As we know, Charlie Munger (Trades, Portfolio) and other gurus make checklists a key part of their investing processes. Phil Fisher, who had a strong influence on Munger, was also a strong proponent of them.
In chapter three of his 1958 book, “Common Stocks and Uncommon Profits and Other Writings,” Fisher laid out his 15 points to watch for in common stocks. More specifically, they are points to consider when buying a stock. It’s a lengthy chapter, and so our digest is in two parts.
Fisher explained investors should use the 15 points to assess companies and their stocks to find good companies that will provide above-average returns: “What attributes should a company have to give it the greatest likelihood of attaining this kind of results for its shareholders?”
The first three points are:
Products or services with enough market potential to significantly increase sales for at least several years.
Speculators and bargain hunters may pursue one-time profits, but this is not the route for the greatest long-term gains. Serious investors should also stay away from situations in which there may be a large sales gain for just a few years. Fisher cited the case of television set sales just before television became established. There had been a short-term boom, then the sales curve flattened out.
He divided companies with outstanding growth records into two camps: “Fortunate and able” and “Fortunate because they are able." In this case, "fortunate" refers to companies that have been lucky and “able” refers to those that have a “high order of business skills.”
Among those that were fortunate and able, he listed The Aluminum Company of America (AA, Financial). He said it had been founded by men with great vision who could see important commercial uses for their product. At the same time, the company had been fortunate because the market for aluminum had grown so large over its first 70 years. As Fisher put it, the company was more the beneficiary of this growth than its instigator, thanks to factors such as the growth of aircraft manufacturing.
For an example of companies that grew because they were fortunate because they were able, Fisher chose Dupont, which is now DowDuPont (DWDP, Financial). It began with blasting powder and, in times of peace, its growth would have been about the same as mining and roadbuilding. However, the company had very able leaders and found a much richer path ahead, “Applying the skills and knowledge learned in its original powder business, the company has successfully launched product after product to make one of the great success stories of American industry.”
Management is determined to keep developing products or processes that will further increase total sales—when the growth potential of currently attractive product lines has subsided.
Fisher distinguishes this point from the point above by writing that the second is about management’s attitude. Does the management team recognize the products that drive its growth today will fade in the future? Does it also recognize that new products and markets will have to be developed to maintain its long-term growth?
This ties into the commercial research and development trend that was taking place in post-World War II America. Research and development meant these companies could create their own prosperous futures over the next 10 to 25 years. It also provides a strategy of improving existing products and developing new ones.
For investors, it’s best to find companies with research or engineering focused on products with some relationship to those markets it already operates in. Fisher offers the analogy of a cluster of trees, each growing additional branches from its own trunk.
The company’s research and development is effective in relation to its size.
To quantify how well a company is capitalizing on its R&D, Fisher suggested dividing the cost of research by total sales. This will tell investors what percentage of each sales dollar is being assigned to R&D. The percentage can be compared with that of other companies, or the industry of which the company is a part. There are several caveats to this analysis, of course, including wide variations in how companies define research and development expenses.
There is also the matter of effectiveness in the funding of research—a key management function. Managers must coordinate people and their research to create a team, in the sense that the whole is greater than the sum of the parts. Further, management must also tie together research, production and sales. Failure will lead to higher-than-necessary production costs or to products that don't have enough sales appeal.
Fisher also raised the issue of coordination with top management or, put another way, top management must understand the “fundamental nature of commercial research.” The R&D function should be funded consistently, without being cut each time a company experiences a bad year. The author also decries “crash” programs that see top researchers pulled from their regular work to work on some task of momentary importance.
Evaluation of research by defense contractors poses special challenges. For example, subcontractors may do their own research. If that’s the case, how should those expenses be factored into the R&D of the general contractor? And, what if the federal government has done research that it passes along to the general contractor? Fisher argued that each case would have to be addressed individually.
Wrinkles also appear in the case of defense contracts that might lead to commercial projects. For example, a company might learn principles and techniques it could apply to its commercial lines, and those lines would then become more profitable. That would be of great value to an investor.
Fisher further argued that some of the great successes in his recent past were companies that had found complex and technical defense work. That work would be done at government expense, and the knowledge gleaned from the work could then be applied to commercial work.
And, management should recognize the importance of field research, which might not be considered part of R&D. Field research is a bridge between work in the lab and sales to real customers. Management should control research spending by subjecting it to the test of market demand. Sometimes, for example, a brilliant product may emerge from the lab only to find a market too small to recover research expenses or to have any impact on the bottom line.
As to finding information about management’s skill in R&D and its application, Fisher suggested the “scuttlebutt” method could provide some answers, as could a study of how much in dollar sales or net profits can be attributed to the research. For a company with a stream of new products, the quantitative analysis would likely require a period of years.
Getting that information will reward investors for quite some time. Fisher said, “An organization which in relation to the size of its activities has produced a good flow of profitable new products during such a period will probably be equally productive in the future as long as it continues to operate under the same general methods.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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