Future Tense

Point 11.

Are there other clues as to how outstanding the company may be in relation to its competition?

By definition, this is somewhat of a catch-all point of inquiry. This is because matters of this sort are bound to differ considerably from each other – those which are of great importance in some lines of business can, at times, be of little or no importance in others. For example, in most important operations involving retailing, the degree of skill a company has in handling real estate matters – the quality of its leases, for instance – is of great significance. In many other lines of business, a high degree of skill in this field is less important. Similarly, the relative skill with which a company handles its credits is of great significance to some companies, of minor or no importance to others.

In a number of lines of business, total insurance costs mount to an important per cent of the sales dollar.

Insurance can give a supplemental but indicative check as to how outstanding a particular management may be. This is because these lower insurance costs do not come solely from a greater skill in handling insurance in the same way, for example, as skill in handling real estate results in lower than average leasing costs. Rather, they are the reflection of 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.

Patents are another matter that have varying significance from company to company. For large companies, a strong patent position is usually a point of additional rather than basic strength. It usually blocks off certain subdivisions of the company’s activities from the intense competition that might prevail.

Patents are usually able to block off only a few rather than all the ways of accomplishing the same result. For this reason, many large companies make no attempt to shut out competition through patent structure, but for relatively modest fees license competition to use their patents and, in return, expect the same treatment from these licensees. Influences such as manufacturing know-how, sales and service organisation, customer goodwill and knowledge of customer problems are depended on far more than patents to maintain a competitive position.

The young company starting to develop its production, sales and service organisation is in a different position. Without patents its products might be copied by large entrenched enterprises which could use their established channels of customer relationship to put the small young competitor out of business.

Even here, engineering that is constantly improving the product can prove considerably more advantageous than mere static patent protection. For example, a few years ago a young West Coast electronics manufacturer had great success with a new product. One of the giants of the industry made what was described as a “Chinese copy” and marketed it under its well-known trade name. In the opinion of the young company’s designer, this large competitor managed to engineer all the small company’s engineering mistakes into the model along with the good points. The small manufacturer introduced its own improved model with the weak points eliminated. With a product that was not selling, the large company withdrew from the field.

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

Some companies will conduct their affairs so as to gain the greatest possible profit right now. Others will deliberately curtail maximum immediate profits to build up goodwill and thereby gain greater overall profits over a period of years. Treatment of customers and vendors gives frequent examples of this. One company will constantly make the sharpest possible deals with suppliers. Another will, at times, pay above contract price to a vendor who has had unexpected expense in making delivery because it wants to be sure of having a dependable source of needed raw materials or high-quality components available when the market has turned and supplies may be desperately needed. The difference in treatment of customers is equally noticeable. The company that will go to special trouble and expense to take care of the needs of a regular customer caught in an unexpected jam may show lower profits on the particular transaction, but far greater profits over the years.

The investor wanting maximum results should favour companies with a truly long-range outlook concerning profits.

Point 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 cancel the existing stockholders’ benefit from this anticipated growth?

The typical book on investment devotes so much space to a discussion on the corporation’s cash position, corporate structure, percentage of capitalisation in various classes of securities, etc, that it may well be asked why these financial aspects should not receive more than the amount of space devoted to this one point out of 15. The reason is that it is the basic contention of this book that the intelligent investor should not buy common stocks simply because they are cheap but only if they give promise of major gain.

Only a small percentage of all companies can qualify with a high rating for all or nearly all of the other 14 points listed. Any company which can so qualify could borrow money, at prevailing rates for its size company, up to the accepted top percentage of debt for that kind of business. If such a company needed more cash once this top debt limit has been reached it could raise equity money at some price, since investors are always eager to participate in ventures of this sort.

If borrowing power is not sufficient, however, equity financing becomes necessary. In this case, the attractiveness of the investment depends on careful calculations as to how much the dilution resulting from the greater number of shares to be outstanding will cut into the benefits to the present common stockholder that will result from the increased earnings this financing makes possible.

If equity financing will be occurring within several years of the time of common stock purchase, and if this equity financing will leave common stockholders with only a small increase in subsequent per-share earnings, only one conclusion is justifiable. This is that the company has a management with sufficiently poor financial judgement to make the common stock undesirable for worthwhile investment. Unless this situation prevails, the investor need not be deterred by purely financial considerations from going into any situation which, because of its high rating on the remaining 14 points covered, gives promise of being outstanding. Conversely, from the standpoint of making maximum profits over the years, the investor should never go into a situation with a poor score on any of the other 14 points, merely because of great financial strength or cash position.

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

It is the nature of business that in even the best-run companies unexpected difficulties, profit squeezes, and unfavourable shifts in demand for their products will at times occur. Furthermore, the companies into which the investor should be buying if greatest gains are to occur are companies which over the years will constantly, through the efforts of technical research, be trying to produce and sell new products and new processes.

By the law of averages, some of these are bound to be costly failures.

Others will have unexpected delays and heartbreaking expenses during the early period of plant shake-down. For months on end, such extra and unbudgeted costs will spoil the most carefully laid profit forecasts for the business as a whole. Such disappointments are an inevitable part of even the most successful business. If met forthrightly and with good judgement, they are merely one of the costs of eventual success. They are frequently a sign of strength rather than weakness in a company.

How a management reacts to such matters can be a valuable clue to the investor. The management that does not report as freely when things are going badly as when they are going well usually “clams up” in this way for one of several rather significant reasons. It may not have a programme worked out to solve the unanticipated difficulty. It may have become panicky.

It may not have an adequate sense of responsibility to its stockholders, seeing no reason why it should report more than what may seem expedient at the moment. In any event, the investor will do well to exclude from investment any company that withholds or tries to hide bad news.

Point 15. Does the management have unquestionable integrity?

The management of a company is far closer to its assets than is the stockholder.

Without breaking any laws, the number of ways in which those in control can benefit themselves and their families at the expense of the ordinary stockholder is almost infinite. One way is to put themselves – to say nothing of their relatives or in-laws – on the payroll at salaries far above the normal worth of the work performed. Another is to own properties they sell or rent to the corporation at above-market rates. Among smaller corporations this is hard to detect, since controlling families or key officers at times buy and lease real estate to such companies, not for purposes of unfair gain but in a sincere desire to free limited working capital for other corporate purposes.

Another method for insiders to enrich themselves is to get the corporation’s vendors to sell through certain brokerage firms which perform little if any service for the brokerage commissions involved but which are owned by these same insiders and relatives or friends. Probably most costly of all to the investor is the abuse by insiders of their power of issuing common stock options. They can pervert this legitimate method of compensating able management by issuing to themselves amounts of stock far beyond what an unbiased outsider might judge to represent a fair reward for services performed.

There is only one real protection against abuses like these. This is to confine investments to companies the managements of which have a highly developed sense of trusteeship and moral responsibility to their stockholders.

Any investment may still be considered interesting if it falls down in regard to almost any other one of the 15 points which have now been covered, but rates an unusually high score in regard to all the rest. Regardless of how high the rating may be in all other matters, however, if there is a serious question of the lack of a strong management sense of trusteeship for stockholders, the investor should never seriously consider participating in such an enterprise.

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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