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Robert Abbott
Robert Abbott
Articles (434)  | Author's Website |

Phil Fisher: Understanding Business Leadership

The third dimension of successful investing: How some companies achieve and maintain above-average profitability

December 17, 2018 | About:

To kick off chapter three in part two of his book, “Common Stocks and Uncommon Profits and Other Writings”, Philip Fisher wrote that it was important to know why “above-average profitability” is very important.

As he pointed out, growth costs money:

  • New research and development.
  • Expansion costs.
  • Building or expanding facilities.
  • Covering the costs of initiatives that fail.
  • Higher levels of inventory required.
  • Handling a growing volume of receivables.

To be able to pay these costs, mostly in advance, a company must be profitable. Fisher said this is especially true when costs overall are rising; in the long term, price increases can be passed along to consumers and customers, but in the short term, companies are stuck with extra costs.

Further, Fisher wanted investors to know that profitability can be set out in two ways:

  1. The fundamental way, used by management, which is return on invested assets.
  2. Alternatively, it would be profit margins per dollar of sales, a metric that may be more useful to investors.

The second, alternative measure is critically important in understanding the safety of an investment. As Fisher pointed out, if two companies both experience a 2% increase in operating costs and cannot pass them on, a company with a 1% profit margin could be forced out of business in time while a company with a 10% margin would lose only a fifth of its profits.

There’s yet another matter on Fisher’s mind: If a company generates above-average returns for a lengthy time, competitors are sure to appear. That, in turn, will affect profit margins, and the best protection against that is to operate more efficiently than the newcomers.

With that background discussion completed, Fisher wrote he was ready to get to the heart of the third dimension of conservative investing: Specific characteristics of well-managed companies that enable them to protect their margins over long periods.

One characteristic of such companies is “economies of scale.” For example, a company producing one million units a month should be more efficient than a company that makes only 100,000 of the same units. Yet, that will only work for the larger company if it has highly competent management and, at the same time, the bigger a company becomes, the harder it is to manage well.

Then, there are companies that are both leaders in their field by dollar volume, but also in profitability. Fisher reported these companies are rarely displaced so long as their managements remain competent. Looking back to the previous chapter, he reminded readers that management teams should be able to adequately respond to a changing external environment.

Fisher also threw cold water on the idea of buying the number two or number three companies because, as some experts suggest, number two or number three could move up, but the number one company could only move down. He backed that up with his observations about several companies in the years before 1975: Westinghouse had not been able to get ahead of General Electric (NYSE:GE), Montgomery Ward could not overtake Sears (SHLD) and no company had displaced IBM (NYSE:IBM) from its perch atop the computing industry.

Readers in 2018 will recognize some ironies here: Westinghouse survives, although now as a subsidiary of Brookfield Business Partners (NYSE:BBU), while in the past few years GE has stumbled so badly it may not survive in its current form. Montgomery Ward was swallowed up by Colony Brands Inc. almost two decades ago, while Sears appears to be in its own death throes. As for IBM, and as the world knows, some kids in garages came along just a few years after this book was published in the mid-1970s. From our contemporary perspective, it seems that numbers one, two and three are all susceptible to what Joseph Schumpeter called “creative destruction”.

Getting back to Fisher’s book, the author asked what it takes for a company to achieve a scale advantage. Normally, that arises out of being the first to offer a new product of service that has solid demand and a back-end of good marketing, servicing, product improvement and advertising. A company that can do this becomes an industry leader and a safe choice: As the old saying went, “Nobody gets fired for buying IBM.”

What’s more, the author cited a saying in the pharmaceutical industry: When a worthwhile new product comes to market, the first mover gets and holds a 60% share, plus the bulk of the profits. The first competitor could expect 25% of the market and moderate profits, while the next three companies got 10% to 15% of the market and meagre profits.

Fisher next turned his attention to the soup division of the Campbell Soup Co. (NYSE:CPB), which was then the largest soup canner in the country. He observed it held several advantages over smaller companies:

  • Cost reduction through backward integration (i.e., making their own cans).
  • Enough volume to justify many canning plants at strategic locations.
  • With more plants, shorter hauls for producers and for deliveries to warehouses and stores.
  • Because it is a recognized product name, retailers give it prominent shelf space.
  • Advertising costs less per can because of scale.

While there are also some disadvantages to scale, overall the advantages helped protect Campbell’s profit margin.

Another leadership factor is the competitive advantage of interacting disciplines in a technology sector. For example, a large, established company is likely to have a network of technical support for its products, something challengers may not be able to duplicate because of the costs involved. He suggested Texas Instruments (NASDAQ:TXN) as an example because of the way it dominated the hand-held calculator market (a very big sector at that time).

Finally:

“To summarize the matter of the third dimension of a truly conservative investment: It is necessary not just to have the quality of personnel discussed in the second dimension but to have had that personnel (or their predecessors) steer the company into areas of activity where there are inherent reasons within the economics of the particular business so that above-average profitability is not a short-term matter. Put simply, the question to ask in regard to this third dimension is: “What can the particular company do that others would not be able to do about 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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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website


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