Concerned that investors might interpret his idea of a financial community appraisal too narrowly, Philip Fisher set out to rectify that in chapter five, part two of “Common Stocks and Uncommon Profits and Other Writings.”
He argued that the financial community’s appraisal of a stock was made up of three separate appraisals:
- The market’s overall appraisal of common stocks in general.
- The overall impression of the industry of which the company is a part.
- The appraisal of the company itself.
With that, Fisher launched into an examination of industry appraisals. Over lengthy periods or the life cycle of a product/industry, he reported the price-earnings ratio will decline significantly, as the industry passes from the early stage, with huge markets ahead, to a more mature phase when it is threatened by competition. From his 1975 perspective, Fisher used the then-current electronics industry as an example. This was an age in which the vacuum tube market was being supplanted by semiconductors.
He added that this part of the concept is broadly understood, but far fewer understand that financial community appraisals also can be affected by different emphases within the community. For example, the price-earnings ratios of companies in the chemical industry had been bid up when the market believed these companies were a like a conveyor belt reliably delivering profits year after year.
However, in the 1960s that assessment changed as investors came to think of the chemical industry as being in the bulk commodity business, such as steel and cement. This caused the price-earnings ratio of chemicals to dramatically decline. Yet, as Fisher pointed out, while there were gluts in some areas, there were also areas where research and development were producing unique new products that could be sold at a premium. As he put it, “Opportunities seem almost limitless for human brains to rearrange molecules so as to create products not found in nature that will have special properties to cater to the needs of man better or more cheaply than the previously used natural materials.”
In addition, “first step” producers, the companies working with the most basic raw materials could find ways to improve their output, making it more complex, proprietary and higher priced. So, there continued to be great companies in the industry, firms that did not fit within the stereotypes created for it.
By the middle of 1973, chemical stocks once again were enjoying the confidence of the market; the view was that manufacturing capacity could only be increased gradually and thus would enjoy some years of stability before cutthroat competition emerged again.
The challenge for investors, according to Fisher, was to determine whether the financial community’s view of an industry was warranted by the facts. As seen, the financial community held at least three very different views of the chemical industry in less than two decades — while the industry itself remained largely the same.
The author also gave readers the computer industry, circa 1975, as an example of big changes in price-earnings ratios because the financial community’s appraisal changed while the industry remained essentially the same. This was an age, you may recall, when mainframes were at the center of the computing universe, surrounded by peripherals such as keyboards, printers and extra memory units. Early in the industry’s life cycle, the financial community believed that computing had a wonderful future; it thought a few major companies would dominate the market, although smaller independents might modestly undercut them in the peripherals sector (all of this, remember, was happening just before the revolution of the personal computer).
That view of the industry had changed, though, by the mid-1970s. As Fisher explained, “Today there is a new awareness of the financial strain on small companies with products that are usually leased rather than sold and of the determination of the major computer mainframe manufacturers to fight for the market of the products 'hung on' their equipment. Had the fundamentals changed or was it the appraisal of the fundamentals that had changed?”
His third, and “extreme” example of a significant change in the financial community’s appraisals — despite no meaningful change — was in the franchising industry. Fisher noted that the financial community took quite different views of the fundamentals of franchising in 1969 and in 1972. He wrote, “Here again, as with computer peripheral stocks, all the problems of the industry were inherently there when these stocks were being bought at such high price-earnings ratios but were being overlooked when the prevailing image was one of uninterrupted growth for the company momentarily doing well.”
He went on to say that investors had to face the same hard decision over and over: determining whether the current, prevailing image of an industry by the financial community is justified by the basic economic facts. In summing up, Fisher wrote,
“This point cannot be overstressed: The conservative investor must be aware of the nature of the current financial-community appraisal of any industry in which he is interested. He should constantly be probing to see whether that appraisal is significantly more or less favorable than the fundamentals warrant. Only by judging properly on this point can he be reasonably sure about one of the three variables that will govern the long-term trend of market price of stocks of that industry.”
(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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