Central to Phil Fisher’s classic book, “Common Stocks and Uncommon Profits and Other Writings,” were the 15 points. These form a checklist of positive signs that quality companies give off. The more of the points a company exhibits, the greater the chances it will reward its investors. Some of the signs were more influenced by Fisher’s time than others—the book was published in 1958—but most are timeless.
In chapter eight, the author shows the other side of the coin by providing readers with five potential mistakes many investors make.
Buying promotional (startup) companies
Fisher spoke out against the idea of “getting in on the ground floor,” writing he would not invest in any company that does not have at least two or three years of commercial operation—and at least one year of operating profit—behind it. With an established company, an investor can get hard data on everything from sales to earnings per share and get a sense of management’s effectiveness.
But with a new company, what Fisher called a “promotional company,” investors can see only a “blueprint” and guess about its strengths and weaknesses, which is much more difficult and more open to mistakes. He also pointed to young companies being dominated by one or two individuals who are highly talented in a couple of areas, but have no expertise in other operational areas.
Further, Fisher argued that the financing of promotional companies should be left to specialists who can cover off weaker areas. Finally, he noted there are enough spectacular opportunities among more established companies, making promotional investments unnecessary despite their great attractiveness.
Not buying good, “over-the-counter” stocks
Fisher distinguished among stocks by noting that some issues were more marketable than others, and posited that “over-the-counter” stocks were those that were less marketable. In his time, the market had evolved over the past quarter century (going back to the 1920s). In the earlier part of this period, brokers had a customer base made up of a relatively small number of rich people. Thus, brokers were buying and selling in large blocks made up of thousands of shares.
By the 1950s, that had changed dramatically, with middle-class buyers dominating the market, along with institutional investors buying on behalf of others. Those changes led to new laws and practices in the 1950s and, among other results, the liquidity of stocks had decreased. In turn, many stock brokers became stock salesmen and, as a result, marketability became an issue.
Markets and their participants have continued to evolve, making marketability a lesser issue. Today, an investor who does an online search for "OTC" will likely get back listings that refer to penny stocks. These stocks, as we know, are for speculators, not investors.
Buying based on the “tone” of the report
Was that impressive annual report written by the company’s president—or by the public relations department for his signature? Fisher likened buying a stock based on the tone of its annual report to buying a product based on an attractive billboard ad. In broader terms, he was referring to buying on impulse, and that is something few investors can afford.
The argument also has a flip side: Don’t let an annual report with the wrong tone turn you away from what might be a good company and good investment. To buy well, investors must go beyond the annual reports, to the facts.
Being misled by the price-earnings ratio
Fisher claimed that investors were making a mistake in their reasoning. To illustrate it, he created the fictitious XYZ Corp., a company that has done very well over the past three decades, with constant growth in sales and profits as well as a growing pipeline of new products. This is recognized by market players, and the company sells at nearly twice the price-earnings ratio of the average stock.
The company announces it expects to double its earnings in the next five years. Fisher says some investors believe that since it is currently selling for about twice as much as average stocks, and that it will take five years for its earnings to double, the present price is discounting future earnings. All that leads these investors to assume the stock is overpriced.
What these investors are missing is the likelihood the company will continue bringing out new products that will increase their future earnings in the same way earlier products are generating today’s earnings. Given that, the company’s share price should also double in five years and maintain the existing price-earnings premium when compared to average companies.
Quibbling over “eighths” and “quarters”
First, a word or two about the terminology. Before the 1990s, the investment community used a fractional system rather than a decimal system to do its pricing. Increments between dollars were listed as “eighths” and “quarters,” referring to 12.5 cents and 25 cents respectively. When stock markets began operating some two centuries ago, they based their pricing on “pieces of eight,” which is to say one-eighth of a Spanish doubloon. Based on a Securities and Exchange Commission ruling, prices on and after April 9, 2001 had to be given in dollars and actual cents, and were no longer rounded up or down to the nearest eighth or quarter.
But back to Fisher’s point: He used the example of a man who wanted 100 shares of a specific stock. It was selling at $35 and a half, but he wanted to pay only $35 and put in his order at that price. His saving on the purchase would amount to $50. However, the stock never did dip to $35 again, and the man refused to pay more to buy the shares. Over the following 25 years, the stock rose to more than $500 (making provision for dividends and stock splits). As Fisher put it, “in an attempt to save fifty dollars, this investor failed to make at least $46,500.”
It was a clear case of “penny wise and pound foolish.” The author suggested small investors should follow a simple rule: “If the stock seems the right one and the price seems reasonably attractive at current levels, buy 'at the market.' The extra eighth, quarter or half point that may be paid is insignificant compared to the profit that will be missed if the stock is not obtained. Should the stock not have this sort of long-range potential, I believe the investor should not have decided to buy it in the first place.”
(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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