Reviewing Common Stocks and Uncommon Profits – The Lesser Known Foundation of Buffett’s Investment Philosophy

According to Warren Buffett, if The Intelligent Investor is the best book on investing, then Common Stocks and Uncommon Profits is the second best. Where Graham is the forefather of value investing, Philp Fisher is the founder of growth investing. This means that instead of focusing on minimizing loss of capital, Fisher wants to find stocks that will grow his capital as much as possible, with as little risk as possible. Seeing as Graham’s iteration of value investing is acknowledged to be outdated in many ways, has the same fate befallen Fisher’s concept of growth stocks as presented in Common Stocks and Uncommon Profits? Or is this a book that has withstood the test of time?

The long and short of it:

As far as investing techniques go, Fisher is unique in his advocacy for the “scuttlebutt” method and his insistence on the 15 points. As these two tactics consist of the foundation of Fisher’s investing methodology, we will begin by going over them in detail.

The “scuttlebutt” technique

Fisher’s scuttlebutt technique is easy enough to understand. In essence, it’s about getting off your butt and personally approaching every individual with a stake in the business you’re looking to invest in and asking them good questions that will net informative responses. This means getting an audience with the business’s important clients, competitors, suppliers, ex-employees, as well as research scientists (of a related field). Finally, after first approaching everyone else, Fisher would meet with the company’s executives to fill in the missing gaps in his knowledge. This process is so integral to Fisher’s methodology that if he is unable to get an audience with the necessary people, he will simply stop pursuing the stock and move on to something else.

The 15 points

The 15 points are the factors that make or break a bonanza stock. Not all the 15 points necessarily have to be present, but most of them should be, and the only way to find out if the company truly meets these high standards is by personally speaking with people who know the company. In other words, the whole point of the scuttlebutt is to attain reliable answers to the questions below: 

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

Fisher raises an excellent point about the nature of price-to-earnings ratios. Say for example that we have two companies, Company A and Company B, that each have enormous growth potential. The market is aware of this and thus both Company A and B are selling at a P/E ratio of 20, aka at 20X their earnings. Say 2 years pass and both the companies have doubled their earnings. However, now Company A is selling at only 10X its earnings because its current prospects are not nearly as attractive as it was 2 years ago. Meanwhile, Company B continues to sell at 20X its earnings because the market recognizes its continued propensity for growth. In this situation, although Company A and Company B appear identical from the onset, further investigation on the long-term growth prospects of both companies will reveal Company B to be the far superior investment vehicle. 

Therefore, there needs to occur one of two developments for a company to be a proper growth investment. A) The company takes advantage of being in a new and lucrative industry or B) The company expands into a new and lucrative industry, potentially inventing entirely new products and markets that did not previously exist. These developments can only occur under a highly competent, and ingenious management, a factor that Warren Buffett also holds in high esteem.

2. Does the management have a 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?

Indeed, even the most capable management team can fall victim to complacency. This is why a constant drive for further growth and improvement on part of management is vital for the long-term prospects of the company. Beyond simply the day-to-day tasks of operating a corporation, executives should have in mind a long term plan for future growth and expansion.

3. How effective are the company’s research and development efforts in relation to its size?

The engine that drives prolonged growth is fundamentally the money and effort devoted to research and development, and the overall effectiveness of this effort. The results of a company’s research and development cannot be judged in the span of months or a single year. The investor must patiently wait through not-infrequent research failures, coordination of the development and market teams, and a lengthy shakedown period as the new invention is marketed and factories are fitted for production. The true effectiveness of a company’s R&D efforts can thus only be determined via the scuttlebutt technique, only by approaching experts who know the field of research and the company in question can you gain a true understanding of what’s happening beneath the hood.

It’s worth mentioning that Buffett’s 10th tenet “for every dollar retained, make sure the company has created at least one dollar of market value,” as discussed in The Warren Buffet Way, is a more general take on this point. What ultimately needs to happen is that the company is putting its own money to good use, ultimately generating more value for the shareholder.

4. Does the company have an above-average sales organization?

While R&D is important, it can only ever be as effective as the company’s sale’s department. If the product invented, no matter how brilliant, is too expensive to find a market or isn’t marketed properly, it can still be a terrible drain of resources. So what makes an above-average sales organization? Beyond good leadership and good workers, companies should strive to continually improve their quality of service. As R&D comes up with new innovations, the sales arm needs to be kept abreast of the developments, which means frequently updated training and education to make sure everyone is at the forefront of progress.

5. Does the company have a worthwhile profit margin?

Profit margin is in many ways the company’s margin of safety. Research and development, effective research and marketing campaigns, paying workers fair wages, these all take funding. Profit margin is especially important in the event of inflation. While companies can and do pass along the raised prices to the consumer, there is a period of time before the adjustment can be made when costs are high but the price of products are still low. A company with a higher profit margin for their industry, say 5%, is more likely to make it through this period intact where their competitor, who only has a profit margin of 3% might be severely impacted if inflation rises too far. 

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

In other words, what efforts are the company putting towards the task of cutting costs? Practically speaking, this manifests as efforts to streamline the production process, stimulate workers, and reduce transportation costs. Companies should not attempt to improve profit margins by cutting corners on product quality or worker’s compensation. While companies that do so may see a temporary spike in earnings, Fisher warns us that such arrangements are untenable and thus not suitable for long-term investors.

7. Does the company have outstanding labor and personnel relations?

Even with workers occupying the most basic entry level positions, it is vital to the long term health of the company to promote a communal and positive feeling among workers regarding the company. Workers who are self motivated, feel that they are treated with dignity, and are properly compensated are far more productive and result in far better quality of work for the company. Workers should feel that they can bring grievances to their superiors without repercussion and such grievances should be settled promptly and decisively. 

The simplest way to determine the quality of labor and personnel relations would be to speak with a number of current workers from multiple sectors. Other indications include worker turnover statistics and the company’s relationship with unions – if worker turnover is abnormally high, or the company engages in union busting tactics, the company is likely not a good investment vehicle.

8. Does the company have outstanding executive relations?

The satisfaction of top-level workers are just as, if not more, vital points of consideration as that of the ground floor employee. Outstanding executive relations mean a general sense that merit determines promotions and that high level executives will be promoted internally, rather than brought in from other companies. A chief executive officer brought in externally is typically a very bad sign fir the company’s health. Salary increases should also be given on a performance-basis, and not something executives feel the need to request. Salary differences should also not be so dramatic as a single person taking the lionshare of the earnings. Among top executives, compensation should have a much gentler slope from the CEO on down.

9. Does the company have depth to its management?

Companies have different stages of development. First there is the young company, with potential both for outstanding success and devastating failure. In order for a young company to successfully scale up and transition into an established institutional company, there needs to be an increase in the depth of management. Young companies can be run by one or two massively talented executives but when the scale gets bigger, it quickly becomes too much for an individual to manage. Therefore it is vital for a company’s executive team to comprise a number of talents all working together as a team without undue micromanagement. An executive without the necessary authority to make decisions will never be able to contribute to the company to their full potential.

10. How good is the company’s cost analysis?

This point is included because proper accounting is absolutely vital to good business practice and healthy development but unfortunately, assessing the strength of a company’s cost analysis requires a bit of background in statistics. However, Fisher assures the readers that companies that fulfill the other 14 points on the list (or most of them), then you can be reasonably sure that the accounting has been done to a sufficiently high standard. 

11. Are there other aspects of the 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?

This is a catch-all category that depends on the industry you happen to be investigating. This mostly means a company performing better in context in its competitors. One particular measure of this might be seen in the company’s insurance costs. If the company has an insurance cost that is 35% less than its competitors, this demonstrates a greater “overall skill in handling people, inventory, and fixed property so as to reduce the overall amount of accident, damage, and waste and thereby make these lower costs possible.” Additionally, Fisher urges readers not to hyperfocus on patents, as patents are less important in the long term for the well-being of the company than other more sustainable factors.

12. Does the company have a short-range or long-range outlook in regard to profits?

When the time comes to report quarterly earnings, executives frequently feel pressured to maximize their profits in order to make a good showing for the report. These efforts are ultimately detrimental to the long term profits of the company, as prioritizing future growth and future profit frequently means sinking huge amounts of capital into research projects that may very well fail for the chance of achieving fantastic returns for the future. It also means building good-will among suppliers and clients by absorbing short-term costs because it creates mutually beneficial relationships for all future transactions. 

13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

Fisher specifies that the purely financial aspects of a company is unimportant if all other points on the list are met. However, one element does require special consideration, and that is one which may directly affect the value of the company’s shares. The investor needs to evaluate the company’s current funds, earning power, and further borrowing ability is enough to sustain the cost of future growth. The company should not be forced to issue new shares to raise funds, as doing so will dilute the value of the stocks in your possession. If the company needs to issue new stocks, then the potential growth these funds will bring should more than offset the diluting of value for the stockholder. 

14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointment occur?

To be clear, the unavoidable truth of success and averages means that companies which achieve the best growth will inevitably suffer through costly failures before realizing its potential. The executive team should be open about its poor showings and mistakes, and offer up reasons for why this has brought them closer to greater profitability and plans for implementing what they have learned from the mistakes in their process. 

15. Does the company have a management of unquestionable integrity?

As the company’s management will always have a better understanding of the company affairs and operations than the stock holder, their integrity is of vital importance to the overall value of the company. A dishonest executive team can easily squander invested capital by unduly rewarding their family and close associates through higher-than-appropriate salaries, by assigning  them preferred stocks, or renting/selling properties to the corporation at above-market prices. The only way an investor can guard against this form of risk is by developing a knack for character judgment and thereby ascertaining that the team of executives are fully beyond reproach. Of course, in this endeavor, scuttlebutt is the best and only method.

A few words about market timing

While Phil Fisher agrees wholeheartedly that shares should not be purchased at too high a price, the companies he truly feel to be worth investing in are frequently not cheap. Fisher’s experience has taught him that it’s ultimately pointless to quibble over eighths and quarters. If a company made it through Fisher’s highly exacting standards, then it’s an outstanding company with the potential to not just double in price but grow to by hundreds, and sometimes thousands, of percentage points. Therefore, Fisher concludes, it’s not worth trying to save $500 in purchasing the shares and as a consequence missing out on tens of thousands in profits. Additionally, while it’s valuable to maintain a contrarian attitude, provided you are right, sometimes a stock that is judged to have growth prospects does in fact have growth prospects. A high P/E ratio does not necessarily mean the stock is overpriced and vice versa, sometimes a low P/E ratio indicates genuine issues in the company and the share price is depressed for a good reason.

So having spoken on how Fisher approaches the matter of buying stocks, then is a good time to sell them? Ideally, never. Excellent growth companies will continue their excellent performance not just for you but your offspring also. However, sometimes it can happen that a company has fully exhausted the growth potential of its market and this is the time to sell. And just as other investors also recommend, if the company’s fundamentals, the management most fundamentally, has deteriorated, it would also be a time to sell. Finally, it could simply be that the investor has made a mistake in their assessment. If this is so, the stock should be sold as soon as the error is realized, and not a moment later. Attempts to hold out in hopes of the stock “breaking even” not only runs the risk of seeing your capital devolve even further, but also ties up your funds when you should be reinvesting it in more profitable holdings.

What makes Common Stocks and Uncommon Profits unique?

Among the investors who use fundamental analysis, virtually all adhere to Graham’s theory of value investing and invest primarily with the aim of minimizing risk and finding bargains. Meanwhile, Fisher is an adamant growth investor, in fact the first of his breed. While he still values bargains, he feels that the stocks with true growth potential aren’t given away as obvious a discount. The true bargain, he believes, lies in knowledge gained by proper research via “scuttlebutt” which has not yet occurred to the investing public. Fisher is also among the first to push back against diversification for the sake of risk management. The true way to minimize risk, Fisher maintains, is to have a thorough in-depth understanding of your holdings, something that becomes quickly impossible when one holds any more than 12 different stocks. Putting all your eggs in one basket may not be advisable, but having your eggs in so many different baskets that you can’t keep them all in your sight is not advisable either.

Final thoughts:

Although Fisher makes a strong case for the necessity of the careful and thorough research in a company before committing a significant percentage of your wealth to it’s stock, practically speaking very few people have the connections or the time outside their jobs to put this method into effect. To these people, Fisher suggested finding a competent financial advisor to do the legwork, which would be great, except even financial advisors who can be trusted to go this far for individual stocks are few and far between. So where does this leave the retail investor? Is there actual value in Fisher’s writings?

Yes, I believe there is.

We must not neglect the magnificent technologies available to us today that were no so in Fisher’s time, primarily the internet. While it would still be a far cry from conducting the thorough in person research Fisher insists is mandatory, it’s still a big improvement from only reading financial statements and looking at price averages. By highlighting the main elements that he watches out for when researching companies, Fisher draws our attention to the areas we need to direct our attention in our foray into the interwebs.

At 317 pages, Common Stocks and Uncommon Profits is not long, nor is it short. It’s fairly dense and may take you a fair amount of time to get through. For those who are pressed for time, the most important chapters are Chapter 2 What “Scuttlebutt” Can Do, and Chapter 3 What to Buy. Don’t get me wrong, there is a lot to be learned from every chapter of Fisher’s book but the true value of Fisher’s philosophy is concentrated in these chapters.