What are those matters about which the investor should learn if he is to obtain the type of investment which, in a few years, might show him a gain of several hundred per cent or, over a longer period, a correspondingly greater increase? In other words, what attributes should a company have to give it the greatest likelihood of attaining this kind of result for its shareholders?
There are 15 points with which I believe the investor should concern himself. A company could well be an investment bonanza if it failed fully to qualify on a very few of them. I do not think it could come up to my definition of a worthwhile investment if it failed to qualify on many.
Five of the 15 points are addressed below:
Point 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?
It is by no means impossible to make a fair one-time profit from companies with a stationary or even declining sales curve. Operating economies resulting from better control of costs can create enough improvement in net income to produce an increase in the market price of a company’s shares. This sort of one-time profit is eagerly sought by many speculators and bargain-hunters. It does not offer the degree of opportunity, however, that should interest those desiring to make the greatest possible gains from their investment funds.
Not even the most outstanding growth companies need necessarily be expected to show sales for every year larger than those of the year before. Therefore, growth should not be judged on an annual basis but, say, by taking units of several years each. Certain companies give promise of greater-than-normal growth, not only for the next several-year period, but also for a considerable time beyond that.
Those companies which, decade by decade, have consistently shown spectacular growth might be divided into two groups. For lack of better terms, I will call one group those that happen to be both ‘fortunate and able’ and the other group those that are ‘fortunate because they are able’. A high order of management ability is a must for both groups.
No company grows for a long period of years just because it is lucky. It must have, and continue to keep, a high order of business skill, otherwise it will not be able to capitalise on its good fortune and defend its competitive position from the inroads of others.
The Aluminum Company of America is an example of the ‘fortunate and able’ group. The founders of this company were men with great vision. They correctly foresaw important commercial uses for their new product. However, neither they nor anyone else at that time could foresee anything like the full size of the market for aluminum products that was to develop over the next 70 years. A combination of technical developments and economies, of which the company was far more the beneficiary than the instigator, was to bring this about.
Alcoa has, and continues to show, a high order of skill in encouraging and taking advantage of these trends. However, if background conditions, such as the perfecting of airborne transportation, had not caused influences completely beyond Alcoa’s control to open up extensive new markets, the company would still have grown – but at a slower rate.
Alcoa was fortunate in finding itself in an even better industry than the attractive one envisioned by its early management. Now let us take Du Pont as an example of the other group of growth stocks – those I have described as ‘fortunate because they are able’. This company was not originally in the business of making nylon, cellophane, lucite, neoprene, orlon, milar, or any of the many other glamorous products with which it is frequently associated in the public mind, and which have proven so spectacularly profitable to the investor.
For many years, Du Pont made blasting powder. In time of peace its growth would largely have paralleled that of the mining industry. However, the company’s brilliant business and financial judgement teamed up with superb technical skill to attain a sales volume that is now exceeding $2bn each year. Applying the skills and knowledge learned in its original powder business, the company has successfully launched product after product to make it one of the great success stories of American industry.
I believe that in regard to a company’s future sales curve there is one point that should be kept in mind. If a company’s management is outstanding, and the industry is one subject to technological change and development research, the shrewd investor should stay alert to the possibility that management might handle company affairs so as to produce in the future exactly the type of sales curve that is the first step to consider in choosing an outstanding investment.
Point 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?
Companies that have a significant growth prospect for the next few years because of new demand for existing lines, but which have neither policies nor plans to provide for further developments beyond this, may provide a vehicle for a nice one-time profit. They are not apt to provide the means for the consistent gains over 10 or 25 years that are the surest route to financial success.
It is at this point that scientific research and development engineering enter the picture. It is largely through these means that companies improve old products and develop new ones. This is the usual route by which a management not content with one isolated spurt of growth sees that growth occurs in a series of more or less continuous spurts.
The investor usually obtains the best results in companies whose engineering or research is devoted to products having some business relationship to those already within the scope of company activities.
At first glance, Point 2 may appear to be a mere repetition of Point 1, but this is not the case. Point 1 is a matter of fact, appraising the degree of potential sales growth that now exists for a company’s product.
Point 2 is a matter of management attitude. Does the company now recognise that in time it will almost certainly have grown up to the potential of its present market and that to continue to grow it may have to develop further new markets at some future time? It is the company that has both a good rating on the first point and an affirmative attitude on the second that is likely to be of the greatest investment interest.
Point 3. How effective are the company’s research and development efforts in relation to its size?
For a large number of publicly owned companies, it is not too difficult to get a figure showing the number of dollars being spent each year on research and development, and the per cent of each sales dollar that a company is devoting to this type of activity.
Figures of this sort can prove a crude yardstick that may give a worthwhile hint that one company is doing an abnormal amount of research or another not nearly enough. But unless a great deal of further knowledge is obtained, such figures can be misleading.
In no other major subdivision of business activity are to be found such great variations from one company to another between what goes in as expense and what comes out in benefits as occurs in research. Even among the best-managed companies, this variation seems to run in a ratio of as much as two-to-one. By this is meant some well-run companies will get as much as twice the ultimate gain for each research dollar spent as will others.
If averagely run companies are included, this variation between the best and the mediocre is still greater. This is largely because the big strides in the way of new products and processes are no longer the work of a single genius. It is also necessary to have leaders who can co-ordinate the work of people of such diverse backgrounds and keep them driving toward a common goal. Consequently, the number or prestige of research workers in one company may be overshadowed by the effectiveness with which they are being helped to work as a team in another.
Close and detailed co-ordination between research workers on each developmental project, and those thoroughly familiar with both production and sales problems, is almost as important. Unless this is done, new products, as finally conceived, frequently are either not designed to be manufactured as cheaply as possible or, when designed, fail to have maximum sales appeal.
Finally, there is one other type of co-ordination necessary if research expenditures are to attain maximum efficiency – co-ordination with top management. It might perhaps better be called top management’s understanding of the fundamental nature of commercial research. Development projects cannot be expanded in good years and sharply curtailed in poor ones without tremendously increasing the total cost of reaching the desired objective.
The ‘crash’ programs so loved by a few top managements may occasionally be necessary, but are often just expensive.
A crash program is what occurs when important elements of the research personnel are suddenly pulled from the projects on which they have been working and concentrated on some new task which may have great importance at the moment but which, frequently, is not worth all the disruption it causes. Some top managements do not seem to understand this.
I have heard executives of small but successful electronics companies express surprisingly little fear of the competition of one of the giants of the industry. It is the historic tendency of this larger company to interrupt regular research projects with crash programmes to attain the immediate goals of top management that has produced this feeling.
Finally, in judging the relative investment value of company research organisations, another type of activity must be evaluated; something that is not ordinarily considered as developmental research at all – the seemingly unrelated field of market research. Market research may be regarded as the bridge between developmental research and sales. Top management must be alert against the temptation to spend significant sums on the research and development of a colourful product or process which has a genuine market but will never enjoy a large enough sales volume to get back the cost of the research.
A simpler and often worthwhile method is to make a close study of how much in dollar sales or net profits has been contributed to a company by the results of its research organisation during a particular span, such as the prior 10 years. An organisation which, in relation to the size of its activities, has produced a good flow of profitable new products during such a period will probably be equally productive in the future as long as it continues to operate under the same general methods.
Point 4. Does the company have an above-average sales organisation?
In this competitive age, the products or services of few companies are so outstanding they will sell to their maximum potentials if they are not expertly merchandised. It is the making of a sale that is the most basic single activity of any business. Without sales, survival is impossible.
It is the making of repeat sales to satisfied customers that is the first benchmark of success. Yet, strange as it seems, the relative efficiency of a company’s sales, advertising and distributive organisations receives far less attention from most investors, even the careful ones, than do production, research, finance or other major subdivisions of corporate activity.
There is probably a reason for this. It is relatively easy to construct simple mathematical ratios that will provide some sort of guide to the attractiveness of a company’s production costs, research activity or financial structure in comparison with its competitors. It is a great deal harder to make ratios that have even a semblance of meaning in regard to sales and distribution efficiency.
I believe the Dow Chemical Company, which over the years has proven so rewarding to its stockholders, is an outstanding example of the ideal conservative long-range investment. Here is a company which, in the public mind, is almost synonymous with outstandingly successful research. However, what is not as well known is that this company selects and trains its sales personnel with the same care as it handles its research chemists.
Some of the company’s greatest mental effort is devoted to seeking and frequently finding more efficient ways to solicit from, service, and deliver to, the customer.
In another and quite different industry, International Business Machines is a company which has (speaking conservatively) handsomely rewarded its owners. An IBM executive recently told me that the average salesman spends a third of his entire time training in company-sponsored schools!
To a considerable degree, this amazing ratio results from an attempt to keep the salesforce abreast of a rapidly changing technology. Nevertheless, I believe it is one more indication of the weight that most successful companies give to steadily improving their sales arm.
Point 5. Does the company have a worthwhile profit margin?
Here at last is a subject of importance that properly lends itself to the type of mathematical analysis which so many financial people feel is the backbone of sound investment decisions. From the standpoint of the investor, sales are only of value when, and if, they lead to increased profits. All the sales growth in the world won’t produce the right type of investment vehicle if, over the years, profits do not grow correspondingly.
The wide variation in profit margin between different companies, even those in the same industry, will immediately become apparent.
Such a study should be made, not for a single year, but for a series of years. It then becomes evident that marginal companies – that is, those with the smaller profit margins – nearly always increase their profit margins by a considerably greater percentage in the good years than do the lower cost companies whose profit margins also get better but not to so great a degree. This usually causes the weaker companies to show a greater percentage increase in earnings in a year of abnormally good business than do the stronger companies in the same field. However, it should also be remembered that these earnings will decline correspondingly more rapidly when the business tide turns.
For this reason, I believe that the greatest long-range investment profits are never obtained by investing in marginal companies. The only reason for considering a long-range investment in a company with an abnormally low profit margin is that there might be strong indications that a fundamental change is taking place within the company.
Young companies, and occasionally older ones, will at times deliberately elect to speed up growth by spending all or a very large part of the profits they would otherwise have earned on even more research, or on even more sales promotion, than they would otherwise be doing. What is important in such instances is to make absolutely certain that it is actually still further research, still further sales promotion, or still more of any other activity which is being financed today so as to build for the future that is the real cause of the narrow or non-existent profit margin.
The greatest care should be used to be sure that the volume of the activities being credited with reducing the profit margin is not merely the volume of these activities needed for a good rate of growth.
Next month: Fisher’s points on margin improvement, employee relations, depth of management and cost controls.
Excerpted with permission of the publisher, John Wiley & Sons Ltd, from Common Stocks and Uncommon Profits. Copyright (C) 1996 by Philip A Fisher. Available at bookstores, online booksellers and from Wiley at www.wileyeurope.com
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