Philip Fisher kicked off chapter four of “Common Stocks and Uncommon Profits and Other Writings” by challenging the the use of “accounting-statistical” analysis to choose stocks.
In referring to “statistical” stocks, he appeared to be referencing what Benjamin Graham characterized as bargains or what Warren Buffett (Trades, Portfolio) called “cigar-butt” stocks (every discarded cigar butt has a few puffs left in it). They may be bargains, but Fisher believed they also faced real troubles. He further argued that those coming business troubles would not be discernible, based on a purely statistical analysis. Ultimately, they would prove to be expensive, despite being bargains at the time of purchase.
According to the author, bargain hunters may end up with a profit, but a smaller profit than “the profit attained by those using reasonable intelligence in appraising the business characteristics of superbly managed growth companies.” Part of the reason for this discrepancy are the losses on ventures that did not deliver as expected or their outright failure.
Was this chapter, with its distinction between quality companies and cigar-butt companies, the genesis of Charlie Munger (Trades, Portfolio)’s pitch to Buffett? Munger is credited with moving Buffett away from cheap stocks and toward quality stocks.
Fisher wrote, “The reason why the growth stocks do so much better is that they seem to show gains in value in the hundreds of per cent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.” Whether they are called growth stocks or something else, these securities made “hundreds of per cent each decade” for Buffett and Munger.
Fisher also made a distinction between large firms and small firms. As he put it, at one end of the spectrum there are large companies, financially strong firms with roots deep in the economic soil. Because of this strength, and lower risk, they are of interest to institutional investors such as insurance companies, pension funds and mutual funds.
At the other end of the spectrum are small, and often young, companies that have products that promise a “sensational future.” To fit within the 15 points described in chapter three, they would have outstanding managers and researchers who are developing a new or “economically promising” field.
These small stocks are also risker, so Fisher recommended they only make up a small portion of a portfolio, with the proportion matching the investor’s risk tolerance. He said, “The young growth stock offers by far the greatest possibility of gain. Sometimes this can mount up to several thousand per cent in a decade. But making at least an occasional investment mistake is inevitable even for the most skilled investor.”
As examples of large growth stocks in 1958, Fisher pointed to International Business Machines IBM, Dow Chemical and DuPont; the last two later merged to form DowDuPont DWDP. These three stocks may have been the FAANGs of their day, with each growing five-fold in the 10 years between 1946 and 1956. In addition, they produced income for their holders.
Fisher also wanted us to know that historically, stocks such as these had been winners, “Decade after decade, with only occasional interruptions from such one-time influences as the great 1929–1932 bear market or World War II, these stocks have given almost fabulous performance.”
In the long run, the author expected the consistent gains of more conservative stocks to outperform the volatile smaller stocks because of losses among the latter. He also noted that some young, risky companies will in time have grown to maturity and become of interest to institutional investors.
Next, Fisher made a distinction between large investors and small investors, and their relationships with dividends. He argued larger investors can often afford to ignore dividends and pursue capital appreciation. On the other hand, small investors will not be able to live on dividends, no matter how high the yield, because their portfolios are not big enough. Therefore, they must make a choice between taking a modest income now or patiently waiting while compounding multiplies potential income in the future.
Whatever the case, small investors should only invest their surplus funds. First, they should have a contingency fund which will take care of them in emergencies or situations that require large amounts of ready cash. Fisher also considered all stocks too risky for savings intended for purposes such as future education. Beyond that, such trade-offs will depend on each person’s individual situation.
Success in investing, according to Fisher, comes down to two things: the degree of skill which an investor can apply and good fortune. Who knows, he wrote, what unforeseeable discovery might be made tomorrow in a research lab. That observation would prove to be perceptive as changes of all kinds roiled business and the investment industry in the 60 years since he wrote it.
Consider, for example, the computer revolution that was to follow in the quarter century after 1958. Then, in the 1990s, the power of computing was combined with advanced telecommunications to create the Internet revolution, while biotechnology and other major forces changed society as well. As all this was going on, the investment industry itself was changing, with the further development of mutual funds, including index funds and discount brokerages, among others.
Finally, Fisher argued that numerous studies over the previous 35 years had shown growth stocks—those that reinvested in growth rather than paying dividends—had outperformed stocks that did pay high dividends. Specifically, over a five- or 10-year span, growth stocks had done “spectacularly” better in increasing their capital value. In addition, after a reasonable time, the growth stocks were paying superior dividend returns as well.
(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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