I first read Philip A. Fisher's classic book on investing a few years ago, having first read everything by Benjamin Graham and Warren Buffett. I bought "Common Stocks and Uncommon Profits” mainly because of a quote by Warren Buffett on the cover of my copy. This quote carries a strong message: "I am an avid reader of Common Stocks and Uncommon Profits and can only recommend it to anyone. - Warren Buffett." What is fascinating is that the investment approach described by Fisher is, at first glance, as opposite to Benjamin Graham's approach as one can imagine. If Graham is known as the father of value investing, Fisher is equally recognized as the father of growth investing. I believe that the combination of both approaches has been responsible for Berkshire Hathaway's amazing growth over the last five decades.
"Common Stocks and Uncommon Profits” was published in 1958, about a decade after Benjamin Graham published "The Intelligent Investor". Both men had lived through the years of the Great Depression and proposed detailed systems for investors to achieve the substantial returns of selected stocks while avoiding the traps that can lead to a permanent loss of capital. There were, however, significant differences in approach.
While Graham's advice to the active investor relied on securing holdings in companies with well-established track records generally at low valuations, Fisher was much more open to the concept of seeking out truly outstanding companies and was willing to pay higher valuations to do so in order to achieve much higher returns.
Fisher also believed in what he called scuttlebutt. Scuttlebutt essentially involves seeking information about a company both from published sources and through the "business grapevine".
By talking to management, competitors, suppliers and customers when considering a potential investment, it is often possible to map out a view of the business model that a purely quantitative analysis could not uncover.
In recent years, it has become more difficult to engage with management, especially with regard to the implementation of the "corporate disclosure regime" and other measures to disclose all relevant facts at the same time.
However, Fisher's main point is still valid in that it goes beyond the numbers to get a better understanding of the nature of a company.
Checklists for better decision-making
Fisher devotes the bulk of his book to practical checklists that investors can use to analyse a company. Many of these are indeed quantitative, such as an examination of whether a business model has a worthwhile profit margin. However, most of the items on his list are more qualitative, focusing on factors such as whether management has the right people in research and development, as well as the quality of the sales organization and overall management depth and integrity. Many of these items are very " future-oriented" and are designed to measure the kind of growth that an investor can map based on qualitative factors.
Fisher offers not only guidelines for buying, but also answers to the question of when to sell the investment. For this, he offers a number of important pointers on common mistakes, including over-diversification, buying advertising companies (think dot-com bubble) using downstream criteria such as the "language" of an annual report, and more.
This book shows many differences in approach between Fisher and Graham. But I would say that the most important difference is that Fisher was more willing to invest in companies with higher valuations and promising futures than Graham would have been. Graham generally avoided "giving up" projected growth and required records of past performance and the existence of book value before making commitments. Many growth stocks lack meaningful tangible book value and much of the value associated with such companies lies in brand equity and other forms of goodwill.
Check out Candies: Buffett's turnaround investment
According to Roger Lowenstein's excellent 1995 biography of Warren Buffett, "The Story of an American Capitalist", the 1971 purchase of See's was not one Buffett would normally have made in such a situation. See's Candies was offered for USD 30 million and was hardly a Graham-style investment.
According to the last Buffett biography, "The Snowball: Warren Buffett and the Business of Life" by Alice Schroeder, See's had a tangible value of only USD 5 million at the time. Berkshire shareholders can probably thank Charlie Munger for convincing Buffett to make this investment. Buffett eventually agreed to a USD 25 million purchase of See's, basing the logic of the purchase on See's earning power and brand value. The valuation was about 11.4 times earnings.
Buffett believed See's had significant additional pricing power that was not being used and could be sold at premium prices compared to other sweets such as Russell Stover.
In his 2007 annual shareholder letter on See's Candies, Buffett said the following:
“We bought See’s for USD 25 million when its sales were USD 30 million and pre-tax earnings were less than USD 5 million. The capital then required to conduct the business was USD 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 USD 383 million, and pre-tax profits were USD 82 million. The capital now required to run the business is USD 40 million. This means we have had to reinvest only USD 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 totalled USD 1.35 billion. All of that, except for the USD 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.”
It is clear that See's Candies is a business that is worth many times more today. What was paid to acquire the business in 1971 and it is not a business that requires a large amount of invested capital. The value of See's is the earning power of the business and the earning power does not come from tangible equity. It comes from intangible assets and in particular the brand equity of the business.
Practical application of the Fisher method
What can value investors take away from Philip Fisher's book and from Warren Buffett's application of these concepts? I believe the evidence is overwhelming that buying a company like See's is much more attractive than buying "cigar butt" stocks that are quantitatively cheap but either worthless or offer average prospects for the future. However, any investor seeking higher returns on intangible assets such as brand power should be very sure in their analysis not to invest in the kind of hyped stocks Fisher warns to avoid. In short, it is important to know your "circle of competence" to avoid paying for illusory growth and risking permanent capital loss. With Graham's quantitative approach, it is much less likely to permanently lose capital, but this approach also requires higher turnover relative to lower return opportunities compared to a successful application of Fisher's method.