Philip Fisher part 4 and the Fisher method, Company research, points 2,3 /15

 2. Is management ready to develop new products and processes when the growth potential of the current ones has already been used up?

Few companies have enough current products to sustain decades of growth that will bring the best returns to investors. The company should invest in scientific research and product development. These are the best ways to increase sales in the long term. New products and the development of old ones improve opportunities. Investors usually get the best returns by investing in companies whose new products are related to the current ones.

This does not directly mean that the company should focus only on certain products. It can have several product groups for which it develops new products. A company that creates a foundation for its future growth and focuses on its research foundation will produce the best opportunities for future growth. Developing new products for completely new businesses that do not correspond to the company's current business is more likely to fail.

3. How efficient is the company's product development activities relative to its size?

Many companies report their product development costs, so measuring their efficiency in relation to the size of the company and other companies in the industry does not sound like a complicated task. One big problem with this is that not all companies measure the same cost items in the company's results. An investor can only use the figures to make rough estimates of whether a company is doing an abnormal amount of product development, only clearly less than others. Even in well-managed companies, the differences in efficiency can be a ratio of two to one. The differences between well-managed and poorly managed companies are even greater.

Creating new products and methods requires high-level expertise in several fields. New products are rarely developed by a single genius. Expertise alone is not enough; high-quality management is also needed, which makes people with different backgrounds work efficiently towards a common goal. Coordinating product developers, production and sales is not easy. If this is not done, new products will not be manufactured as cheaply as possible and the new products will not achieve the best possible sales. In this case, the risk is that the market will be taken over by more efficient competitors.

Senior management must also understand the importance of product development processes. Development projects should not be expanded in good years and suddenly reduced in bad ones. Some in senior management may suddenly transfer experts from other important projects to their own purposes, temporarily suspending projects for the sake of a momentary important project. This is rarely sensible. The essence of successful commercial research is that the company focuses only on projects from which the highest profits are expected compared to the costs. Many in the company's management did not understand this since Fisher. Company management must avoid the temptation to invest heavily in projects whose markets are too small to make significant profits.

If an investor cannot find the company's reported figures for product development investments, he can try to find answers himself by talking to researchers in the field at universities and research institutes, competitors and statistical offices. A simpler approach might be to examine a company's profits and sales growth compared to its R&D investments over a longer period. Fisher suggests ten years as one possible period.

Philip Fisher part 3 and the Fisher method, Company research, intro and point 1/15

 Researching Companies

After finding ideas, Fisher began researching companies. He used many sources, including financial statements, competitors, customers, subcontractors, and former employees. Fisher himself was amazed at how accurate a picture he could get of a company’s strengths and weaknesses by using multiple sources who were involved with the company. Without the confidentiality of the sources, this would not have been possible. Fisher had to gain the trust of each of his sources. He also had to live with this trust for decades, because his network of sources would have disappeared. The biggest weakness of Fisher’s method is its duration. Good opportunities can disappear while the company is being researched.

The questions had to be intelligent and well-prepared. Competitors were one of the best sources. By going through five companies in the business sector and asking intelligent questions about the strengths and weaknesses of their competitors, Fisher was able to create a surprisingly accurate and detailed picture. He got a clear picture of the capabilities of the people, or management, by talking to subcontractors, customers, and other people who worked with the management. He had to be careful with former employees, because their motives were not always pure. It is important for an investor to understand the reasons for their departure from the company. Former employees were not so much reliable sources as those who left voluntarily.

Fisher had fifteen points that he examined for each company. Almost all of them had to be true for him to talk to the management. These points mainly dealt with the quality of the managers and the characteristics of the business. Important quality factors for management included honesty, long-term perseverance, openness to change and conservatism in accounting. Important characteristics of the company included growth orientation, high profit margins, high return on capital and investment in product development. The list of fifteen points:

1. Do the company's products or services have significant growth potential that will last for several years?

Declining or flat sales do not offer investors the opportunity for high returns in the long term. A company can increase its profits in the short term, but it cannot do so in the long term. An investor aiming for high returns is only looking for long-term growth, which will increase the company's returns. An investor also cannot focus on companies whose business can be expected to grow for a while, but then stop. Even the fastest growing companies do not increase their sales every year. Sales of new products and services grow in spurts. Do not expect continuous steady development. Business cycles also matter. They bring their own fluctuations to sales. Growth rates should not be assessed annually but rather viewed over several years. Many companies can demonstrate that their growth will continue beyond the next few years.

Fisher divided growing companies into two groups, namely those that happened to be competent in the growth sector and those that grew while they were competent. As examples of the first group, he described Alcoa, which focused on aluminum, and Du Pont, which originally operated as a gunpowder manufacturer until it moved on to manufacturing polymers such as nylon and Teflon. Both groups can make a lot of money for an investor if their managers are competent.

One of the most important factors in investment success is the investor's ability to understand what the company's sales growth will look like in the future. Incorrect estimates can be disastrous. In addition, the investor must constantly understand how well the company's management can see technological changes and take care of product development that enables growth. A careful investor constantly studies how management takes care of sales growth by focusing the best employees and resources on increasing sales in the long term. Fulfilling this point was one of the most important conditions for Fisher in finding an investment target.

Philip Fisher part 2. Fisher method and finding ideas

 Fisher's method

The idea behind Fisher's method is to find the best business, run by the best management, and invest in it without worrying too much about the numbers. His goal was to find a few excellent investment targets and stick with them for decades. Fisher's method can be divided into three parts: finding ideas, researching companies with the help of customers, subcontractors, and former employees, among others, and meeting management. This requires time, understanding of the business, and skill.

It took Fisher months to find an investment target. In today's rapidly changing world, it can seem like an eternity. It's not, because investments are intended to be held for decades. The process of a few months is a small price to pay for decades of returns. The investor must think for himself whether the time required by Fisher's method is necessary for the returns he is seeking. The answer is individual.

Making a single investment was a labor and pain for him. This took months. Fisher rarely went so far as to visit the companies and talk to the management. According to him, only about one in 250 ideas led to an investment. About one in 100 ideas led to a conversation with management, and on average, about one in five ideas led to researching the company. He rarely needed to spend months researching an investment because most companies were eliminated early on using the method. This method is similar to modern automated stock research using key figures, but Fisher focused mostly on the quality aspect rather than crunching numbers. Some of the quality factors are reflected in the company's numbers, so Fisher also paid attention to what.

Finding Ideas

Fisher used his business contacts and other investors to find investment targets. Using his business contacts, he got a fifth of his ideas and four fifths from other investors. This came as a surprise when he looked at where he got his ideas. He had thought that business contacts would bring most of his ideas. He didn't listen to just anyone many times, but most of his ideas came from a few investors and the rest from business contacts.

He gave each young investor the opportunity to meet with him once to talk about their investment. He rarely met with the same person more than once. He was open to a second meeting and a willingness to exchange ideas if, after the first meeting, he believed the investor was exceptionally capable. These people gave him many ideas over the decades. He had a fifteen-point checklist that he went through with each idea. He only got more than one idea from the same person twice. The other was his son Ken Fisher, whose ideas he used three times. Both of the other person’s ideas made him lose money.

You can use other investors to find ideas, but you have to be selective in how you use them. Not all investors who seem to be successful are skilled or intelligent. They may have longer-term luck than others. Fisher used other people’s ideas only when he was sure of the other investor’s ability and the goodness of his ideas. Only by carefully examining the ability of others can you use their ideas. Without certainty of competence, there is no point in thinking about using anyone's ideas. If you can't form it, then there is no point in listening to them. In the age of social media, there are thousands of people offering their opinions as facts. You just need to find a few people you are sure are competent and use only their ideas and your own. I recommend that you do your own research on companies.

Competence is not guaranteed by a reputation as an investment guru or a few years of success in bull markets. Long-term, or decades of continuous high returns say more. In the age of social media, it is also not guaranteed by large groups of followers, which say more about the faith of herd souls than about real competence. It is also not guaranteed by the use of difficult terms. The ability to simplify difficult things as far as is reasonable, but no further, tells much more. This is an exceptional ability that is found in all the top investors I have studied. Fisher is no exception.

Philip Fisher, part 1 Short Introduction

 Introduction

“If you can’t do something better than others, don’t do it at all!”

Philip Fisher was a pioneer of the quality company philosophy. He believed that quality business and management would produce the best results for investors in all circumstances. Whether it was inflation, deflation, or times of steady growth, quality was the best option for him. He was at his best as an investor when he put his money in industrial companies that utilized natural sciences to develop market-conquering products. He also believed that financial institutions and consumer products companies offered top targets, but he did not believe that he could definitely find them himself. One reason for the latter was perhaps his excessive belief in rationality, when the cornerstone of many consumer products companies’ business is the brand, which is mostly the result of irrationality. He believed that he would get the best results from companies that utilize technology. His investment results support this argument. He believed that too many investors were focusing on companies in too many industries.

Fisher did not believe in diversification, but concentrated his holdings in a smaller number of companies. The majority of his portfolio was in a few stocks. His longest-standing holdings were Motorola and Texas Instruments. He owned them from the 1950s until the early 2000s. According to his son, in his last years he was already demented and unable to make rational decisions. No one has published exact investment results about him, so it is impossible to say how well he did. By investing in Motorola and Texas Instruments alone, he made extremely good returns.

Fisher was a patient, intelligent, uncompromising thinker. He loved three things most: walking, working, and caring. He could walk long distances, enjoying every moment while being at his most relaxed. He walked to and from work every day. He was a minimalist whose only luxury was the view from his home. He never wanted to change anything in his life. He was in his office from nine to four. One reason he always walked to work was that he didn't like crowds and didn't want to communicate with others. He had a few clients and he lectured at Stanford for a while. His book Common Stocks and Uncommon Profits served as a textbook there for a long time. He was also afraid of everything and everything all the time. He worried so much that he didn't take much risk when investing. That's why he didn't become as rich as he could have been.

Benjamin Graham's mistakes and summary

 The mistakes of master investors should be divided into two parts. The first part is investment mistakes and the second is thinking mistakes. Evaluating investment mistakes is the easiest part. In them, losses tell the absolute truth. Finding mistakes in thinking is not easy. Finding them never tells the absolute truth. It is more about the perspective of the one who finds the mistakes than the truth. Some of the investors in the book have admitted their thinking mistakes themselves. Others have not realized them themselves. Graham is among the latter, at least according to the sources I have found about him.

Graham's biggest relative losses came in the late 1920s and early 1930s. In the late 1920s, Graham was worried when prices were at their peak. At that time, his investment firm Graham-Newman was leveraged. It had most of its investments in stocks and a small part as short positions. The firm lost just under 70% of its capital by the end of 1932. Graham had not trusted his own instincts and therefore lost a lot of money. Considering the leverage and the general decline in stock prices, it can be said that the company survived well compared to its starting points. The Dow lost a maximum of 90% in the same period. It is difficult to estimate the size of the mistake, but I can say with a clear conscience that the leveraged portfolio was a mistake. The investments were on average better than the indices, so Graham did not make any shocking mistakes. I have no information about the content, so I cannot say anything about individual investments during that time.

As I already mentioned, understanding the fallacy is difficult and is always based on the author's estimates. Another reason for the fallacy is that more information is constantly being released and Graham lived at a time when there was much less of it to share. One such factor is the concept of permanent competitive advantage. This is what Graham did not recognize during the decades that he passed on his understanding of markets and companies. He believed that when profit margins were high, they would decrease over time, because high margins would attract new competitors, increasing pressure to lower prices. A sustainable competitive advantage is real and can arise in many ways. One is the image created by a brand or the brand created by the image. An example from Graham's time is Coca Cola, whose sustainable competitive advantage certainly existed even in his time. I consider the failure to understand sustainable competitive advantage to be Graham's biggest mistake.

In addition, Graham's mistakes include a rather short investment horizon and a lack of a safety margin, which he has partially compensated for through diversification. Graham often gave an investment two years to prove its worth. He advised selling if it did not happen, no matter how good the future seemed. He also advised selling a stock if it achieved the target increase in value faster. For example, in 1974, he advised buying stocks, diversifying them into at least twenty stocks, when the market price of companies was a maximum of 2/3 of their book value. He advised selling individual stocks when they rose to their book value. This leads to short-term action and the investor often misses the biggest value increases. Companies move in the same direction for an average of more than a couple of years. This often happens through profit improvements.

Evaluating the magnitude of the errors mentioned in the previous paragraph is not simple, so I will leave it to you. I want to mention one thing against which you need to evaluate it, and it can be found in the parts of Graham's definition of investing. "The purpose of investing is the preservation of capital and a satisfactory return." Both options can be found in the previous paragraph, because Graham emphasized a diversified portfolio, a reasonable price paid, and a satisfactory return meant something different to him than to many others.

Brief summary

Investing is an activity where long-term, i.e. several decades of returns tell the truth about the goodness of an investor. Graham's long-term returns are not as exceptional as those of many other investment masters mentioned in the book. Graham did not focus on making maximum profit but wanted to get a satisfactory return with a low risk of losing capital, as can be seen from his definition of investing. He succeeded excellently in this. Whether he is a master investor is up to you to judge.

I think he is overrated as an investor. He can still be considered a pioneer. He was also a better teacher than an investor. Many of his disciples have done much better than him. He has created a few concepts and ways of doing things that work well even today. Margin of Safety and Mr. Market are still important concepts. The use of margin of safety has been refined by a few of his disciples and have been more successful than him. This is what should happen if the teacher is successful in his work. Mr. Market is a brilliant concept and there is no better way to describe the irrationality of the market. Many apostles of the efficient market concept disagree with this, but they are more wrong.

Graham was a genius. He could write well. His books are masterpieces. I recommend Intelligent Investor to every investor. Security Analysis is more difficult to understand and I recommend reading it to those who have been investing for a longer time. Both have their own shortcomings. Despite these, they are among the best books about investing that I have read. Both books are investments with high returns. I also recommend other sources of Graham's ideas if you have the time. However, I consider the books mentioned to be the most important.

Benjamin Graham about owners and inflation

 According to Graham, owners do not really care about their own interests. They let management act as they please when it is not in the owners' interest. Most owners never even consider the option of management acting against them. As a result, management controls the company and the owners as a larger group submit to its will. A company should always primarily act in the best interests of the owners and not give management the power to act the way they want. The owners, as a larger group, can decide how the company operates and, if necessary, get rid of managers who do not pursue their interests.

On average, managers know more about the company's business than the owners. This does not mean that they think in the owners' interest or that they are always capable of doing their jobs. Owners should not give managers the opportunity to act as they please, even though they are more likely to be right. Investors should investigate the actions of management if they find an attractive investment or owns part of the company. Many companies are poorly managed, which costs the owners lots of money.

The interests of owners and management are not always the same. In particular, compensation systems can destroy the value of a company. Options can generate significant income for management at the expense of owners. They can make management focus more on increasing the share price than on the value of the company. Options often create destructive incentives for managers, which hurts owners. Compensation systems that are higher than normal are always a red flag. The amount of compensation received by management is not directly proportional to their efficiency. Management can also grow the company in order to justify their increasing compensation.

In addition to the management team, listed companies also have a board of directors. The owners elect them at the general meeting. The board of directors must promote the interests of the owners. This works in theory, but in practice it is often overlooked. This is because management often proposes board members to the general meeting. In this case, board members can promote the interests of management because they receive a salary. This can happen if a board member does not promote management's interests. Often, the board of directors and the management team work in symbiosis, pursuing each other's interests while the owners are less concerned. Understanding the internal dynamics of the management team helps to understand whose songs the board representing the owners is singing.

The interests of the owners are not identical. In Finland, the owners of a listed company do not always follow the same line in terms of taxation. An ownership stake of more than 10% means tax-free dividends. This pushes the owners into different positions. It can change the dividend policy to favor large owners, which should reduce the attractiveness of the company as an investment. In the United States, on the other hand, the interests of the owners intersect, for example, when index funds own companies. There, the company management is allowed to decide, for example, on the management of pension assets, so index funds may have a conflict of interest with other owners. The management can threaten to transfer pension assets to another fund company if the index fund interferes with its proposals. This is one of the disadvantages of the growth of index funds.

The owner must guard his interests. Few owners do that. Individual owners can rarely influence the investment targets, but nothing prevents them from gathering a larger group of shareholders and thus influencing the company management or board. One option is always to sell the shares, but few owners do so even when there are reasons to do so.

Graham on inflation

Inflation is a creeping income trap. It eats away at investors’ returns year after year. About once a century it peaks, and once a century there is a longer period of deflation. Both are exceptional cases. They affect investors’ returns significantly in the short term, but over decades the effects of both even out. Graham’s Intelligent Investor states that from 1915 to 1970, the average inflation rate in the United States was 2.5%. In the 1970s and 1980s, inflation was much higher. After this exceptional period, inflation leveled off and has been roughly at the 1915-1970 levels.

From these starting points, we can conclude that inflation will probably be high at some point. This happened in 2021 and 2022. No one knows when that will happen gain. In the long run, stocks are the most effective inflation hedge, but in shorter time frames, there may be better alternatives. This applies especially to companies that can either increase their efficiency more than inflation destroys profits or companies that can raise the prices of their products more than costs rise. In the best case, a company can do both. Graham believed that assets on a company's balance sheet, such as real estate, machinery, and raw materials, protect investors more effectively than direct investments in gold or real estate.

When inflation becomes exceptionally high, most companies are unable to increase their earnings enough to offset the increase in costs caused by inflation. This increases the debts which increases costs. This makes bonds, among other things, more attractive alternatives. This exceptional situation will not continue for decades, but it makes bonds better options for investors than stocks. Investors need to monitor cost developments because it is not easy to notice the acceleration of inflation. It almost always takes a part of the investor's returns. Deflationary environments are an exception. At least the United States offers investors the opportunity to buy inflation-protected government bonds. Hedging against inflation is not free, so everyone should decide how much it is worth paying for it.

Benjamin Graham and manic-depressive Mr. Market

Manic-depressive Mr. Market can be your friend or your enemy. You can’t control it, but you can control how it affects you. Mr. Market offers a price at which you can either buy or sell shares. If you are not satisfied with the offer, he will come back to it later. This continues from moment to moment, and the real value of the investment is of little importance in the short term. Emotions drive Mr. Market, and you can’t do anything about them. You have to accept them.

A manic Mr. Market moves stock prices up, and a depressive one moves them down. Most of the time, he is almost right. In that case, you cannot determine with sufficient certainty whether the prices are reasonable. Mr. Market can steer prices in the wrong direction for years. Prices go higher and lower than few people believe. This is more the rule than the exception. The direction can change in the blink of an eye, and you cannot predict it. In the long run, Mr. Market is more right than wrong. By acting wisely, you can benefit from both directions. You can buy when the price is lower than the true value and sell when it is higher. Most of the time should be spent doing nothing. Sometimes Mr. Market offers opportunities, in which case it offers you a large margin of safety. In these cases, you need to be able to invest significant amounts. Take full advantage when you can, because you may have to wait years.

A wise investor never has to sell shares, but he sells them because the prices offered by Mr. Market are clearly higher than their true value. The market will go in the wrong direction whether you like it or not. Never invest money that you cannot afford to lose. Mr. Market offers an almost 100% guarantee that it will move some of your investments in the wrong direction and for a long time. If you cannot afford to lose money, it will lose it. As an individual investor, you are in a better position because you can choose, because you are taking advantage of the market. Large organizations are practically forced to take prices offered by Mr. Market all the time.

You need to control your actions. You can avoid unnecessary expenses and keep expectations of future returns reasonable, while others are hysterically chasing the price increases. Investors’ expectations matter. Usually, when the market goes up, so do expectations of returns. During the tech bubble in 1999, investors’ expected returns were 19% per year for the next decade. This meant that results would grow by about 5.7 times in ten years. It is worth noting that the US gross domestic product grew by six times in the last century. This estimate of future prices was completely absurd.

You can reduce Mr. Market’s influence on you by following his actions less often. Following him makes it easier for your subconscious to believe that the prices he offers represent real value. Your subconscious is constantly looking for clues in environment. By following prices, you create anchors for yourself, according to which you determine the value of your investments. At the same time, the calculations and their parameters of your analysis can guide you without realizing it towards the price determined by the market.

A rational investor always tries to keep extra cash to exploit the emotional turmoil of Mr. Market. Sometimes Mr. Market can offer so many attractive options that you have to use almost all your money. You need incredible control to exploit emotional turmoil, which is not easy when Mr. Market, with the help of other investors, offers assessments that contradict your views for years. No one can completely resist them. People are animals that crave action. Even Warren Buffett needs action sometimes, as his partner Charlie Munger has stated, among other things, about Buffett's Berkshire investment in Salomon Brothers.

Mr. Market can affect even patient investors when a large enough herd is running in the same direction. Graham’s story of the oilman at heaven’s gate illustrates the influence of the hordes well: Saint Peter informed the oilman that the places reserved for the oilmen were full. The oilman said, “Can I say four words to them?” Peter says, “Why not?” All the oilmen start rushing from heaven to hell. Peter says, “Well done, now there’s room for you here.” The oilman thinks for a while and says to Peter, “I think I’m going to hell, there may be some truth to the rumor after all.” Unfortunately, this is how we usually act, even though we resist the movements of the people for a long time.