Philip Fisher's Risk Scale

By Marc Pentacoff

In Conservative Investors Sleep Well (1975), Philip Fisher lays out a risk scale for growth investors. The descriptor “growth” is superfluous for Fisher - he views his risk schema as applying to all equity investments. As we will see below, for instance, he classifies Graham-style cigar butts in his second worst risk category.

Fisher, however, is looking to buy and hold whereas Graham was looking to sell when he had a sure profit. The great irony, which was not missed by a young Buffett, was that a substantial level of profits from an investment in Graham Newman Corp. was generated when they bought a large block of GEICO, amounting to 25% of partnership assets. This, as it happened, triggered a provision in the Investment Company Act of 1940 and they had to divest the GEICO stock to shareholders, creating a secondary market for the shares just as GEICO began to grow by expanding its coverage universe, en route to becoming the fifth largest auto insurer by 1972.

The purchase and tax-free divestment, for those Graham Newman shareholders who held, was one of the best moves of Graham Newman Corp. It is reported that Buffett, who never owned a share of Graham Newman, had half his assets in GEICO at one time during this period. The reason this investment worked out so well, clearly, is not because it was a “net net,” etc., but because it was purchased at attractive prices and then began to grow.

There are multiple formulations of Philip Fisher’s approach. In the formulation found in Conservative Investors Sleep Well, Fisher argues for evaluating firms on 3 dimensions: (1) their superiority in production, marketing, research, and financial skills, (2) their management and culture, and (3) the overall attractiveness of their business. And then, there is the fourth dimension, aka (4) the stock's valuation in the context of its relative prospects, as derived from the first three dimensions. The relationship between the first three dimensions and the fourth dimension are what determines the risk of an investment for Philip Fisher.

Like Ben Graham and his margin of safety, Philip Fisher’s “risk of an investment” is driven primarily by the price of an investment compared to its value, the latter of which in Philip Fisher is necessarily more liberal than the intrinsic value formulas found in Graham.

Graham is always viewing the past as a source of safety and the future as a hazard, although he does begin to wonder in the mid-1970s if, perhaps, “there is no safety but in growth.” Fisher perspective is nearly the opposite. He does not view the past as a source of safety except insofar as it illustrates the ability of a firm to manage change. The future will be different from the past and will invariably feature accelerating change - he is Heraclitean. And, because of this, the past cannot be considered a source of safety. All investment, in the end, must be justified by the future. It is not a mere hazard.

In this context, Fisher is looking to only invest in the best possible businesses. This philosophy is captured in a quote found at the start of Common Stocks and Uncommon Profits:

“...finding really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear...Listed on the various stock exchanges of the nation today are not just a few, but scores of companies in which it would have been possible to invest, say, $10,000 somewhere between twenty-five and fifty years ago and today have this purchase represent anywhere from $250,000 to several times this amount...within the lifetime of most investors… there were available scores of opportunities to lay the groundwork for substantial fortunes for oneself or one’s children. These opportunities did not require purchasing on a particular day at the bottom of a great panic. The shares of these companies were available year after year at prices which make this kind of profit possible. What was required was the ability to distinguish these relatively few companies with outstanding investment possibilities from the much greater number whose future would vary all the way from the moderately successful to the complete failure.” (Emphasis mine.)

The statement here is not mere opinion. Indexing works because, in the process of buying the index, one also buys that small fraction of securities which perform extraordinarily well. The rounded return mode, aka the most frequent return over, say, a 10-year time frame, is 0%. The mean is significantly higher than the median, indicative of a positive skew in the distribution. It is this average which is understood to approximately represent the return of the index. And just as water runs downhill, if one could only buy the best stocks in the index, the return would be extraordinary.

In a recent examination of some 62,000 global stocks by Bessembinder, et. al. (2019), most stocks did not outperform US monthly treasury bills. Only 40.5% of global stocks and 43.7% of US stocks have outperformed monthly treasuries. The top performing 811 stocks (1.33% of all stocks) accounted for all of global wealth creation since 1990 itself defined as the excess return over monthly treasuries. And while Bessembinder (2017) shows a significant wealth creation skew between 1926 and 2017 in the United States, this skew is even more pronounced internationally with less than 1% of firms accounting for all of the wealth created outside the US. Finally, the paper notes that 5 firms of the 62,000 stocks available - Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOG) (GOOGL) and Exxon (XOM) - account for 8.27% of all net wealth creation.

Now, picking the top 5 firms is arbitrary and simply what the authors of the paper chose but, since we are on Seeking Alpha and discussing Fisher, let’s just reflect on the firm in the 6th position: good old Berkshire Hathaway (BRK.B). This 6th place achievement is all the more remarkable when you consider the size of Buffett’s executive team compared to the others in the top 5. For a long time, Berkshire basically just had Buffett and Charlie Munger - they had no specific technical superiority whatsoever. What technical superiority did they possess? Perhaps just the analytical combination of Graham and Fisher. Buffett, despite the fame of his Grahamite background, has said he is actually 100% Graham, 100% Fisher. Let’s see how Fisher sets up his risk scale.

In determining the risk of an investment, Fisher’s method requires understanding the underlying business and management in detail. This is not, exactly, for the faint of heart - as Buffett says in the above link, Fisher's approach is not as teachable as Graham's method.

Below, we outline the three dimensions of analysis which helps determine the quality of an investment for Fisher. It is this quality which is then compared to the price of the investment to determine whether the investment is conservative.

Superiority in Production, Marketing, Research and Financial Skills

The broad point is that the firm must be way above average in all regards. This means they are the low cost producer or operator, have a strong marketing organization, with an outstanding research and technical team. It means that the firm has superior financial skills, e.g., in terms of its cost accounting, overall financing sophistication, and financial forecasting abilities.

Great Management

The factors which produce the above results are from the people of the firm: the management, employees and overall culture of the firm. As Andy Grove has pointed out, the way to best control complex, ambiguous, and uncertain aspects of business decision making is by cultivating the right culture - this helps employees make the best decisions in the face of complexity, uncertainty and ambiguity. Does the firm's management and employees recognize that the world is changing at an ever-increasing rate? Do the employees genuinely view the firm as a good place to work? Is management willing to “submit itself to the disciplines required for sound growth?” E.g., is the firm willing to lose out on immediate profit for a far greater profit in the future?

A Qualitatively Attractive Business

Does the firm have a sufficient profit margin? What can the particular company do that others would not be able to do about as well? Is the business and its markets naturally attractive? The answers to these questions and elements will dictate the overall quality of the firm.

With that groundwork laid, we can quote from Fisher to illustrate his schema of risk. Lo and behold.

#1 - Best Risk, Cheap Growth

“On the lowest end of the risk scale and most suitable for wise investment is the company that measures quite high in regard to the first three dimensions but currently is appraised by the financial community as less worthy, and therefore has a lower price-earnings ratio, than these fundamental facts warrant.”

#2 - Second Best Risk, Fairly Valued Growth

“The next least risky and usually quite suitable for intelligent investment is the company rating quite high in regard to the first three dimensions and having an image and therefore a price-earnings ratio reasonably in line with these fundamentals. This is because such a company will continue to grow if it truly has these attributes."

#3 - Third Best Risk, Expensive Growth

“Next least risky and, in my opinion, usually suitable for retention by a conservative investor who own them but not for fresh purchase with new funds are companies that are equally strong in regard the first three dimensions but, because of these qualities, have become almost legendary in the financial community, have an appraisal or price-earnings ratio higher than is warranted by even the strong fundamentals...”

#4 - Fourth Best Risk, Traditional Value Investing, cheap stagnant companies

“Continuing up our scale of ascending risks, we come next to the stocks that are average or relatively low in quality with regard to the first three dimensions but have an appraisal in the financial community either lower than, or about in line with, these not very attractive fundamentals. Those with a poorer appraisal than basic conditions warrant may be good speculations but are not suitable for the prudent investor. In the fast-moving world of today there is just too much danger of adverse developments severely affecting such shares.”

#5 - Fifth Best Risk, Expensive Crap

“Finally we come to what is by far the most dangerous group of all: companies with a present financial community appraisal or image far above what is currently justified by the immediate situation. Purchases of such shares can cause the sickening losses that tend to drive investors away from stock ownership in droves and threaten to shake the investment industry to its foundations.”

In our ongoing growth and tech series, exclusive to PRO+ subscribers, we will begin to classify our growth coverage according to this scale, more precisely illustrating our perspective on the relative merits of different growth securities. (See our coverage list below.)

It shouldn’t be a surprise that most growth securities today trade between a risk #2 and #3 - that is, they are fairly valued to overvalued. Quite frankly, a lot of growth securities are overvalued today, more so than in recent years, and there will be pain in due course. Some of this is the nature of the game, of course, because great firms with great prospects only occasionally sell at prices which are clearly unjustified by the future.

Naturally, there is usually a reason why the market discounts the future of a firm which otherwise has significant investment characteristics on the first 3 dimensions. At times, these are due to temporary setbacks from existing growth plans. Or it is due to the limited profitability of the firm during the investment phase of a new project which is sure to grow earnings for years to come. Or perhaps, there is the short-term traders fear of negative news flow - the proverbial “voting” overwhelming the “weighing.” Or perhaps evidence of accelerating growth is underappreciated by the market, and the shares, lagging the actual performance of the firm, have become attractive through the progressive divergence of firm level performance and tardy share price appreciation.

Whatever the reason, history shows that in the flux and vicissitudes of the market, great firms will, at irregular intervals, trade at great prices. ”These opportunities did not require purchasing on a particular day at the bottom of a great panic,” says Fisher. Waiting for the fat pitch, those glimmering Risk #1s, is justified by history and experience.

Please see our companion article on good growth stock analysis written for Seeking Alpha contributors.

PRO+ Exclusive Tech and Growth Coverage:

• Nutanix, Part 2 (7/21/2019)
• Salesforce (7/14/2019)
• Alteryx (6/23/2019)
• Arista Networks (6/16/2019)
• Alphabet (6/9/2019)
• Pure Storage, Part 2 (6/2/2019)
• CrowdStrike (5/26/2019)
• Square (5/19/2019)
• Workday (5/12/2019)
• Apple (5/5/2019)
• Zscaler (4/28/2019)
• MongoDB (4/21/2019)
• Grubhub (4/14/2019)
• Splunk (4/7/2019)
• Booking Holdings (3/31/2019)
• Pure Storage (3/22/2019)
• Nutanix (3/15/2019)

Interesting in signing up for PRO+? Find out more about PRO+ here and sign up here.

See also Newtek Business Services' Dividend Sustainability Analysis (Includes 2020 Annual Dividend Projection) on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.