One of the investing books I most enjoyed reading this past year was Philip Fisher's Developing an Investing Philosophy. (This title is now out of print, but is included as part of the "other writings" in modern copies of Common Stocks and Uncommon Profits.) It's a very personal account of how Philip Fisher developed as an investor -- from his beginnings as a "statistician" (what securities analysts were called in the late 1920s) fresh out of the then-fledgling Stanford Graduate School of Business, to his entrepreneurial founding of his own investment company in 1932 during the depths of the Great Depression (which, ironically, turned out to be the perfect time to start such a business), to the eventual maturation of his investment philosophy over the course of the next two decades.
Fisher's writings have been especially influential in the development of our qualitative Rule Maker investment criteria, which we revamped this past year. Below is a summation of these four qualitative guidelines which we look for in any Rule Maker. (We'll soon incorporate this material into Step 6 (Rule Maker Criteria) of our 11 Steps to Rule Maker investing. Also be on the lookout for a replacement of Step 7 on Quality vs. Valuation (QuaVa), which no longer represents our point of view on how valuation plays into Rule Maker investing.)
1. At least one sustainable competitive advantage -- and the more, the better.
A sustainable competitive advantage is the fertile soil for long-term wealth creation. As Warren Buffett often quips, find a company surrounded by a wide moat filled with crocodiles, and you've taken the first step towards identifying a company worth owning for many, many years. Finding companies with at least one sustainable competitive advantage is the first step toward locating the Rule Makers you'll want to hold for years, maybe decades.
In looking at competition, be sure to take a wide view. The competitive landscape is far more than a company's head-to-head rivals. Competition also potentially includes any powerful buyers and suppliers, the threat of new entrants, and the threat of substitute products. Is it any wonder that Intel Chairman Andy Grove says that "only the paranoid survive" in the business world?
But what exactly is a sustainable competitive advantage (hereafter, SCA)? Here's a definition: SCA is not only about doing it better (though that's certainly part of it), it is also about doing it different. There are probably as many varieties of SCAs as there are great businesses. What they all have in common, however, is differentiation -- something that sets apart a company's product or service from the rest of the pack. More specifically, a product or service is differentiated when it is: 1) unique, 2) widely valued, and 3) rewarded for its uniqueness with a premium price.
Brands, trade names, patents, de facto standards, consumer monopolies, and superior distribution systems are just a few examples of sustainable competitive advantage.
2. Great management of unquestionable integrity and with a track record of excellence.
When making an investment, no matter how much research you do on a particular company, it's just plain impossible to know everything. Therefore, the best way to minimize the risk and maximize the opportunity of what you don't know is to buy a company with best-of-class management.
As Philip Fisher wrote, "The success of a stock purchase does not depend on what is generally known about a company at the time purchase is made. Rather it depends upon what gets to be known about it after the stock has been bought."
In Fisher, we find the roots of Rule Maker investing. His approach was to buy the truly exceptional growth company that could be held forever (ideally). Fisher summed up the process of finding these types of companies in his famous "15 Points." These characteristics, in Fisher's words, were "to distinguish the relatively few companies with outstanding investment possibilities from the much greater number whose future would vary all the way from the moderately successful to the complete failure."
Fully seven of Fisher's 15 Points are related to the qualities of a successful management team. In fact, in an interview with Forbes a few years ago, Fisher stated that the one thing he'd change if he updated his writing would be to place even more emphasis on management than he did when writing Common Stocks.
Using the seven Fisher Points related to management quality, here are some characteristics of great management (with their associated Fisher Point number):
- Unquestionable integrity (Point 15)
- Commitment to new product development (Point 2)
- Outstanding labor and personnel relations (Point 7)
- Outstanding executive relations (Point 8)
- Managerial depth (Point 9)
- Long-range outlook on profits (Point 12)
- Open communication with investors (Point 14)
3. Expanding possibilities that will allow the company to have a future that's sweeter than the present.
We want to invest in businesses that can be bigger and stronger five or ten years from now than they are today. How much bigger? Our stated goal is to achieve value growth in our portfolio of 2x/5y. This means that we look to invest in companies that can double their value every five years. That's why we look for companies to grow sales at 10% each year, with the hope that increased efficiency will translate into about 15% growth in earnings, on average, over time. That might not sound like fast growth, but most Rule Maker companies have to create enormous amounts of value to achieve this goal.
That leads us to ask such questions as:
- Will the company be more or less relevant in the future as it is today?
- Does the company compete in an industry that will support growth?
- Does the company have lots of options to grow?
4. A reasonable purchase price that allows for the clear possibility of 2x/5y.
This last one is an investment criterion. With Rule Makers, our goal is to buy at a price that allows us to have a good shot at doubling our money (2x) over the course of five years (5y) -- that's a 14.9% annual return. The 2x/5y pursuit is not so much a matter of stock valuation, but rather of business evaluation. In order to assess the likelihood of a company's market cap doubling in the next five years, you need a solid understanding of the underlying business and its future prospects. Learning to apply this technique takes some time. Here's a recent article in which we assessed eBay (Nasdaq: EBAY) according to the 2x/5y rule.
In conjunction with 2x/5y, here are five practical valuation principles for Rule Maker investing:
- Business quality is more important than valuation. If it's not a top-notch business run by top-notch managers... well, the ocean is wide, move on to better fishing grounds. The Rule Maker investing strategy -- which focuses on simplicity and pushes investors to think like business owners and hold shares for the long term -- wants to identify dominant companies with sustainable advantages.
- The goal is to avoid overpaying, not to get the "best" or "perfect" price. Because Rule Makers are superior businesses with sustainable growth prospects, they will usually be selling at premium prices. So, expect to pay up for a Rule Maker. But be cautious -- paying too dear a price, even for a phenomenal company, jeopardizes your chances of achieving 2x/5y.
- Apply the Zen of Rule Maker -- that is, take what the market gives you. If everybody hates pharmaceutical stocks because of "what Congress might do," then give those companies a close look. If everybody loves Cisco and is calling it "the greatest stock ever," consider steering clear of it for the time being. Warren Buffett explains it like this: "I will tell you the secret of getting rich on Wall Street. You try to be greedy when others are fearful, and you try to be very fearful when others are greedy."
- Stay fully invested. Be selective in your individual stock investments, but do not try to time the market overall. If there are no attractive individual stocks at a given time, invest your long-term savings in a good index fund (e.g., Vanguard Index 500) or index share (e.g., S&P 500 Spiders on the AMEX, symbol SPY).
- Don't sell based purely on valuation. If you bought at a reasonable price, and if your company is continuing to create value, then your best bet is to enjoy the economic bliss of tax-free, commission-free compounding wealth. Ideally, when you buy a great company, you'll never have to sell. But do be sure to re-evaluate your holdings at reasonable intervals (at least quarterly). If a company's business quality shows signs of permanent deterioration and/or if the company is extremely overvalued, consider selling.
One note in closing: This will be my final article as a Motley Fool. What a ride it's been -- the past two years and three months have been extraordinarily fun and learning-packed. I especially appreciate the opportunity to have worked with such an incredible group of past and present Rule Maker co-managers. Although it's been a rough few years for the Rule Maker Port's returns, I'm confident the portfolio and its philosophy are on more solid footing now than ever before. As for me, I'll be joining America Online to pursue new challenges. And, to be sure, I look forward to rejoining the Foolish community as a Motley Fool fan.
Fool on!
Matt Richey is co-manager of the Rule Maker Portfolio. At the time of publication, he owned shares of eBay. The Motley Fool is investors writing for investors.
