How do you evaluate stocks for maximum profits?
Philip A. Fisher, author of the bestselling book “Common stocks and uncommon profits”, describes how this should be done in the book. More specifically, he explains the analysis method “Scuttlebutt”, which is what he himself used for assessment of common stocks.
As Fisher modestly puts it:
“The purpose of this book is not to point out every way such money [money in the stock market] can be made. Rather, it is to point out the best way.”
Scuttlebutt is the technique of using ”Main Street” resources to find out if a stock is good or not. This means asking employees at the firm in question, at firms of competitors, and at firms of suppliers and customers about the company. Most people instead trust Wall Street resources when it comes to judging potential business investments. Wall Street sources are not as reliable though, because they are not involved in the business and they are always trying to sell you products, which might not be in your best interest.
Standard procedures. Here follows the takeaways in a summarized format.
- Talk to people!
- Evaluate the market potential.
- Look for companies which keeps producing great products.
- A strong sales organization is key.
- Great labor relations are important.
- Great executive relations are vital.
- The company should have a long-term outlook regarding profits.
- Transparency in communication is a must!
- Don’t sell just because a stock has gone up. Don’t buy just because a stock has gone down.
- Fish in the right pond.
It should be mentioned that “Common stocks and uncommon profits” does have a lot of other great points as well. With nearly 40 initial takeaways considered, these were tough picks to make.
Anyways, here are the takeaways in expanded form:
1. Talk to people!
Go to five companies within the industry that you are researching. Ask each of them about strengths and weaknesses of the other four firms. Preferably, you’d speak to managers, but they are also the ones with the least amount of time. What will emerge from this information is a quite detailed picture about the industry and about which company that would make a great investment. If competitors talk about your investment target with respect, and maybe even fear, you are one step closer of finding a great investment.
You can connect with these people through LinkedIn, by visiting a company store (if they are a business-to-consumer corporation), or by calling people, using numbers provided at the company’s contact page on the web.
Competitors are not the only valid option though. Others are:
- Research scientists in universities
- Trade associations
- Former employees (the information from these people can be of immense value, but is usually influenced by negativity)
Doing research in this way takes a lot of time, so save it until you have narrowed your research down to a few companies only.
2. Evaluate the market potential.
When you buy a company for long-term hold, you want to make sure that the market in which the business is operating has potential. Two main components for judging this is:
- The current market share of the company.
- The growth of the market. One thing that is important to evaluate is if the market has a lot of reoccurring revenue. For instance, the radio market had a huge upswing until 90% of all Americans owned one, then the growth stagnated.
Let’s say that you want to buy a company within the fishing business, operating in Sweden. The company owns the whole value chain and sells fish to consumers. Today, the company has revenues of $0,75 B. The market is estimated to be $1,5 B. yearly, so the market-share is 50%. The growth of the market is equal to the growth of the Swedish population plus inflation, around 3% per year. One additional assumption is that the company will be valued similar in the future and that the profit margin remains.
How much can you expect to earn from such an investment in 10, 20 and 30 years?
The upper limit is that the company conquers 100% of the market in those time periods. In that case, the growth can be calculated using the following formula:
Current market share * X#years = 1,03#years
So, this company can earn (maximum):
- 10,4% + dividends per year, in 10 years
- 6,6% + dividends per year, in 20 years
- 5,4% + dividends per year, in 30 years
On the other hand, if the company only would have had 30% market share and the market would grow by 5% yearly, you would get:
- 18,4% + dividends per year, in 10 years
- 11,5% + dividends per year, in 20 years
- 9,3% + dividends per year, in 30 years
Even though 100% of the market rarely is possible to conquer, this method can be used to asses if your forecasts are reasonable. You’ll see that for any company it’s seldom possible to grow by, for instance, 20% per year, because the company will outgrow the market it is operating in.
Lesson to be learned: Market potential matters.
3. Look for companies which keeps producing great products.
To create a single successful product line might be attributed to luck. To keep producing the goods with the highest demand can only be attributed to great entrepreneurship. You want to find companies of the last-mentioned kind. Look for aspirations of going into new markets, or adding additional products to existing markets, in the annual reports. If that can’t be found, your company might not have the right management attitude for long-term growth.
4. A strong sales organization is key.
“In this competitive age, the products or services of few companies are so outstanding that they will sell to their maximum potentialities if they are not expertly merchandised. It is the making of the sale that is the most basic single activity of any business.”
In today’s competitive landscape, this is probably more important than ever.
The problem here is that it is hard to construct mathematical ratios for the sales organization for an investor, you probably won’t be able to gather the data necessary, since it’s not public.
Scuttlebutt! Luckily, competitors and customers alike are very keen to express themselves about sales.
5. Great labor relations are important.
Prolonged strikes have a significant impact on production and custom relations, and must be avoided at all cost. This is the difference between bad labor relations and okay ones. However, the difference between mediocre personnel relations and good personnel relations is also huge. It leads to higher productivity and reduced costs for training and hiring workers.
To judge if the relations are good, here are a few indications:
- The salary is above industry standard
- Worker turnover is lower than industry standard
- No strikes in recent years
- No unionization
6. Great executive relations are vital.
These are the persons that can make or break any venture. Make sure that they have the right incentives and have a good relation to the company by inspecting that:
- The salary is above industry standard
- The turnover is low
- Executives own shares in the business
7. The company should have a long-term outlook regarding profits.
A few businesses create great profits today at the expense of the profits tomorrow. For the long-term investor, this is undesirable. A company aiming for profits in the long run creates strong relations with their employees, their customers, and their suppliers. A company aiming for profits in the short run lets their employees work for minimum wage, scams their customers with substandard quality products and vague deals, and switches regularly between low-cost suppliers.
I once had a bike, which I bought at Halfords during a stay in the Netherlands. After a few weeks, the spokes on my rear wheel were loose, and I was told to come in and get free service to fix it. For some reason, I didn’t. I kept riding the bike for a couple of months, even letting my brother stay on the carrier a few times. The carrier, made of pure steel, and the rim, got so crooked after a while that it was no longer possible to ride the bike.
That’s when I decided that it was time for service. So, I got into the store expecting that I would have to pay up to replace half of the parts on the bike to be able to ride it again. But I was mistaken. Halfords replaced all the crooked parts and repaired it all for free, even though it was obvious that I had mistreated the poor bike. This is how you create strong customer relations.
On another occasion, many years ago, me and my family were going to Fuerteventura in the middle of the Swedish winter. Even the polar bears fled south that winter, and we were looking forward to the trip a great deal. A week before the trip, our travel agency called us and told that the hotel which we had booked no longer had an agreement with the agency. Instead we were promised another, newly renovated, place to stay, which had similar features as the prior one.
When we arrived, we realized it wasn’t similar at all. The room didn’t have the kitchen we were promised, and the hotel didn’t even have a pool that was finished. It was under construction! We called the agency and demanded to be relocated to another hotel.
We solved this issue by eating at the all-inclusive buffet (not paid for) and using the pool of the original hotel (located nearby), so the trip was pleasant anyways. But we’ll never use that agency again, and neither will any of our friends. This is how you ruin customer relations.
8. Transparency in communication is a must!
This is one of the most important points. As an investor, you can never know what information a company decides to disclose for you. Yes, there are rules, but there are also a lot of grey zones. You want the company to be transparent in the communication because you want to know that they are showing you the actual situation, not some dressed up fairytale. Be careful with businesses that are eager to tell you as soon as something positive happens, but clams up when negative news arrives, until forced to reveal them years later.
On a similar note, pick stocks were the management have great integrity. The management is much closer to the assets of a company than the investor is, and the number of ways that they can benefit at the expense of the shareholders (legally!) are infinite. Therefore, only invest when the moral of management is unquestionable.
9. Don’t sell just because a stock has gone up. Don’t buy just because a stock has gone down.
Selling or buying should never be a decision based on the trend of the stock (at least not as a value investor, traders might argue differently, but that is a topic for another time).
Imagine this case:
You can pick 3 classmates for investment after school graduation. You pay a certain amount and then you’ll obtain a right for 10% of their salary every year. After this you get to do anything with these rights. You can even sell them to the highest bidder. 10 years later, one of your investments has done tremendously. She is now the chief of the sales unit in the norther Europe at H&M. The Persson family (owners) are talking about her as a possible successor for the whole company. You now get an offer to get 600 % of what you paid in the beginner for your right of 10% of her salary. Would you accept that? Probably not. Likewise, would you invest more in the guy that, 10 years after your initial investment, still works at a graduate position, earning the same salary as when he graduated? Probably not either.
10. Fish in the right pond.
So many opportunities, so little time.
To evaluate any opportunity takes a considerable amount of work. No one has got the time to asses every company, so how do we chose which ones to look at? Fisher looks at the balance sheet and the financial position of the company initially. Whenever he can’t find sufficient information about a business, he drops the case. He then considers it too risky.
“To make big money on investments it’s unnecessary to get some answer to every investment that might be considered. What is necessary is to get the right answer a large proportion of the very small number of times actual purchase are made.”
(You’ll probably need to read that twice. I did.)
Visiting a company is the last thing in a thorough analysis. Fisher buys between 50-75% of the companies that he decides to visit. Furthermore, he buys 2% of the companies he evaluates. And about 0,4% of the companies he considers.
Is there anything missing? What do you think are the top 10 takeaways from “Common stocks and uncommon profits”? Do you want me to develop on any of the subjects? Let us know in a comment!
Do you want to learn more about Scuttlebutt? Buy the book from Amazon today through this link:
Probably blew that one … Would Fisher approve of this sales organization?
For more investment tips delivered on behalf of the fishers of Sweden, stay tuned!