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Lessons from Philip Fisher - III

Apr 12, 2010

What does one look for in a stock to know whether it is attractive?

This is perhaps one of the most frequently asked question on the stock markets. But for the amateur investor just beginning to learn the art of investing, it also one of his biggest quandaries. This is not only because there are no easy answers to the above question. But also because there are as many different answers to the question.

Most perplexing to an investor still trying to learn the ropes is the fact that each self-confessed expert who makes his appearance in various mass media seems to have his or her own strong opinion. Infact, many seem to be in complete disagreement with the other.

And so, despite the innumerable answers, the question still remains. Which factors does one give the most importance to while selecting a stock?

To every serious investor's relief, Philip Fisher explicitly laid down a list of factors one should look at. He further gave a detail reasoning as to why each of these factors should be considered. As also how one should gauge each company's standing on these factors. We shall cover each of factors in the next few articles of this Philip Fisher series.

Before we start off with the first of these factors, one must note that a company may well turn out to be a great investment even if it does not qualify on a few of these factors. But if it does not qualify on a great majority of them, such a company will be far from the kind of stellar long term investment that we look for. Additionally, while many of these factors will try to judge the policies that a company seeks to follow, others will deal with how efficiently a company actually executes its stated policies.

We move on now to the first factor to be considered in searching for the most profitable type of equity investments - continued and substantial sales growth over many years.

For a company to be able to see the kind of significant growth in size that we desire, it is absolutely indispensible that it see a commensurate growth in its revenues. So how does one know whether a company will be able to see this kind of tremendous sales growth in the decades to come? The first step is to have a look at its products and services to see if they have market potential sufficient enough to witness this kind of sales growth.

Fisher divides the companies that have shown spectacular growth over a period of decades into two major categories - ones that are 'fortunate and able', and ones that are 'fortunate because they are able.'

The first category of companies includes those whose core businesses have seen enough external changes to ensure that demand has continuously moved upwards. But the important distinction to make here is that many of these changes are often external, and under no direct control of the management. An example that Fisher gives of this kind of a company is the Aluminum Company of America (Alcoa). A combination of technological developments and reduction in costs of aluminum production led to a staggering growth in the market for aluminium products over the course of many decades. An example is the ultimate development of air planes at the time that made commercial air travel a possibility. These were changes that no one, including Alcoa's very own founders, foresaw at the outset. Nonetheless, the management showed a great deal of skill in encouraging and taking advantage of these trends.

However, what is most important to note in this case is that company itself was not the driver behind these changes that took place. It was merely a beneficiary.

The second category of companies that Fisher refers to, and the ones we are most interested in, is the ones that are 'fortunate because they are able'. These are companies that consciously exploit their skill in a core business to move into other related but additional businesses. These businesses in turn provide the source for further sales growth once growth in the core business reaches a plane. Such conscious effort on the part of the management is what gives these kind of companies continued long term growth that is more in control of the company rather than external factors.

An example that Fisher gives of this kind of a company is Motorola. Early on in the US, radio-television companies saw a short but big spurt in sales as families across the US bought TVs for the first time. Post that, growth for companies in this business hit a plateau. But not for Motorola. It used its core electronic skills to build up sizable businesses in other related electronic fields such as communication and automation equipment. This equipment found use in many industrial and military applications that set the company for rapid sales growth for the next many years. To the extent that these businesses, in the matter of just a few years, took over the company's core radio-television business in both size and importance.

In effect, the managements of companies such these take advantage of the resources and skills already present in the company. And they do this in such a way so as to ensure that the company sees continued growth from new sources of revenue developed by the company.

This was an explanation of the first aspect of major sales growth that one should look for in a company. But in judging the same, Fisher adds a caveat. And that is that even the most superior growth companies should not be expected to show sales growth every single year. The intricacies of commercial research, problems of marketing new products, and the vagaries of the business cycle will have a major influence on year-to-year comparisons. Therefore growth should not be judged on an annual basis but by taking units of several years.

With that, we conclude our discussion of the first major aspect in our quest for superior growth companies. In the next article we will look at the other essential aspects one should consider for unearthing outstanding investments.

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