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Lessons from Philip Fisher - V

Jul 12, 2010

There are many elements in the field of analysing stocks that cannot be answered by mathematical formulae. Sure, ratios can be calculated for the various components of business performance. And they usually are. However, each company's case is usually different in some or the other way. Numbers may very well be important. But understanding the stories behind the numbers is equally, if not more, important.

Nothing exemplifies this better than Philip Fisher's insights into how to analyse the research and development (R&D) strength of a company. The R&D division is very important to the kind of company we seek for investment. For if a company is to continue to grow its sales at a fast clip over 10 - 20 years, intensive R&D efforts will lay the foundation for this. In this article, we present Fisher's insights on how to gauge a company's R&D strength.

It's always quite easy to calculate the R&D expenses of a company as a percentage of its sales. This figure for a particular company is then often compared to that of its peers. Numerous other comparisons are also usually drawn. Like that with the industry average, with other individual companies, with historical trends etc. All with the intention of gauging the level of each company's research effort. But is this a useful method of doing so?

Like we mentioned earlier, there are no generic answers that apply across the board. It depends on each situation and each individual company. This is because R&D expenses cover a wide gamut of activities, the treatment of which may be different for different companies. Some managements may consider a particular expense as R&D expense, others as part of manufacturing expenses. Thus it is Fisher's contention that if all companies were to report R&D expenses on a comparable accounting basis, R&D expense ratios may actually look very different.

R&D expenses have another unique feature that must be kept in mind. The amount of ultimate benefits companies derive out of their R&D differs widely among companies. For each rupee spent on research, one well run company may very well get twice as much benefit than the another. This happens especially in the case of companies that are much better at managing and coordinating their research departments than others. Thus just comparing the research expenditure of various companies on a blanket basis may sometimes be of very limited usefulness.

Some examples may drive the point home -

  • A company may have a very good collection of highly skilled scientists, experts and labs. But it may lack good leaders who can effectively coordinate the work of such technical personnel towards a common goal. Thus a company which has such sound leadership will have a one-up over the other one, even if its researchers are of a relatively lower stature.

  • Coordination between the research division, and manufacturing & sales personnel is also an area where many companies flounder. If this is a weak link, then the company runs the risk of finally coming up with products that may not be manufactured in the most cost effective way. Or they may lack the sales appeal needed for them to be a success in the market.

  • The attitude of top management can also have a huge influence on the final profitability of the research activities of a company. Specific R&D projects that have lavish budgets in the company's good years cannot be suddenly and drastically cut during a bad year. This takes away from the effectiveness of the research project. Many managements are not sensitive to this fact. And they end up escalating the total costs of a project.
So how does a careful investor go about arriving at a conclusion about the efficacy of a company's R&D activities?

There are two ways.

  • The scuttlebutt. A surprisingly complete picture about company's research activities can emerge if intelligent questions about the above mentioned points are asked by an investor. These questions can be asked to a diversified group of research people. Some from within the company. Some who belong to the company's competitors. People from academics, government agencies and other independent research firms who deal in the same field should also be approached.

  • There is also another simpler but useful method that Philip Fisher suggests. That is to find out how much of a particular year's revenues and profits have been due to the results of company's R&D efforts over a long duration of time prior to that year. Ten years is a good benchmark. A company which has produced a good flow of profitable new products over a long period can be counted on to continue such a performance. Provided its methods and management remain the same that is.
And in that manner, an investor can look to truly understanding a company's R&D abilities.

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