Philip Fisher Articles: Competitive Advantage

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FISHER ON COMPETITIVE ADVANTAGE

Philip Fisher is the father of growth investing. He looked to invest in companies with high growth potential, but also looked to buy at reasonable valuations. Even high earnings growth companies fall out of favor, become overlooked or are misunderstood from time to time. Fisher concentrated his considerable talent on finding a select handful of rapidly growing companies at attractive prices, which are rare finds but highly rewarding. As he held these rare gems, he continually tried to refine methods to assess their sustainable competitive advantage that would make them more and more valuable in future years.

A good company will be one with 'certain inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future'. Fisher looked for companies which consistently succeeded in doing things better than others in the industry. He never forgot to apply the advice of Dr. Dow (of Dow Chemical) to companies: 'If you can't do a thing better than others are doing it, don't do it at all.' Given the inherent risks of holding stocks you should only place money with companies that have both a strong competitive spirit and a strong competitive position.

Companies with high profit margins attract attention from other companies that start to regard that market segment as an 'open jar of honey owned by the prospering company. The money will inevitably attract a swarm of hungry insects bent on devouring it'. The company has to find a way of protecting its honey pot. One method is by outright monopoly. Fisher cautions against investing in this type of firm. Most monopolies are eventually curtailed by the authorities. Even those that are ignored by the regulatory bodies are liable to suddenly breakdown, and are therefore not safe to invest in.

The best way to keep the insects out is to be so efficient that present and future competition consider it futile to try to do battle. The implied threat is that they will have to commit themselves to huge expenditures, and the best they can hope for is parity in terms of output efficiency. The worst will be a damaging price war that will make their shareholders hop up and down in indignation at the irrational strategy.

Economies of scale are a potential source of competitive advantage. Fisher was very much aware of this, but said that, too often, as the organization becomes larger, the operating ocst benefit is offset by the inefficiencies produced by the additional bureaucratic layers of middle management. Senior executives become increasingly isolated from the activities of subdividions and far-flung complexes; decisions are delayed and ill informed.

The greatest advantages of being the largest firm in the industry are often to be found, not on the manufacturing side of the business, but on the marketing side. Fisher was particularly enthusiastic about this. If the company is first with a new product or service and backs this up with good marketing, servicing and product improvement it may be able to establish 'an atmosphere in which new customers will turn to the leader largely because the leader has established such a reputation for performance (or sound value) that no one is likely to criticize the buyer adversely for making this particular selection'.

When a company becomes the leader in its field it seldom gets displaced so long as its management remains competent. The notion that the purchasing of the stock of the number two or number three firm in the industry is a wise investment, because they have the potential to take the premier position, whereas the leader can only go down, is regarded by Fisher as not being borne out by evidence. A well-entrenched leader with dynamic, forward-looking vigilant managers is more likely to see off a challenge than to succumb to it.

Some companies possess the advantages of low production costs and a well-recognized brand name as well as a host of other key resources to swat those pesky insects. Fisher (in the 1970s) liked to quote the case of Campbell, the soup producer. It had cost reduction through scale and backward integration, a recognized product, the most prominent position in retail outlets and one of the largest display areas, and it could spread its marketing costs over billions of cans of soup.

The competitive advantage may not come from the core activity of the firm. For example, in some retail sectors the basic business of selling goods gives the firm competitive parity and no more. What gives the edge is the skill a firm might have in handling real estate issues, for example, the quality of its leases.

Patents can provide defence against competition in the short and medium term. Fisher was cautious on this point: 'In our era of widespread technical know-how it is seldom that large companies can enjoy more than a small part of their activities in areas sheltered by patent protection. Patents are usually able to block off only a few rather than all the ways of accomplishing the same result'. He believed that even technologically led firms need other forms of protection to maintain competitive positions and succeed over the long term. These include manufacturing know-how, the quality of the sales and service organization, customer goodwill and knowledge of customer problems. 'In fact, when large companies depend chiefly on patent protection for the maintenance of their profit margin, it is usually more a sign of investment weakness than strength. Patents do not run on indefinitely. When the patent protection is no longer there, the company's profit may suffer badly'.

An alternative to patents is superiority in being able to bring together knowledge from more than one science. If you can find a firm that is way ahead of the field in this mastery of, not one, but two technologies and the interplay between these scientific disciplines, then you may have found a bonanza investment.

An excellent marketing team can create in its customers the habit of almost automatically specifying its product for reorder. Competitors find this position very difficult to weaken. For the dominant firm to achieve its position it has to do a number of things: first, build a reputation for quality and reliability; second, make sure the customer realizes the need for high quality and reliable inputs to its processes, so that it will not take the risk of buying an inferior product; third, ensure that competitors serve only small segments of the market so your brand becomes synonymous with the product item.

To achieve maximum profits the cost of the product has to be a small part of the customer's input costs. This means that a switch to a rival product from an unknown supplier will save only a small amount, but the risk of malfunction will play on the mind of the buyer. Finally, it is best to have a market structure where there are many small customers rather than a few large ones. If these customers are very specialized then all the better, because the dominant company will attune its marketing and distribution to the needs of its customers resulting in a close relationship, personal contact and targeted marketing (e.g., salesmen spending a great deal of time with customers trying to help them find solutions). These become important attributes that potential competitors would find almost impossible to emulate. It would take a major shift in technology or a decline in the firm's efficiency to lose its hold on the honey pot.

The company in possession of a strong competitive position needs to be aware of the dangers from overexploitation in the short run. It should not aim for returns on capital many times those available in the industry generally. A spectacular profit creates an irresistible inducement for a fantastic range of companies to try and compete and carry off some of the honey. Fisher suggests that a profit margin consistently 2 or 3% greater than the next best competitor is 'sufficient to ensure a quire outstanding investment'.

Credits: This article is compiled from writings of Philip Fisher and summaries found in Glen Arnold's Valuegrowth Investing, 2002.

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