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Lessons from Philip Fisher - VII

Jun 14, 2012

Profit maximization can be considered the most important objective for a business. After all shareholders invest their hard earned money into the business in the hope of commensurate reward for their 'risk capital'. Nowadays the concept has expanded into a three pronged approach where people, planet and profit are the three pillars of achievement. This helps measure organizational success on economic, ecological and social grounds. However in this article we will focus on one of Phillip Fisher's most important investing criteria: i.e. profits.

Does the company have a profit-margin worth looking at?

Let's say you are stuck on the boat in the middle of the sea without any drinking water. All the water in the sea surrounding you would not make an iota of a difference since you cannot drink it. Similarly if sales keep on growing without growth in profits it won't make any difference to an investor. Increased sales without a corresponding increase in profits is meaningless. This is why an understanding of a company's profit margin - or the ratio of profits to sales is important.

When one analyses company profit margins over a period of a few years one can see an evident variation among different companies in the same industry. When the industry is in trouble most companies report lower profit margins and profitability improves when the industry is prosperous.

Phil Fisher advises investors to go for companies that have the best profit margins in the industry. While marginal companies may see a greater improvement in margins during boom times, they can all but collapse during the tough times. However, there is one important deviation from this rule. Some companies try and speed up growth by investing in research and development (R&D) and sales promotion measures. This may dampen profit margins temporarily; however it can be highly accretive over the long run. One needs to take care, however, that these expenses will help facilitate higher growth over the long term and not just sustain growth at current levels.

What is the company doing to sustain its profit margins?

When one buys a car or a television one buys it on the basis of the current utility of the product. Unfortunately this is not the case with stocks. The success of a stock purchase does not depend on what is generally known about the company at the time of the purchase. Rather it depends on what is discovered about the company after it is bought. Now if only all investors had crystal balls

Therefore it is not the profit margins of the past, but rather the future profit margins which are of concern to an investor. We are living in an inflationary environment where salaries and wages go up every year and input costs also increase every other day. All these are threats to a company's profit margins.

Some companies are fortunate enough to be able to raise prices to sustain profit margins. This is because they are in industries where the demand of their products is abnormally strong; for example petrol. Or because the selling prices of competitive products have gone up, in the case of a few FMCG products. However, improving profit margins in this way may sometimes only be a temporary phenomenon. As new production capacity is added, most of the gains from these price increases get wiped out and then profit margins start to shrink.

However, there are other companies who manage to improve profit margins by far more ingenious means than just increasing prices. They are able to improve their margins by changing product mix or change in capital allocation. These companies constantly review their processes and procedures to see where economies of scale can be brought in. A few examples of such companies are Apple Inc, with its revolutionary products and Infosys' ability to retain margins through its off-shoring advantage and superior project delivery. A prospective investor should keep an eye on companies with an ability to maintain margins through ingenious means or streamlining or operations rather than solely by increasing prices.

Does the company have a long range or short range profit outlook?

No better example can be seen of long range or short range outlook than in the stock markets. A person who is in it for the short term may just book 15-20% gains on a stock purchase. But may lose out on potential multi-baggers over the long term.

Similarly some companies are out to make the maximum profits in the shortest possible time while others sacrifice near term profits in order to build a sustainable business and reap the benefits over the long term. These companies treat their suppliers, customers and even other stakeholders with care. These companies know that the relationships will be built with a strong foundation for the future. A savvy investor should try and identify the companies with a true long-term outlook concerning profits.

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