Learn from Philip Fisher What to Avoid in Stock Investing

[Dennis Ng]

PHILIP FISHER: on what to Avoid in Stock Investing

Philip Fisher, author of the classic Common Stocks and Uncommon Profits, is the doyen of growth investors. He sought companies with high growth potential, but he also looked to buy at a reasonable price that gave good value. Even high earnings growth stocks fall out of favor, become overlooked and sell for less than their underlying worth from time to time.

Fisher is perhaps best known for his very early investment into Texas Instruments--in 1956!--on a hunch about a new technology called semiconductors. Today, let’s take a look at the nine warning signs outlined by Fisher for stocks to avoid.

Rejecting companies that have made mistakes
Fisher’s high-growth companies were generally involved in pioneering technologies. Failure, on occasion, is part and parcel of progress. Other stock pickers gave Fisher his chance to accumulate sotck in companies that had shown a good average success to average failure ratio in the past.

The less informed investors tend to dump the stock when earnings drop sharply below previous estimates: ’time and again the investment community’s immediate consensus is to downgrade the quality of the management. As a result, the immediate year’s lower earnings produce a lower than historic price earnings ratio to magnify the effect of reduced earnings. The shares often reach truly bargain prices.’

If these companies are run by exceptionally capable people, and the mistakes are only transient, the investor will do better by placing money here than if he or she invested in a company with a management that tends to go along with the crowd, and doesn’t take the risk of pioneering.


Playing the ’in and out’ game
Despite Fisher’s extensive experience he rejected the idea that he could predict short-term price movements, and thereby benefit by selling a stock when it appeared to be too high with the expectation of buying it back again after a price correction.

There is: ’A risk to those who follow the practice of selling shares that still have unusual growth prospects simply because they have realized a good gain and the stock appears temporarily overpriced.... These investors seldom buy back the stock at higher prices when they are wrong and lose further gains of dramatic proportions....I do not believe it possible to play the in and out game and still make the enormous profits that have accrued again and again to the truly long-term holder of the right stocks.’


Fisher was equally critical of those who relied on economic forecasts to time investments, which he regarded as ’silly.’ He likened the current state of our knowledge of economics (for forecasting future business trends) to the science of chemistry in the days of alchemy in the Middle Ages. There are rare occasions when speculative enthusiasm pushes stocks to ridiculous extremes (such as 1929, 1987, 2000) when an economic analysis will predict what is likely to occur. However, such analysis would be useful only one year in ten.

Fisher said, ’The amount of mental effort the financial community puts into this constant attempt to guess the economic future from a random and probabily incomplete series of facts makes one wonder what might have been acomplished if only a fraction of such mental effort had been applied to something with a better chance of providing useful... (the) investor should ignore guesses on the coming trend of general business or the stock markets. Instead he should invest the appropriate funds as soon as a suitable buying opportunity arises.’

Impatience
This is a common issue, but one that merits repeating for emphasis. There is a need for ’patience if big profits are to be made from investment. Put another way, it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.’

The urge to follow
’Doing what everybody eles is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.’

Trying to ’come out even’ on a poor investment
The difficulty people have accepting that they made a mistake causes them to avoid taking a loss on an investment and thereby making explicit, for all the world to see, that they made a bad choice: ’More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.’

Rejecting stocks trading on lesser markets
Generally the investor should confine buying to those stocks listed on stock markets which afford a reasonably high degree of liquidity and regulation. However, it is often the case that many stocks quoted on smaller exchanges are sufficiently liquid and regulated to be of interest to the investor. Indeed, wonderful opportunities can be missed if investors overlook these markets as potential hunting grounds.

Judging a stock on the basis of its previous price change
To evaluate a stock on the basis of the price ranges at which it sold in recent years puts the emphasis on ’what does not particularly matter, and diverts attention from what does matter.’

The crucial facts needed as an input to the appraisal are to be found in the current and future influences on the performance of the underlying business. What happened to the stock price a few months or years ago is irrelevant.

Speculators sometimes try to pleat that they are being rational: they might say, ’well, the price has traded in a range for many years, it is due for a rise.’ The hidden logical assumption is that stocks go up about the same amount, and it is just a matter of spotting when it is the turn of that particular stock.

Equally nonsensical is the belief that because a stock has already ’risen a lot’ it will not go any further. Past movements are of little relevance to the future. What does matter is the background conditions leading to growth over the next few years, and whether they are already reflected in the price or not. To understand these you must understand the business, not how to read charts.


Start ups
Start-up companies, particularly in the high technology field, are often alluring. They may have an exciting new invention or are at the forefront in an industry with great growth prospects. It is very tempting to try to ’get in on the ground floor’ by buying into such companies.

Fisher avoided companies that did not have an operating history of two or three years and at least one year of operating profit. His reasoning was that the investor needs to be able to evaluate the quality of the operations of the major functions of the business (production, sales, cost accounting, research, management teamwork, and so on) and this is very difficult to do for a very young company.


The opinions of qualified observers on the matter of the company’s strengths and weaknesses will not yet be properly informed. Likely future difficulties or competitive threats can only be guessed at. In short, Fisher-type analysis is simply not possible, and the stock buyer is therefore gambling, unless they have highly specialized skills and knowledge.

Over-stressing diversification
Everyone is aware of the horrors of putting too many eggs into one basket. Few people consider the ’evils’ of the other extreme. ’This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put in them.’

Fisher regarded it as appalling that investors were persuated to spread their funds between 25 or more stocks. The investor, or his advisor, is highly likely to be placing money in companies of which they know little. The result is that only a small proportion of the money is left for placement in companies of which they have a thorough understanding. ’It never seems to occur to them, much less to their advisers, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.’

He draws an analogy with an infantryman stacking rifles to illustrate the degree of diversification needed. The ’stack’ would be unstable with just two rifles. Five or six, properly placed, would be much firmer. ’However, he can get just as secure a stack with five as he could with fifty.’ Fisher suggested that if the investor was focused on large well-entrenched growth stocks then the minimum degree of diversification should be five such stocks-- with no more than 20% in each.

[Excalibur]

PHILIP FISHER: on what to Avoid in Stock Investing

hi Dennis,

Your comments were very relevant and useful. I have read the book only once and probably missed some of the factors you mentioned. I think you probably give your value-added knowledge from various sources to make these pointers valid and relevant.

At the beginning, I came across some terms that I was not familiar and felt that the book may not be an interesting read. e.g. 1) Scuttlebutt - gossips, grapevine, rumour 2) Neophyte - novice (in baseball sport)

I read the first part but it was some american history, characters and life story of Philip Fisher as seen by his son and the relationship with his father by Kenneth. Just like reading story book. Kenneth was frank about his opinion on his father and had no qualm in disclosing some embarassing moments and situation such as some mistakes made by his 70 years old father. The failure could be partly due to dementia/Azhemier disease and attachment to out-dated principles (or stocks that make money for him).

Kenneth Fisher pointed out that some principle like holding your stock for long term (similiar to Warren Buffet's concept of buying a good company forever) may not be practical now. So maybe a good lesson for us not to follow even the most savvy investors after they had passed the age of 70.

The 15 points are essential how a good company should operate. It reminds me of the management study in NUS about how a company can have sustainable competitive advantages.

e.g. Philip Fisher looked for
1) an innovative company (good company always invested heavily on R&D and always have new products)
2) good management (CEO has good leadership and working relationship at all level)
3) collaborative and cooperative relationship with labour union
4) people oriented company (who pay employee well and expect loyal and hardworking employee)
5) effective operation, manufacturing, production, logistics
6) strong marketing/sales team
7) high gross margin/net margin
consistent sales growth
etc

If a company can fulfill all these 15 criteria, it is not only a good company. I think it is like looking for a perfect company (in an imperfect world) which is not only very hard to find and if exists, is seldom under-valued.

Also, Philip Fisher uses his "Scuttlebutt" methods which may involve a lot of research, interview time and also the ability to sift out wrong information (i.e. wisdom to tell what is rumor, gossip or truth)

Some points that the above factors may not be feasible or sustainable in long term
1) Innovative company may not be first mover or leader in the market forever. e.g of Philip's later years failure in the book are Motorola, Texis Instrument

2) Capable company management or leadership may change and the result may not be predictable. (unless a company like GE which has a systematic way of grooming successor from within and not sure if the system still in practice). Nowsaday, most company will rather employ someone with proven track from competitors or outside the industry to lead) However, this may or may not necessary be good for the company.

Sometimes, CEOs were employed from outside to turnaround an ailing company. Only some are able to turnover albeit only for a few years but hardly longer. e.g. Lee was able to revive Chrysler from the brink of bankrupt but only a few years. HP had changed several CEO hoping for a dramatic turnaround and had been an admirable employer until they changed staff-oriented policy to that of hire-and-fire system. Even the best CEO also cannot save the ailing Japan and American Airlines.

So it would be difficult for us to judge if good company & its management can continue to perform. e.g. HP & many tech firm changes CEO quite often. The results were mixed. Most turned to quick fixes such as cost-cutting, sub-contracting, out-sourcing to raise bottomline for a short time frame but failed to turnaround the company in the long term as they didn't find the root cause of their failure.

The Apple's board of Director and CEO sacked founder Steve Jobs because he didn't work well with his team and staff in 1978. 20 years later, who would then expect an ousted founder without proper university education can revive and make the company thrive? Of course, the years outside Apple definitely helped Steve Jobs to grow and become a better leader, calmer person and expert innovator. He was a perfectionist and so it was hard for him to get along with most of his employees and co-workers. So, Apple for the most part of its history will not be qualified to be a good company to buy.

3) The rule of game changed especially in rapid technological age. Product lifecycle was shortened and inventory obsoletesence was a big concern. Great company who were Market leaders were displaced in a matter of a few months to few years. Even non-technological firms were not spared from the shift of technological advancement and internet evolution E.g. new marketing media in digital format were gradually taking over traditional media. Some who are slow to react lost their market share and market leadership. e.g. Kodak Eastman failed to notice the shift to digital camera format and lost the game totally

Some companies were able to use technological advancement in production and logistics system to marginalise their bigger siblings or market leaders. e.g Dell was able to carve a niche and gained substantial market share in the almost commoditized PC market while other big names such as IBM, Compaq and HP struggled with the PC business.

The book quoted quite a fair number of old story of success in stocks market from 1929 to 1958. Times are changing. Now it is a totally different era and technology age. At best, these successes can only be read as stories as quoted by Kenneth Fisher.

The book consists of another section: Conservative Investors Sleep Well (another book by Philip fisher)

the book provides good overview on evaluating promising firms like functional, people and business factors which can be some good reading. However, if one has no time to read annual reports of listed firms, how do one evaluate these above factors. Also, he said that annual reports and financial numbers cannot be totally trusted.

so getting rich may require quite a fair amount of works to be done. there is no free lunches.

For the past 2 months, I have been learning a lot from the value/growth and technical analysis of investment. Still a long way to go and it is never too late to learn.

If someone noticed more learning points that I missed, kindly give your guidance.

BTW, as I re-read my comments, I realised I was following religiously to what Philip Fisher said about how to choose a good company and noticed some of its fallacy and shortcoming. On the other hand, Dennis was more focus and tell us how to avoid the bad investment choices. The latter is easier to grasp and follow.

So, I think it would be easier to read Dennis's summary of the book in 5 minutes than spending 20 hours to read the book and get more confused.

Thank you, Dennis

Cheerio
TOny

[Dennis Ng]

PHILIP FISHER: on what to Avoid in Stock Investing

hi Dennis,

Your comments were very relevant and useful. I have read the book only once and probably missed some of the factors you mentioned. I think you probably give your value-added knowledge from various sources to make these pointers valid and relevant.

So, I think it would be easier to read Dennis's summary of the book in 5 minutes than spending 20 hours to read the book and get more confused.

Thank you, Dennis

Cheerio
TOny

Hi Tony,

just to clarify, the above is not written by me.

It was downloaded by me from internet several years ago, however, I have not taken note of the author of the post, which is why I didn't credit the person.

I want to clarify this as it is NOT my intention to take credit for an article which I didn't write.

Yes, as you mentioned, Philip Fisher has very strict criteria on what constitutes a good stock.

Similarly, Warren Buffett also has very strict criteria on what constitutes a good stock, and if a stock can fulfill all the criteria, it would seem almost a Perfect company in an imperfect world, and personally, I cannot find any company that fulfill all of the criteria set by either Warren Buffett or Philip Fisher.

Nonetheless, as I mentioned, there is still value in learning some of the things from Philip Fisher and Warren Buffett and in my seminar, actually I try to combine what both said that I think are relevant and can be applied to choosing Stocks in today's era.

Information is NOT Knowledge and nowadays, with the advent of internet and easy access to information, there is actually problem of information overload.

Thus, my Stock seminar basically is an attempt for me to try to combine what I think works in the Real World from many sources of learning, including from my multi-millionaire sifus and various other people such as Warren Buffett, Philip Fisher, Benjamin Graham, Jim Rogers, George Soros etc. Try to help people sieve through all the countless information out there and filter down to Useful Practical Knowledge that works in investing in the Real World.

During my learning process, as I read more and more books from more and more authors, I went through a period that I was getting more confused, rather than more enlightened, but then, slowly and surely, I managed to find out what is relevant and useful and try to pick and choose those that seem to work and apply to my own investing...

This is why I conduct Seminars on Stock Investing. Becos I think rather than people going through Trials and Errors like I did, and also going through such phases of learning, such as getting more confused, why not I help them "short cut" and teach them what works, at least I found that it works for me in Singapore stock market, including Fundamental Analysis and Technical Analysis.