Philip Fisher Articles: Stocks To Avoid

Posted on Wallstraits.com before.


PHILIP FISHER: STOCKS TO AVOID

Philip Fisher, author of the classic Common Stocks and Uncommon Profits, is the doyen of growth investors. He sought companies with high growth potential, but he also looked to buy at a reasonable price that gave good value. Even high earnings growth stocks fall out of favor, become overlooked and sell for less than their underlying worth from time to time. Fisher is perhaps best known for his very early investment into Texas Instruments--in 1956!--on a hunch about a new technology called semiconductors. Today, let’s take a look at the nine warning signs outlined by Fisher for stocks to avoid.

Rejecting companies that have made mistakes

Fisher’s high-growth companies were generally involved in pioneering technologies. Failure, on occasion, is part and parcel of progress. Other stock pickers gave Fisher his chance to accumulate sotck in companies that had shown a good average success to average failure ratio in the past. The less informed investors tend to dump the stock when earnings drop sharply below previous estimates: ’time and again the investment community’s immediate consensus is to downgrade the quality of the management. As a result, the immediate year’s lower earnings produce a lower than historic price earnings ratio to magnify the effect of reduced earnings. The shares often reach truly bargain prices.’ If these companies are run by exceptionally capable people, and the mistakes are only transient, the investor will do better by placing money here than if he or she invested in a company with a management that tends to go along with the crowd, and doesn’t take the risk of pioneering.

Playing the ’in and out’ game

Despite Fisher’s extensive experience he rejected the idea that he could predict short-term price movements, and thereby benefit by selling a stock when it appeared to be too high with the expectation of buying it back again after a price correction. There is: ’A risk to those who follow the practice of selling shares that still have unusual growth prospects simply because they have realized a good gain and the stock appears temporarily overpriced.... These investors seldom buy back the stock at higher prices when they are wrong and lose further gains of dramatic proportions....I do not believe it possible to play the in and out game and still make the enormous profits that have accrued again and again to the truly long-term holder of the right stocks.’

Fisher was equally critical of those who relied on economic forecasts to time investments, which he regarded as ’silly.’ He likened the current state of our knowledge of economics (for forecasting future business trends) to the science of chemistry in the days of alchemy in the Middle Ages. There are rare occasions when speculative enthusiasm pushes stocks to ridiculous extremes (such as 1929, 1987, 2000) when an economic analysis will predict what is likely to occur. However, such analysis would be useful only one year in ten.

Fisher said, ’The amount of mental effort the financial community puts into this constant attempt to guess the economic future from a random and probabily incomplete series of facts makes one wonder what might have been acomplished if only a fraction of such mental effort had been applied to something with a better chance of providing useful... (the) investor should ignore guesses on the coming trend of general business or the stock markets. Instead he should invest the appropriate funds as soon as a suitable buying opportunity arises.’

Impatience

This is a common issue, but one that merits repeating for emphasis. There is a need for ’patience if big profits are to be made from investment. Put another way, it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.’

The urge to follow

’Doing what everybody eles is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.’

Trying to ’come out even’ on a poor investment

The difficulty people have accepting that they made a mistake causes them to avoid taking a loss on an investment and thereby making explicit, for all the world to see, that they made a bad choice: ’More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.’

Rejecting stocks trading on lesser markets

Generally the investor should confine buying to those stocks listed on stock markets which afford a reasonably high degree of liquidity and regulation. However, it is often the case that many stocks quoted on smaller exchanges are sufficiently liquid and regulated to be of interest to the investor. Indeed, wonderful opportunities can be missed if investors overlook these markets as potential hunting grounds.

Judging a stock on the basis of its previous price change

To evaluate a stock on the basis of the price ranges at which it sold in recent years puts the emphasis on ’what does not particularly matter, and diverts attention from what does matter.’ The crucial facts needed as an input to the appraisal are to be found in the current and future influences on the performance of the underlying business. What happened to the stock price a few months or years ago is irrelevant.

Speculators sometimes try to pleat that they are being rational: they might say, ’well, the price has traded in a range for many years, it is due for a rise.’ The hidden logical assumption is that stocks go up about the same amount, and it is just a matter of spotting when it is the turn of that particular stock. Equally nonsensical is the belief that because a stock has already ’risen a lot’ it will not go any further. Past movements are of little relevance to the future. What does matter is the background conditions leading to growth over the next few years, and whether they are already reflected in the price or not. To understand these you must understand the business, not how to read charts.

Start ups

Start-up companies, particularly in the high technology field, are often alluring. They may have an exciting new invention or are at the forefront in an industry with great growth prospects. It is very tempting to try to ’get in on the ground floor’ by buying into such companies. Fisher avoided companies that did not have an operating history of two or three years and at least one year of operating profit. His reasoning was that the investor needs to be able to evaluate the quality of the operations of the major functions of the business (production, sales, cost accounting, research, management teamwork, and so on) and this is very difficult to do for a very young company. The opinions of qualified observers on the matter of the company’s strengths and weaknesses will not yet be properly informed. Likely future difficulties or competitive threats can only be guessed at. In short, Fisher-type analysis is simply not possible, and the stock buyer is therefore gambling, unless they have highly specialized skills and knowledge.

Over-stressing diversification

Everyone is aware of the horrors of putting too many eggs into one basket. Few people consider the ’evils’ of the other extreme. ’This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put in them.’ Fisher regarded it as appalling that investors were persuated to spread their funds between 25 or more stocks. The investor, or his advisor, is highly likely to be placing money in companies of which they know little. The result is that only a small proportion of the money is left for placement in companies of which they have a thorough understanding. ’It never seems to occur to them, much less to their advisers, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.’

He draws an analogy with an infantryman stacking rifles to illustrate the degree of diversification needed. The ’stack’ would be unstable with just two rifles. Five or six, properly placed, would be much firmer. ’However, he can get just as secure a stack with five as he could with fifty.’ Fisher suggested that if the investor was focused on large well-entrenched growth stocks then the minimum degree of diversification should be five such stocks-- with no more than 20% in each.

------------------

Previous Philip Fisher articles

1. Philip Fisher Articles: Finding Growth Stock
2. Philip Fisher Articles: Investing in Growth
3. Philip Fisher Articles: Conservative Investors Sleep Well
4. Philip Fisher Articles: Switching Stocks
5. Philip Fisher: 15 Checklist When Buying A Stock
8. Philip Fisher: 10 Commandments That An Investor Must Not Do
9. Philip Fisher Articles: Over-Diversification