Buffett's ability to buy smaller companies has diminished, it could be argued that Buffett's philosophy currently bears a closer resemblance to that of Fisher than Graham.
It is also important to bear in mind that Buffett is unable to generate the historic returns he once did due to the dozens of billions of capital he is required to manage. He has more or less been forced into more of a growth and long-term hold orientation over the last few decades, currently focusing on the outright purchase of businesses which will throw billions of dollars in cash in the foreseeable future.
Value investors love to talk about the concepts of Ben Graham and Warren Buffett in regard to value investing. Sadly, the timeless concepts of Philip Fisher are rarely discussed. I find that rather odd since the concepts of Fisher continually turn up when one reads Buffett or Greenblatt or any other earnings-based value investors for that matter, although the concepts rarely bear the original contributors name. Fisher rather than Buffett, Graham or Greenblatt is the focus of this series of articles, more specifically how one can understand and employ the timeless investment concepts of Philip Fisher to generate better long-term gains in their portfolios. After all, that is the goal of virtually every value investor.
Buy and Hold
"If the job has been correctly done when a common stock is purchased, the time to sell it is almost never." Philip Fisher
Every time the market drops precipitously, guests show up on the various investment channels proclaiming that buy-and-hold is dead. They always provide charts which strategically pick a particular time frame and show how a particular stock or more commonly the S&P index has gone nowhere for 10 years or whatever time frame suits their purposes. It is similar to the gold vs. S&P charts which have become ubiquitous on cable and satellite advertising, of course the charts generally start around 2000, at the apex of the S&P overvaluation.
Philip Fisher did not buy the indexes. In fact, he did not believe much in diversification; rather, he purchased large positions in a few companies which he deemed to be extraordinary in nature. He preferred to hold the stocks for decades, many times adding when the price of the stock dropped significantly. Fisher considered himself a conservative investor although he frequently paid above-average market multiples for stocks which he considered to be exceptional. His books provided detailed rationale and characteristics of the qualitative features of such companies.
Chapters one through three in one of Fisher's least known books "Conservative Investors Sleep Well" http://www.amazon.com/Conservative-investors-sleep-Philip-Fisher/dp/0060112565/ref=sr_1_1?ie=UTF8&s=books&qid=1305738967&sr=1-1 provides "buy and hold" investors with a detailed description of certain characteristics of outstanding businesses, while four, five and six evaluate the factors which influence the market pricing a stock. A synopsis of the key concepts from the first three chapters can also be found in newer versions of Fisher's classic "Common Stocks and Uncommon Profits". In the appendix, that is a partial source of my data. New volumes of "Common Stocks and Uncommon Profits" also include the first six chapters of "Conservative Investors Sleep Well". The following is a summary of some of Fisher's key points in identifying conservative companies which merit long-term buy and holds.
Low Cost Producers and Growth
Warren Buffett identifies low-cost producers as one of the three sources of a durable competitive advantage. It appears that he expanded upon the concept originally discussed by Philip Fisher. Fisher felt that the lowest-cost producers had the ability to survive economic downturns which would drive out weaker competition. Further, during times of prosperity such companies had the ability to drive growth internally instead of diluting shares or incurring added debt to finance the growth.
Fisher appears to have influenced Buffett and later Greenblatt in his rationale that dividends are a poor method of creating value for investors in true growth companies. Although Fisher did not specifically calculate the rate of return on invested capital in his investments, he felt that successful reinvestment of profits and their influence on the growth of a company was paramount. More specifically he mentions that Wall St. is willing to assign a higher price to earnings multiple for companies that are considered to be market leaders in that area. Without question, the notion of a PEG ratio which was popularized by Peter Lynch was rooted in Fisher's investment philosophy.
Fisher's Law of Stock Movement
"Every significant price move of any individual common stock in relation to stocks as a whole occurs as a result of a changed appraisal of that stock by the financial community"
The dilemma that the individual investor faces is whether to retain the stock for the long term or sell it when the price exceeds it current intrinsic value. Fisher maintained that most investors who sell a high quality stock in hopes of buying it back after it recedes sufficiently in price, generally fail in their attempt. Thus even if the growth company becomes significantly overvalued in the short term it generally behooves an investor to hold for the long term so long as they are invested in an extremely high quality company.
Buffett has faced this dilemma with Coke (NYSE:KO) and received criticism upon occasion for not selling down his large position after extreme appreciation has rendered the company overvalued. He has steadfastly maintained Fisher's assertion in the case of Coke. Additionally, he precisely followed Fisher's advice when he purchased shares following the debacle that resulted when Coke temporarily changed their soft drink formula. That "temporary insanity" resulted in an extreme bargain price for a premium company when the financial community suddenly and mistakenly changed their appraisal of Coke based upon their misstep. The appraisal proved to be ephemeral in nature when Coke quickly reintroduced their Coca Cola Classic.
Buffett's purchase of Coca Cola proved to be pure genus resulting in astronomical long-term gains for Berkshire. Whether the current valuation metrics and dividend justify the current price is another question. In my personal opinion, the large capital gains which would be incurred as well as the resulting precipitous stock drop which would occur as soon as the news hit that Buffett was selling, virtually ensures that Berkshire will hold the stock at least until Buffett has retired.
Fisher discusses in detail how Wall St. assigns different multiples to various market sectors or entire stock markets based upon perceptions of current macroeconomic concerns. Frequently these appraisals are fleeting in nature and provide excellent entry points for high quality companies. Living through the depression as well as the inflationary crash of the 1970s, Fisher understood well how general market conditions could influence the price to earnings valuations of stock. He notes that the best time to buy or add to one's position in premium companies is during times of economic disruption.
Fisher was a pioneer investor in technology stocks and early semiconductor companies; adhering to his philosophies would have produced extreme wealth for Microsoft (NASDAQ:MSFT) investors in the decade of the 1990s or Apple Computer (APPL) in the first decade of the 21th century. Included in his most famous tech investments were Motorola and Texas Instruments (TXI) purchased in 1955. Those two subsequently became the creme-de-la-creme of technology companies for the next several decades. Fisher continued to hold shares of Motorola until his death in 2004.
It should be noted that when Fisher selected these two future tech icons they were considered to be highly speculative; at the time he purchased Motorola and Texas Instruments, only IBM was considered to be a safe investment in the technology sector. An ironic situation indeed, in light of the fact that IBM was once rejected as a speculation when a young Ben Graham presented the stock to his early employers when IBM was know as Calculating-Tabulating-Recording Company.
Profit to Sales Ratios
It appears that the inflationary bear market of the 1970s had a significant effect on Philip Fisher's views about the importance of price to sales ratios vs. return on assets. He stated:
"Although managers rely heavily on return of assets in considering new investments, investors must recognize that historic assets stated at historic costs distort comparisons of firms' performance. Favorable profit to sales ratios, notwithstanding differences in turnover ratios, may be a better indicator of the safety of an investment, particularly in an inflationary environment."
In other words, inflationary conditions tend to diminish a company's future ROA, particularly one that requires substantial plant and equipment assets which tend to increase in price along with the price of maintenance capex during inflationary periods. Simply stated, the cost of growing sales or merely maintaining existing equipment becomes more costly. In essence, ROA is reflecting profitability on a pre-inflation basis. Thus trailing ROA is overstated looking forward and the safety of the investment diminishes.
Companies with higher operating margins which indicate a competitive advantage are much better equipped to deal with inflationary pressures or at least survive during severe inflationary conditions.
Most investors who make their fortune in the market do so by buying and holding one or more outstanding companies. Long-term investors in Microsoft, Apple Computer or Abbott Labs for that matter became rich by the Philip Fisher approach to investing. In every single case, traditional value investors who focused upon the principles of Ben Graham rather than Fisher would have sold out long before they became rich; few would have ever found another company as good as the one they sold and most would have paid a higher percentage of capital gains taxes along the way.
Ben Graham abandoned his traditional investing methodology, recording a large part of his fortune, by holding Geico. Geico was originally an extreme value proposition which converted from a traditional value proposition to a Fisher-type growth stock. To his credit, Graham was savvy enough to adapt his methods and record much of his fortune by holding Geico as a growth entity.
The influence of Fisher upon renowned value investors including Peter Lynch, Joel Greenblatt and Warren Buffett is unmistakable. As the Berkshire-Hathaway fortune grows, capital allocation based more upon Fisher's approach than Graham's becomes inevitable. Even diehard Grahamites including myself can learn from the lessons of Fisher.
The next installment in the series will focus on evaluating management and what Fisher refers to as the "people factor".
"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Fisher