Checking the Fundamental of the Company
There is a powerful unseen force that allows people to act irrationally. This unseen force is a mindless, lemminglike imitation of others, no matter how irrational their actions may be. We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of superior information but are reacting themselves to the principle of social proof. A snowballing effect occurs.
If you applied the very fundamental business and investment principle of “The Fifteen Points” rather than following the crowd and got your information sources from “Main Street” (individuals who are familiar with the company) instead of Wall Street (analysts), you would never have bought any of the scandal stocks that so penetrated the news of the 2000-2002 bear (down) market. The likes Brokat, Enron, Tyco, and WorldCom are always easily avoided. Those who fell for these stocks depended on gossip and Wall Street opinion rather than fundamental verification of the business’ strengths.
It should be remembered that knowing the rules and understanding these common mistakes will do nothing to help those who do not have some degree of patience and self discipline. In the stock market a good nervous system is even more important than a good head.
The Fifteen Points would easily eliminated all scandal stocks because they were Internet pipe-dreams, or whatever, with basically 1999 hype but nothing real there, only hope and thin air to support them. Think how many Internet stocks had no real profit margin at all and no plan to achieve profitability much less to improve it, and no fundamental research, and no ability to exist without future equity financing. And, and, and. They couldn’t have made it on half the Fifteen Points. Then, too, the Fifteen Points by exclusion would have eliminated quite a lot of other weak companies but they would have served you nicely - getting you into the high quality companies, which might today lay the groundwork for a great fortune for you.
The Fifteen Points
What need investor to know if he or she is to obtain the type of investment which in few years might show him a gain of several hundred percent, or over a longer period of time might show a correspondingly greater increase. In other words, what attributes should a company have to give it the greatest likelihood of attaining this kind of results for its shareholders?
These Fifteen Points are about very fundamental business features that can’t be faked. It is a basic investment principle that seems only understood by a small minority of successful investors.
1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products that will further increase total sales when the growth potential of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
Comments to point 1, 2 and 3:
Point one is a matter of fact and point two is a matter of management attitude.
A high order of management ability is a must. This is the most basic point – the competency of top management itself. No company grows for a long period of years just because it is lucky. It must have and continue to keep a high order of business skill, otherwise it will not be able to capitalize on its good fortune and to defend its competitive position from the inroads of others.
Investor must be alert and watch if the management is and continues to be in highest order of ability; without this, the sales growth will not continue. But not even the most outstanding growth companies need necessarily to be expected to show sales for every single year larger than those of the year before. Changing in the business cycle would have an effect on sales and earnings. It is the nature of business that even the best-run companies unexpected difficulties, profit squeezes, and unfavorable shifts in demand for their products will at time occur.
Two types of companies that could expect to achieve above-average growth are “fortunate and able” and “fortunate because they are able.” Studies of the history of corporations such as Du Pont, Intel, L’Oréal, Sony, Nestlé, Motorola show how clearly this type of company falls into the fortunate because they are able. If Du Pont had stayed with its original product, blasting powder, the company would have fared as well as most typical mining companies. But because Du Pont capitalized on the knowledge it had gained through the manufacturing of gunpowder, Du Pont was able to launch new products, including nylon, cellophane, and Lucite. These products created their own markets, producing billions of dollars in sales for Du Pont. Du Pont would not have succeeded over the long term without a significant commitment to research and development. Even non-technical businesses need a dedicated research effort to produce better products and more efficient services.
The investors usually obtains the best results in companies whose R&D (Research & Development) is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities. This does not mean that a desirable company may not have a number of divisions, some of which have product lines quite different from others. It does mean that a company with research centered around each of these divisions, like a cluster of trees each growing additional branches from it own trunk, will usually do much better than a company working on a number of unrelated new products which, if successful, will land in several new industries unrelated to its existing business.
Great companies will constantly through the efforts of R&D tries to produce and sell new products. By the law of averages, some of these are bound to be costly failures. Other will have unexpected delays and heartbreaking expenses during the early period of plant shakedown. For months on end, such extra and unbudgeted costs will spoil the most carefully laid profit forecasts for the business as a whole. Such disappointments are an inevitable part of even the most successful business. Even the most brilliantly managed companies; a percentage of failures are part of the cost of doing business. If met forthrightly and with good judgment, they are merely one of the costs of eventual success. They are frequently a sign of strength rather than weakness in a company.
It is apt to take from five to seven or more years from the time a research project is first conceived until it has a significant favorable effect on corporate earnings. Therefore, even the most profitable research project is pretty sure to be a financial drain before it eventually adds to the stockholders’ profit. If the cost of research is high, the cost of too little research may be even higher.
The degree of skill of experts is only part of what is needed to produce outstanding results. It is also necessary to have leaders who can coordinate the work of people of such diverse backgrounds and keep them driving toward a common good.
Close and detailed coordination between research workers on each project and those thoroughly familiar with both production and sales is very important. It is no simple task for management to bring about this close relationship between R&D, production, and sales.
A company that has already proven itself, that has produced a good flow of profitable new products during the past five to ten years will probably be equally productive in the future as long as it continues to operate under the same simple, crystalline concept that flows from deep understanding about the intersection of the following circles:
1) What can we be the best in the world at (and, equally important, what we cannot be the best in the world at)?
2) What drive our economic engine?
3) What are we deeply passionate about? The idea here is not to stimulate passion but to discover what makes you passionate.
The great companies are more like hedgehogs – simple, dowdy creatures that know “one big thing” and stick to it. The bad companies are more like foxes – crafty, cunning creatures that know many things yet lack consistency.
There is a powerful unseen force that allows managers to act irrationally and supersede the interests of its shareholders. The force is the institutional imperative – mindless, lemminglike imitation of other managers, no matter how irrational their actions may be. (Be aware of managers who justify their actions based on the logic that if other companies are doing it, it must be all right. One measure of management’s competence is how well they are able to think for themselves and avoid the herd mentality.
If you talk to the company asked him or her this question:
“What are you doing that your competitors aren’t doing yet?” The emphasis was on the word yet.
The company that is always asking itself that question never become complacent. It is never caught behind. It never starves for intellectual grist to chew through toward a better future. It engages in continuous self-analysis and in a never-ending search for improvement. It is the company that coupled with the integrity and management intellect lives the Fifteen Points. It is the company that constantly will be the industry leader.
“What are you doing that your competitors aren’t doing yet?” implies driving the product market, forcing others to follow, and dominating for the betterment of customers, employees, and shareholders, which is a sheer greatness.
Regardless of the size of the company, what really counts is the management having both a determination to attain further important growth and an ability to bring its plans to completion. The general characteristic of such companies is the management that does not let its preoccupation with long range planning prevent it from exerting constant vigilance in performing the day-to-day tasks of ordinary business outstanding well.
4. Does the company have an above-average sales organization?
It is the making of sale that is the most basic single activity of any business. Without sales, survival is impossible. It is the making of the repeat sales to satisfied the customers that are the first benchmark of success. Look around you at the companies that have proven outstanding investments. You will see the companies that have both well to highly developed logistics and distribution and a constantly improving sales organization.
One time profit can be made in the company that because of manufacturing or research skill obtains some worthwhile business without a strong sale organization. However, such companies can be quite vulnerable. For steady long-term growth a strong sales arm is vital.
In today competitive world, many things are important to corporate success. However, outstanding sales, R&D (Research & Development), and production may be considered the three main columns upon which such success is based. Saying that one is more important than another is like saying that the heart, the lungs, or the digestive tract is the most important single organ for the proper functioning of the body. All are needed for survival, and all must function well for vigorous health.
The sales organization becomes the inevitable link between the marketplace and the R&D unit. It is the responsibility of the sales organization to help customers understand the benefits of a company’s products and services.
5. Does the company have a worthwhile profit margin?
From the standpoint of the investor, sales are only of value when and if they lead to increased profits. The first step in examining profits is to study a company’s profit margin, that is, to determine the number of cents of each dollar or sales that is brought down to operating profit. Most of the really big investment gains have come from companies having relatively broad profit margins.
Superior investment returns are never obtained by investing in marginal companies. Those companies often produce adequate profits during expansion periods but see their profits decline rapidly during difficult economic times. For this reason invest in companies that are not only the low cost producer of products or services but are dedicated to remaining so. A company with a low breakeven point, or a correspondingly high profit margin, is better able to withstand depressed economic environments. Ultimately it can drive out weaker competitors thereby strengthening its own market position. A company that is able to maintain adequate cost controls over its assets and working capital needs is better able to manage its cash needs and avoid equity financing.
High profit margins reflect not only a strong business but also management’s tenacious spirit for controlling costs. Indirectly, shareholders own the profits of the business. Every dollar that is spent unwisely deprives the owners of the business a dollar of profit. Companies with high-cost operations typically find ways to sustain or add to their costs, whereas companies with below-average costs pride themselves on finding ways to cut expenses.
When companies loudly report, “Record earnings per share,” investors are misled into believing that management has done a superior job year after year. A true measure of annual performance, because it takes into consideration the company’s ever-growing capital base, is return on equity – the ratio of operating earnings to shareholder’s equity.
The cash-generating ability of a business determines its value. No earnings are created equal. Companies with high fixed assets to profits will require a larger share of retained earnings to remain viable than companies with lower fixed assets to profits, because some of the earnings must be earmarked to maintain and upgrade those assets. To determine the real cash flow (owner earnings), add depreciation, depletion, and amortization charges to net income and then subtract the capital expenditures the company needs to maintain its economic position and unit volume.
How management reinvests cash earnings will determine whether you will achieve an adequate return on your investment. If your business generates more cash than is needed to remain operational, observe closely the actions of management. A rational manager will only invest excess cash in projects that produce earnings at rates higher than the cost of capital. If those rates are not available, the rational manager will return the money to shareholders by increasing dividends and buying back stock. Irrational managers will constantly look for ways to spend cash rather than return the money to shareholders. Instead of buying back shares or raising dividend, they often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is overpriced and completely beyond his or her realm of understanding. There is a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them. This insures that losses will be maximized. Often billion of dollars are spent on exciting acquisitions and rampant restructuring, then those no longer exciting acquisitions are sold off for less than the original price. Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette? Loss of focus is what most worries investors when contemplate investing in business that general look outstanding. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.
If the company has been able to earn above-average returns on capital, the gain in market value of the business should exceed the sum of the company’s retained earnings, thus creating more than one dollar of market value for every dollar retained.
In regard to young companies and occasionally older ones will sometimes deliberately decide to accelerate their growth by spending all of the profits they would otherwise have earned on even more R&D (Research & Development) and on even more sales promotion than it would otherwise be doing. What is important in such instances is to make absolutely certain that is actually still further R&D, still further sales promotion, and still more of any other activities which are being financed today to build the future, which are the real cause of the narrow or non-existing profit margin. However, with exception of companies of this type, investors desiring maximum gains over the years should best stay away from low-profit margin or marginal companies.
6. What is the company doing to maintain or improve profit margin?
Remember, it is not the profit margins of the past but those of the future that are basically important to the investor. Some companies achieve great success by maintaining product-engineering departments. The core function of such departments is to design new equipments that will reduce the costs and thus offset or partially offset the rising trend of wages. The prospective investor should give attention to the amount of ingenuity of the work being done on new ideas to improving profit margins. The companies that are doing the most successful work along this line are very likely to be the ones that have built up the organization with know-how to continue doing great things in the future. They are likely to be in the group that offers the greatest long-range rewards to their shareholders.
7. Does the company have outstanding labor and personal relations?
Most investors may not fully appreciate the profits from good labor relationships. Few of them fail to recognize the impact of bad labor relationship. However, the difference in profitability between a company with good labor relationships and one with mediocre labor relationships is far greater than the direct cost of strikes. If worker feel that they are fairly treated by their employer, a background has been laid wherein efficient leadership can accomplish much in increasing productivity per worker. Furthermore, there is considerable cost in training each new worker. Those companies with an abnormal labor turnover have therefore an element of unnecessary expenses, which can be avoided by better-managed enterprises.
Great companies usually have genuine desire and ability to treat their employees well. Some of the companies with the very best labor relationships are completely unionized, but they have learned to get along with their union with a reasonable degree of mutual respect and trust.
The company that makes above average profits while paying above average wages for the area in which it is located is likely to have good labor relationships.
8. Does the company have outstanding executive relations?
If having good relationship with workers is important, a good relationship among the members of Chief Executive Office is vital. These are men whose judgment, ingenuity, and teamwork will in time make or break any venture. The company that offers greatest opportunities will be the one that has a good executive climate. From the lowest levels on up to top executives there is a feeling that promotions are based on ability, and not factionalism. Salary adjustments are reviewed regularly. Salaries are in line with the standard of the industry and the locality. Management will bring outsiders into anything other than starting jobs only if there is no possibility of finding anyone within the organization who can be promoted to fill the position.
9. Does the company have depth to its management?
The investor should have some idea of what can be done to prevent corporate disaster if the key man should no longer be available. Nowadays this investment risk with an otherwise outstanding small company is not as high as it seems, in view of the recent tendency of big companies with plenty of management talent to buy up outstanding smaller units.
Companies worthy of investment are those that will continue to grow. Sooner or later a company will reach a size where it just will not be able to take advantage of further opportunities unless it starts developing executive talent in some depth.
Development of proper management in depth can only occurs if there is delegation of authority. If from the very top on down, each level of executives is not given real authority to carry out assigned duties in the way as ingenious and efficient as each individual’s ability will permit, good executive materials become much like healthy young animals so caged in that they cannot exercise. They do not develop their faculties because they just do not have enough opportunity to use them.
Those organizations where the top personally interfere with and try to handle routine day-to-day operating issues seldom turn out to be the most attractive type of investments. No matter how able one or two bosses may be in handling all this detail, once a corporation reaches a certain size executives of this type will get in trouble on two fronts. First, too much detail will have arisen for them to handle. And second, capable people just are not being developed to handle the still further growth that should lie ahead.
10. How good are the company’s cost analysis and accounting controls?
No company is going to have outstanding success for a long period of time if it cannot break down its overall costs with sufficient accuracy and detail to show the cost of each small step in the operation. Only in this way will a management know what most needs its attention.
If the management does not have a precise knowledge of the true cost of each product in relation to the others, the company is under an extreme handicap. It becomes almost impossible to establish pricing policies that will insure the maximum obtainable overall profit consistent with discouraging undue competition. There is no way of knowing which products are worthy of special sales effort and promotion. Worst of all, some apparently successful activities may actually be operating at a loss and unknown to management.
A company well above average in most other aspects of business skill will probably be above average in this field, too, because great company understands the basic important of experts accounting controls and cost analysis.
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues about how outstanding the company may be in relation to its competition?
Patents are usually able to block off only a few rather than all the ways of accomplishing the same results. In fact, when large companies depend largely on patent protection for the maintenance of their profit margin, it is usually more a sign of weakness than strength. Patents do not run on indefinitely. When the patent protection no longer there, the company’s profit may suffer badly. R&D that is constantly improving the products can prove more advantageous than mere static patent protection. It has been true many times that it is the constant leadership in engineering, and not patent, that is the fundamental source of protection.
12. Does the company have a long-range outlook in regard to profits?
Some companies will conduct their affairs to gain the greatest possible profit right now. Others will deliberately curtail maximum immediate profits to build up goodwill and thereby gain greater overall profits over a period of years. The company that will go to special trouble and expense to take care of the needs of regular customers may show lower profits on the particular transaction, but far greater profits over the years. The investor wanting maximum results should favor companies with a truly long-range outlook concerning profits.
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares than outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
Company’s cash plus further borrowing ability should be sufficient to take care of the capital needed to exploit the prospects of the next several years. If the borrowing ability is not sufficient, however, equity financing becomes necessary. In this case, the attractiveness of the investment depends on careful calculation of how much the dilution resulting from the greater number of shares to be outstanding which will cut into the stockholder benefits.
14. Does the management talk freely to investors about its affairs?
Investors will do well to exclude investment in any company that withholds or tries to hide bad news. You can tell much about CEOs by the way they communicate to their shareholders. Does the management report the progress of the business in such a ways that you understand how each operating division is performing? Does the management confess its failures as openly as it trumpets its success? Most important, does management forthrightly proclaim that the company’s prime objective is to maximize the total return of their shareholder’s investment?
15. Does the company have a management of unquestionable integrity?
Without breaking the law, the numbers of ways in which those in control (the management) can benefit themselves at the expense of the ordinary shareholders are almost infinite. There is only one real protection against abuses. This is to confine investments to companies that have a highly developed sense of trusteeship and moral responsibility to their shareholders. If there is a serious question about the lack of a strong management sense of integrity, the investor should never consider himself or herself participating in such an enterprise. Superbly managed companies usually have a management of unquestionable integrity.
Probably most costly of all to the investor is the abuse by insiders of their power of issuing stock options. Abuse in issuing stock options often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance.
If you applied these fifteen points and got your information sources from “Main Street” (competitors, customers, and suppliers) instead of analysts’ noise (Wall Street), you would never have bought any of the scandal stocks that so penetrated the news of the 2000-2002 bear (down) market. The likes Brokat, Enron, Tyco, and WorldCom are always easily avoided. Those who fell for these stocks depended on gossip and Wall Street opinion rather than fundamental verification of the business’ strengths.
The Fifteen Points would easily eliminated all scandal stocks because they were Internet pipe-dreams, or whatever, with basically 1999 hype but nothing real there, only hope and thin air to support them. Think how many Internet stocks had no real profit margin at all and no plan to achieve profitability much less to improve it, and no fundamental research, and no ability to exist without future equity financing. And, and, and. They couldn’t have made it on half the Fifteen Points. Then, too, the Fifteen Points by exclusion would have eliminated quite a lot of other weak companies and would have served you nicely - getting you into the high quality companies.
In 2000-2002 we have had the worst bear market since the great depression in 1974 or the other great depression in 1937-1938. An extended bear market can test everybody’s patience and unsettle the most experienced investors. No matter how good you are at picking stocks, your stocks will go down, and just when you think the bottom has been reached, they will go down some more. Many investors have had their faith in prior investment belief shattered. But if you own companies that have the Fifteen Points and don’t get carried away by what are “fads and fancies,” you will come through this period just fine. When the prices are at their lowest and the company is still in terrific shape, the company that possesses the Fifteen Points, this is exactly the perfect time to buy more shares. The price might go lower before it goes up again. But it won’t matter much a few years from now.
One of the most important personal qualities needed if big profits are to be made from investment is patience. Unless you have the patience and the courage to hold on to the shares during the corrections, you’re an odds-on favorite to become a mediocre investor. It’s not always brainpower that separates good investors from bad, often it’s discipline.
Moving with the herd, doing what everybody else is doing, and therefore what you have an almost irresistible urge to do (social pressure), is almost often the wrong thing to do at all. I thought the difficulties of the crowd of small investors who have unintentionally picked up all sorts of ideas and investment notions that can prove expensive over a period of years, possibly because they had never been exposed to the challenges of more fundamental investment concepts. Practice thinking for yourself using solid investment fundamentals as your guide rather than following the herd.
Finding the really outstanding companies and staying with them through all the fluctuations of the stock market proved far more profitable than to move in and out of market, trying to catch the waves. What is important is 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. If you use the solid investment fundamentals as your guide rather than following the crowd and Wall Street noise (analysts), you might discover some young enterprise, which might today lay the groundwork for a great fortune for you.
Reading only the financial reports of a company is not enough to justify an investment. The essential step in conservative investing is to uncover as much about the company as possible from those individuals who are familiar with the company. Scuttlebutt - a cross-section of the opinions of those who in one way or another are concerned with any particular company – will provide substantial clues that will enable you to identify outstanding investments.
From the Fifteen Points I could fathom generally where a company fit into the market competition and how it would or wouldn’t prosper. And Scuttlebutt is simply about finding out from “Main Street” sources if a company is strong or weak. Most people don’t use this approach, relying instead on the local rumor and Wall Street noise (analysts).
The Scuttlebutt
Scuttlebutt means avoiding malarkey mills (local rumors, analysts’ noise, etc.) and seeking information from competitors, customers, and suppliers, all of whom have a vested interest in the target company, and few of whom have any reason to see the company unrealistically. It means talking to sales representatives of a company’s competitors, who inherently have a basis to see the competitors negatively but typically don’t if the competitor is great. It means talking to the research people and management members of the competitors as well. If all those people see the strength in the competitor’s operation and respect it or even fear it, well, simply said, it isn’t Brokat or WorldCom. You can count on it.
If you applied this process over the years to lots of stocks you would gain insights to the key areas you need to focus on to gain important information about the company you want to buy. The keys are focus on the customers, competitors, and suppliers.
Consider the scandal stocks or other overvalued portfolios. Not one could have passed the test via scuttlebutt because if you talked to competitors, they weren’t overly scared of those slinky companies. If you talked to the customers or suppliers, they weren’t overly impressed either. The customers weren’t impressed because the products weren’t all that good by relative comparison. The venders and suppliers weren’t all that impressed because the vendor’s other customers would have been doing better and ordering more – the real sales volume wasn’t there. And the competitors would not have held these companies in awe because they did not hold them at competitive disadvantage.
It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a cross-section of the opinions of those who in one way or another are concerned with any particular company. Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge. However, competitors are only one source of information. It is equally astonishing how much can be learned from both vendors and customers about the real nature of the companies with whom they deal. In the case of really outstanding company, the preponderant information is so crystal clear that even a house wife who knows nothing about business will be able to tell you which companies are likely to be of interest to taking the next step of investigation.
In appraising the business characteristics of companies, you need only to devote a tiny fraction of time or mental effort. Sit down in an undisturbed isolation and pore over balance sheets, corporate earning statements, and trade statistics, you will glean important information about the company, in which you want to invest. Your goal is to get the greatest total profit for the least risk. Successful investor is usually an individual who is inherently interested in business problems.
Recognize the basic improvement in fundamentals that started some years before. And then buy the company’s shares just before the improvement in earning power has been reflected in the market price for these shares can similarly mean a chance to get into the right sort of company at the right time. If the particular increase in earnings has not yet produced an upward move in the price of the company’s shares in one or two years, an investor will still in the long run make money if he buys into outstanding companies.
Investors should ignore any guesses on the coming trend of general business or the stock market. Instead he should invest as soon as the suitable buying opportunity arises. In contrast to guessing which way general business or the stock market may go, he should be able to judge with only a small probability of error about what the company is going to do in relation to business in general. He is making his bet upon something that he knows to be the case, rather than upon something about which he is largely guessing.
Young growth companies have the greatest possibility of gain. Sometimes this can mount up to several thousand percent in a decade. But making at least an occasional investment mistake is inevitable even for the most skilled investor. If the stock is bought according to the Fifteen Points rule any losses that might occur should be temporary, resulting from a period of unanticipated decline in the stock market as a whole. Meanwhile, if properly selected, the so-called high risky type could significantly increase the total capital gain, but the risk has more to do with the investors than with the categories. These young “risky” companies will by time reach a point in their own development where their stocks will no longer be carrying anything like the former degree of risk but may even have progressed to a status when institutions have begun buying them. The growth stocks, over five or ten year span, have proven spectacularly better so far as their increase in capital value is concerned. The growth stocks had not only shown a marked superiority in the field of capital appreciation, but also given a reasonable time, they had grown to a point where they showed superiority in the matter of dividend return as well.
What to sell
If mistake is recognized quickly, losses, if any, should be smaller than if the stock bought in error judgment had been held for a long period of time. Even more important, the money that was tied up in the undesirable situation is freed to be used for something else that, if properly selected, should produce substantial gains.
However, there is a complicating factor that makes the handling of investment mistakes more difficult. If we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous thing in which we can indulge ourselves in the entire investment.
More money has probably been lost by investors holding a stock they really did not want until they “could at least come out even.” If to these actual losses are added the profits that might have been made through the proper reinvestment, the cost of self-indulgence becomes truly big.
Furthermore this dislike of taking a loss, even a small loss, is just illogical. If the real objective of common stock investment is the making a gain of a great many hundreds percent over a period of years, the difference between, says, a 20 percent loss becomes a comparatively insignificant matter.
While losses should never cause strong self-disgust or emotional upset, neither should they be passed over. They should always be reviewed with care so that a lesson can be learned from each of them. If the particular elements that caused a misjudgment on a common stock purchase are thoroughly understood, it is unlikely that another poor purchase will be made through misjudging the same investment factors.
If the stocks no longer qualify to the Fifteen Points, they should be sold. This is why investors should be constantly alert. It explains why it is of such importance to keep at all times in close contact with the affairs of the companies.
When companies deteriorate they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did.
Sometimes management deteriorates because success has affected one or more key executives. Smugness, complacency, or inertia replaces the former drive and ingenuity. Success can expose us to dangerous consequences. A kind of paradoxical claim to make about something we all reach for, yet it’s true. Everybody battles for success; too few people are aware of its profound impact. Success tends to breed arrogance, complacency, and isolation. Success can lose mind faster than prejudice.
More often management deteriorates because a new top management does not measure up to the standard of performance set by their predecessors. Either they no longer hold to the policies that have made the company outstandingly successful, or they do not have the ability to continue to carry out such policies.
When a deterioration of management happens the affected stocks should be sold at once, regardless of how good the general market may look.
Sometimes deterioration of the company happens because after growing spectacularly for many years, a company will reach a stage where the growth prospects of its market are exhausted. It will only progress at about the same rate as the national economy does. In any event, the company should be recognized as no longer suitable for a worthwhile investment. Such a stock should then be sold. In this instance, selling might take place at a more leisurely pace than if management deterioration had set in.
This kind of change may not be due to any deterioration of the management. Many managements show great skill in developing related or allied products to take advantage of growth in their immediate field. They recognize, however, that they do not have any particular advantage if they jump into unrelated business.
Postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly. Many investors disposed of a company that was to show stupendous gain in the years ahead because of the fear of a coming bear market. Frequently the bear market never came and the stock went right on up.
(When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price, fear of something else happening still prevented their reentry.)
If the company is really the right one, the stock that was purchased short before the bear market; the next bull market should see the stock making a new peak well above those so far attained. And then if it becomes overpriced the stock should be sold.
Overprice means that the stock is selling at an even higher ratio in relation to the expected earning power. But how can one say with moderate precision what is overpriced for an outstanding company with an unusually rapid growth rate?
Suppose that instead of selling at twenty-five times earning, as usually happens to growth stocks, the stock is now at thirty-five times earnings. If the growth rate is so good that in another ten years the company might well have quadrupled, it isn’t really of such big concern whether at the moment the stock might or might not be 35 percent overpriced. If for a while the stock loses, say, 35 percent of its current market quotation, this isn’t really such a serious matter. It is the maintaining of our position rather than the possibility of temporarily losing a small part of our capital gain that is really important.
There is still one other argument investors sometimes use to separate themselves from the profits they would otherwise make. This one is the most ridiculous one of all. It is that the stock they own has had a huge advance. Outstanding companies, the only type that I believe the investor should buy, can grow in many decades. The company behind a stock can have a practice of selecting management talent in depth and training such talent in company policies, methods, and philosophies in a way that will retain and pass on the corporate vigor for generations. Look at Du Pont, L’Oréal, Sony, Motorola after the death of their brilliant founders.
Never sell the stocks as long as the company behind it maintains the characteristic of an unusually successful enterprise. A decade after Wal-Mart came public it gained 20-fold. If you held the stock for another decade, you would overall have made 250-fold gain.
Ten Don’ts for Investors
1. Don’t buy into promotional companies
With promotional companies, you’re better off to wait until they turn a profit before you invest. IPO (Initial Public Offering) of brand-new enterprises are very risky because there’s so little to go on. Four out of five have been long-term disappointments. Waits for earnings. You can get ten baggers in companies that have already proven themselves. It’s never too late not to invest in an unproven enterprise. It’s better to miss the first move in a stock and wait to see if a company’s plans are working out.
2. Don’t ignore a good stock just because it is traded “over the counter”
Actively traded stocks on the stock market have no advantage over the better over-the-counter stocks. Small and medium-size companies sometimes refused to list their stocks on the smaller exchanges. Instead they have chosen the over-the-counter markets until their companies reach a size that would warrant “big board” – that is, NYSE, Nikkei, or DAX – listing.
3. Don’t buy a stock just because you like the tone of its annual report.
Attractive photographs and nicely colored charts do not necessarily reflect an able management team. Allowing the general words and tone of an annual report to influence a decision to purchase a common stock is much like buying product because of an appealing advertisement on billboard and not based on understanding its quality. It is important to go beyond them to the underlying facts. Like any other sales tools they are prone to put a corporation’s “best foot forward.” They seldom present balanced and complete discussions of the real problems and difficulties of the business. Often they are too optimistic.
4. Don’t assume that the high price at which a stock may be selling in relation to earning is necessarily an indication that further growth in those earning has largely been already discounted in the price.
What is important here is thoroughly understanding the nature of the company, with particularly reference to what it may be expected to do some years from now.
If a big earning spurt that lies ahead is a one-time matter, and the nature of the company is not in such a situation, in which new sources of earning will be developed when the present one is fully exploited. Then the high price earnings ration does discount future earnings. This is because, when the present big earning spurt is over, the stock will settle back to the same selling price in relation to its earnings as run-off-mills shares.
However, if the company deliberately and consistently developing new sources of earning power, and if the industry is one promising to afford equal growth spurts in the future, the price-earnings ratio five or ten years in the future is rather sure to be above the average stocks. Stocks of this type will frequently be found to be discounting the future much less than many investors believe. This is why some of the stocks that at first glance appear highest priced may be the biggest bargains.
5. Don’t quibble over eights and quarters
If the stock seems the right one and the price seems reasonably attractive at the current levels, buy “at the market.” The extra eight, or quarter, or half point that may be paid is insignificant compared to the profit that will be missed of the stock is not obtained. Should the stock have not a long term potential, the investor should not have decided to buy it in the first place.
6. Don’t overstress diversification
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.
7. Don’t be afraid of buying on a war scare
War is always bearish on money. To sell stocks at the threatened or actual outbreak of hostilities to get into cash is an extreme financial lunacy. Actually the opposite should be done. Investors should ignore the scare psychology of the moment and definitely begin buying. In every instance, stocks dipped sharply on the fear of war and rebounded sharply as the war scare subsided.
8. Don’t be influenced by what doesn’t matter
Statistics of former years’ earning and particularly of per share price ranges of former years quite frequently have nothing to do with the case.
The company might have fallen into the hands of an inefficient management and slipped so badly in relation to its competitors. Or on the other hand, there might be changes in the management, establishment of an outstanding research department, and the company may have developed a series of new and highly profitable products.
The fact is that a stock has or has not risen in the last several years is of no significance whatsoever in determining whether it should be bought now. What does matter is whether enough improvement has taken place or is likely to take place in the future.
Just knowing, by itself, that four or five years ago a company’s per share earnings were either four times or a quarter of this year’s earnings has almost no significance in indicating whether a particular stock should be bought or sold. Again, what counts is the knowledge of the background/fundamental conditions of the company. An understanding of what probably will happen over the next several years is of really importance. It is the next five years’ earnings, not those of the past five years that now matter to us as investors.
9. Don’t fail to consider time as well as price in buying a true growth stock
When the indications are strong that very important gains in earning power are going to appear, deciding the time you will buy rather than the price at which you will buy may bring you a stock at or near the lowest price.
10. Don’t follow the crowd
Practice thinking for yourself using the very fundamental business and investment principle of “The Fifteen Points” rather than following the herd. There is a powerful unseen force that allows people to act irrationally. The force is mindless, lemminglike imitation of others, no matter how irrational their actions may be. We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of superior information but are reacting themselves to the principle of social proof. A snowballing effect occurs.
Lemmings are small rodent indigenous to tundra region and are noted for their mass exodus to the sea. In normal periods, lemmings move about during their spring migration in search of food and new shelter. Every three to four years, however, something odd begins to happen. Because of high breeding and low mortality, the population of lemmings being to rise. As soon as their ranks swell, lemmings begin an erratic movement under darkness. Soon, this bold group begins to move in daylight. When confronted by barriers, the numbers of lemmings in the pack in creases until the panic-like reaction drive them through or over the obstacle. As this behavior intensifies, lemmings begin to challenge other animals they normally would avoid. Although many lemmings die from starvation, predators, and accidents, most reach the sea. There they plunge in and swim until they die from exhaustion. The behavior of lemmings is not fully understood.
It should be remembered that knowing the rules and understanding these common mistakes will do nothing to help those who do not have some degree of patience and self discipline. In the stock market a good nervous system is even more important than a good head.
If you applied the very fundamental business and investment principle of “The Fifteen Points” rather than following the crowd and got your information sources from “Main Street” (individuals who are familiar with the company) instead of Wall Street (analysts), you would never have bought any of the scandal stocks that so penetrated the news of the 2000-2002 bear (down) market. The likes Brokat, Enron, Tyco, and WorldCom are always easily avoided. Those who fell for these stocks depended on gossip and Wall Street opinion rather than fundamental verification of the business’ strengths.
It should be remembered that knowing the rules and understanding these common mistakes will do nothing to help those who do not have some degree of patience and self discipline. In the stock market a good nervous system is even more important than a good head.
The Fifteen Points would easily eliminated all scandal stocks because they were Internet pipe-dreams, or whatever, with basically 1999 hype but nothing real there, only hope and thin air to support them. Think how many Internet stocks had no real profit margin at all and no plan to achieve profitability much less to improve it, and no fundamental research, and no ability to exist without future equity financing. And, and, and. They couldn’t have made it on half the Fifteen Points. Then, too, the Fifteen Points by exclusion would have eliminated quite a lot of other weak companies but they would have served you nicely - getting you into the high quality companies, which might today lay the groundwork for a great fortune for you.
The Fifteen Points
What need investor to know if he or she is to obtain the type of investment which in few years might show him a gain of several hundred percent, or over a longer period of time might show a correspondingly greater increase. In other words, what attributes should a company have to give it the greatest likelihood of attaining this kind of results for its shareholders?
These Fifteen Points are about very fundamental business features that can’t be faked. It is a basic investment principle that seems only understood by a small minority of successful investors.
1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products that will further increase total sales when the growth potential of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
Comments to point 1, 2 and 3:
Point one is a matter of fact and point two is a matter of management attitude.
A high order of management ability is a must. This is the most basic point – the competency of top management itself. No company grows for a long period of years just because it is lucky. It must have and continue to keep a high order of business skill, otherwise it will not be able to capitalize on its good fortune and to defend its competitive position from the inroads of others.
Investor must be alert and watch if the management is and continues to be in highest order of ability; without this, the sales growth will not continue. But not even the most outstanding growth companies need necessarily to be expected to show sales for every single year larger than those of the year before. Changing in the business cycle would have an effect on sales and earnings. It is the nature of business that even the best-run companies unexpected difficulties, profit squeezes, and unfavorable shifts in demand for their products will at time occur.
Two types of companies that could expect to achieve above-average growth are “fortunate and able” and “fortunate because they are able.” Studies of the history of corporations such as Du Pont, Intel, L’Oréal, Sony, Nestlé, Motorola show how clearly this type of company falls into the fortunate because they are able. If Du Pont had stayed with its original product, blasting powder, the company would have fared as well as most typical mining companies. But because Du Pont capitalized on the knowledge it had gained through the manufacturing of gunpowder, Du Pont was able to launch new products, including nylon, cellophane, and Lucite. These products created their own markets, producing billions of dollars in sales for Du Pont. Du Pont would not have succeeded over the long term without a significant commitment to research and development. Even non-technical businesses need a dedicated research effort to produce better products and more efficient services.
The investors usually obtains the best results in companies whose R&D (Research & Development) is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities. This does not mean that a desirable company may not have a number of divisions, some of which have product lines quite different from others. It does mean that a company with research centered around each of these divisions, like a cluster of trees each growing additional branches from it own trunk, will usually do much better than a company working on a number of unrelated new products which, if successful, will land in several new industries unrelated to its existing business.
Great companies will constantly through the efforts of R&D tries to produce and sell new products. By the law of averages, some of these are bound to be costly failures. Other will have unexpected delays and heartbreaking expenses during the early period of plant shakedown. For months on end, such extra and unbudgeted costs will spoil the most carefully laid profit forecasts for the business as a whole. Such disappointments are an inevitable part of even the most successful business. Even the most brilliantly managed companies; a percentage of failures are part of the cost of doing business. If met forthrightly and with good judgment, they are merely one of the costs of eventual success. They are frequently a sign of strength rather than weakness in a company.
It is apt to take from five to seven or more years from the time a research project is first conceived until it has a significant favorable effect on corporate earnings. Therefore, even the most profitable research project is pretty sure to be a financial drain before it eventually adds to the stockholders’ profit. If the cost of research is high, the cost of too little research may be even higher.
The degree of skill of experts is only part of what is needed to produce outstanding results. It is also necessary to have leaders who can coordinate the work of people of such diverse backgrounds and keep them driving toward a common good.
Close and detailed coordination between research workers on each project and those thoroughly familiar with both production and sales is very important. It is no simple task for management to bring about this close relationship between R&D, production, and sales.
A company that has already proven itself, that has produced a good flow of profitable new products during the past five to ten years will probably be equally productive in the future as long as it continues to operate under the same simple, crystalline concept that flows from deep understanding about the intersection of the following circles:
1) What can we be the best in the world at (and, equally important, what we cannot be the best in the world at)?
2) What drive our economic engine?
3) What are we deeply passionate about? The idea here is not to stimulate passion but to discover what makes you passionate.
The great companies are more like hedgehogs – simple, dowdy creatures that know “one big thing” and stick to it. The bad companies are more like foxes – crafty, cunning creatures that know many things yet lack consistency.
There is a powerful unseen force that allows managers to act irrationally and supersede the interests of its shareholders. The force is the institutional imperative – mindless, lemminglike imitation of other managers, no matter how irrational their actions may be. (Be aware of managers who justify their actions based on the logic that if other companies are doing it, it must be all right. One measure of management’s competence is how well they are able to think for themselves and avoid the herd mentality.
If you talk to the company asked him or her this question:
“What are you doing that your competitors aren’t doing yet?” The emphasis was on the word yet.
The company that is always asking itself that question never become complacent. It is never caught behind. It never starves for intellectual grist to chew through toward a better future. It engages in continuous self-analysis and in a never-ending search for improvement. It is the company that coupled with the integrity and management intellect lives the Fifteen Points. It is the company that constantly will be the industry leader.
“What are you doing that your competitors aren’t doing yet?” implies driving the product market, forcing others to follow, and dominating for the betterment of customers, employees, and shareholders, which is a sheer greatness.
Regardless of the size of the company, what really counts is the management having both a determination to attain further important growth and an ability to bring its plans to completion. The general characteristic of such companies is the management that does not let its preoccupation with long range planning prevent it from exerting constant vigilance in performing the day-to-day tasks of ordinary business outstanding well.
4. Does the company have an above-average sales organization?
It is the making of sale that is the most basic single activity of any business. Without sales, survival is impossible. It is the making of the repeat sales to satisfied the customers that are the first benchmark of success. Look around you at the companies that have proven outstanding investments. You will see the companies that have both well to highly developed logistics and distribution and a constantly improving sales organization.
One time profit can be made in the company that because of manufacturing or research skill obtains some worthwhile business without a strong sale organization. However, such companies can be quite vulnerable. For steady long-term growth a strong sales arm is vital.
In today competitive world, many things are important to corporate success. However, outstanding sales, R&D (Research & Development), and production may be considered the three main columns upon which such success is based. Saying that one is more important than another is like saying that the heart, the lungs, or the digestive tract is the most important single organ for the proper functioning of the body. All are needed for survival, and all must function well for vigorous health.
The sales organization becomes the inevitable link between the marketplace and the R&D unit. It is the responsibility of the sales organization to help customers understand the benefits of a company’s products and services.
5. Does the company have a worthwhile profit margin?
From the standpoint of the investor, sales are only of value when and if they lead to increased profits. The first step in examining profits is to study a company’s profit margin, that is, to determine the number of cents of each dollar or sales that is brought down to operating profit. Most of the really big investment gains have come from companies having relatively broad profit margins.
Superior investment returns are never obtained by investing in marginal companies. Those companies often produce adequate profits during expansion periods but see their profits decline rapidly during difficult economic times. For this reason invest in companies that are not only the low cost producer of products or services but are dedicated to remaining so. A company with a low breakeven point, or a correspondingly high profit margin, is better able to withstand depressed economic environments. Ultimately it can drive out weaker competitors thereby strengthening its own market position. A company that is able to maintain adequate cost controls over its assets and working capital needs is better able to manage its cash needs and avoid equity financing.
High profit margins reflect not only a strong business but also management’s tenacious spirit for controlling costs. Indirectly, shareholders own the profits of the business. Every dollar that is spent unwisely deprives the owners of the business a dollar of profit. Companies with high-cost operations typically find ways to sustain or add to their costs, whereas companies with below-average costs pride themselves on finding ways to cut expenses.
When companies loudly report, “Record earnings per share,” investors are misled into believing that management has done a superior job year after year. A true measure of annual performance, because it takes into consideration the company’s ever-growing capital base, is return on equity – the ratio of operating earnings to shareholder’s equity.
The cash-generating ability of a business determines its value. No earnings are created equal. Companies with high fixed assets to profits will require a larger share of retained earnings to remain viable than companies with lower fixed assets to profits, because some of the earnings must be earmarked to maintain and upgrade those assets. To determine the real cash flow (owner earnings), add depreciation, depletion, and amortization charges to net income and then subtract the capital expenditures the company needs to maintain its economic position and unit volume.
How management reinvests cash earnings will determine whether you will achieve an adequate return on your investment. If your business generates more cash than is needed to remain operational, observe closely the actions of management. A rational manager will only invest excess cash in projects that produce earnings at rates higher than the cost of capital. If those rates are not available, the rational manager will return the money to shareholders by increasing dividends and buying back stock. Irrational managers will constantly look for ways to spend cash rather than return the money to shareholders. Instead of buying back shares or raising dividend, they often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is overpriced and completely beyond his or her realm of understanding. There is a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them. This insures that losses will be maximized. Often billion of dollars are spent on exciting acquisitions and rampant restructuring, then those no longer exciting acquisitions are sold off for less than the original price. Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette? Loss of focus is what most worries investors when contemplate investing in business that general look outstanding. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.
If the company has been able to earn above-average returns on capital, the gain in market value of the business should exceed the sum of the company’s retained earnings, thus creating more than one dollar of market value for every dollar retained.
In regard to young companies and occasionally older ones will sometimes deliberately decide to accelerate their growth by spending all of the profits they would otherwise have earned on even more R&D (Research & Development) and on even more sales promotion than it would otherwise be doing. What is important in such instances is to make absolutely certain that is actually still further R&D, still further sales promotion, and still more of any other activities which are being financed today to build the future, which are the real cause of the narrow or non-existing profit margin. However, with exception of companies of this type, investors desiring maximum gains over the years should best stay away from low-profit margin or marginal companies.
6. What is the company doing to maintain or improve profit margin?
Remember, it is not the profit margins of the past but those of the future that are basically important to the investor. Some companies achieve great success by maintaining product-engineering departments. The core function of such departments is to design new equipments that will reduce the costs and thus offset or partially offset the rising trend of wages. The prospective investor should give attention to the amount of ingenuity of the work being done on new ideas to improving profit margins. The companies that are doing the most successful work along this line are very likely to be the ones that have built up the organization with know-how to continue doing great things in the future. They are likely to be in the group that offers the greatest long-range rewards to their shareholders.
7. Does the company have outstanding labor and personal relations?
Most investors may not fully appreciate the profits from good labor relationships. Few of them fail to recognize the impact of bad labor relationship. However, the difference in profitability between a company with good labor relationships and one with mediocre labor relationships is far greater than the direct cost of strikes. If worker feel that they are fairly treated by their employer, a background has been laid wherein efficient leadership can accomplish much in increasing productivity per worker. Furthermore, there is considerable cost in training each new worker. Those companies with an abnormal labor turnover have therefore an element of unnecessary expenses, which can be avoided by better-managed enterprises.
Great companies usually have genuine desire and ability to treat their employees well. Some of the companies with the very best labor relationships are completely unionized, but they have learned to get along with their union with a reasonable degree of mutual respect and trust.
The company that makes above average profits while paying above average wages for the area in which it is located is likely to have good labor relationships.
8. Does the company have outstanding executive relations?
If having good relationship with workers is important, a good relationship among the members of Chief Executive Office is vital. These are men whose judgment, ingenuity, and teamwork will in time make or break any venture. The company that offers greatest opportunities will be the one that has a good executive climate. From the lowest levels on up to top executives there is a feeling that promotions are based on ability, and not factionalism. Salary adjustments are reviewed regularly. Salaries are in line with the standard of the industry and the locality. Management will bring outsiders into anything other than starting jobs only if there is no possibility of finding anyone within the organization who can be promoted to fill the position.
9. Does the company have depth to its management?
The investor should have some idea of what can be done to prevent corporate disaster if the key man should no longer be available. Nowadays this investment risk with an otherwise outstanding small company is not as high as it seems, in view of the recent tendency of big companies with plenty of management talent to buy up outstanding smaller units.
Companies worthy of investment are those that will continue to grow. Sooner or later a company will reach a size where it just will not be able to take advantage of further opportunities unless it starts developing executive talent in some depth.
Development of proper management in depth can only occurs if there is delegation of authority. If from the very top on down, each level of executives is not given real authority to carry out assigned duties in the way as ingenious and efficient as each individual’s ability will permit, good executive materials become much like healthy young animals so caged in that they cannot exercise. They do not develop their faculties because they just do not have enough opportunity to use them.
Those organizations where the top personally interfere with and try to handle routine day-to-day operating issues seldom turn out to be the most attractive type of investments. No matter how able one or two bosses may be in handling all this detail, once a corporation reaches a certain size executives of this type will get in trouble on two fronts. First, too much detail will have arisen for them to handle. And second, capable people just are not being developed to handle the still further growth that should lie ahead.
10. How good are the company’s cost analysis and accounting controls?
No company is going to have outstanding success for a long period of time if it cannot break down its overall costs with sufficient accuracy and detail to show the cost of each small step in the operation. Only in this way will a management know what most needs its attention.
If the management does not have a precise knowledge of the true cost of each product in relation to the others, the company is under an extreme handicap. It becomes almost impossible to establish pricing policies that will insure the maximum obtainable overall profit consistent with discouraging undue competition. There is no way of knowing which products are worthy of special sales effort and promotion. Worst of all, some apparently successful activities may actually be operating at a loss and unknown to management.
A company well above average in most other aspects of business skill will probably be above average in this field, too, because great company understands the basic important of experts accounting controls and cost analysis.
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues about how outstanding the company may be in relation to its competition?
Patents are usually able to block off only a few rather than all the ways of accomplishing the same results. In fact, when large companies depend largely on patent protection for the maintenance of their profit margin, it is usually more a sign of weakness than strength. Patents do not run on indefinitely. When the patent protection no longer there, the company’s profit may suffer badly. R&D that is constantly improving the products can prove more advantageous than mere static patent protection. It has been true many times that it is the constant leadership in engineering, and not patent, that is the fundamental source of protection.
12. Does the company have a long-range outlook in regard to profits?
Some companies will conduct their affairs to gain the greatest possible profit right now. Others will deliberately curtail maximum immediate profits to build up goodwill and thereby gain greater overall profits over a period of years. The company that will go to special trouble and expense to take care of the needs of regular customers may show lower profits on the particular transaction, but far greater profits over the years. The investor wanting maximum results should favor companies with a truly long-range outlook concerning profits.
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares than outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
Company’s cash plus further borrowing ability should be sufficient to take care of the capital needed to exploit the prospects of the next several years. If the borrowing ability is not sufficient, however, equity financing becomes necessary. In this case, the attractiveness of the investment depends on careful calculation of how much the dilution resulting from the greater number of shares to be outstanding which will cut into the stockholder benefits.
14. Does the management talk freely to investors about its affairs?
Investors will do well to exclude investment in any company that withholds or tries to hide bad news. You can tell much about CEOs by the way they communicate to their shareholders. Does the management report the progress of the business in such a ways that you understand how each operating division is performing? Does the management confess its failures as openly as it trumpets its success? Most important, does management forthrightly proclaim that the company’s prime objective is to maximize the total return of their shareholder’s investment?
15. Does the company have a management of unquestionable integrity?
Without breaking the law, the numbers of ways in which those in control (the management) can benefit themselves at the expense of the ordinary shareholders are almost infinite. There is only one real protection against abuses. This is to confine investments to companies that have a highly developed sense of trusteeship and moral responsibility to their shareholders. If there is a serious question about the lack of a strong management sense of integrity, the investor should never consider himself or herself participating in such an enterprise. Superbly managed companies usually have a management of unquestionable integrity.
Probably most costly of all to the investor is the abuse by insiders of their power of issuing stock options. Abuse in issuing stock options often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance.
If you applied these fifteen points and got your information sources from “Main Street” (competitors, customers, and suppliers) instead of analysts’ noise (Wall Street), you would never have bought any of the scandal stocks that so penetrated the news of the 2000-2002 bear (down) market. The likes Brokat, Enron, Tyco, and WorldCom are always easily avoided. Those who fell for these stocks depended on gossip and Wall Street opinion rather than fundamental verification of the business’ strengths.
The Fifteen Points would easily eliminated all scandal stocks because they were Internet pipe-dreams, or whatever, with basically 1999 hype but nothing real there, only hope and thin air to support them. Think how many Internet stocks had no real profit margin at all and no plan to achieve profitability much less to improve it, and no fundamental research, and no ability to exist without future equity financing. And, and, and. They couldn’t have made it on half the Fifteen Points. Then, too, the Fifteen Points by exclusion would have eliminated quite a lot of other weak companies and would have served you nicely - getting you into the high quality companies.
In 2000-2002 we have had the worst bear market since the great depression in 1974 or the other great depression in 1937-1938. An extended bear market can test everybody’s patience and unsettle the most experienced investors. No matter how good you are at picking stocks, your stocks will go down, and just when you think the bottom has been reached, they will go down some more. Many investors have had their faith in prior investment belief shattered. But if you own companies that have the Fifteen Points and don’t get carried away by what are “fads and fancies,” you will come through this period just fine. When the prices are at their lowest and the company is still in terrific shape, the company that possesses the Fifteen Points, this is exactly the perfect time to buy more shares. The price might go lower before it goes up again. But it won’t matter much a few years from now.
One of the most important personal qualities needed if big profits are to be made from investment is patience. Unless you have the patience and the courage to hold on to the shares during the corrections, you’re an odds-on favorite to become a mediocre investor. It’s not always brainpower that separates good investors from bad, often it’s discipline.
Moving with the herd, doing what everybody else is doing, and therefore what you have an almost irresistible urge to do (social pressure), is almost often the wrong thing to do at all. I thought the difficulties of the crowd of small investors who have unintentionally picked up all sorts of ideas and investment notions that can prove expensive over a period of years, possibly because they had never been exposed to the challenges of more fundamental investment concepts. Practice thinking for yourself using solid investment fundamentals as your guide rather than following the herd.
Finding the really outstanding companies and staying with them through all the fluctuations of the stock market proved far more profitable than to move in and out of market, trying to catch the waves. What is important is 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. If you use the solid investment fundamentals as your guide rather than following the crowd and Wall Street noise (analysts), you might discover some young enterprise, which might today lay the groundwork for a great fortune for you.
Reading only the financial reports of a company is not enough to justify an investment. The essential step in conservative investing is to uncover as much about the company as possible from those individuals who are familiar with the company. Scuttlebutt - a cross-section of the opinions of those who in one way or another are concerned with any particular company – will provide substantial clues that will enable you to identify outstanding investments.
From the Fifteen Points I could fathom generally where a company fit into the market competition and how it would or wouldn’t prosper. And Scuttlebutt is simply about finding out from “Main Street” sources if a company is strong or weak. Most people don’t use this approach, relying instead on the local rumor and Wall Street noise (analysts).
The Scuttlebutt
Scuttlebutt means avoiding malarkey mills (local rumors, analysts’ noise, etc.) and seeking information from competitors, customers, and suppliers, all of whom have a vested interest in the target company, and few of whom have any reason to see the company unrealistically. It means talking to sales representatives of a company’s competitors, who inherently have a basis to see the competitors negatively but typically don’t if the competitor is great. It means talking to the research people and management members of the competitors as well. If all those people see the strength in the competitor’s operation and respect it or even fear it, well, simply said, it isn’t Brokat or WorldCom. You can count on it.
If you applied this process over the years to lots of stocks you would gain insights to the key areas you need to focus on to gain important information about the company you want to buy. The keys are focus on the customers, competitors, and suppliers.
Consider the scandal stocks or other overvalued portfolios. Not one could have passed the test via scuttlebutt because if you talked to competitors, they weren’t overly scared of those slinky companies. If you talked to the customers or suppliers, they weren’t overly impressed either. The customers weren’t impressed because the products weren’t all that good by relative comparison. The venders and suppliers weren’t all that impressed because the vendor’s other customers would have been doing better and ordering more – the real sales volume wasn’t there. And the competitors would not have held these companies in awe because they did not hold them at competitive disadvantage.
It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a cross-section of the opinions of those who in one way or another are concerned with any particular company. Go to five companies in an industry, ask each of them intelligent questions about the points of strength and weakness of the other four, and nine times out of ten a surprisingly detailed and accurate picture of all five will emerge. However, competitors are only one source of information. It is equally astonishing how much can be learned from both vendors and customers about the real nature of the companies with whom they deal. In the case of really outstanding company, the preponderant information is so crystal clear that even a house wife who knows nothing about business will be able to tell you which companies are likely to be of interest to taking the next step of investigation.
In appraising the business characteristics of companies, you need only to devote a tiny fraction of time or mental effort. Sit down in an undisturbed isolation and pore over balance sheets, corporate earning statements, and trade statistics, you will glean important information about the company, in which you want to invest. Your goal is to get the greatest total profit for the least risk. Successful investor is usually an individual who is inherently interested in business problems.
Recognize the basic improvement in fundamentals that started some years before. And then buy the company’s shares just before the improvement in earning power has been reflected in the market price for these shares can similarly mean a chance to get into the right sort of company at the right time. If the particular increase in earnings has not yet produced an upward move in the price of the company’s shares in one or two years, an investor will still in the long run make money if he buys into outstanding companies.
Investors should ignore any guesses on the coming trend of general business or the stock market. Instead he should invest as soon as the suitable buying opportunity arises. In contrast to guessing which way general business or the stock market may go, he should be able to judge with only a small probability of error about what the company is going to do in relation to business in general. He is making his bet upon something that he knows to be the case, rather than upon something about which he is largely guessing.
Young growth companies have the greatest possibility of gain. Sometimes this can mount up to several thousand percent in a decade. But making at least an occasional investment mistake is inevitable even for the most skilled investor. If the stock is bought according to the Fifteen Points rule any losses that might occur should be temporary, resulting from a period of unanticipated decline in the stock market as a whole. Meanwhile, if properly selected, the so-called high risky type could significantly increase the total capital gain, but the risk has more to do with the investors than with the categories. These young “risky” companies will by time reach a point in their own development where their stocks will no longer be carrying anything like the former degree of risk but may even have progressed to a status when institutions have begun buying them. The growth stocks, over five or ten year span, have proven spectacularly better so far as their increase in capital value is concerned. The growth stocks had not only shown a marked superiority in the field of capital appreciation, but also given a reasonable time, they had grown to a point where they showed superiority in the matter of dividend return as well.
What to sell
If mistake is recognized quickly, losses, if any, should be smaller than if the stock bought in error judgment had been held for a long period of time. Even more important, the money that was tied up in the undesirable situation is freed to be used for something else that, if properly selected, should produce substantial gains.
However, there is a complicating factor that makes the handling of investment mistakes more difficult. If we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous thing in which we can indulge ourselves in the entire investment.
More money has probably been lost by investors holding a stock they really did not want until they “could at least come out even.” If to these actual losses are added the profits that might have been made through the proper reinvestment, the cost of self-indulgence becomes truly big.
Furthermore this dislike of taking a loss, even a small loss, is just illogical. If the real objective of common stock investment is the making a gain of a great many hundreds percent over a period of years, the difference between, says, a 20 percent loss becomes a comparatively insignificant matter.
While losses should never cause strong self-disgust or emotional upset, neither should they be passed over. They should always be reviewed with care so that a lesson can be learned from each of them. If the particular elements that caused a misjudgment on a common stock purchase are thoroughly understood, it is unlikely that another poor purchase will be made through misjudging the same investment factors.
If the stocks no longer qualify to the Fifteen Points, they should be sold. This is why investors should be constantly alert. It explains why it is of such importance to keep at all times in close contact with the affairs of the companies.
When companies deteriorate they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did.
Sometimes management deteriorates because success has affected one or more key executives. Smugness, complacency, or inertia replaces the former drive and ingenuity. Success can expose us to dangerous consequences. A kind of paradoxical claim to make about something we all reach for, yet it’s true. Everybody battles for success; too few people are aware of its profound impact. Success tends to breed arrogance, complacency, and isolation. Success can lose mind faster than prejudice.
More often management deteriorates because a new top management does not measure up to the standard of performance set by their predecessors. Either they no longer hold to the policies that have made the company outstandingly successful, or they do not have the ability to continue to carry out such policies.
When a deterioration of management happens the affected stocks should be sold at once, regardless of how good the general market may look.
Sometimes deterioration of the company happens because after growing spectacularly for many years, a company will reach a stage where the growth prospects of its market are exhausted. It will only progress at about the same rate as the national economy does. In any event, the company should be recognized as no longer suitable for a worthwhile investment. Such a stock should then be sold. In this instance, selling might take place at a more leisurely pace than if management deterioration had set in.
This kind of change may not be due to any deterioration of the management. Many managements show great skill in developing related or allied products to take advantage of growth in their immediate field. They recognize, however, that they do not have any particular advantage if they jump into unrelated business.
Postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly. Many investors disposed of a company that was to show stupendous gain in the years ahead because of the fear of a coming bear market. Frequently the bear market never came and the stock went right on up.
(When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price, fear of something else happening still prevented their reentry.)
If the company is really the right one, the stock that was purchased short before the bear market; the next bull market should see the stock making a new peak well above those so far attained. And then if it becomes overpriced the stock should be sold.
Overprice means that the stock is selling at an even higher ratio in relation to the expected earning power. But how can one say with moderate precision what is overpriced for an outstanding company with an unusually rapid growth rate?
Suppose that instead of selling at twenty-five times earning, as usually happens to growth stocks, the stock is now at thirty-five times earnings. If the growth rate is so good that in another ten years the company might well have quadrupled, it isn’t really of such big concern whether at the moment the stock might or might not be 35 percent overpriced. If for a while the stock loses, say, 35 percent of its current market quotation, this isn’t really such a serious matter. It is the maintaining of our position rather than the possibility of temporarily losing a small part of our capital gain that is really important.
There is still one other argument investors sometimes use to separate themselves from the profits they would otherwise make. This one is the most ridiculous one of all. It is that the stock they own has had a huge advance. Outstanding companies, the only type that I believe the investor should buy, can grow in many decades. The company behind a stock can have a practice of selecting management talent in depth and training such talent in company policies, methods, and philosophies in a way that will retain and pass on the corporate vigor for generations. Look at Du Pont, L’Oréal, Sony, Motorola after the death of their brilliant founders.
Never sell the stocks as long as the company behind it maintains the characteristic of an unusually successful enterprise. A decade after Wal-Mart came public it gained 20-fold. If you held the stock for another decade, you would overall have made 250-fold gain.
Ten Don’ts for Investors
1. Don’t buy into promotional companies
With promotional companies, you’re better off to wait until they turn a profit before you invest. IPO (Initial Public Offering) of brand-new enterprises are very risky because there’s so little to go on. Four out of five have been long-term disappointments. Waits for earnings. You can get ten baggers in companies that have already proven themselves. It’s never too late not to invest in an unproven enterprise. It’s better to miss the first move in a stock and wait to see if a company’s plans are working out.
2. Don’t ignore a good stock just because it is traded “over the counter”
Actively traded stocks on the stock market have no advantage over the better over-the-counter stocks. Small and medium-size companies sometimes refused to list their stocks on the smaller exchanges. Instead they have chosen the over-the-counter markets until their companies reach a size that would warrant “big board” – that is, NYSE, Nikkei, or DAX – listing.
3. Don’t buy a stock just because you like the tone of its annual report.
Attractive photographs and nicely colored charts do not necessarily reflect an able management team. Allowing the general words and tone of an annual report to influence a decision to purchase a common stock is much like buying product because of an appealing advertisement on billboard and not based on understanding its quality. It is important to go beyond them to the underlying facts. Like any other sales tools they are prone to put a corporation’s “best foot forward.” They seldom present balanced and complete discussions of the real problems and difficulties of the business. Often they are too optimistic.
4. Don’t assume that the high price at which a stock may be selling in relation to earning is necessarily an indication that further growth in those earning has largely been already discounted in the price.
What is important here is thoroughly understanding the nature of the company, with particularly reference to what it may be expected to do some years from now.
If a big earning spurt that lies ahead is a one-time matter, and the nature of the company is not in such a situation, in which new sources of earning will be developed when the present one is fully exploited. Then the high price earnings ration does discount future earnings. This is because, when the present big earning spurt is over, the stock will settle back to the same selling price in relation to its earnings as run-off-mills shares.
However, if the company deliberately and consistently developing new sources of earning power, and if the industry is one promising to afford equal growth spurts in the future, the price-earnings ratio five or ten years in the future is rather sure to be above the average stocks. Stocks of this type will frequently be found to be discounting the future much less than many investors believe. This is why some of the stocks that at first glance appear highest priced may be the biggest bargains.
5. Don’t quibble over eights and quarters
If the stock seems the right one and the price seems reasonably attractive at the current levels, buy “at the market.” The extra eight, or quarter, or half point that may be paid is insignificant compared to the profit that will be missed of the stock is not obtained. Should the stock have not a long term potential, the investor should not have decided to buy it in the first place.
6. Don’t overstress diversification
Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. It never seems to occur to them that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.
7. Don’t be afraid of buying on a war scare
War is always bearish on money. To sell stocks at the threatened or actual outbreak of hostilities to get into cash is an extreme financial lunacy. Actually the opposite should be done. Investors should ignore the scare psychology of the moment and definitely begin buying. In every instance, stocks dipped sharply on the fear of war and rebounded sharply as the war scare subsided.
8. Don’t be influenced by what doesn’t matter
Statistics of former years’ earning and particularly of per share price ranges of former years quite frequently have nothing to do with the case.
The company might have fallen into the hands of an inefficient management and slipped so badly in relation to its competitors. Or on the other hand, there might be changes in the management, establishment of an outstanding research department, and the company may have developed a series of new and highly profitable products.
The fact is that a stock has or has not risen in the last several years is of no significance whatsoever in determining whether it should be bought now. What does matter is whether enough improvement has taken place or is likely to take place in the future.
Just knowing, by itself, that four or five years ago a company’s per share earnings were either four times or a quarter of this year’s earnings has almost no significance in indicating whether a particular stock should be bought or sold. Again, what counts is the knowledge of the background/fundamental conditions of the company. An understanding of what probably will happen over the next several years is of really importance. It is the next five years’ earnings, not those of the past five years that now matter to us as investors.
9. Don’t fail to consider time as well as price in buying a true growth stock
When the indications are strong that very important gains in earning power are going to appear, deciding the time you will buy rather than the price at which you will buy may bring you a stock at or near the lowest price.
10. Don’t follow the crowd
Practice thinking for yourself using the very fundamental business and investment principle of “The Fifteen Points” rather than following the herd. There is a powerful unseen force that allows people to act irrationally. The force is mindless, lemminglike imitation of others, no matter how irrational their actions may be. We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of superior information but are reacting themselves to the principle of social proof. A snowballing effect occurs.
Lemmings are small rodent indigenous to tundra region and are noted for their mass exodus to the sea. In normal periods, lemmings move about during their spring migration in search of food and new shelter. Every three to four years, however, something odd begins to happen. Because of high breeding and low mortality, the population of lemmings being to rise. As soon as their ranks swell, lemmings begin an erratic movement under darkness. Soon, this bold group begins to move in daylight. When confronted by barriers, the numbers of lemmings in the pack in creases until the panic-like reaction drive them through or over the obstacle. As this behavior intensifies, lemmings begin to challenge other animals they normally would avoid. Although many lemmings die from starvation, predators, and accidents, most reach the sea. There they plunge in and swim until they die from exhaustion. The behavior of lemmings is not fully understood.
It should be remembered that knowing the rules and understanding these common mistakes will do nothing to help those who do not have some degree of patience and self discipline. In the stock market a good nervous system is even more important than a good head.
posted by Inspirational Articles at 1:07 AM
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