Much of our buy-to-hold Rule Maker investment philosophy is derived from the writings of Philip Fisher, one of the most influential investors of all time. Today, I'd like to talk about Fisher's Conservative Investors Sleep Well (available in Fisher's Uncommon Stocks and Uncommon Profits and Other Writings collection).
In this book, Fisher concentrates on the characteristics of conservative investments. By conservative, Fisher means an investment that is most likely to "conserve (i.e., maintain) purchasing power at a minimum of risk." Fisher breaks such investments down into four dimensions, which I'll casually refer to as 1) marketing; 2) people; 3) uniqueness; 4) valuation. Let's go through each of them.
The first dimension relates to superiority in production, marketing research, and financial skills. The best measure of superior production skill is gross margin. Fisher wants to invest in companies that are the lowest-cost producers or able to produce at a cost in-line with any of their competitors. This is a bit like our desire to invest in companies that have gross margins of greater than 50%, as defined in our Rule Maker Criteria.
Fisher's reasoning for looking for low-cost producers are akin to ours. Being a low-cost producer allows a company to better survive a market downturn. It also enables a company to earn enough to generate internally a significant portion of the funds it needs to finance its future growth. Fisher reminds us that being able to finance growth from operations decreases the need to issue new shares or create additional debt. He believes that the fixed-interest payments that arise when debt is incurred greatly increase the risk of common stock ownership. We agree.
The only difference between our focus on gross margins and Fisher's is that he only requires that a company be the leader in its industry -- with gross margins anywhere. Our focus, though, is on the light businesses that can charge twice as much as it costs to manufacture their products (gross margins above 50%).
Fisher also spends a lot of time looking for great marketing teams and strong sales forces. A strong marketer is a company that is always able to respond to the needs of its customers by supplying what is needed today, not what was needed yesterday. This means that it is able to respond on a timely basis to changes in customer taste. It also means that the company is able to make potential customers aware of the advantages of its product or service.
Fisher also looks for companies that make significant investments into researching new technologies. New technology typically offers opportunities to produce new and better products as well as to perform services in a better way or at a lower cost than ever before. It's also important that this research team work closely with marketing teams to ensure that their work is aligned with what the marketplace is calling for at present.
Financial skills are also critical to success, according to Fisher. It is important for a company to know with some degree of accuracy how much it makes on each product. If it doesn't, then it won't know where to focus its efforts in order to realize maximum gains. Further, conservative accounting and careful projections are a necessity at a Fisher company.
And there's a little bit more...
Fisher calls the second dimension in a "Conservative Investment" the People Factor. What an investor is looking for here is a chief executive who is dedicated to long-term growth and who has also surrounded himself with a highly competent team in charge of the various divisions and functions of the company. In addition, the company should have sufficient talent within its ranks to be able to promote from within.
It is also important to create a working environment that makes employees at all levels feel like their company is a good place to work. As a general rule, those workers that are happy with their place of work perform better than those that are not. Strikes in the recent past at companies such as General Motors and Northwest Airlines are examples of situations that could cause problems for an enterprise and its owners.
The third dimension focuses on making sure that it is known that the company can do things others would not be able to do as well. The focus here is on businesses having certain inherent characteristics that allow for above-average profitability, not just in the present but far into the future as well. One way in which this can be measured is in terms of the profit margin that we look for in our Cash King companies. Having a sufficiently high profit margin helps pay for future growth.
Part of the profit stream that a company earns has to be used for such activities as research and development, test marketing, marketing of new products, and all the other operating costs of expanding the business. In all cases, it's important to remember that companies will make mistakes. Even though we'd like all endeavors to be successful, we have to allow for the fact that they cannot be. A company must be able to fund and survive and learn from both its successful and unsuccessful activities.
The fourth dimension relates to valuation. Fisher puts the basic risk in any investment on a scale. At the lowest end of the scale are those companies that measure quite high in the first three dimensions that are also not highly thought of by the financial community. The next least risky are those companies that measure quite well in the first three dimensions that are selling at a price in-line with these fundamental characteristics.
One step beyond that group are companies that are equally strong in the first three dimensions but are so highly regarded by the investment community that they appear to be overvalued. Fisher does believe, however, that such investments are usually more suitable for retention than for new investment. The main reason that he believes that they are still worthwhile holdings is that if their fundamentals are genuinely strong, then over time they will increase earnings enough to justify not just current prices but considerably higher prices as well.
When it comes to Rule Maker stocks, we believe that as far as an initial purchase goes, a stock can be purchased even if it falls into this group. However, when we add more money to any of our stocks, as a general rule, we'll be adding it to stocks that fall into the first two of Fisher's risk groups.
Below these three groups are any companies that fall short of Fisher's criteria. You cannot, he reminds us, make a smart investment in a mediocre company if you're buying for the long haul -- no matter what its share price. We agree.