Continuing with the dimensions of conservative investing, Philip Fisher addressed the fourth of them in chapter four of part two of “Common Stocks and Uncommon Profits and Other Writings.”
Those first three dimensions were:
1. Superior production, marketing, research and financial skills.
2. Outstanding managerial competence in the areas above.
3. Strong business leadership.
The price-earnings ratio is at the center of the fourth dimension, and the dimension itself is the relationship between the ration and stock prices. As to the ratio itself, it is calculated by dividing the current price by the earnings per share and is a widely recognized valuation tool.
According to Fisher, it is also a hurdle for many investors, including “many professionals who should know better,” by causing confusion. Why the confusion? Because they do not have clear understanding of the dynamics driving significant price moves in individual stocks.
On the other hand, many investors have profited because they do understand and refuse to sell quality stocks just because the price-earnings ratio suddenly looks high in comparison with a previous valuation to which the market had become accustomed.
Fisher wrote it is critical investors look below the surface to understand why prices undergo these sharp changes. He offered this law of prices changes: “Every significant price move of any individual common stock in relation to stocks as a whole occurs because of a changed appraisal of that stock by the financial community.”
He offered the example of a company that seemed ordinary; it previously earned $1 per share and traded at 10 times earnings, which is $10 per share. But it was not quite ordinary because while most companies in its industry have been slowing down, this company had grown thanks to brilliant new products and better margins on existing products.
As a result, it reported $1.40 per share in earnings last year and $1.82 per share this year, as well as promises of more such increases for several years to come. Because of these gains, the price-earnings ratio had jumped to 22, which is high in comparison to its industry peers, but in line with high-quality companies with similar growth prospects.
Further, 22 times $1.82 is $40.04, meaning the stock has “legitimately” gained 400% in two years. From a broader perspective, this improvement suggests the company now has a strong management team, one capable of growing at above-average rates in the next one or two decades.
The author went on to observe:
“The matter of 'appraisal' is the heart of understanding the seeming vagaries of price-earnings ratios. It should never be forgotten that an appraisal is a subjective matter. It has nothing necessarily to do with what is going on in the real world about us. Rather, it results from what the person doing the appraising believes is going on, no matter how far from the actual facts such a judgment may be.”
In other words, the stock prices rise and fall “according to the current consensus of the financial community as to what is happening and will happen regardless of how far off this consensus may be from what is really occurring or will occur.”
So why then should investors bother with the fundamentals, or the three dimensions of conservative investing previously described? The answer, said Fisher, is in timing. Sometimes, the appraisal of the financial community may be at odds with the facts. For a time, a company’s shares will sell for more or for less than their intrinsic worth.
In some cases, this mispricing may last for years, but ultimately the stock price should come to match the intrinsic value. Fisher added that investors often overreact; in the case of an overpriced stock, the market may go to the other end of the spectrum and undervalue it. As he noted, re-examinations often take place under the emotion pressure of falling prices, leading to overemphasis on the negative. It would appear, then, that conservative investors should time their buying to get stocks when they are undervalued to some extent. This, of course, is also consistent with the value investing approach.
According to Fisher, “We are now in a position to begin to get a true perspective on the degree of conservatism—that is, of basic risk in any investment.”
The least risky, and wisest, investment is a company that scores very well on the first three dimensions but is appraised as less valuable by the investment community. This means it will have a lower price-earnings ratio than the fundamentals warrant.
What Fisher calls the “next least risky and usually quite suitable for intelligent investment” are companies that rate highly on the first three dimensions and in which the financial community’s consensus is near the fundamentals-driven price.
Third from the top are companies worth keeping by conservative investors who already own them—but not worth adding to—are companies that are strong on the first three dimensions and have become near-legendary in the financial community, giving them a price-earnings ratio higher than warranted by the fundamentals.
Fourth are the stocks considered average or relatively low in quality in relation to the first three dimensions and have a financial community appraisal that is at or below intrinsic value. Fisher considers such stocks suitable for speculators, but not for conservative investors. He added, “there is just too much danger of adverse developments.”
Fifth, “the most dangerous group of all” are companies that have a financial community assessment that is far above what the fundamentals and the three dimensions would justify. For this group, there is more than just the risk of adverse developments; there is the potential of sickening losses.
Finally, Fisher directed readers' thoughts back to what he called the law of price changes: “Every significant price move of any individual common stock in relation to stocks as a whole occurs because of a changed appraisal of that stock by the financial community.” He pointed out the word “significant” was important in the context of price changes because it excludes minor price changes, the daily ups and downs seen among almost all stocks.
(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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