"Don't take any wooden nickels." — Famous adage
I have taken a few wooden nickels during my investment career, although when I bought them I thought they were solid gold. As it turns out the gold was merely a thin veneer which covered a piece of rotting wood. Most of my "wooden nickels" were a result of not paying attention to Philip Fisher's "Ten Don'ts For Investors."
The more I read about investing the more I appreciate the philosophy and writings of Philip Fisher. His influence upon modern investment thought is extremely pervasive; many of the concepts that he wrote about five decades ago have become nearly ubiquitous among value investors. Bits and pieces of his philosophy appear in almost every synopsis or profile of every value investor or fund manager who is worth his salt.
Today's article deals with the famous don'ts that Fisher explained in precise detail in his classic work, "Common Stocks and Uncommon Profits." I will follow the don'ts with some personal analysis.
The Don'ts
1) Don't buy into promotional companies.
Have you ever bought into an early-stage company with little or no revenues? Perhaps it was a junior mining stock with great promise and large untapped reserves, or an Internet company that promised a new and unique business model. Or maybe it was a biotech company which was testing a new drug which would prolong the life of a cancer patient.
Frequently such companies become excellent "story stocks" and may move quite quickly based upon speculation. However, when one revisits their balance sheets years later, they generally display extreme accumulated deficits (negative earnings) and show high amounts of additional paid-in capital (they issued a lot of secondary shares).
In most cases these promotional companies never get "off the ground," although their management is frequently skilled at extracting money in IPOs or secondary offerings.
2) Don't ignore a good stock just because it trades "over the counter."
Back in the 1950s when Philip Fisher wrote "Common Stocks and Uncommon Profits," "over-the-counter" referred to stocks that did not list or trade on the floor of a stock exchange. Fisher claimed that smaller and even medium-sized companies who did not qualify for the NYSE frequently chose to trade over-the-counter rather than listing on a regional exchange or the AMEX which was in its infancy. The smaller exchanges were frequently littered with disreputable stocks offering little or no value for the investor.
He felt that so long as a retail investor was treated fairly by his broker it made little difference whether a stock listed on an established exchange. At that time, over the counter market makers frequently handled significant shares and liquidity was rarely an issue in trading reputable stocks that did qualify for listing on the NYSE.
Today a similar example would be buying foreign stocks over the counter on the Pinksheets which did not list as ADRs on the NYSE. Such companies as pharmaceutical and chemical titan Bayer, which trades over-the-counter under the ticker symbol BAYRY.PK, would be a modern-day example. The quality of the company is the issue, not the method in which the stock is purchased.
3) Don't buy a stock just because you like the "tone" of its annual report.
Frequently annual reports are little more that glorified PR, complete with pretty pictures. I no longer receive annual reports through the mail and that suits me just fine. I prefer a company which cuts costs rather than attempts to influence my opinion of a stock by aesthetic means.
A perfect example of such an exhibition was the St. Joe (JOE, Financial) annual report from the early 2000s. The Annual was one of the most brilliant pieces of art work I ever witnessed, but the information came with a coat of "high gloss" complete with beautiful pictures and management commentary that built upon that positive tone. Unfortunately for investors, the front part of the Annual contained almost no useful information. I must confess I was extremely impressed at the time; I should have paid more attention to Fisher.
4) 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.
This principle applies to the Apple Computers (AAPL, Financial) of the world, particularly when they are still in the early stages of their growth. Specifically, the best growth companies with the best long-term prospects appear to be expensive on the basis of their trailing PE ratio. In reality, their price is a function of their continued growth rather than their lofty trailing PE ratio.
Since 2003 Apple has appeared to have future growth priced into the stock; the stock price always appears to be expensive. The same is true for Google (GOOG, Financial) since its IPO at around $100 a share. In both cases growth has been highly underestimated in relation to the companies' current earnings. In such cases the PEG ratio rather than the high trailing PE ratio becomes the more accurate valuation metric. Although Fisher never coined the term, it appears he laid the foundation for Peter Lynch in the formation of the PEG concept of valuing a stock.
5) Don't quibble over eights and quarters.
Before the decimal system, stock prices were reflected in fractions; a quarter referred to 0.25 in today's system. It seems like Warren Buffett is the only one who can quibble about a quarter and get his way.
I once put in a limit buy order for Scientific Games Corp. (SGMS) — 10 cents under the ask price when the stock was trading in the mid-$5s early in 2003. I never filled a single share; my limit order expired a few months later at nearly double its price. I almost called the bottom but in the immortal words of the late Maxwell Smart, "I missed it by that much." That was an extremely expensive dime in light of the fact the Scientific Games never quit rising until it hit the high $30s.
6) Don't overstress diversification
Now we are getting to the meat and potatoes of investing theory. Peter Lynch tabbed it as "diworsification." Warren Buffett recommended the practice only for those who do not understand what they are doing, and James Montier demonstrated statistically that holding only eight stocks would eliminate 83% of the risk to one's portfolio.
Once again it appears that the aforementioned investors brilliance in regard to limiting diversification was expounded upon by Fisher in the 1950s. Fisher found it appalling that professional investors would accord so high a percentage of their portfolios to companies that they did not understand well. The fear of "putting too many eggs in one basket" led to the overreaction of trying to watch too many eggs in too many different baskets. The result was underperformance.
Montier expounded upon the dangers or over diversification in Chapter 4 of his book, "Value Investing Tools and Techniques for Intelligent Investment." It seems that the fears of Fisher were born out in a study by Randy Cohen et al. That et al guy sure does conduct a lot of research; my apologies for the old joke.
Cohen's study demonstrated that the top ideas of US fund managers from 1991 to 2005 showed an average return of 19% vs. 12% for the market. However, the overall performance of the managed funds seldom outperformed the market index on a long-term per annum basis. In other words, precisely what Fisher feared turned out to be the case: The managers were generally successful in their best ideas but their overall performance was severely impaired by their tendency to invest in too many companies in the name of safety.
7) Don't be afraid to buy on a war scare.
Fisher noted that involvement in a war tended to drop equity prices but offered an excellent time to invest since inflation tended to rise in the countries which became involved. He also pointed out that it was paramount that the US won these world wars or the result might have been quite different. Typically, during inflationary times equity prices tend to increase at least in a nominal sense. The worst place to be is in cash which steadily loses it buying power.
The exception noted was WWI when the US entered late after accumulating a huge fortune by selling materials to Europe throughout the course of the war, resulting in an inflationary economic boom in the US. Of course the situation was temporary, and it helped set the stage for the first great deflationary bear market of the 20th century, which began in 1919 and ended in the late summer of 1921.
The main lesson that Fisher is teaching is that one must be heavily invested in stocks when inflation is imminent, although exactly the correct time to deploy one's capital is a difficult question.
8) Don't forget your Gilbert and Sullivan, i.e., don't be influenced by what doesn't matter.
This section could be translated as nothing is more worthless than a trailing PE; its all about the future and one's ability to foresee the future of company, based upon Fisher's famous 15 principles.
Fisher tells the story of his brilliant investment in Texas Instruments (TXI, Financial) when it was a very ordinary sort but was sitting upon the breakthrough which led to the age of semiconductors. Texas Instruments' earnings increased from 50 cents in 1955 to $3.50 per share in 1959, after four years of lackluster growth from 1952 to 1955.
I believe the section is insightful in viewing the cyclical nature of most technology stocks. Fisher pointed out that most tech stocks encounter a series of years of lackluster performance between large growth spurts. He further points out when a great technology company achieves extreme success one can expect its earnings multiple to increase as well as its earning per share.
I will credit Fisher as one of the first to discover the time to buy cyclical companies is when they appear overpriced at a point when they are approaching the bottom of their cyclical trough. That is a lesson that every investor should heed.
9) Don't fail to consider time as well as price in buying a true growth stock.
In other words if you know that the an innovative product such as an iPod is about a year away and you believe the product will be a game-changer, do not be afraid to purchase shares enough if you believe the stock appears overpriced based upon it current status.
Of course this implies that an investor holds extreme insight about the company, something that relatively few investors possess. Fisher was indeed an exception when it came to such insight, very similar to Buffett.
10) Don't follow the crowd.
Fisher, like all great investors, was a contrarian at heart. He particularly liked to purchase stocks during times of macroeconomic gloom or when a particular sector came into disfavor by the investment community. Many times depressed sectors resulted in unduly discounted companies which he believed had particularly good prospects looking forward.
He used the postwar period following WWII as an example of a buying opportunity for Dow Chemical (DOW, Financial). Although Dow was headed for record profits following the war, Wall St. was discounting its long-term prospects since prior post-war periods suggested that such earnings surges were temporary in duration, and both the Civil War and WWI were soon followed by deflationary periods.
Fisher on the other hand was quite familiar with the new products which Dow was set to introduce and did not buy into the argument that wars must be followed by a decisive bear market. Of course Fisher was proven correct about the prospects for Dow Chemical, although a deflationary bear market did develop from 1946 to 1949.
One of my favorite Buffett quotes describes the Fisher approach perfectly:
When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.
Conclusion
Philip Fisher's ten don'ts for investors provides investors with timeless advice on how to avoid common pitfalls that lead to underperformance. Many veteran investors still fall prey to several of Fisher's key don'ts. Over-diversification and the tendency to follow the crowd are still nearly endemic in the Wall St. community. If an otherwise seasoned investor is able to rid themselves of those two investing flaws, the long-term capital appreciation of their portfolios is almost certain to improve decisively.
I have taken a few wooden nickels during my investment career, although when I bought them I thought they were solid gold. As it turns out the gold was merely a thin veneer which covered a piece of rotting wood. Most of my "wooden nickels" were a result of not paying attention to Philip Fisher's "Ten Don'ts For Investors."
The more I read about investing the more I appreciate the philosophy and writings of Philip Fisher. His influence upon modern investment thought is extremely pervasive; many of the concepts that he wrote about five decades ago have become nearly ubiquitous among value investors. Bits and pieces of his philosophy appear in almost every synopsis or profile of every value investor or fund manager who is worth his salt.
Today's article deals with the famous don'ts that Fisher explained in precise detail in his classic work, "Common Stocks and Uncommon Profits." I will follow the don'ts with some personal analysis.
The Don'ts
1) Don't buy into promotional companies.
Have you ever bought into an early-stage company with little or no revenues? Perhaps it was a junior mining stock with great promise and large untapped reserves, or an Internet company that promised a new and unique business model. Or maybe it was a biotech company which was testing a new drug which would prolong the life of a cancer patient.
Frequently such companies become excellent "story stocks" and may move quite quickly based upon speculation. However, when one revisits their balance sheets years later, they generally display extreme accumulated deficits (negative earnings) and show high amounts of additional paid-in capital (they issued a lot of secondary shares).
In most cases these promotional companies never get "off the ground," although their management is frequently skilled at extracting money in IPOs or secondary offerings.
2) Don't ignore a good stock just because it trades "over the counter."
Back in the 1950s when Philip Fisher wrote "Common Stocks and Uncommon Profits," "over-the-counter" referred to stocks that did not list or trade on the floor of a stock exchange. Fisher claimed that smaller and even medium-sized companies who did not qualify for the NYSE frequently chose to trade over-the-counter rather than listing on a regional exchange or the AMEX which was in its infancy. The smaller exchanges were frequently littered with disreputable stocks offering little or no value for the investor.
He felt that so long as a retail investor was treated fairly by his broker it made little difference whether a stock listed on an established exchange. At that time, over the counter market makers frequently handled significant shares and liquidity was rarely an issue in trading reputable stocks that did qualify for listing on the NYSE.
Today a similar example would be buying foreign stocks over the counter on the Pinksheets which did not list as ADRs on the NYSE. Such companies as pharmaceutical and chemical titan Bayer, which trades over-the-counter under the ticker symbol BAYRY.PK, would be a modern-day example. The quality of the company is the issue, not the method in which the stock is purchased.
3) Don't buy a stock just because you like the "tone" of its annual report.
Frequently annual reports are little more that glorified PR, complete with pretty pictures. I no longer receive annual reports through the mail and that suits me just fine. I prefer a company which cuts costs rather than attempts to influence my opinion of a stock by aesthetic means.
A perfect example of such an exhibition was the St. Joe (JOE, Financial) annual report from the early 2000s. The Annual was one of the most brilliant pieces of art work I ever witnessed, but the information came with a coat of "high gloss" complete with beautiful pictures and management commentary that built upon that positive tone. Unfortunately for investors, the front part of the Annual contained almost no useful information. I must confess I was extremely impressed at the time; I should have paid more attention to Fisher.
4) 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.
This principle applies to the Apple Computers (AAPL, Financial) of the world, particularly when they are still in the early stages of their growth. Specifically, the best growth companies with the best long-term prospects appear to be expensive on the basis of their trailing PE ratio. In reality, their price is a function of their continued growth rather than their lofty trailing PE ratio.
Since 2003 Apple has appeared to have future growth priced into the stock; the stock price always appears to be expensive. The same is true for Google (GOOG, Financial) since its IPO at around $100 a share. In both cases growth has been highly underestimated in relation to the companies' current earnings. In such cases the PEG ratio rather than the high trailing PE ratio becomes the more accurate valuation metric. Although Fisher never coined the term, it appears he laid the foundation for Peter Lynch in the formation of the PEG concept of valuing a stock.
5) Don't quibble over eights and quarters.
Before the decimal system, stock prices were reflected in fractions; a quarter referred to 0.25 in today's system. It seems like Warren Buffett is the only one who can quibble about a quarter and get his way.
I once put in a limit buy order for Scientific Games Corp. (SGMS) — 10 cents under the ask price when the stock was trading in the mid-$5s early in 2003. I never filled a single share; my limit order expired a few months later at nearly double its price. I almost called the bottom but in the immortal words of the late Maxwell Smart, "I missed it by that much." That was an extremely expensive dime in light of the fact the Scientific Games never quit rising until it hit the high $30s.
6) Don't overstress diversification
Now we are getting to the meat and potatoes of investing theory. Peter Lynch tabbed it as "diworsification." Warren Buffett recommended the practice only for those who do not understand what they are doing, and James Montier demonstrated statistically that holding only eight stocks would eliminate 83% of the risk to one's portfolio.
Once again it appears that the aforementioned investors brilliance in regard to limiting diversification was expounded upon by Fisher in the 1950s. Fisher found it appalling that professional investors would accord so high a percentage of their portfolios to companies that they did not understand well. The fear of "putting too many eggs in one basket" led to the overreaction of trying to watch too many eggs in too many different baskets. The result was underperformance.
Montier expounded upon the dangers or over diversification in Chapter 4 of his book, "Value Investing Tools and Techniques for Intelligent Investment." It seems that the fears of Fisher were born out in a study by Randy Cohen et al. That et al guy sure does conduct a lot of research; my apologies for the old joke.
Cohen's study demonstrated that the top ideas of US fund managers from 1991 to 2005 showed an average return of 19% vs. 12% for the market. However, the overall performance of the managed funds seldom outperformed the market index on a long-term per annum basis. In other words, precisely what Fisher feared turned out to be the case: The managers were generally successful in their best ideas but their overall performance was severely impaired by their tendency to invest in too many companies in the name of safety.
7) Don't be afraid to buy on a war scare.
Fisher noted that involvement in a war tended to drop equity prices but offered an excellent time to invest since inflation tended to rise in the countries which became involved. He also pointed out that it was paramount that the US won these world wars or the result might have been quite different. Typically, during inflationary times equity prices tend to increase at least in a nominal sense. The worst place to be is in cash which steadily loses it buying power.
The exception noted was WWI when the US entered late after accumulating a huge fortune by selling materials to Europe throughout the course of the war, resulting in an inflationary economic boom in the US. Of course the situation was temporary, and it helped set the stage for the first great deflationary bear market of the 20th century, which began in 1919 and ended in the late summer of 1921.
The main lesson that Fisher is teaching is that one must be heavily invested in stocks when inflation is imminent, although exactly the correct time to deploy one's capital is a difficult question.
8) Don't forget your Gilbert and Sullivan, i.e., don't be influenced by what doesn't matter.
This section could be translated as nothing is more worthless than a trailing PE; its all about the future and one's ability to foresee the future of company, based upon Fisher's famous 15 principles.
Fisher tells the story of his brilliant investment in Texas Instruments (TXI, Financial) when it was a very ordinary sort but was sitting upon the breakthrough which led to the age of semiconductors. Texas Instruments' earnings increased from 50 cents in 1955 to $3.50 per share in 1959, after four years of lackluster growth from 1952 to 1955.
I believe the section is insightful in viewing the cyclical nature of most technology stocks. Fisher pointed out that most tech stocks encounter a series of years of lackluster performance between large growth spurts. He further points out when a great technology company achieves extreme success one can expect its earnings multiple to increase as well as its earning per share.
I will credit Fisher as one of the first to discover the time to buy cyclical companies is when they appear overpriced at a point when they are approaching the bottom of their cyclical trough. That is a lesson that every investor should heed.
9) Don't fail to consider time as well as price in buying a true growth stock.
In other words if you know that the an innovative product such as an iPod is about a year away and you believe the product will be a game-changer, do not be afraid to purchase shares enough if you believe the stock appears overpriced based upon it current status.
Of course this implies that an investor holds extreme insight about the company, something that relatively few investors possess. Fisher was indeed an exception when it came to such insight, very similar to Buffett.
10) Don't follow the crowd.
Fisher, like all great investors, was a contrarian at heart. He particularly liked to purchase stocks during times of macroeconomic gloom or when a particular sector came into disfavor by the investment community. Many times depressed sectors resulted in unduly discounted companies which he believed had particularly good prospects looking forward.
He used the postwar period following WWII as an example of a buying opportunity for Dow Chemical (DOW, Financial). Although Dow was headed for record profits following the war, Wall St. was discounting its long-term prospects since prior post-war periods suggested that such earnings surges were temporary in duration, and both the Civil War and WWI were soon followed by deflationary periods.
Fisher on the other hand was quite familiar with the new products which Dow was set to introduce and did not buy into the argument that wars must be followed by a decisive bear market. Of course Fisher was proven correct about the prospects for Dow Chemical, although a deflationary bear market did develop from 1946 to 1949.
One of my favorite Buffett quotes describes the Fisher approach perfectly:
When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.
Conclusion
Philip Fisher's ten don'ts for investors provides investors with timeless advice on how to avoid common pitfalls that lead to underperformance. Many veteran investors still fall prey to several of Fisher's key don'ts. Over-diversification and the tendency to follow the crowd are still nearly endemic in the Wall St. community. If an otherwise seasoned investor is able to rid themselves of those two investing flaws, the long-term capital appreciation of their portfolios is almost certain to improve decisively.
