By Ravi Nagarajan
Published on April 25, 2009 at 12:23 pm
I first read Philip A. Fisher’s classic book on investing several years ago after first reading everything I could find written by Benjamin Graham and Warren Buffett. I picked up Common Stocks and Uncommon Profits primarily because of a quote by Warren Buffett on the cover of my copy. That quote carries a strong endorsement: “I am an eager reader of whatever Phil has to say, and I recommend him to you. — Warren Buffett”. What is fascinating is that the investment approach described by Fisher is, at first glance, about as different from Benjamin Graham’s approach as one can imagine. If Graham is known as the father of value investing, Fisher is equally well recognized as the father of growth investing. I believe that the combination of both approaches has been responsible for the amazing growth of Berkshire Hathaway over the past four decades.
Common Stocks and Uncommon Profits was published in 1958, about a decade after Graham published The Intelligent Investor. Both men had experienced the years of the Great Depression and proposed detailed systems for investors to capture the substantial returns offered by well chosen stocks while avoiding the pitfalls that can result in permanent loss of capital. Yet there were substantial differences in approach. While Graham’s advice for the enterprising investor relied on securing interests in companies with well established track records generally at low valuations, Fisher was much more open about the concept of seeking out truly outstanding businesses and being willing to pay higher valuations in exchange for the prospect of much higher returns.
Fisher also believed in what he referred to as “Scuttlebutt”. Essentially, scuttlebutt involves seeking out information about a business from both published sources as well as through the “business grapevine”. By speaking to the management of a prospective investment, competitors, suppliers, and customers, one can often assemble a view of the business that a pure quantitative analysis could not reveal. In recent years, speaking to company management has grown more difficult with the implementation of “Regulation Fair Disclosure” and other measures intended to promote simultaneous disclosure of all relevant facts. However, Fisher’s main point is still valid in terms of looking beyond the numbers to gain a better understanding of the nature of a business.
Checklists For Better Decision Making
Fisher devotes the bulk of his book to convenient checklists that investors can use to analyze a business. Many of these are in fact quantitative in nature, such as an examination of whether a business has a worthwhile profit margin. However, the majority of the items in his list are more qualitative and focus on such factors as whether management has the right people in research and development, the quality of the sales organization, and overall management depth and integrity. Many of these points are very “forward looking” in nature and intended to measure the kind of growth an investor can project based on qualitative factors.
In addition to providing guidelines for what to purchase, Fisher addresses issues such as when to sell and provides a number of important pointers related to common mistakes, including excessive diversification, buying into promotional companies (think of the dot com bubble), using superficial criteria such as the “tone” of an annual report, and more.
Reading this book reveals many differences in approach between Fisher and Graham, but I would say that the most important difference is that Fisher is much more willing to pay higher valuations for companies with bright future prospects than Graham would be willing to pay. Graham generally avoided “paying up” for projected growth and demanded track records of past performance as well as the presence of book value prior to making commitments. Many growth stocks lack meaningful tangible book value and much of the value associated with such companies reside in brand equity and other forms of goodwill.
See’s Candies: Buffett’s Watershed Investment
According to Roger Lowenstein’s excellent 1995 biography of Warren Buffett, The Making of an American Capitalist, the purchase of See’s in 1971 was not one that Buffett was initially “sold” on when presented with the opportunity. See’s Candies was offered for $30 million and was hardly a Graham style investment. According to Alice Schroeder’s recent Buffett biography, The Snowball, See’s had only $5 million in tangible asset value at the time. Berkshire shareholders can probably credit Charlie Munger, Berkshire’s Vice Chairman, for convincing Buffett to make this investment. Buffett eventually agreed to a $25 million purchase of See’s and based the logic of the purchase on See’s earnings power and brand equity. The valuation paid was approximately 11.4 times trailing earnings. Buffett believed that See’s had significant additional pricing power that was not being leveraged and could sell for premium prices compared to other candies such as Russell Stover.
Let’s see what Buffett had to say about See’s Candies in his 2007 annual letter to shareholders:
We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.
Clearly See’s Candies is a business that is today worth many times the amount paid to acquire the company in 1971, and it is not a business that requires a high level of invested capital. The value of See’s is the earnings power of the business and that earnings power does not come from tangible equity. It comes from intangible assets, and specifically from the brand equity of the business.
Practical Application of Fisher’s Techniques
What can value investors take away from Philip Fisher’s book and from Warren Buffett’s application of these concepts? I believe that the evidence is overwhelming that buying a business like See’s is far more attractive than buying “cigar butt” investments that are quantitatively cheap but either dying or offering average prospects for the future. However, the big caveat is that any investor seeking the higher payoffs accruing to intangible assets like brand power must be very sure in his analysis to avoid buying into the sort of promotional stocks that Fisher warned us to avoid. In short, knowing your “circle of competence” is critical to avoid paying up for illusory growth and taking the risk of permanent loss of capital. Losing capital permanently is much less likely with Graham’s quantitative approach, but that approach also entails higher turnover and lower potential returns compared to a successful application of Fisher’s techniques.