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Lessons from Philip Fisher - X

Oct 9, 2012

Over our past few articles we have focused on what important factors an investor should look at while buying a stock. The criteria to be kept in check include employee relations, company management, profitability, sales strategies etc. In this article we will focus on the last few criteria a savvy investor should look at while making an investment decision. In our subsequent articles we will focus on important decisions regarding timing i.e. when to buy and when to sell.

Let's see what Phil Fisher has to say about the answers to a few miscellaneous but none the less important questions.

How good are the company's cost analysis and accounting controls?

A company that doesn't have an accurate pulse on what is going on in its costing department will never have outstanding success in the long run. If a firm that cannot break down its overall costs with accurate detail, its management will not be able to decide what areas to focus on. Most successful companies like Hindustan Unilever do not make a single product, but rather make a large number of products. If they don't have a clue as to how their input costs are increasing they will not be able to take timely price hikes and thus protect margins. Nor would the management be able to decide which products are worthy of promotion and special sales effort. Despite the importance of costing and accounting controls, this information is difficult for an average investor to ascertain. Usually it is safe to presume a company that has a good degree of consistency in margins across economic cycles will perform satisfactorily in this area as well.

Are there important industry specific metrics or other aspects that can give investors a clue about the business?

The Tata group of companies has businesses that range from salt to automobiles. While management principles and accounting fundamentals may be the same, no two industries are alike. Some industries are straightforward and relatively easy to understand. Others may be more complicated and have a number of specific areas which may be of import to a savvy investor. Let's see a few examples.

The airline industry is unique and an investor has to look at a few specific metrics before he or she can even think of investing. These include aircraft utilization (average no. of hours that an aircraft can fly in a 24 hour period), load factor (percentage of available seats that are filled), available seat kilometer (number of available seats x kilometers flown), fuel costs, plane leases etc. The retailing sector also has a number of specific metrics. The same store sales (difference in revenue generated by existing outlets), quality of its leases, sales per square foot etc are all important to this industry.

There are also other factors that can differ from company to company. Indian public sector banks for example have large outstanding pension liabilities which need to be amortized over the next few years. Private sector banks on the other hand do not have to bear this liability. Patents are also a differentiating factor among companies. A strong patent position can also be a formidable strength, which Apple recently demonstrated in a US$ 1 bn patent infringement lawsuit versus Samsung.

Will the company need significant equity financing in the future, diluting shareholder's benefit?

A successful company that can tick off all the points mentioned earlier in our series can either fund its future operations either through internal accruals or through borrowings at prevailing rates. If a company still needs more cash once its debt limit is reached it can look at equity financing. However this has to be looked at with caution. Equity financing is more expensive than debt especially as some ownership and future upside has to be parted with.

If the investor has properly analyzed the investment, any equity raising at a later date will be at prices much higher than current levels, so he or she should not be concerned. This is because near term financing will have produced enough increase in earnings so that by the time a new round of funding is needed the stock will be at a substantially higher level. This is the basic principal which guides private equity and venture capital investments.

But sometimes things don't happen according to the plan. SKS Microfinance had a much publicized Initial Public Offering (IPO) in 2010, selling close to 17 m shares at Rs 935 each. Facing a huge capital crunch post the microfinance crisis in Andhra Pradesh the company was now forced to raise capital through a Qualified Institutional Placement (QIP) and a Preferential Allotment at a low price of Rs 75.4 per share. Investors who invested at the time of the IPO and continue to hold onto their shares are pretty much holding a damp squib.

If equity financing is very frequent in the company, it tends to leave shareholders with only a small increase in subsequent per-share earnings. This means that the management has poor financial judgment and the firm is value destructive. This is why investors are recommended to purchase stocks with high average long-term Return on Equity (RoE).

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