Many investors have heard of Warren Buffett, but perhaps less know of Phillip Fisher and his stock investing rules.
Fisher is one of the investment greats with a stellar track record of investing in well-managed, high-quality growth stocks for the long term.
His most famous investment was that of Motorola – he bought the stock in 1955 and did not sell it for the remainder of his life (he passed away in 2004).
In his book “Common Stocks and Uncommon Profits”, Fisher came up with a checklist of 15 characteristics to look out for when it comes to buying growth stocks.
Part 1 of this series shall look at his first three criteria.
1. Does the company have the products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
For the first point, Fisher is challenging the investor to study the potential of the company’s products or services to command a significant market share.
These products or services may groundbreaking enough to beat the competition such that customers will choose the company’s products over its competitors.
Sales growth is one of the key attributes to look for when assessing a growth company as it is the main driver of profit growth.
The key here is to assess if the products have “market potential”, a term that refers to whether the company has a unique selling proposition or competitive moat compared to its competitors.
For instance, would its product pipeline enable the company to grow its sales over time, or will price competition erode whatever margins or advantage the company has?
This is not an easy question to tackle but it is an essential one if you wish to find out if the company you are researching has revenue growth potential over the long term.
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potentials of currently attractive product lines have largely been exploited?
In this second point, Fisher looks at the company’s research and development (R&D).
Most manufacturing companies will allocate some of their budgets to R&D spending to ensure they develop products and/or services which remain in demand, and to upgrade their older products over time.
One way to measure this is to review the Company’s R&D expenditure with its revenue and to compare this % across its competitors.
Generally, larger and more established companies need to spend less on R&D as a % of their sales.
This gives them an edge as it allows them to remain competitive but may stunt other smaller companies that may not have the same financial muscle.
Next, you should assess if the new products which the company is developing have good sales potential when compared to existing products.
The company will usually articulate this in their management discussion and analysis (MD&A) section on the progress being made with new product development.
It may also give a hint on the market potential for these new products, as well as the timeline for completion as well as sampling and testing (if applicable).
Investors can delve into these facts to get a clearer picture of how the Company will fare by looking at its R&D expenditure, product pipeline and planned marketing strategies for these new products.
3. How effective are the company’s research and development efforts in relation to its size?
This follows up on point two and looks at the effectiveness of the company’s R&D efforts.
The way to do so is to look at sales growth over the years and compare it against the R&D expense as a percentage of revenue.
Perform this same computation for its competitors to get a clear picture of how efficient the company’s R&D effort is.
For example, company A may be spending just 3% of its revenue to enjoy a 10% sales growth, while company B may also be enjoying 10% sales growth but has to spend 10% of its revenue on R&D.
All things being equal, company A has an obvious advantage over company B as it needs to spend a lower proportion of its revenue to achieve a similar quantum of sales growth.
Of course, another factor to consider is the absolute sales generated by each company, as companies with a larger sales “base” generally find it tougher to grow in percentage terms.
A second example would be a scenario where companies C and D both spend 3% of their revenue.
Company C enjoys a strong 15% rise in revenue while company D sees a decline of 5% in its revenue the following year.
From this information, we can conclude that all factors being equal, company C’s R&D efforts bore more fruit than those of company D.
Stay tuned for part two where we look at the next three points within Phillip Fisher’s 15-point checklist.
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Disclaimer: Royston Yang does not own any of the companies mentioned.