Note: This article formed part of the April 2015 Special Report sent to subscribers of our premium newsletter Value Investing Almanack.
If you are a Warren Buffett fan, chances are slim that you haven’t heard of Philip Fisher. He belongs to the league of those very few super investors who have shaped Buffett’s investing style.
In his 2013 letter to investors, Buffett ranked Fisher’s book next to Ben Graham’s books –
…Phil Fisher put it wonderfully 54 years ago in Chapter 7 of his Common Stocks and Uncommon Profits, a book that ranks behind only The Intelligent Investor and the 1940 edition of Security Analysis in the all-time-best list for the serious investor.
Despite being considered as a super investor, Philip Fisher was little known to general public and rarely interviewed. He is widely respected and admired in the value investing circles all over the world. He is also known for his ‘scuttlebutt’ approach, which simply means seeking information from competitors, customers, and suppliers, all of whom have a vested interest in the company.
He wasn’t among those who made decisions just by reading annual reports. He believed in getting first hand information about the company from various sources.
Now, when it comes to following an advice, it’s more sensible to first take up the recommendation about “what NOT to do” instead of “what to do”. So, in the spirit of inversion, let me explore some of the don’ts in investing recommended by Fisher through his various interviews and writings.
1. Don’t Buy into Promotional Companies
I know quite a few people who are eagerly waiting for the e-commerce companies to hit the stock market in spite of knowing that each of these companies is bleeding money. What they don’t realize is that they lack the specialized knowledge about the operations of these promotional companies and it’s extremely challenging for a small investor to predict how these companies will behave as publicly owned corporations.
Fisher recommends staying away from such stocks –
…when a company is still in the promotional stage, all an investor can do is look at a blueprint and guess what the problems and the strong points may be. This is a much more difficult thing to do. It allows a much greater probability of error in the conclusions reached….There are enough spectacular opportunities among established companies that ordinary individual investors should make it a rule never to buy into a promotional enterprise, no matter how attractive it may appear to be.
According to Fisher, trying your hands at such stocks is a sure shot case of venturing outside your circle of competence and the odds are very high that you will make a mistake. These kinds of companies ride on the hope that in future they will make fortune. Unfortunately, in absence of any established track record about business operations, nobody knows how the business will unfold under different market cycles. It’s a matter suited for specialized investors like private equity groups and venture capitalists. So stay away!
2. Don’t Buy Based on The “Tone” of Annual Report
Many a times, the annual report content (except the financials) is written by a public relations agency instead of the management themselves. And it’s not easy to figure that out. The management has a vested interest in presenting an overly optimistic picture of the company. Fisher warns –
It is well to remember that annual reports nowadays are generally designed to build up stockholder good will. It is important to go beyond them to the underlying facts. Like any other sales tool they are prone to put a corporation’s “best foot forward”. They seldom present balanced and complete discussions of the real problem and difficulties of the business. Often they are too optimistic.
When the management claims everything to be hunky dory, then it should invite a healthy scepticism. Don’t ignore the possibility that the facts are being sugar coated for you or the management is trying to hide its problems. Perhaps, the management’s intention isn’t evil but they are genuinely falling for overconfidence bias. Remember – When it sounds too good to be true, it usually is.
Laura Rittenhouse’s Investing Between The Lines is a great book to learn how to decode CEO communications.
3. Don’t Assume That P/E Has Already Discounted The Future Growth
Somebody who practices Ben Graham’s classic cigar butt approach will not touch a high P/E stock even with a 10 feet pole.
What Fisher recommends is that high P/E shouldn’t blindly be considered a proxy for overvalued. You shouldn’t ignore the fact that a good quality business with good prospects for future usually commands higher P/E as compared to other average businesses.
For example, in India, Nestle is one business which has commanded an unusually high PE/ for past two decades and in spite of that it has been a great wealth compounder. Not just established businesses but there are cases where a relatively new company with not much of a past track record of high quality earnings may be going through a P/E expansion because of some fundamental shift in the business. Fisher writes –
It seems almost impossible for many investors to realize, in the case of a stock that in the past has not sold at a comparably high price-earnings ratio, that the price-earnings ratio at which it is now selling may be a reflection of its intrinsic quality and not an unreasonable discounting of further growth.
Of course it goes without saying that you should always verify if the recent increase in earnings is just a temporary spurt or a sustainable earnings growth. Prof. Sanjay Bakshi has penned down his thoughts in this tremendously insightful presentation on why you should pay up for quality. It’s a must read!
4. Don’t Get Anchored to a Price
Fisher suggests –
For the small investor wanting to buy only a few hundred shares of a stock, the rule is very simple. If the stock seems the right one and the price seems reasonably attractive at current levels, buy at-the- market. The extra eighth, or quarter, or half point that may be paid is insignificant compared to the profit that will be missed if the stock is not obtained. Should the stock not have this sort of long-range potential, I believe the investor should not have decided to buy it in the first place.
Here, there is a caveat for investors who transact large chunks of shares. In their case the act of buying/selling large chunks at market price may itself cause the price to fluctuate a lot. So bear in mind that this heuristic of “buying at-the-market price” makes more sense for small investors dealing with relatively small number of shares.
5. Don’t Overstress Diversification
There aren’t many investors who have suffered because of lack of diversification, but the ill effects of over- diversification are rampant. Fisher says –
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.
Riskier than inadequate diversification is diversifying into stocks without having sufficient knowledge about them. When you have one bad stock and you diversify that money into another five bad stocks, it doesn’t reduce the risk in any way. It just creates an illusion of safety and makes your returns worse. Peter Lynch even had a term for it – diworsification.
Fisher writes –
Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself…An investor should always realize that some mistakes are going to be made and that he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best.
6. Don’t be Afraid of Buying on a War Scare
In this don’t, Philip Fisher exclusively addresses the situation of war but I think it’s applicable for any event related to large scale political disturbance or even to negative news about a macroeconomic situation. The first reaction of majority of people in such instances is to rush to sell their stocks. According to Fisher –
To sell stock at the threatened or actual outbreak of hostilities so as to get into cash is extreme financial lunacy…This is the time when having surplus cash for investment becomes least, not most, desirable.
So don’t shy away from greed when others are being fearful.
7. Don’t be Influenced by What Doesn’t Matter
Everything that can be counted (or measured) doesn’t necessarily count. Just because you have found an interesting fact about stock price or any other related number doesn’t mean that it contributes to future earnings growth or even future stock price for that matter.
Stock recommendation experts fill up their research reports with historical numbers and their associated patterns. However, you have to realize that future growth and earnings don’t depend on past prices.
Fisher warns –
The fact that a stock has or hasn’t risen in the last several years is of no significance whatsoever in determining whether it should be bought now. What does matter is whether enough improvement has taken place or is likely to take place in the future to justify importantly higher prices than those now prevailing.
It doesn’t mean that you should completely ignore the past earnings and prices. However, giving them importance they don’t deserve sends you on a dangerous path.
8. Don’t Follow The Crowd
The problem with following the crowd is that you become the crowd. Following crowd feels safe but it also keeps you stuck at average. And average doesn’t cut it. It’s not easy to develop independent thinking because the opinion of those around us creates a powerful influence on our minds. Our brains have been wired by evolution to fall prey to social proof bias.
If you can overcome this psychological force while making an investment decision, you can separate yourself from the crowd and rise above average. Fisher explains –
…[One] should be extra careful when buying into companies and industries that are the current darlings of the financial community, to be sure that these purchases are actually warranted – as at times they well may be – and that he is not paying a fancy price for something which , because of too favorable interpretation of basic facts is the investment fad of the moment.
These ideas have been discussed in great detail in Fisher’s book Common Stocks and Uncommon Profits. The book deserves a place in every investor’s book shelf.
Fisher’s investment philosophy has stood the test of time, and continues to benefit investors to this day. I think it would be obvious to you by now that missing Fisher’s book is not an option for any serious investor who intends to compound his wealth over long term in stock markets.