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Book extract – No margin for error

Point 6.

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

The success of a stock purchase does not depend on what is generally known about a company at the time the purchase is made. Rather, it depends upon what gets to be known about it after the stock has been bought. Therefore, it is not the profit margins of the past but those of the future that are basically important to the investor.

In the age in which we live, there seems to be a constant threat to profit margins. Some companies are in the seemingly fortunate position that they can maintain profit margins simply by raising prices. This is usually because they are in industries in which the demand for their products is abnormally strong or because the selling prices of competitive products have gone up even more than their own. In our economy, however, maintaining or improving profit margins in this way usually proves a relatively temporary matter. This is because additional competitive production capacity is created. This new capacity sufficiently outbalances the increased gain so that, in time, cost increases can no longer be passed on as price increases.

Profit margins then start to shrink. When profit margins of a whole industry rise because of repeated price increases, the indication is not a good one for the long-range investor.

In contrast, certain other companies, including some within these same industries, manage to improve profit margins by far more ingenious means than just raising prices. Some companies achieve great success by maintaining capital-improvement or product-engineering departments. The sole function of such departments is to design new equipment that will reduce costs and thus offset, or partially offset, the rising trend of wages. Many companies are constantly reviewing procedures and methods to see where economies can be brought about.

None of these things can be brought about in a day. They all require close study and considerable planning ahead. The prospective investor should give attention to the amount of ingenuity of the work being done on new ideas for cutting costs and improving profit margins. Fortunately, this is a field about which most top executives will talk in some detail.

The companies which are doing the most successful work along this line are very likely to be the ones which have built up the organisation with the know-how to continue to do constructive things in the future. They are extremely likely to be in the group offering the greatest long-range rewards to their shareholders.

Point 7. Does the company have outstanding labour and personnel relations?

Most investors may not fully appreciate the profits from good labour relations. Few of them fail to recognise the impact of bad labour relations.

The effect on production of frequent and prolonged strikes is obvious to anyone making even the most cursory review of corporate financial statements.

However, the difference in the degree of profitability between a company with good personnel relations and one with mediocre personnel relations is far greater than the direct cost of strikes. If workers feel that they are fairly treated by their employer, a background has been laid wherein efficient leadership can accomplish much in increasing productivity per worker. Furthermore, there is always considerable cost in training each new worker. Those companies with an abnormal labour turnover have therefore an element of unnecessary expense avoided by better managed enterprises.

Companies with good labour relations usually are ones making every effort to settle grievances quickly. The small individual grievances that take long to settle and are not considered important by management are ones that smoulder and finally flare up seriously. In addition to appraising the methods set up for settling grievances, the investor might also pay close attention to wage scales. The company that makes above-average profits while paying above-average wages for the area in which it is located is likely to have good labour relations. The investor who buys into a situation in which a significant part of earnings comes from paying below-standard wages for the area involved may in time have serious trouble on his hands.

Finally, the investor should be sensitive to the attitude of top management toward the rank-and-file employees. Underneath all the fine-sounding generalities, some managements have little feeling of responsibility for, or interest in, their ordinary workers. Their chief concern is that no greater share of their sales dollar go to lower echelon personnel than the pressure of militant unionism makes mandatory. Nothing is done to make ordinary employees feel they are wanted, needed and part of the business picture.

Nothing is done to build up the dignity of the individual worker. Managements with this attitude do not usually provide the background for the most desirable type of investment.

Point 8. Does the company have outstanding executive relations?

If having good relations with lower echelon personnel is important, creating the right atmosphere among executive personnel is vital. These are the men whose judgement, ingenuity and teamwork will, in time, make or break any venture. Because the stakes for which they play are high, the tension on the job is frequently great. So is the chance that friction or resentment might create conditions whereby top executive talent either does not stay with a company or does not produce to its maximum ability if it does stay.

The company offering greatest investment opportunities will be one in which there is a good executive climate. Executives will have confidence in their president and/or board chairman. This means, among other things, that from the lowest levels on up there is a feeling that promotions are based on ability, not factionalism. A ruling family is not promoted over the heads of more able men. Salary adjustments are reviewed regularly so that executives feel that merited increases will come without having to be demanded. Salaries are at least in line with the standard of the industry and the locality. Management will bring outsiders into anything other than starting jobs only if there is no possibility of finding anyone within the organisation who can be promoted to fill the position. Top management will recognise that wherever human beings work together, some degree of factionalism and human friction will occur, but will not tolerate those who do not co-operate in team play so that such friction and factionalism is kept to an irreducible minimum. Much of this the investor can usually learn without too much direct questioning by chatting about the company with a few executives scattered at different levels of responsibility.

The further a corporation departs from these standards, the less likely it is to be a really outstanding investment.

Point 9. Does the company have depth to its management?

A small corporation can do extremely well and, if other factors are right, provide a magnificent investment for a number of years under really able one-man management. However, all humans are finite, so even for smaller companies the investor should have some idea of what can be done to prevent corporate disaster if the key man should no longer be available. Nowadays, this investment risk with an otherwise outstanding small company is not as great as it seems, in view of the recent tendency of big companies with plenty of management talent to buy up outstanding smaller units.

However, companies worthy of investment interest are those that will continue to grow. Sooner or later a company will reach a size where it just will not be able to take advantage of further opportunities unless it starts developing executive talent in some depth.

Those matters discussed in Point 8 are, of course, needed for development of proper management in depth. But such management will not develop unless certain additional policies are in effect as well. Most important of these is the delegation of authority. If from the very top on down, each level of executives is not given real authority to carry out assigned duties in as ingenious and efficient a manner as each individuals’ ability will permit, good executive material becomes much like healthy young animals so caged in that they cannot exercise. They do not develop their faculties because they just do not have enough opportunity to use them.

Those organisations where the top brass personally interfere with and try to handle routine day-to-day operating matters seldom turn out to be the most attractive type of investments.

Point 10. How good are the company’s cost analysis and accounting controls?

No company is going to continue to have outstanding success for a long period of time if it cannot break down its overall costs with sufficient accuracy and detail to show the cost of each small step in its operation.

Only in this way will a management know what most needs its attention.

Only in this way can management judge whether it is properly solving each problem that does need its attention. Furthermore, most successful companies make not one but a vast series of products. If the management does not have a precise knowledge of the true cost of each product in relation to the others, it is under an extreme handicap. It becomes almost impossible to establish pricing policies that will ensure the maximum obtainable overall profit consistent with discouraging undue competition. There is no way of knowing which products are worthy of special sales effort and promotion. Worst of all, some apparently successful activities may actually be operating at a loss and, unknown to management, may be decreasing rather than swelling the total of overall profits. Intelligent planning becomes almost impossible.

In spite of the investment importance of accounting controls, it is usually only in instances of extreme inefficiency that the careful investor will get a clear picture of the status of cost accounting and related activities in a company in which he is contemplating investment. Direct enquiry of company personnel will usually elicit a completely sincere reply that the cost data are entirely adequate. Detailed cost sheets will often be shown in support of the statement. However, it is not so much the existence of detailed figures as their relative accuracy which is important. The best that the careful investor usually can do in this field is to recognise both the importance of the subject and his own limitations in making a worthwhile appraisal of it. Within these limits he usually can only fall back on the general conclusion that a company well above average in most other aspects of business skill will probably be above average in this field, too, as long as top management understands the basic importance of expert accounting controls and cost analysis.

Next month: Fisher’s points on competition, financing, management integrity and the short term versus the long term.

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


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