Monday, July 25, 2011

Growth Investing - Philip A. Fisher


In one of his shareholder letters, Warren Buffett told his readers that the terms "value investing" and "growth investing" were really the same thing.  He felt that a value investor should be looking for companies whose business prospects and profits appear to be on an increasing trajectory for the foreseeable future.  Wall Street views growth stocks as those whose revenues and profits increase at annual rates which exceed, by a substantial amount, the average increases of those financial attributes for the general market.

Investing in stocks whose revenues and earnings are growing at a pace exceeding that of the market ("growth stocks") is a well respected investment philosophy.  The most famous proponent of growth investing was Philip A. Fisher, who wrote his classic, Common Stocks and Uncommon Profits in 1958.  Mr. Fisher was born in 1907 and started his own money management company in 1931.  He headed Fisher & Company until 1999, retiring at the age of 91.  He looked for companies which devoted a  large portion of their earnings to research and development of new products.  He was a long term investor.  His son, Kenneth Fisher, who has continued the family tradition of money management, reported that Mr. Fisher invested in Motorola in 1955 and held the stock until his death in 2004.

Philip Fisher listed 15 attributes to look for in a promising stock.  He indicated that a company should provide its customers with a product or service with a potential market large enough to provide significant sales increases in future years.  In addition to the product, the company also had to be able to improve on that product through continuous research and development in order to be ready to sell the new model (in today's parlance, its Version 2.0) when the current model had run its life cycle and to repeat this over and over again while also developing new products.   Mr. Fisher looked for a company with a significant percentage of its sales dollars devoted to research.  Not only must the product have a large market potential, but it also must be able to generate a significant profit margin for the company.  He also wanted to know what steps a company was taking to protect and increase its profit margin.

In addition to these financial characteristics, Mr. Fisher was interested in a company's labor relations, the depth of its management bench, its executive development program and the quality of its expense controls.  He wanted a company capable of financing its growth with earnings or debt.  Mr. Fisher recognized that if the company needed to raise additional capital through stock offerings, the existing shareholders' ownership percentage was going to be diluted by the issuance of additional shares to new investors.  If an investor owns 100 shares of a company which has issued 1,000 shares, he or she has a 10% interest in the company.  If that company issues an additional 1,000 shares and the shareholder does not buy any additional shares, then that 100 share percentage drops from 10% to 5%.

Three management traits were of also important to Mr. Fisher.  First, he wanted to find companies whose management was interested in the long term success of the company, not its next quarterly results.  Second, the management had to be honest with the shareholders in the bad times as well as the good ones.  He explained this as follows:

Furthermore, the companies into which the investor should be buying if greatest gains are to occur are companies which over the years will constantly, through the efforts or technical research, be trying to produce and sell new products and new processes.  By the law of averages, some of these are bound to be costly failures......How a management reacts to such matters can be a valuable clue to the investor.  The management that does not report as freely when things are going badly as when they are going well usually "clams up" in this way for one of several rather significant reasons.  It may not have a program worked out to solve the unanticipated difficulty.  It may have become panicky.  It may not have an adequate sense of responsibility to its stockholders seeing no reason why it should report more than what may seem expedient at the moment.  In any event, the investor will do well to exclude from investment any company that withholds or tries to hide bad news.

The third, and most important, management trait Mr. Fisher required was that the executives in charge have the utmost integrity and see themselves as stewards of the shareholders' business.

As with all forms of investing, relying solely on one concept can lead to trouble.  One of the more famous examples of growth investing gone wrong is the "Nifty Fifty."  This was the name given to 50 large cap stocks on the New York Stock Exchange which had consistent earnings growth during the bull market of the late 1960's and early 1970s.  Unfortunately, those companies became viewed as "one decision" stocks, i.e., buy and hold them with little or no thought to their financial condition or business prospects other than their earnings growth rates.  In that bull market, the P/E ratios paid for some of these stocks grew to as high as 50.  Even more troubling, the P/E ratios for the companies increased at a rate far in excess of the earnings increases of the companies.  As is usually the case, "Nifty Fifty" investors suffered large losses when the bottom fell out of the market later in the 1970s and prices crashed.

In order to get a full appreciation of the tenets of growth investing, an individual can do no better than to read this investment classic.  The above excerpt comes from Common Stocks and Uncommon Profits republished by John Wiley & Sons, Inc. under its Wiley Investment Classics series in 1997.

Comments are welcome.

Monday, July 18, 2011

Carrett, Graham, Frank & Buffett - A Reprise (2)


The four gentlemen also felt that a company's return on equity ("ROE") was an important measure of its financial strength.  The higher the ROE number, the better the job the company's management is doing for the shareholders.  To understand what ROE is and what it means to an investor, I'm afraid we will have to look at some accounting principles, but I'll try to keep it as short and simple as possible.

There are a few accounting terms we need to address in order to fully understand the term ROE.  Obviously, the most important one is the word, equity.  Book Value of the securities issued by a company is the price it received when it sold them to investors in a public offering - not the current market price of those securities.  A company's capitalization is the book value of all securities issued by a company: its common stock, any preferred stock and any bonds or other long term debt.  Typically, the term capital refers to the book value of a company's issued common stock.  Equity means the capital (the common stock book value) plus the company's retained earnings.  You may remember that retained earnings are the earnings of a company not paid out in dividends after all expenses have been paid.

Therefore, the Equity of a company is usually smaller than that company's Capitalization, but if the company has operated at a profit in the past, its Equity should be larger than the Capital of the company.  ROE is the ratio of the annual earnings of a company divided by its equity, the book value of its common stock plus retained earnings.  An individual investor might also compare the ratio of the earnings to the current market price of a stock.  Al Frank suggested that a 15% ROE or a 15% return measured against the current price of shares were measures of a potentially good investment.  

However, there is one trap in this metric.  An individual investor should look for a company with a high ROE whose debt is not excessive.  If the equity percentage of the total capitalization of a company is only 10% and the remaining 90% is debt, it would not be hard to have a high ROE.  The equity percentage is very small and the company could be viewed as overleveraged.  A company worth considering as an investment should have a high ROE (15%-20% or better) based on a significant equity base with moderate debt.  One sign of good business management is a high ROE on large equity.

The gentlemen recommended that the individual investor also look for companies with a history of dividend payments (even better if the dividends have been regularly increased) and a history of increasing earnings.  By history, they meant at least the last 5 years.  As mentioned above, another sign of a well managed company was one with a moderate amount of debt when compared to the company's total capitalization.  This means that the earnings of the company can be directed towards increasing the business and paying dividends; not paying interest to lenders.  A certain amount of debt is to be expected; but if the company is heavily indebted (significantly more debt than equity), this could presage financial problems for the company during difficult economic times.  Given traditional economic cycles, the individual investor must expect some periods of economic stress during his or her investment career.  It is during a down economy or recession when truly strong business managers excel and keep their companies on track.

We have now devoted approximately 10 blogs to learning about fundamental analysis from four highly regarded value investors.  If what they have to say makes sense to you as an individual investor, I recommend you read at least one of the books from Carret, Graham or Frank to learn more.  Regardless of which one you choose (I suggest reading all of them) you should also read, in any event, either the first or the second edition of Lawrence A. Cunningham's collection of Buffett's shareholder letters, The Essays of Warren Buffett: Lessons for Corporate America.

There are two subsets of fundamental value investing:  growth investing and contrary investing.  We will address those next.

Comments are always welcome.

Monday, July 11, 2011

Carrett, Graham, Frank & Buffett - A Reprise (1)


The collective careers of Phillip Carret, Benjamin Graham, Al Frank and Warren Buffet span almost 100 years in the stock market.  The similarities among their respective investment strategies are striking.  In this and the next blog, I will try to list some of those areas of consensus.  A list of those financial attributes on which all four men agreed could be used by an individual investor as a basis for selecting stocks for his or her portfolio based on fundamental value principles.

All four of them invested in companies, not stocks.  The first rule was that any investment analysis be conducted in a business like manner.  They each ignored what the market crowd said about a stock.  They wanted to understand a company's business; the product or service the company provided to its customers and its financial condition.  As Warren Buffett told his shareholders, he approached an investment in a publicly traded stock as if he were going to buy the entire company.  Carret, Graham and Frank each started their individual stock analyses in much the same way.

Carret, Graham and Frank discussed asset allocation, i.e., the division of an investment portfolio between equities and bonds.  In general, they all recommended approximately a 50/50 split between stocks and bonds.  You may remember that I mentioned an allocation based on an investor's age in an earlier blog, with the investor's age representing the amount of the portfolio being invested in income producing securities, bonds, and the balance, after subtracting his or her age from 100, in stocks.

Diversification was also recommended by them.  Buffett took the counter position, suggesting that an investor concentrate his or her purchases in a small number of stocks.  Carret, Graham and Frank recommended diversification with ownership in 10 to 30 different stocks, in a wide range of industries.  In my earlier blog on Al Frank's New Prudent Speculator, I mentioned Mr. Frank's rule that no company should represent more than 5% of the total value of an individual's holdings.  Following this rule would result in an investor holding at least 20 different stocks, which should be in as many different industries.  Buffett agreed with Al Frank on time diversification, i.e., longer holding periods reduce overall market risk.  Warren Buffett told his Berkshire Hathaway shareholders that his preferred holding time for an investment was somewhere close to "forever."

Another metric they all mentioned is a stock's price/earnings ratio ("P/E").  A company's P/E is very much like the price per pound for food.  The lower the P/E, the cheaper the purchase, regardless of the actual dollar price of the stock.  A stock selling for $80 per share with a P/E of 10 is cheaper than a stock selling for $40 per share with a P/E of 15.  The actual price for a dollar of earnings is one of the easiest ways to measure what an investor is actually paying for shares.  Warren Buffett looks at a company's P/E to see if the company has an "attractive price."  Just like the price per pound for hamburger, a P/E reflects how expensive the stock is.  The lower the better.  However, an individual investor can not just pick stocks with low P/Es, since in some instances the market may have correctly evaluated the company as a bad investment and given it a low P/E ratio.  The P/E ratio is only one of several metrics that must be used to find a promising investment.

We will continue with this list of their recommended attributes for an investment in the next blog.

I welcome your comments.

Monday, July 4, 2011

Warren Buffett


If there were a Mount Rushmore for investment greats, Warren Buffett's face would surely be depicted.  A student of Benjamin Graham, Mr. Buffett started out his investment career in Omaha, Nebraska.  He never left and,over 50+ years, shrewdly invested in stocks, bonds and insurance companies.  He made himself a multi billionaire and many of his early investors multimillionaires.

Mr. Buffett's company, Berkshire Hathaway, is the vehicle through which he makes his investments.  It is publicly traded and could be viewed as a gigantic mutual fund run by one of the most successful fund managers in history.  Ironically, the name of the company comes from one of his early investment mistakes, a New England textile manufacturer which he liquidated after many years of financial struggle.  He admits that this investment was based, in large part, on his early investment style; the one he learned from Benjamin Graham - buying companies as cheaply as possible.  Sometimes companies are cheap because they should be, not because the market has mistakenly undervalued them.  These days Mr. Buffett says he looks for investments with an "attractive price."

Unlike most fund managers on Wall Street, Mr. Buffett has the majority of his wealth invested in his company.  The company's results have the same effect on him as on his investors, i.e., he "eats what he cooks."  By living in Omaha, he also avoids the "group think" so common on Wall Street.  He explained this by recounting a story from Mr. Graham:

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do:  An oil prospector moving to his heavenly reward, was met by St. Peter with bad news. "You're qualified for residence:, said St. Peter, "but, as you can see, the compound reserved for oil men is packed.  There's no way to squeeze you in."  After thinking a moment, the prospector asked if he might say just four words to the present occupants.  That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, "Oil discovered in hell."  Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions.  Impressed, St. Peter invited the prospector to move in and make himself comfortable.  The prospector paused.  "No," he said, "I think I'll go along with the rest of the boys.  There might be some truth to that rumor after all."

There have been a multitude of books written about Warren Buffett, his life and his investment strategy.  The best way to learn his value investing methods is to read his annual letter to the Berkshire Hathaway shareholders, the first of which was written in 1977.  As with Philip Carret's book, The Art of Speculation, these letters provide an "at the time" history of what was going on then in the financial world.  An individual investor interested in value investing could not do much better than to read these letters and, in effect, learn from the master.  On the right side of this blog site is a link to those letters on the Berkshire website.

An even easier way to learn how Buffett thinks is to read The Essays of Warren Buffett: Lessons for Corporate America, an authorized compilation of material from the shareholder letters edited by Lawrence A. Cunningham.  The first edition was published in 2001, and a second edition came out in 2008.  His writing style is professional and his humor self deprecating.  I look forward to reading his new letter each year and often reread them to refresh my ideas on investments.

I can not add to the volumes of information on Mr. Buffett, so I'll stop here.  In our next blog, I will try to coalesce the value investment strategies of Phillip Carrett, Benjamin Graham, Al Frank and Warren Buffet.

Comments are always welcome.