Investor Philip Fisher would assess companies by asking:
- Are sales of the company’s products likely to increase over the next few years?
- Does the company have a quality sales team?
- How effective are the company’s R&D efforts?
Benjamin Graham formalized the discipline of value investing in 1934 when he published Security Analysis. His principles state any investment should be worth substantially more than an investor pays for it.
Graham sought companies with strong financial positions; minimal debt, above-average profit margins; and ample cash flow. His analysis operated on the premise that financials would capture everything investors ought to know. Graham was far from interested in meeting with management or the company’s product pipeline. It was more essential for him to thoroughly understand the business.
Margin of safety
Graham’s secret to sound investing is the “margin of safety,” or buying a security for less than its intrinsic worth. If the discount is big enough, not only does it provide the opportunity for significant returns, it serves as a safety net if the investment thesis doesn’t work out as planned; the business falters; or the market has a meltdown. It even allows for some error in the estimation of value.
Gauging the underlying value of a business is subjective. Look for low price-to-earnings or low price-to-book-value stocks. Only a few businesses might be undervalued; many deserve their low prices.
Graham often invested in “cigar butts:” companies tossed aside by Wall St., but with a few puffs left. These companies had liquid assets (minus debt) worth more than the market cap of the entire company.
How did Graham spot such deals? By taking advantage of what he called Mr.Market. Think of him as your partner in a private business. On any given day he’ll offer to buy your share or sell you his. Yet his mood fluctuates between incredible optimism (and high prices), to overwhelming depression (when he sells low).
A wise investment should be based on the fundamental value of the underlying business, rather than the direction or mood of the
market. And buy when Mr.Market is severely depressed; sell when he’s irrationally exuberant.
A search for quality
Twenty years after Graham introduced value-investing principles, another investor entered the scene: Philip Fisher, who’s growth-oriented. He sought outstanding businesses and paid reasonable premiums in exchange for the prospect of much higher returns. But finding the kind of businesses that fit his criteria required research, or what he referred to as “scuttlebutt.”
Scuttlebutt is a term that refers to a water cask kept on a ship’s deck. It was the gathering place for the exchange of gossip. Fisher related the term to investing, to describe the process of tapping into the business grapevine.
In Common Stocks and Uncommon Profits, Fisher outlined 15 points to identify excellent businesses with great future prospects. He talked to companies’ employees, suppliers, retailers and customers. He examined the quality of management, personnel and executive relations, and dissected their competition.
So what does Graham have to do with Fisher? We recommend the intellectual marriage of both men’s principles. A thorough understanding of the business, combined with the quantitative aspects sought by Graham, is a surefire way to make intelligent investment decisions.
A value approach takes time and research, plus the temperament to withstand Mr. Market’s mood swings. True value investing is contrarian, so find value managers who practise what they preach.