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Common Stocks & Uncommon Profits - summary

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Here's a summary I made while reading through "Common Stocks & Uncommon Profits", a book written by legendary investor, Phil Fisher.

15 points to look out for

The 15 points are the attributes of a company which give it the greatest likelihood of providing massive returns to investors. A company could be an investment bonanza even if it fails to qualify on a few of the 15 points, but is not a worthwhile investment if it fails to qualify on many.

1. Does the company have products or services with sufficient market potential to make a possible sizable increase in sales for at least several years?

"Close to the very heart of successful investing is finding companies which are developing new products & processes or exploiting new markets." "Are these lines where, as the industry grows, it would be relatively simple for newcomers to start up & displace the leading units? If the nature of the business is such that there is little way of preventing newcomers from entering the field, the investment value of such growth as occurs may prove rather slight."

A high order of management ability is a must - no company grows for a long period of years just because it is lucky. It must have & continue to keep a higher order of business skill, otherwise it will not be able to capitalise on its good fortune & to defend its competitive position from the inroads of others. Is management able to take advantage of its skills & knowledge to go into unrelated lines affording still further growth possibilities. The investor must be alert as to whether the management is & continues to be of the highest order of ability; without this, the sales growth will not continue.

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potentials of currently attractive product lines have largely been exploited?

The usual route management would follow is through scientific research & development engineering. "The investor usually obtains the best results in companies whose engineering or research is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities...a company with research centred around each division, like a cluster of trees each growing additional branches from its own trunk, will usually do much better than a company working on a number of unrelated new products which, if successful, will land it in several new industries unrelated to its existing business."

3. How effective are the company's research & development efforts in relation to its size?

"In no other major subdivision of business activity are to be found such great variations from one company to another between what goes in as expense & what comes out in benefits as occurs in research." Calculate research expenses by total sales. "Companies vary enormously in what they include or exclude as research & development expense". "The essence of successful commercial research is that only tasks be selected which promise to give dollar rewards of many times the cost of the reserach." How much in dollar sales or net profits has been contributed to a company by the results of its research organisation during the prior 10 years?

4. Does the company have an above-average sales organisation?
5. Does the company have a worthwhile profit margin?

What is the profit : sales ratio, over a series of years? Those companies with the smaller profit margin nearly always increase their profit margins by a considerably greater % in the good year than do the lower-cost companies, whose profit margins also get better, but not to so great a degree. This usually causes the weaker companies to show a greater percentage increase in earnings in a year of abnormally good business than do the stronger companies in the same field."

One needs to test whether the reason for the low profit margin is not that the company is doing more research for the future.

"With the exception of the companies in which the low profit margin is being deliberately engineered in order to further accelerate the growth rate, investors desiring maximum gains over the years had best stay away from low profit-margin on marginal companies."

6. What is the company doing to maintain or improve profit margins?

It is not the profit margins of the past but those of the future that are important. When profit margins of a whole industry rise because of repeated price increases, the indication is not a good one for the long-range investor.

7. Does the company have outstanding labour & personnel relations?

This is particularly important in South Africa, with the threat of strikes never far away. But the difference in the degree of profitability between a company with good personnel & one with mediocre personnel relations is far greater than the direct costs of strikes.

Check labour turnover - there is a high cost in training a new person. Equally significant is the relative size of the waiting list of job applicants wanting to work for one company as against others in the same locality. In an area where there is no labour surplus, companies having an abnormally long list of personnel seeking to enter their employ are usually companies that are desirable for investment fromt he standpoint of good labour & personnel relations.

"In this day of widespread unionisation, those companies that still have no union or a company union, probably also have well above average labour & personnel relations...On the other hand, unionisation is by no means a sign of poor labour relations."

The investor who buys into a situation in which a significant part of earnings comes from paying below-standard wages for the area involved may in time have serious trouble on his hands.

8. Does the company have outstanding executive relations?

Salaries are at least in line with the standard of the industry & locality. Management only bring outsider into anything other than starting jobs only if there is no possibility of finding anyone within the organisation who can be promoted to fill the position.

9. Does the company have depth to its management?

Who is the key man, and what happens if he is no longer available? How much delegation of authority is there? "If from the very top on down, each level of executives is not given real authority to carry out assigned duties in as ingenious & efficient a manner as each individual's ability will permit, good executive material becomes much like healthy young animals so caged in that they cannot exercise."

10. How good are the company's cost analysis & accounting controls?

Management need a precise knowledge of the true cost of each product, to understand each product's profitability (which informs decisions like which product to promote). It's not the existence of detailed figures so much as their accuracy which is important.

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

"For example, in most important operations involving retailing, the degree of skill a company has in handling real estate matters - the quality of its leases, for instance, is of great significance...Similarly, the relative skill with which a company handles its credits is of great significance to some companies & of minor or no importance to others."

Check comparative leasing costs per dollar of sales, and the ratio of credit loss.

In some lines of business, total insurance costs mount to an important % of the sales dollar.

Patents are another matter having varying importance.

12. Does the company have a short-range or long-range outlook in regard to profits?

"The company that will go to special trouble & expense to take care of the needs of a regular customer caught in an unexpected jam may show lower profits on the particular transaction, but far greater profits over the years."

13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing shareholders' benefit from this anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but 'clam up' when troubles & disappointments occur?
15. Does the company have a management of unquestionable integrity?

"Regardless of how high the rating may be in all other matters, if there is a serious question of the lack of a strong management sense of trusteeship for stockholders, the investor should never seriously consider participating in such an enterprise."

What to buy

For anyone risking a significant stake, the rule to follow "is to put most of his funds into the type of company which, while perhaps not as large as a Dow, Du Pont or an International Business Machines, at least comes closer to that type of stock than to the small young company."

When to buy

Outstandingly desirable companies are usually working on the very frontiers of scientific technology, they are developing various new products or processes from the laboratory through the pilot plant to the early stages of commercial production. All of this costs money & is a drain on other profits of the business, but if the investment's good there'll ultimately be an improvement in earnings.

Capital investments & stock prices reactions

When the first full-scale commercial plant is established, there will probably be a shake-down period of 6 to 8 weeks, to get the equipment adjusted to the required operating efficiency & to weed out the 'bugs'.

Even in the early stage of commercial production the extra sales expense involved in building sufficient volume for a new product to furnish the desired margin of profit is such that the out-of-pocket losses at this stage of development may be greater than they were during the pilot-plant period.

Typically the price of the share is bid up when word gets around of a revolutionary new product, then is bid up further when the pilot-plant starts operations. Then, when month after month difficulties crop up in getting the plant started, and unexpected expenses cause earnings to dip, down goes the price of the stock. At last, the good news arrives that the plant is running smoothly & a 2 day rally occurs in the price of the stock. But, in the following quarter when special sales expenses cause a further sag in net income, the stock falls to the lowest price in years. At this point the stock might prove a sensational buy.

Since the same techniques are used, the 2nd, 3rd, 4th & 5th plants can be done without the delays & special expenses of the shake-down period of the first plant.

Temporary setbacks

"The company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these trouble are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock & give promise of being solved in a matter of months rather than years, he will probably be on prety safe ground in considering that this is a time when the stock may be bought."

Capital intensive extensions

"In industries such as chemical production, where large amounts of capital are required for each dollar of sales, another type of opportunity sometimes occurs. A new plant will be erected for, say, $10m. A year or 2 after these plants are in full-scale operation, the company's engineers will go over them in detail. They will come up with proposals for spending an additional, say, $1.5m. For this 15% greater total capital investment the engineers will show how the output of the plants can be increased by 40% of previous capacity. Since the plants are already profitable & 40% more output can be made & sold for only 15% more capital cost, & since almost no additional general overhead is involved, the profit margin on this extra 40% of output will be unusually good. If the project is large enough to affect the company's earnings as a whole, buying the company's shares just before this improvement in earnings power has been reflected in the market prices for these shares can similarly mean a chance to get into the right sort of company at the right time."

When to sell

"If the job has been correctly done when a common stock is purchased, the time to sell it is - almost never." There are only 3 reasons to sell.

When a mistake has been made in the original analysis

..."& it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed."

Don't qualify in terms of the 15 points

"Sales should alway be made of the stock of a company which, becausse of changes resulting from the passage of time, no longer qualifies in regard to the 15 points...to about the same degree it qualified at the time of purchase." This is usually as a result of a deterioration in management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did.

"There is a good test as to whether companies no longer adequately qualify in regard to this matter of expected further growth...This is for the investor to ask himself whether at the next peak of a business cycle the comparitive per-share earnings will probably show at least as great an increase from present levels as the present levels show from the last known peak of general business activity."

"Selling in the hope of switching into a still better common stock."

Dividends

Stockholders get no benefit from retained earnings when:

Management pile up cash & liquid assets far beyond any present or prospective needs of the business.

When management can get only a subnormal return on the capital already in the business.

"With ever rising costs, the total accumulated depreciation is seldom enough to replace the outmoded asset"

DONT'S for investors

Don't buy promotional companies

In an established company an investor can observe the company's production, sales, cost accounting & management teamwork. In contrasts, when a company is still in the promotional stage, all an investor or anyone else can do is look at the blueprint & guess what the problems & strong points may be.

Don't ignore a good stock just because it is traded OTC
Don't buy a stock just because you like the 'tone' of its annual report

Often they are too optimistic.

Don't assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the prices
Don't quibble over eighths & quarters
Don't overstress diversification

"Buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification."

Don't be afraid of buying on a war scare

Just be sure to buy into companies either with products or services the demand for which will continue in wartime, or which can convert their facilities to wartime operations. It is not that war is likely to be profitable to stockholders, it is just that money becomes even less desirable.

Don't give price ranges at which a stock has sold in former years undue importance

"By giving heavy emphasis to the 'stock that hasn't gone up yet' they are unconsciously subscribing to the delusion that all stocks go up about the same amount & that the one that has already risen a lot will not climb further while the one that has not yet gone up has something 'due' it. Nothing could be further from the truth. The fact that a stock has or has not risen in the last several years is of no significance whatsoever in determining whether it should be bought now. What does matter is whether enough improvement has taken place or is likely to take place in the future to justify importantly higher prices than those now prevailing."

Don't fail to consider time as well as price in buying a true growth stock
Don't follow the crowd

Finding a growth stock

Identify analysts whose work you respect in selecting common stocks for growth, & listen eagerly to details they might furnish concerning any company within your range of interest that they consider unusually attractive for major appreciation.

3 things not to do once you've identified an exciting company:

  1. Do not approach anyone in mangement

  2. Do not spend hours & hours going over old annual reports making minute studies of minor year-by-year changes in the balance sheet.

  3. Do not ask every stockbroker you know what he thinks of the stock

What Fisher does do:

Then he tries to see or phone every key customer, supplier, competitor, ex-employee or scientist in a related field that he knows or whom he can approach through mutual friends. If Fisher doesn't have enough contacts, he gives up and moves onto something else.

Only after 'scuttlebutt' has obtained a large part of the data in the chapter on the 15 points & the investor has gathered at least 50% of all the knowledge he needs to make the investment, should management be approached. No corporate officer can be expected, unasked, to volunteer the most significant weak points. However, if they discover you know about the weakness, they may furnish you with a realistic answer as to whether anything is being done to remedy it.

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