Posted on by CTKS

Common Stocks and Uncommon Profits

Despite being a classic, “Common Stocks and Uncommon Profits” remains one of the best investment books I have read as it contains many timeless principles on how to profit from the stock market. Here, I will share some of Philip Fisher’s most valuable insight on assessing whether a company is a suitable investment.

Scuttle-buttling

A term coined and popularised by Fisher, scuttle-buttling refers to the act of obtaining information of a company from those who deal with it. This includes competitors, vendors (suppliers), customers, employees, university and government researchers, ex employees and executives of trade associations.

You should note that the executives of the company itself, the very people who should know the company best, are not on that list. And neither is the media. This is because it is often not in the executives’ interest to be completely upfront about everything regarding their business. Additionally, the press does a rather poor job reporting what truly matters.

Social butterflies will thus be overjoyed to learn that their broad network can give them invaluable insight into businesses that the general public do not have access to. Others, on the other hand, will find that they may not have such connections and in most situations, they may even have none.

Thankfully, scuttle-buttling is not the be-all and end-all when assessing a company. It is merely one of the methods investors can utilise to obtain surprisingly accurate information. Occasionally, the opportunity to utilise this technique will arise and investors should know what kinds of questions to ask.

15 points to look for in a company

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years

This is a point that is repeated time and time again by may wildly successful investors. We want to invest in a business that has a long runway, not one that has a spurt in growth that quickly drops off in a few years. This does not mean that the revenue and earnings must increase every year as revenue and earnings don’t grow linearly. A few bad years are fine as long as the general trend in the long run is clearly increasing.

There are two types of businesses that can accomplish this. The first type is those that are “lucky and able” to do so. Their revenues grow due to unforeseen increase in demand out of the firm’s control. Many natural resource companies fall into these category where stumbling into an extremely valuable deposit can make or break the company – it is mostly a product of luck and cannot be foreseen. The second group is the “lucky because they are able” group. They strategically position themselves for growth by creating new products of entering new industries. Such companies actively seek out new business prospects. This category is where we wish to concern ourselves.

2. Does management have 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?

The companies that have the greatest appreciation in price are those that are able to achieve prolonged periods of high growth. It thus goes without saying we wish to invest in companies that are actively reinvesting profits to achieve even greater growth.

A simple marker for this is to look at how much a firm invests in research and development. The best results usually arise when R&D is devoted to products that are complementary to the current business model. Think about Apple expanding their product line and Microsoft investing heavily into gaming.

3. How effective are the company’s R&D efforts in relation to its size

The question to ask here is “how much profit does $1 investing in research produce?” This looks like a rather straightforward question but is actually relatively challenging to answer. A simple comparison can be made between the percentage of revenue invested in research each year and the growth in revenue and earnings can bear some insight. However, investors have to be aware that the fruits of R&D may only show up materially in five or even 10 years down the road. Thus, they have to be looking at a long period for such comparisons to be useful.

4. Does the company have an above average sales team

In today’s competitive world, most products don’t just sell themselves. The ability of a company’s sales team is almost as important as the product itself. An outstanding product will not be profitable if a company does not know how to market it and push it out to customers. However, the ability of a sales team is intangible and there is no financial ratio to assess this. Thus, many investors choose to ignore it. This is where scuttle-buttling is useful as employees and customers will almost surely have insight that the general public do not.

5. Does the company have a worthwhile profit margin

Firms with higher margins are more resilient during periods of high inflation and are able to maintain profitability even if competition increases. Persistently high margins are also an indication of an economic moat that allows the company to charge a premium while keeping competitors at bay.

Occasionally, low margins are temporary as majority of profits are reinvested. Such was the case with Amazon and Netflix in the past. These company can prove to be interesting investments as they may be underappreciated by the general public. Otherwise, it is wiser to stick to firms with higher profit margins.

6. What is company doing to maintain or improve profit margins?

While a surge in demand may improve a company’s profit margins, the effect is only temporary. We are more concerned with long term structural changes that will create sustainable improvements in the company’s margins. Some examples include reducing costs by harnessing economies of scale or building an economic moat that will allow it to raise prices and/or protect it’s profit margins from competitors.

7. Does company have outstanding labour personnel relations

Fisher argues that the benefits of excellent relations compared to mediocre ones is underestimated. To get a rough gage of labour relations, look at employee turn over rate, whether there is unionisation and a history of constant and prolonged strikes. However, do note that having unions and strikes are not instant red flags, how they interact with the company is much more important than whether there is a union.

8. Does company have outstanding executive relations

We hope to see that the company promotes executives based on ability and not connections. This is often an issue in family led organisations. Scuttle-buttling can yield many useful information regarding this point. When there is an executive position being filled, we hope to see that it is someone from inside the company rising through the ranks. Be wary of companies that consistently hires new personnel to fill the highest levels of management. This could signal that the there is a lack of talent or that the management is not fair.

9. Does company have depth to its management

We don’t want the company to be a one man show where the entire company depends on one personality. We want teamwork, all the way at the highest level of management. This is definitely a hard quality to assess but a look at the management compensation can provide some hints. Furthermore, we can use an elimination process – it is easier to spot which companies are a one man show.

10. How good are the company’s cost analysis and accounting controls?

Cost analysis and accounting controls are crucial to making good business decisions. However, this is hard to analyse. The best investors can do is analyse other metrics such as profitability as a company that performs well in other areas will likely do well in this as well.

11. Are there other aspects of 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

Looking at a company’s growth and earnings may not be sufficient to ascertain if they are outstanding investments. There may be other aspects apart from their core business that is crucial to their growth strategy. Some examples include handling insurance, real estate, patents, customer relations and service, sales team and manufacturing know how.

12. Does company have long term or short term outlook on profits?

As buy-and-hold investors, we want to invest in a company to be able to compound earnings for a very long time. It thus follows that we don’t want to invest in a company that maximises short term profits in order to pump up it’s stock at the expense of reinvestment for future growth.

This can be observed from a company’s actions and growth strategy which can be found in it’s annual reports. I find it useful to pen down some of the pointers of the company’s growth strategy and brainstorm on where evidence of such actions will show up, be it increased expenditure on sales and marketing or increased R&D. These plans have long gestation period and it is useful to go a few years back to see how the company has progressed.

13. Will it require equity funding that will dilute current shareholders?

Take a look at debt, cash flows and cash on hand and compare it to how much they need to reinvest in order to achieve their goals. If they are short on cash and have exhausted all debt options, they will likely need to issue shares in the short term. This will dilute shareholders and might mean that the company may not be a good investment.

14. Does management talk freely about its affairs when times are good but “clams up” when troubles and disappointments occur?

It is part and parcel of business to have ups and downs. By the law of averages, not all new initiatives will succeed and there is bound to be costly failures. Even the best companies in the world such as Microsoft and Amazon are not spared from these failures. Such failures present excellent opportunities to assess the management team. Executives that clams up either has no plan or does not have a sense of responsibility to shareholders.

15. Does company have management of unquestionable integrity?

This is undoubtedly the most important factor in assessing whether a company will make a great investment. Even if all the other 14 points are excellent but management is not honest, investors should stay away from the company as it is unlikely that management will be fair to shareholders.

These 15 points can be used as a checklist. With the exception of the last point, it is not necessary to be outstanding in all the other 14 points for a company to qualify to be a good investment. A company that lacks in one or two points but does exceptionally well in the other points can still make an excellent investment. I hope that this article summarises what to look for in a company and helps you make sound investment decisions in time to come.

Posted on by CTKS · 1 Comment

Buy Right And Hold On Or Buy Low Sell High?

Buy low sell high, duh! Everyone knows that that is the way to make money in the stock market. You buy something for less than what it is worth and attempt to sell it at a higher price in the future. Yet, many investors have taken this saying out of context, creating this misguided notion that they have to frequently buy and sell in order to make a profit. They thus end up trading, attempting to make a quick profit. Perhaps the tendency to do so is innate. We all know that dips and corrections are part and parcel of the markets but it remains something that is psychologically challenging to endure. However, studies after studies have shown that the money is in holding on.

The logic behind buying right and holding on is so simple that many belittle it. When you invest in a great business capable of generating greater than average return on investment for many years, time is on your side. Simply holding on will allow your investment to compound.

I recently read “100-to-1 in the stock market” by Thomas W. Phelps and “100 baggers” by Christopher Mayer, two books analysing 100 baggers. A 100 bagger is a stock that has appreciated a 100-fold. Thus, a $10,000 investment will turn into a million dollars. My initial reaction is that stocks like this must be few and far between. I was proven wrong.

In “100-to-1 in the stock market”, Thomas W. Phelps found that starting from 1932, a different stock could have been bought in each of thirty-two different years and every dollar invested would have grown to $100 or more by 1971. In fact, from 1932 to 1964, more than 365 different securities appreciated a 100-fold or more in four to forty years.

At this point, I was of the opinion that technology has advanced by leaps and bounds since then and there is not much left to invent or innovate. Thus, such monstrous growth enjoyed by companies of the past is unlikely to repeat itself.

I was proven wrong once again, and happily so. In his book “100 Baggers”, Christopher Mayer again found more than 365 different 100 baggers from 1962 through 2014. The important lesson to draw here is not that we missed another 365 opportunities. Instead, it is that as long as humans remain humans, the world will keep changing. Consumer trends will constantly evolve, leading to new unmet demand which require new inventions and innovations, creating the next generation of 100 baggers.

Additionally, both books detailed 100 baggers in a wide variety of industries, not just in emerging sectors such as technology, internet and biotech but also in “boring” and “old-school” industries such as consumer businesses. While it may be hard to fathom that there are that many future 100 baggers, history has shown that they are out there, waiting to be found.

If you are convinced that there are many future 100 baggers out there waiting to be discovered by those who seek them, here are a few qualities of 100 baggers to aid you in your search.

1. Growth, growth and more growth

There is no way around it. For the share price of a company to appreciate a 100 fold, it’s earnings has to increase tremendously. So, you need growth – and lots of it. But not just any growth. You want quality, value-adding growth. You want to avoid companies that doubles it’s earnings but also doubles the total shares outstanding. In other words, focus on earnings per share instead of raw earnings. At the same time, beware of companies that increase sales by cutting prices or acquiring companies for inflated prices. Both of these drive down return on equity – the company is investing more and getting back less. These are kind of growth you want to avoid. Focus on companies that has lots of room to expand and reinvest its earning. Such companies will be able to compound earnings over an extremely long period of time. These qualities will show up in the balance sheet as high organic growth (growth without acquisition) and high return on investment.

2. Lower multiples and smaller companies preferred

Growth is only one part of the equation. The other half of the DNA of a 100 bagger is a huge increase in earnings multiple. For instance, if price-to-earnings (PE) ratio remains the same, earnings will have to increase a 100 fold in order for the company to be a 100 bagger. However, if PE ratio quadruples, earnings only need to increase 25 fold. Now that is a much more achievable feat. Together, lots of growth and a low multiple forms the twin engine of 100 baggers.

Along a similar note, smaller companies are preferred. Big tech do have decent growth rates but do you think they are able to grow to a 100 times? Probably not. Apple, as great as it has been and is, won’t become a 100 bagger from current levels. At a 100 times of today’s value, Apple’s market cap will be more than 12 times the size of the US economy. It could be a good stock for some time yet, but eventually, the law of large numbers start to work against you. That being said, you don’t have to go looking at penny stocks. Mayer found that the median sales figure of the 365 names in his study was about $170 million. As a rule of thumb, he recommends focusing on companies with market caps of less than $1 billion.

The caveat here is that while lower multiples and smaller market cap are preferred, they are by no means a prerequisite. There are certainly many great businesses that have higher multiples (and justifiably so). This does not make them poor investments. On the flip side, there are many companies with low multiples because they are declining. Beware of these value traps. Similarly, there are many great companies with market caps above $1 billion that have the DNA of a multi-bagger. The point I am trying to make here is that nothing is cast in stone. Always make your own judgement.

3. Economic moats are a necessity

100 baggers are requires a high return on capital for a long time. A moat will keep competitors at bay, allowing the company to compound it’s earnings at above average rates for a long time. Without moats, competitors will steal away market share, driving return on investment down. Thus, extraordinary growth rates without moats are simply unsustainable. A company with a great product but no barriers to entry may be able to return double or even triple one’s investment. However, they will rarely return much more than that. It thus pays to spend some time thinking about whether the company in question possess economic moats. A moat, no matter how narrow, is a necessity.

4. Owner-operators preferred

Although not a necessity, it does help to have a owner call the shots as well. A CEO with some skin in the game will have his/her interest aligned with yours. What’s good for them is good for you, and vice versa. You can thus have greater conviction that they won’t take actions that allow them to gain at your expense. You can figure out how much stake the executives of a company has in it’s proxy report. I recommend that you spend additional time to do some research on whether the shares that the executive owns are mainly options given to them or common stock that they have purchased. The common wisdom is that options will align the interest of the management team with that of the shareholders. I won’t dive into details, but fixed price options with a long expiration date have the potential to distort the management’s interest. It is best if management own commons stock, and even better if they have to fork out their own money to buy them. That being said, there are many 100 baggers that are not owner led. Having an owner-operator is just an added benefit that gives you conviction to hold on through thick and thin.

Of course, finding a 100 bagger is easier said than done. However, even if I do not find a 100 bagger, I am optimistic that this search will turn up some decent multi-baggers, making the effort more than worthwhile. Nonetheless, 100 bagger or not, the most crucial step in the search for multi-baggers is to hold on.

“To make money in stocks you must have the vision to see them, the courage to buy them and the patience to hold them. Patience is the rarest of the three.”

Thomas Phelps

There is no use in buying right if one does not hold on.