Phil Fisher, author of Common Stocks and Uncommon Profits, has been one to always talk about the power of how conservative investors sleep well, and he really hammers this topic in his Part 2 section of the book by identifying 4 key points.
Superiority in Production, Marketing, Research and Financial Skills
Fisher starts off this chapter by talking about the major importance of being the lowest cost producer. Obviously when you’re the lowest cost producer, you’re likely going to be able to make the best margins, but there’s other reasons as well.
Being the lowest cost producer allows you the ability to outlast competition in tough times and then also gives you the ability to grow when you need to, and to be able to support your own growth.
This is so important because you can outlast some of the other smaller companies that might not be able to make it through these tough times and then when times are good and you’re able to grow, you can do so without having to generate more shares of the company.
It is important to note that with this type of low-risk company, the rewards also are usually lower than a high-risk company – but that doesn’t mean that they are low!
In addition to low-cost, you need to have a very strong marketing organization. It is the job of the marketing organization to make sure that the public knows about the product and it’s the job of marketing to make sure that the company knows what the public wants. Providing a product that the public wanted two years ago will not do anyone any good. It’s simply a waste of time and money.
The marketing organization needs to be in tune with the public’s wants and desires and be able to get those products to them and explain the benefits of their product to that same public group. This might mean that they need more sales people, advertising, special marketing groups, or anything else to help paint their picture.
The company also needs to have outstanding research and technical efforts. Regarding this, Fisher keys in on two main topics:
- Make a new and better product
- Decrease costs of the current product offering
Both of these are fairly self-explanatory to as to how and why this will allow the company to maintain, or create, their competitive advantage. If they can continuously develop new products, or decrease the costs of their current products, it’s going to allow the company to continue to stay a step ahead of the competition.
And finally, the company needs to have incredible financial skills. It sounds so obvious, but so many companies cannot accurately identify how much they’re making (or losing) on each product.
If you can’t do this, you won’t know what products to market more towards, what products to discontinue, and what products might be worth exploring more into.
In other words, you really have no idea at all about finance, the backbone of the business. In addition to not knowing, if you’re a bad budgeter and can’t manage your costs, the company won’t be able to identify potential red flags before they occur. Again, another major thing to be aware of.
The People Factor
So many companies say that people are their most important asset, and I think that this is 100% true. A company with real investment merit is one that promotes from within.
This sort of company will keep employees motivated and when these employees become managers, they understand the innerworkings of the company and the company culture.
Bringing in a new CEO means that there is an issue with existing management and that you don’t trust the current pipeline of talent that you should’ve been developing at the lower levels of your company. So how can you identify this?
Look at top management to see if it’s a one man show or not – their salaries should be a gradual drop-off from the CEO and down rather than a huge, drastic drop. This is one way to really show you just how important the CEO is vs. the other top managers.
The company must recognize that the world in which it is operating is changing at an ever-increasing rate. The employees should feel comfortable to always question and challenge the way that things are being done. If not, things will get stagnant and not progress as they should to stay competitive.
Your employees are your best spokespeople for the company. If they’re not treated right, how do you expect people to actually want to invest their own money in the company.
If someone that is being paid by the company doesn’t respect that company, then nobody will. So how does a company treat people right?
- People must be treated right
- Need to have good benefits
- Need to think their opinions are valued and they’re not being bossed around
- Need to be rewarded financially and in recognition
The Management team must be willing to submit itself to the disciplines required for sound growth. Many managements are focused on showing the best numbers at the end of an accounting period, such as minimizing their inventory to make the balance sheet look better for earnings.
This is the definition of a short-term fix. It’s essentially a band aid. These companies are spending more time, money and resources to minimize inventory at the end of a quarter simply to raise it right back up immediately after until the next end of the quarter.
Investment Characteristics of Some Businesses
Something that Fisher really keys in on is that when evaluating companies, simply looking at EPS isn’t as effective as everything that you want. For instance, a company might generate the same amount of earnings on 1/3 of the revenue because their profit margin is three times higher – so which is better?
Fisher prefers the higher profit margin because it gives them more room to grow and more room for error if things turn bad or competition increases, and they have to shrink profit margins. Things like that are important to keep in mind.
Some people will look to target the second or third best performing company in an industry or group of companies, thinking that if they can grow to the #1 company then there’s higher upside.
While this makes sense in theory, Fisher says that this very rarely occurs and way more often than not, the #1 company stays #1 and the rest will shuffle around a bit.
Look for companies that find a way to create their own competitive advantage. An example is Campbell who makes their own cans. Doing so allows them to be able to produce them cheaper because the scale is so high, as well as minimizing the extra freight costs.
While soup isn’t expensive, the freight to move the expensive cans is, so minimizing the freight costs is a huge cost savings for the company.
Typically, a small company can create a competitive advantage but its hard for them to maintain it as other competitors with more money and manpower are coming after them. This is incredibly important to see if these companies are able to continually adapt or if it’s a couple good ideas and then they’re stagnant.
In general, Fisher really narrows this down to one key thing to look for when finding an investable company – What can the company do well that others cannot do well? If the answer is nothing, that is a major red flag.
Price of a Conservative Investment
The last point that Fisher brings up is the power of being conservative. Nowadays, many investors don’t actually know what makes a stock go up or down a considerable amount. He’s not referring to the 2% swing in a day because of trade wars – he’s talking about big, 25%+ swings that you can see. People just don’t understand what causes these.
He sees so many people that will see a stock increase 50% and then immediately sell to lock in those gains that they received. I’ll never criticize making money, but you likely are going to experience some opportunity loss, so it’s just a risk appetite as every other part of investing is.
As Fisher says, “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.”
So, what he’s saying is that this substantial move is happening because there has been some fundamental change that’s occurred. A key that he says to focus on is that buying undervalued stocks can create great gains simply by just becoming properly valued stocks.
If you focus on an undervalued stock and things swing back to how they should be, those gains will still be very strong.
The thing with overvalued stocks is that they’re a bubble and that the bubble always bursts. Make sure that you’re not close enough to it, and definitely don’t be inside that bubble.
I highly recommend that you take a look at this chapter if you’re wanting to learn more about what Fisher thinks makes up a conservative investment and how you can find one. He goes much more in depth than what I do here, and I think you’ll leave a much better investor than you were before reading!