Philip Fisher believed very strongly that investors should understand the financial community’s various appraisals: of stocks in general, of the industry of which a company is a part (covered in part two, chapter five) and its appraisals of individual companies.
In part two, chapter six, he set out to explain how the community deals with the appraisals of individual companies. As in previous chapters, the price-earnings ratio is at the center of his attention.
He has written that conservative investors should look for companies that rank highly on his first three dimensions:
- Superior production, marketing, research and financial skills.
- Outstanding managerial competence in the areas above.
- Strong business leadership.
The fourth dimension tackled dramatic changes in share prices and the price-earnings ratio. Fisher stated his law of price changes this way: “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.” In chapter five, he explained how this might occur in the context of sentiment about an industry.
Following up in chapter six, he addressed price and price-earnings changes in the context of specific companies. To start, he noted that the closer the financial community’s appraisal is to the highest ratings under the first three dimensions, the higher the price-earnings ratio. Conversely, the poorer the ratings, the lower the ratio.
Fisher accused some investors of taking a mathematical approach that is too simple when choosing between two stocks. He gave the example of two stocks that are expected to grow at 10% per year. If one of those stocks has a price-earnings ratio of 10 and the other has a price-earnings ratio of 20, then the stock selling at 10 times seems cheaper. But if the cheaper company has lots of leverage (debt), then it may not be cheaper because of interest costs. Further, he expected that any interruption in the expected growth rate would affect the lower price-earnings ratio stock more.
A variation on this problem can occur when investors come to incorrect conclusions because they rely too much on comparisons of price-earnings ratios among stocks that appear to offer similar growth potential. For example, assume there are two stocks with an equal likelihood of doubling their earnings in the next four years. Both sell at 20 times earnings, while equally sound companies with zero growth potential sell at 10 times earnings.
Four years later, assume both high-growth stocks have doubled their earnings, but one is expecting flat earnings over the following four years, while the other is expected to double its earnings again. The financial community will then value the two companies based on their expectations, meaning the company that is expected to double its earnings again will continue to sell at 20 times. But the company expecting flat earnings will begin selling at 10 times, despite having doubled its earnings in the previous years.
Fisher added, “All this can be summarized in a basic investment rule: The further into the future profits will continue to grow, the higher the price-earnings ratio an investor can afford to pay.” But he urged investors to use this rule with caution, that they should never forget that actual variations in the price-earnings ratio will not come from what will happen in reality, but from what the financial community believes will happen.
As noted, there is a third type of appraisal in addition to appraisals of industries and of individual stocks. That third type is the financial community’s appraisal of stocks in general. Fisher offers a couple of extreme examples, the first being the euphoric period between 1927 and 1929. At the other end of the spectrum was the financial community’s deep skepticism about stocks between mid-1946 and mid-1949. In the latter period, stocks were selling at low price-earnings ratios despite good earnings because investors believed there must be a post-war depression just around the corner. As we, and Fisher, know in hindsight, both of those outlooks were spectacularly wrong.
When considering the financial community’s outlook for stocks in general, there is a real-world financial factor in play: interest rates. When interest rates are high, investment capital tends to flow to long- or short-term money markets, resulting in less demand and lower prices for stocks. The opposite occurs when interest rates are low.
There is also an effect from the public’s bias toward saving or spending. When the public is inclined to save a higher percentage of its income, the capital pool grows more quickly and creates greater demand for stocks. Fisher observed this aspect has less influence than interest rates. He also noted that new stock issues could have an effect as well, but a lesser effect than interest rates and spend/save biases.
In wrapping up the whole of the fourth dimension, he wrote:
“The price of any particular stock at any particular moment is determined by the current financial-community appraisal of the particular company, of the industry it is in, and to some degree of the general level of stock prices. Determining whether at that moment the price of a stock is attractive, unattractive or somewhere in between stock depends for the most part on the degree these appraisals vary from reality. However, to the extent that the general level of stock prices affects the total picture, it also depends somewhat on correctly estimating coming changes in certain purely financial factors, of which interest rates are by far the most important.”
(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.)
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