Common Stocks and Uncommon Profits
The 15 Points To Look For In A Common Stock
In this chapter, Philip Fisher sheds light on 15 aspects that we can consider while evaluating the future growth and performance of a company:
1.The product and service offered by a company:
It is crucial to understand whether a company’s product/service has the potential to generate sufficient demand such that it can gather a significant market share in the future.
Companies can make short-term profits by cutting costs. A company that can anticipate a market change will be able to sustain its sales for a significant period of time. The author gives the example of a radio manufacturer and explains that the sale of radios was high as long as there were no TVs. After the introduction of TVs, the sale of radios went down massively.
2.Research and development of new products to replace existing potential product lines.
According to the author, we should invest in a company that has an ongoing research project to replace existing product lines with better and upgraded products so that it can retain its existing market share. A management that is smart enough will realize that a product tends to do better when its metrics are improved over time when compared to a newly launched product. The management of a company should never be complacent. They should always be on the move and look for new and better ways to improve their products.
3.Company's investment in research and development with respect to its size.
The R&D figure of a company is easily available in its annual report. Many analysts compare this figure to another company in the same industry. Some analysts even compare it with the industry average. What most analysts don’t realize is that the R&D figure can be misleading because it is upon the management to decide which expense will be categorised under this head.
For R&D efforts to be successful, the author suggests three ways:
1.Coordination with the R&D team
2.Coordination between the research team and the business and operations team
3.Coordination with the management of the company
Many companies start researching on a project but stop halfway in. According to the author, the research of an upcoming project should never stop. It should always be completed.
Another activity that complicates the calculation of a research expense is the amount of research that is related to defense contracts. Profit margins from a defense contract are generally very low, and every contract is subject to competitive bidding. For example, a company wins the bid for the first installment of a project but loses the second installment to a competitor. This is why profits from these kinds of projects are not sustainable.
Expenses related to market research should also be considered while calculating the research expense of a company.
A company that puts significant efforts into its R&D is more likely to have a positive outcome in the future than a company which does not.
4.Company’s effort to sales, advertisement, and distribution
A company’s success largely depends on three factors:
Regular sales to satisfied customers is the first benchmark of success in a company. Specific sales ratios don’t always reflect the full picture of a company. These ratios are far too simplified and the nature of a company can’t be understood just by looking at them.
Customers and competitors of a company have the true knowledge of its sales, but it is very hard to get those answers from them. Moreover, a company’s effort to inform a customer/client about its product specifications or service benefits is essential. Proper distribution, such that the customers of a company are easily able to acquire its products is critical for a positive return on investment. A company should make its best effort in finding more efficient ways to improve its service offerings and delivery systems.
5. Does the company have a healthy profit margin?
A company’s sales growth should be corresponding with its profits. If a company’s sales are growing but its profits are stagnant, then there might be a problem in that company. This is why it is a better option to look for the profit margin of a company. A company with a high-profit margin is a good company to invest in. Common mathematical analysis of a company always measures its yearly revenues and profit margins.
6. Company’s efforts towards maintaining and improving its profit margins:
A stock should be purchased on the basis of expectation of its future earning capacity, and not on its current earnings. For example, Tesla is currently a loss-making company, but people expect electric cars to be the future of our world.
Increasing costs can decrease the ability of a company to maintain its profit margins. We should buy the shares of those companies which can maintain their profits by increasing the price of their products. Ideally, we should look to buy those companies which have capital improving programs, and through which they try to design new equipment which can reduce the manufacturing cost of their products.
7. Labour turnover, personnel relations, and employee growth:
Companies which generate profits by reducing wages to a point which is below the industry standards are likely to have negative relations with their laborers. We shouldn’t invest in these companies. To identify these companies, we can look at the grievance cell. Companies that make an effort to solve all the grievances of their employees are likely to have good labor relations. Regular labor strikes is not a good sign, whereas companies that generate high profits and pay high wages as well are optimal to invest in. Companies with high employee retention and growth signify a positive image of personnel relations. Those companies have a higher rate to succeed in the future.
8. Relation with executive personnel:
The company which offers the best investment opportunities is the company where a good executive climate exists. Promotions in a company should be based on the ability of a person. A company’s management is responsible for making crucial decisions and adjustments. Hence, we should analyze the relations between a company and its executives before investing in it.
9. Stability, organization, and approach of the management:
It is vital to have stable and organised management with a good depth of knowledge, where newer ideas and changes can be implemented. This enables the introduction of better processes, efficient practices, and even improved products/services that help a company to maintain a healthy growth rate. A top management which evaluates suggestions from low-ranked personnel in the same organization is a positive sign.
10. Cost analysis, accounting, and auditing techniques:
A successful company should diversify its revenue generation, i.e., it should develop several good products. If one product flops, other products will make up for that loss. The overall cost of an organization should be divided, and all the unnecessary costs should be deleted. Proper accounting techniques provide the opportunity for an investor to make a well-informed decision using economic, mathematical, and statistical analysis of such numerical data.
A company which has a higher than average insurance costs will have lower profit margins than its competitors. Strong patent positions can give a company an easier path to high sustained profits. As soon as a patent's tenure ends, a company’s profits may suffer badly. Patents are not relevant for every industry.
Aspects such as skilled labors, past experiences, reputation, existing market share, or even patents help a company gain a competitive advantage. Philip Fisher suggests investors evaluate companies with such traits.
12. Does the company focus on short-run or long-run gains in profit?
The author recommends investing in companies which have long-term plans because it signifies they have stronger foundations and relations with their vendors, customers, and clients. Such companies have a higher potential to exploit their existing market share.
A company with a short-term approach will try to generate maximum returns for the current period, while a company with a long-term approach may report losses in the current period but will surely generate high profits in the long run.
13. Does the company have sufficient growth potential to allow stockholders to benefit from that growth?
Investors should analyze a company's debt and its potential to repay its debts. A company which takes heavy debt or equity financing is a bad sign. For checking whether a company is debt heavy or not, solvency ratios like Debt/equity ratio, etc. should be used. Any organization which can finance its growth through its retained earnings or without taking a huge amount of debt is a positive sign. Investors should look to invest in these companies.
If a company has many dilutive securities, it is not a good sign because dilutive securities have the potential to reduce a shareholder’s return.
14. Approach of management towards investors in times of distress:
During times of trouble, the approach of a management and its communication with the investors becomes an important factor to analyse. A company with a strong contingency plan will talk freely with its investors and vice versa.
The demand for a company’s product is bound to go up or down during its life cycle. Companies which don't disclose information freely during a down point will panic. When in panic, a company’s ability to think critically is lost. Hence, such companies should be avoided.
15. The integrity of the company’s management:
Philip Fisher concludes the chapter with this final point that highlights infinite legal ways through which a management can exploit their power for personal gains. This adversely affects the investor and hence, is an important factor.
An investor should look at the integrity of management. To do this, go back 5 years and check whether the management delivered on what it said. This is very important. A company whose integrity is unquestionable is the one we should buy.