The quest for quality the Philip Fisher way

By Research Desk

---

Even when the numbers look solid, do not invest in a stock without a qualitative evaluation. Do this using Fisher's 15 criteria

There are heaps and heaps of books on the quantitative aspects of stock investing, while far fewer deal with how to evaluate them qualitatively. Philip A. Fisher's Common Stocks and Uncommon Profits is widely acknowledged as the most authoritative work on this aspect of stock investing. No less an investor than Warren Buffett acknowledges his debt to Fisher. It was on account of Fisher's influence that Buffett stopped investing in cheap stocks (something his original mentor Benjamin Graham advocated) and started hunting for quality growth stocks, even if he had to pay a substantial price for them.

In his book Fisher suggests 15 qualitative parameters which can enable investors to discover quality growth stocks. Fisher says that investors can hold on to such quality stocks for decades. As these companies grow in size and their market value expands, so will the investor's wealth. Fisher allows a small concession: he admits that not every company is going to fulfil all his 15 criteria, and yet some of them could be worthwhile purchases. Let us now turn to his 15 criteria:

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for several years?
A company that is to enjoy a prolonged period of spectacular growth must have products that address large and expanding markets.

2. Does the management have the determination to continue developing products and processes that would further increase sales when the potential of currently attractive product lines has been exploited?
Eventually all markets mature. To maintain above-average growth over decades, a company must continually develop new products, expand existing markets, or enter new ones. It could even try a combination of all these options.

3. How effective are the company's research and development efforts in relation to its size?
A company's R&D efforts must be efficient and effective at the same time.

4. Does the company have an above-average sales organisation?
In this highly competitive era, few products or services can sell well in the absence of expert merchandising.

5. Does the company have a worthwhile profit margin?
It is not enough for a company to show tremendous growth; growth must also lead to a worthwhile level of profits so that investors can be rewarded.

6. What is the company doing to maintain or improve its profit margins?
According to Fisher, "It is not the profit margins of the past but those of the future that are important to the investor." A company's strategy for reducing costs and expenses is vital.

7. Does the company have outstanding labour and personnel relations?
The investor should reassure himself on this count as frequent and prolonged strikes disrupt production.

8. Does the company have outstanding executive relations?
A company should work hard on maintaining good morale among its executives. This is possible if there is no favouritism, and when performance is the only yardstick for promotion.

9. Does the company have depth in its management?
When a company starts growing at an exponential pace, a deep pool of management talent becomes a prerequisite for sustaining growth. Hence, the company's top management cadre must shoulder the responsibility of nurturing tomorrow's leaders seriously.

10. How good are the company's cost analysis and accounting controls?
Fisher writes, "If the management does not have a precise knowledge of the true cost of each product in relation to others, it is under extreme handicap." He further adds that without a full understanding of its cost structure, the company will never be able to fully utilise its strengths or work on its weakness. A discerning investor should find out which companies keep a tight rein on costs, as these are the right companies to invest in.

11. Are there other aspects of the business, somewhat peculiar to the industry concerned, which can give the investor clues regarding whether the company stands out vis-à-vis its competition?
It is critical for the investor to understand which factors determine success in a particular industry, and how a particular company stacks up vis-à-vis its rivals on these counts. Relevant mathematical ratios and a comparison of companies within the same industry can provide the right answers.

12. Does the company have a short-range or long-range outlook regarding profits?
Investors who are scouting for quality stocks should favour companies with a long-range outlook. The easiest way to check this fact is by examining how the company treats its suppliers, vendors, customers and all those involved with the company on a contractual basis. A company that suffers a loss in order to maintain its business relations with one of these stakeholders will show a one-time dip in its profit, but will more than make up for it over the years through the goodwill that it earns.

13. In the foreseeable future, will the growth of the company require so much equity financing that the larger number of shares outstanding will almost cancel the existing stockholders' earnings from the anticipated growth?
Investors should seek out companies with sufficient cash or borrowing capacity to be able to fund growth without diluting the interests of its current shareholders, as follow-on equity offerings do.

14. Does management talk freely to investors about its affairs when things are going well but clam up when troubles and disappointments occur?
Every company will go through difficult phases. Fisher has strong opinions on management's level of candour. He says: "...the investor will do well to exclude from investment any company that withholds or tries to hide bad news."

15. Does the company have a management possessing unquestionable integrity?
Accounting scandals that have taken place in the past highlight the importance of management that puts shareholders' interests above its own. Warns Fisher: "Regardless of how high the rating may be in all other matters, if there is a serious question about the lack of a strong sense of trusteeship in the management towards shareholders, the investor should never seriously consider participating in such an enterprise."

Conducting such an elaborate qualitative evaluation of a company would certainly take a lot of time, as it requires interviewing different stakeholders to gain insight into aspects of the company that don't necessarily figure into any published reports. Fisher's answer to this problem was to run a highly concentrated portfolio comprising barely eight to 10 stocks