Investment Advice from Gurus: 15 things to look for in a Stock

Last updated on: October 24, 2007 at 8:38 am by Desh Kapoor

Investment Advice from Gurus: 15 things to look for in a Stock 2007-10-24T08:38:00-05:00 Desh Kapoor

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I would like to start a series where I bring the investment advice of the gurus of stock investment to my readers. These are the gurus who, I believe, were the greatest ever. Here is the first one from Phil Fisher from his book “Common Stocks and Uncommon Profits”.

He has a chapter in the book where he lists “fifteen points to look for in a common stock”. Fisher introduces these 15 points as:

There are fifteen points with which I believe the investor should concern himself. A company could well be an investment bonanza if it failed fully to qualify on a very few of them. I do not think it could come up to my definition of a worthwhile investment if it failed to qualify on many. Some of these points are matters of company policy; others deal with how efficiently this policy is carried out. Some of these points concern matters which should largely be determined from information obtained from sources outside the company being studied, while others are best solved by direct inquiry from company personnel.

1. Does the company have products or services with sufficient market potential to make a sizable increase in sales for at least several years? It is important here to distinguish between two types of companies: 1. Fortunate and Able and 2. Fortunate because they are able. According to Fisher, no company can grow for a sustained period of time purely on luck. It must have and keep a high degree of business skill to capitalize of the good fortune and fight the competition.

2. Does the management have the determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? For this to be true the company should understand the basic question “What business we are in?” and therefore understand its core competencies and focus of high level of R&D. While the first point seems to be similar to this second one, Fisher qualifies the former as a “matter of fact, appraising the degree of potential sales growth that now exists for the company”, and the latter as “a matter of management attitude”. Only the companies scoring high on the first point and upto the mark on this second should be of investment interest.

3. How effective are the company’s research and development efforts in relation to its size? This point underscores the second one. A few things are important to note here: i. what is included in the R&D expense – this figure can be manipulated easily, so be careful ii. The expenditure in research needs to be related to the benefits that comes out of it. There can a huge difference in the benefit/cost ratio of the successful companies vs the not so successful companies. Therefore, R&D is important, but it needs to satisfy business goals!

4. Does the company have an above average sales organization? Here we are talking of the efficiency of a company’s sales, advertising, and distributive organizations. It is not just enought to manufacture or create but also be able to sell and build a brand out of what you have!

5. Does the company have a worthwhile profit margin? The profit margins should not be measured in “good business years” for that is the time when companies with marginal margins do well too. It is important to look at the sustainability of these margins. And Fsiher explaines “I believe that the greatest long range investment profits are never obtained by investing in marginal companies. The only reason for considering a long range investment in a company with an abnormally low profit margin is that there might be strong indications that a fundamental change is taking place within the company”

6. What is the company doing to maintain or improve profit margins? This follows from the #5. It is important to sustain the margins over a long period of time. How can this be gauged? By looking at the amount of ingenuity of the work being done on new ideas for cutting costs and improving profit margins. This is obviously a subjective assessment, but an important one.

7. Does the company have an outstanding labor and personnel relations? Now, this point seems like it is only with respect to the old economy manufacturing companies, but in Fisher’s mind, it had a broader scale. According to him, good treatment of the employees increases the productivity and also lessens turnover – which reduces the cost that is spent in training a new worker. This is specifically true in terms of Indian IT companies like TCS. These companies do not care much about their employees leaving and replacing them with new (and cheaper ones). Little do they realize that such exodus results in two things: low productivity and lowering of quality. I wonder if such loss in quality and productivity can be compensated by lower cost of the new worker? But to one who has not fully grasped the concept of productivity, such talk is mumbo-jumbo!

8. Does the company have an outstanding executive relations? This is a very important point. In Fisher’s own words “The company offering greatest investment opportunities will be one in which there is a good executive climate. Executives will have confidence in their president and/or board chairman.” It is important that rank and file of the company understands that the promotions in the company are based on ability and meritocracy and not factionalism or nepotism.

9. Does the company have depth to its management? This point is related to succession management of leadership. It is not just important to have just one great CEO, but a successive tree of leaders who can take over from the incumbents in a seamless manner. Before you invest in any company you should know that not just legally, but business-wise as well, it is a going concern!

10. How good are company’s cost analysis and accounting controls? Well, this was 1950’s when Fisher wrote this. However, it is as true today as it was then. Two things must be working for the investors – 1. the company ought to know the cost of what it is selling 2. the basis to calculate the cost (accounting) should be reasonable and honest!

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? Fisher calls it the “catch-all” of all other points. This difference maybe in terms of a patent or a distinction that others do not possess – say like Coca Cola has its brand. Now, Warren Buffett is known to have learnt a lot from Phil Fisher. Perhaps this is one point he has practiced the best. He usually invests in companies that have a clear lead on its competitors in terms of its distinction and its sales activity is almost like a “toll-gate” model.

12. Does the company have a short range or long range outlook in regard to profits? Long term vision as opposed to short term vision is what one should really look at! If, that is (as I would expect) one is in the race for the long term. How a company treats its vendors and customers usually gives important clues on this front. I believe that how a company treats its employees, customers and vendors is what really counts the most.

13. In the foreseeable future will the growth of the company require sufficient financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth? Dilution in equity is harmful to an equity investor if increase in stock does not entail a greater increase in the earnings. So dilution in equity should not lead to a dilution of EPS. The aim afterall for any investor is not to buy a stock because it is cheap – but because it gives him/her the greatest opportunity of returns. Hence, it is important to know how much capital investment a company still needs to keep going. Again, Buffett is known to stay clear of such companies that need large capital investment to grow. Coke really trades on its name and formula – it does not need to set up the plants itself!

14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur? Not everything that a management and company does will be successful. There will be some successes and some failures. How a company reacts in such times and comes off from such a situation is a testimony to its resillience. The successful companies reinvent themselves in the face of heavy odds and downturns. Such companies, that can reconstruct their business model to triumph again are usually the best investment opportunities.

15. Does the company have a management of unquestionable integrity? A company management needn’t break any law to benefit themselves and their families! The ways to benefit at the expense of stockholders legally is infinite. Like Alan Simpson once said: If you have integrity, nothing else matters. If you don’t have integrity, nothing else matters. In the new emerging markets, where it is very easy to lose one’s integrity and choose an alternative and less honest path, this trait is critical!!

These 15 principles from Philip Fisher are timeless in terms of their importance in stock investing. It does not matter how sophisticated financial markets may have become, even today the people who make the most profit.. sustained high profit from stocks are those who follow these basic but critical principles. Mathematical and financial wizadry can only take you so far. Example of LTCM which boasted of two Nobel Prize winners in Economics (Merton and Scholes – who are fathers of option pricing!) on their board, yet it went bankrupt, is very instructive!

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