We Study Billionaires - The Investor’s Podcast Network - TIP646: How To Understand A Business Like A Pro w/ Kyle Grieve

Starting point is 00:00:00 You're listening to TIP. Learning about public companies is hard work. If you want to be a well-informed investor, you need to keep up with things such as quarterly and annual reports, both of the businesses that you currently own, but also of the businesses that you are researching. Then on top of that, you need to listen to quarterly Q&A's or read conference call transcripts of those same businesses. And lastly, you need to do those exact same tasks for the businesses that you own, as well

Starting point is 00:00:27 as the competitors of those businesses. But to be as knowledgeable as possible, you have to go deeper than gathering information just from what is most easily shared and accessible. And I think the book Common Stocks and Uncommon Profits by Philip Fisher does an absolutely wonderful job of helping you do exactly this. So this book accomplishes multiple important investing concepts. First, it's a practical guide that shows you what information that you should be looking for. And second, it explains why that information is so important. And then lastly, it does a really good, job of just supplying you with ample historical case studies that Philip Fisher went through

Starting point is 00:01:05 and he connects it really well to all the concepts that he teaches. So some of the analytical areas of importance that I know you'll become much more proficient in after listening to this episode are details on some of the simplest ways just to find incredible new products and services, whether that's in segments of businesses that you're looking at or maybe an entirely new product service. You'll learn why the price earnings ratios are just less of a concern when you have a really good view of a business's future multiple years into the future. You'll learn how to assess a business's research and develop expenses and how to really find out if businesses' R&D expenses are really producing value into the future. And you'll learn why investing in growth is so important,

Starting point is 00:01:48 especially in today's age of high inflation. So you won't want to miss this episode if you strive to improve your analytical framework by learning as much about a business as possible. Now, let's get right into this week's episode. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Kyle Greve. Welcome to the Investors podcast. I'm your host Kyle Grieve, and today is going to be a solo episode. I'm going to be going over one of the most impactful books that I've read on investing,

Starting point is 00:02:43 and I know it's one of Warren Buffett's favorites as well. And that's going to be common stocks, uncommon profits by Philip Fisher. So in 1969, Warren Buffett said, quote, I am 15% Fisher and 85% Benjamin Graham, unquote. However, Robert Hector intelligently pointed out that Warren had changed a lot since then. Robert's hunch is that if Warren were asked this question today, he thinks it would probably be a lot closer to 50-50 between Philip Fisher and Benjamin Graham. Once I read this, I realized I should probably take Philip Fisher's teachings a lot more seriously. I will do exactly this with you today. We're going to cover Philip Fisher's book in a lot more detail.

Starting point is 00:03:22 This is the second time I read this book and the second time I got way, way, way, way more out of it. and part of that is just the podcasting process. But the reason that I think this time I got a lot more out of it is that I've deepened my fascination for deep due diligence. The first time I read it, I was a much more novice investor and it was not as important to me as it is now. But you know, due diligence is a very popular subject in investing circles, but it's also not necessarily taught to the public in much depth.

Starting point is 00:03:57 Professional fund managers and analysts are the, masters of the craft, but it's hard to learn from them as much as what they do is, you know, kind of kept close to their chest. It's, you know, it's the tools of their trade. They don't necessarily want to divulge it to everyone because it gives up some of their advantage. But, you know, I think Philip Fisher did a wonderful job in this book discussing how we can learn as much as possible about one specific business using a variety of different resources. So Philip Fisher writes, I spent part of such spare time as I had in reviewing both the successful and, more importantly, the unsuccessful investment actions that I had seen others take during the preceding 10 years.

Starting point is 00:04:35 I began seeing certain investment principles emerge from the review, which were different from some of the most commonly accepted as gospel in the financial community. So as you can see here, Fisher, like Benjamin Graham and Warren Buffett, was a contrarian. He observed principles that were not part of standard Wall Street dogma, and he doubled down on that with a ton of success. Another contrarian insight he had was about the strength of holding outstanding companies. He observed that holding outstanding companies and staying with them through the gyrations that included World War I, the Great Depression, and World War II would have produced very high returns compared to buying low and just selling high.

Starting point is 00:05:13 One of the common themes that I've come across while researching multi-begger stocks is that small is good. Every research piece I've come across has the highest returns in the lowest decile or quartile compared to the rest of the sample size. And I think Philip was aware that small companies could deliver outsized returns compared to their larger counterparts. Philip understood that companies that could grow sales and profits faster than the industry as a whole would end up outperforming. But he also realized that company size matters less than the ability of management to ideate growth strategies and execute on these strategies. Now, how does Philip envision an investor finding a business that can grow sales and profits faster than the industry for multiple years.

Starting point is 00:05:54 That's one of the most critical questions in the book, and he hopes to answer it. Fisher admits that the investors not involved in the day-to-day operations of a business will just not be able to get the same information as a well-informed analyst or an insider of that business will have access to. He mentions a few corporate areas that would be important to understand at a much deeper level, such as executives, a business's production process, its sales organization, and its R&D department. But here's a problem. Insiders with knowledge of these areas are unlikely to divulge all of the information you want

Starting point is 00:06:26 to someone not involved in the business. After all, giving your competitors shortcuts to compete with you is not a wise business decision. I see this often when analyzing a business where I ask myself, I really wish I could understand the economics of each segment of this business much better. But then I think competitors are probably asking the same questions. And if the business gave up that information, it would quickly lead to capital and entering the markets, and that company's profits or margins being eroded away.

Starting point is 00:06:54 My favorite example of this was with Amazon Web Services. So let's rewind back to 2006, the year AWS was launched. And it wasn't even mentioned in their shareholder letter. Perhaps it just wasn't worth mentioning at that point because it was just an idea in its infant stage. Now we go to 2010, and in the shareholder letter, it was briefly mentioned just one time. Go forward again in 2015, and now it's mentioned 21 times. and at this point, AWS was producing $7.8 billion in revenue and about 6.5% of Amazon's total revenue. This means from 2006 to 2015, AWS grew from producing zero revenue to $7.8 billion,

Starting point is 00:07:33 an astronomical growth rate that they weren't in any rush to share with competitors. 2015 is the first year that Amazon also shared the profit margins from AWS. In 2015, they had $265 million in operating income, only a 3% operating profit margin. Today, that operating margin is at 30%. So, if we're truly to learn about a business, how does Philip Fisher suggest we overcome the fact that insiders in the business won't be open to sharing everything about a business? Fisher suggests using the business grapevine.

Starting point is 00:08:05 Fisher writes, It is amazing what an accurate picture of the relative point of strength and weaknesses of each business in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company. Most people, particularly if they feel there is no danger of their being quoted, like to talk about the field of work in which they are engaged and will talk freely about their competitors.

Starting point is 00:08:30 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 surprisingly detailed and accurate picture of all five will emerge. But competitors aren't the only source of information on a specific business. We can also learn from vendors, customers, trade associations, executives, research scientists in a variety of fields such as governments, universities, or other competitors. Another great source I've used is current and former employees. If you have a rapport with someone in this position, they may be more willing to open up

Starting point is 00:09:07 and be as honest as possible about the current environment. Once you have someone to talk to, the next step is to ask the right questions. Philip Fisher did a fantastic job in his book. of breaking down 15 points to look for in a business that fit his criteria. You can use his criteria to ask the best possible questions or to prompt you in the right direction. I'm going to go over a few of them that I find the most useful in a little more detail. So he had 15.

Starting point is 00:09:33 Some of them just, you know, I didn't think were quite as applicable or as important. So I'm just going to go over the ones that I found most impactful so that this episode doesn't go too long for you. So the first one here I want to go over is, you know, does a product or service exist with a large multi-year growth runway? So if you want a business that you can hold for multiple years, you want growth that can last for multiple years as well. This point is just so important. I think it's so important. That's why he made this his first point of the checklist.

Starting point is 00:10:05 So when you look at a business's products and services, you should aim to determine if there will continue to be a market for them many years into the future. You want to know if their products will continue selling and hopefully increase the units that they can sell in the future. If you determine the product doesn't have a bright future or that its competition can create a better product, that's a very good signal that the opportunity is a pass. The next point here is, does the management team have the right makeup to continue developing new and improved products once the current growth initiative is complete? You want to look for management that is incentivized to continue creating shareholder value. While shareholder value can be created via distributions, rarely will managers find as good of an opportunity as investing back into their own business at very high rates of return.

Starting point is 00:10:51 So when you are assessing a business, look at things such as the performance of past product releases, projects in their pipeline, growth initiatives for current products, and adjacent use cases. Fisher doesn't discuss much about incentives and alignment, but I think they are key concepts that can help investors stay aligned with management. You want management to be aligned with you as a shareholder, and one of the best ways to ensure that is very high levels of insider ownership. So in the 1984 Berkshire Hathaway shareholder letter, Warren wrote, with 47% of Berkshire stock, Charlie and I don't worry about being fired, and we receive our rewards as owners, not managers. Thus, we behave with Berkshire's money as we would with our own.

Starting point is 00:11:35 That frequently leads us to unconventional behavior, both in investments and general. business management. So when your CEO has 99% of his net worth in the stock of the business he's managing for you and himself, the alignment is as close to perfect as you're going to get. So next point here. How effective are the company's research and development efforts in relation to its size? So I've always kind of grappled with how to assess the use of capital into research and development and then figuring out what kind of profits the R&D spend of a given business is producing for the business. I'm not sure an exact figure is necessary to see that a business is intelligently deploying R&D, so let's go over that in a little more detail. Fisher has some

Starting point is 00:12:19 advice to help us determine the efficacy of R&D to the fundamentals of a business. A simpler and often worthwhile method is to make a close study of how much in dollar sales or net profits has been contributed to a company by the result of its research organization during a particular span, such as the prior 10 years. An organization which in relation to the size of its activities has produced a good flow of profitable new products during such a period will probably be equally productive in the future as long as it continues to operate under the same general methods. So let's take a look at some examples using his framework right here. If we look at Alphabet's R&D spending over the last decade, I get a figure of $242 billion. So now when we look at the last 12 months revenue, they are at $307 billion and we look at their net income and we get a figure of $74 billion.

Starting point is 00:13:16 So those numbers look pretty good, but I think we probably need to compare it to another business. Maybe there's not necessarily a close comparison for Alphabet, but let's just throw another kind of tech type company like Microsoft and take a look. So over the last decade, they spent $171 billion in R&D. And this has resulted in a trailing 12-month revenue of $236 billion and a trailing 12-month net income of $86 billion. So that means Alphabet has seen about 30% of its R&D budget turn into profits in the last decade, which seems like a very good number. And then Microsoft has seen about 50% of its R&D budget turn into profits, which is obviously very, very good. So those are some of the numbers that you're going to be looking at at some of these very impressive businesses. and obviously that could mean good things for the future.

Starting point is 00:14:00 So with the massive sums of money being spent on R&D by these businesses, you can see why it's going to be very difficult for other businesses to come in and try and compete with them. So Adam Cecil pointed out in his wonderful book where the money is, high gross margins allow businesses to spend more on R&D, which can further cement their competitive advantages. An additional point worth mentioning from Adam Cecil is that R&D spend is treated like an expense that will not produce future revenue and profits for a business according to GAAP accounting. So Adam's argument is that R&D does create value in the future, and if it was amortized on the

Starting point is 00:14:37 income statement, you would get a much more accurate reality of the value it creates as net income would be a much higher figure. So on to the next point here, does the company have a worthwhile profit margin? And what is it doing to maintain or improve it? You could just as easily replace profit with cash flow in here. Protecting profit margins is vital to a business's success. It's also a great indicator of a business's moat. So if you find a business with a long history of stable or even rising profit margins, you are probably looking at a business with a deep and wide moat. One of my favorite examples is Copart. Copart's net margins have grown from 15% in 2014, which is very respectable to 33% today, which is extraordinary. Chuck Ackery has said

Starting point is 00:15:22 that the average American business has profit margins in the high single digits. So a margin of 33% is three to four times as high as the average American business. The problem with high margins is that competitors can see them too. And what this means is that it can attract more capital into the industry which can eat into the leader's margins. But this only happens if there is a path to compete with the business. And in Copart's case, this path isn't so simple and therefore it hasn't happened yet. Now, Copart has done a great job increasing margins and seems to have a near impenetrable mode. The next point is, does the company have outstanding labor and personnel relations? I think Fisher understood very well how important good relationships between employees and employers

Starting point is 00:16:06 are. There is a wonderful graph that depicts what drives shareholder returns over different time periods. In the short term, it's things like sentiment change, but when you look 10 plus years, the biggest variable is the people and culture in that business. So Ian Castle came to a similar conclusion in his book, Intelligent Fanatics. My biggest takeaway from that book was the importance of having great relationships with employees and making them truly feel like they were a part of the company and its growth story. Nearly all the businesses and the leaders that he profiled placed very high levels of importance on empowering their people to work as hard as possible by aligning incentives.

Starting point is 00:16:44 When you have well-aligned incentives and have owner-employees, a lot of value can be created. A hidden value of this is in the output that a worker can complete. One of my favorite examples from Intelligent Fanatics was Newcor, a steel products producer. Through former CEO, Kenneth Iverson's incentive program, he was able to generate astronomical output rates compared to competitors. Whereas most businesses in the steel industry had total costs of about $80 per ton of steel produced, New Corps dropped that in half to $40. So the reason that they were able to achieve these incredible rates of efficiency was that employees at all levels and management as well were incentivized to produce

Starting point is 00:17:25 past their quota. So if we take that incentive program away, employees would basically probably just do the minimum amount of work needed to meet their quota. But New Corps system incentivize employees to push past that quota, which was a win for New Corps shareholders and its employees. On the other hand, you most definitely want to develop an awareness of when relationships between employees and management are weak or weakening. This can signal that the company culture isn't that strong or that the company's policies are not conducive to retaining talent that is often needed for a company to continue growing. The best way to do this is to talk to current and former employees.

Starting point is 00:18:03 Glassdoor is an imperfect system for doing this analysis. Another method that I've kind of turned to is just hopping on LinkedIn going to. to a company's profile on LinkedIn, looking for a couple of people that work for them. I'm reaching out to them and seeing what kind of information that I can get. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord,

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Starting point is 00:22:22 That's Shopify.com slash WSB. All right. Back to the show. So the next point here that I want to go over is what competitive advantages does the business have that make it different from competitors? For this analysis, I prefer referencing Hamilton Helmer's book Seven Powers. You can learn more about this book in an episode that I did where I got to interview him on TIP episode 600. So the powers that I found most prevalent are six out of seven of them.

Starting point is 00:22:52 One of them is just you just don't see very often. So let's just go over what they are. So the first one is going to be scale economies. Scale economies is essentially when a business where unit cost decline as volume increases. So Costco is a very, very simple example of this. Costco makes deals with their suppliers. They buy them in very, very high quantities. Oftentimes they'll buy all of the quantity of one of their suppliers.

Starting point is 00:23:21 And because they're able to buy up so much of it, they are able to secure lower prices. And because they're able to secure lower prices, they then go a step further. And they actually pass those savings on to the customers of Costco. And that's why Costco has such loyal customers. So the second power here is network economies. Network economies is defined as a business where the value realized by a customer increases as a user base increases. So I think, you know, Amazon is a very, very simple example of this.

Starting point is 00:23:47 You know, if you're looking for a new product, you're going to just hop on Amazon.com and you're going to type in whatever you want in the search bar. And then, you know, who knows how many products will come up. You search, I don't know, Kleenex. And you might get a couple hundred different products showing up. then you can further refine the process. You can look at only things that are four stars or higher. You can look at things that are cheaper or more expensive.

Starting point is 00:24:11 You can look at ones from specific suppliers. Maybe there's someone that you really like. And so because Amazon's search criteria has all of this data, basically the more people and the more suppliers that are on there means that they get more and more data. And that allows the user to improve their experience, the more and more they use Amazon. So the third one here is counter positioning, which is defined as a business that adopts a new superior

Starting point is 00:24:37 business model that incumbents cannot mimic due to the anticipated cannibalization of their existing business. So the simple example here is just what Hamilton Helmer uses in his book, which is Netflix versus Blockbuster. You know, Netflix moved towards this rental business that made tons of sense for customers, but unfortunately didn't make sense for Blockbuster's business model. and when Blockbuster finally tried to kind of replicate the business model of Netflix, they were way, way, way too late and just didn't work out and, you know, look at Netflix now

Starting point is 00:25:11 and Blockbuster has one location, I believe, in Oregon now. So that counter positioning is a great power for a business to have. The next power here I want to go over is just switching costs. Switching costs are found in a business where customers expect a greater loss than the value they gain from switching to an alternate. One of my most favorite examples here is just Constellation Software. I mean, Constellation Software has, I think, somewhere around 1,000 businesses now. So obviously, you know, they don't just have one switching costs, but they have so many different types of businesses.

Starting point is 00:25:42 And one of the business industries that they're in are in the medical field. So for instance, they have a patient flow software in hospital. So, you know, that patient flow is embedded in the hospital. All the doctors, nurses, and any other support staff know how to, you know how to. to use that exact patient flow software. So, you know, the facts are if you wanted to switch out of that software, you're going to have to retrain everyone that's going to cost money. It's going to cost time. It's going to cost headaches. So a lot of these types of products, they're just super sticky. They stick around and they stick around for a very, very long period of time.

Starting point is 00:26:17 So switching costs also a wonderful moat to have. So the next power or moat, as I refer to it, is branding. So a business with good branding is a business that enjoys a higher perceived value to an objectively identical offering due to historical information about it. So, easiest example, LVMH, I think everyone's probably aware of that. You look at all their high-priced purses. Of course, you can buy another purse from a competitor for probably a fraction of the price, right? But LVMH has this history and it's developed this incredible amount of trust and perceived value and scarcity with its customer base. and that's why LVMH can get away with charging such a premium for their high-priced apparel

Starting point is 00:27:02 and why they've been doing it for a really long time and they're probably going to be doing it for a really long time into the future. So the last power here that I like is cornered resources. So a business with the cornered resource is a business that has preferential access to a coveted resource that independently enhances value. So pharmaceuticals is probably one of the simplest examples that Hamilton-Helmer mentioned to me when I got to speak to them. So when you think about it, you know, let's say murder.

Starting point is 00:27:26 Merck owns the IP on a drug, and basically that drug will last. It'll have a, you know, a length of time where no one can kind of copy it. And during that entire time, Merck basically will get 100% of the profits from the sale of that drug. Obviously, it ends at some point. But while they have it, it's very, very good. An example, I really like his Todd House Helter at Evo, which is a company that we obviously talk about a lot on the show. So he's a guy where if he was poached off of Evo, he would probably carry a lot of value with the other company that he's with.

Starting point is 00:28:03 So hopefully he sticks with Evo. So the point of all this analysis and looking at MOTS is to really identify why. One business is superior to others in the industry. But more important than just finding out which is the best, you want to focus on finding out why it's the best. So even more importantly, you want to get a very good grasp of, whether this advantage is sustainable over long time periods. A company with an advantage for just a few quarters has a very low probability of succeeding

Starting point is 00:28:33 over the long term. So if you want a wonderful business, you should be placing a very large emphasis on finding the durability of a company's moat. The next point here is, does the company have a short range or long range outlook regarding profits? So this is one of my favorite areas to look at in a business. Why? Because I'm constantly searching for alignment between management and shareholders as a

Starting point is 00:28:55 long-term shareholder myself, I tend to be attracted to businesses that think in the same light. So I just listen to my co-host, Clayfinks, episode TIP 637 on the Amazon shareholder letters, and I think Amazon has done a tremendous job focusing on the long term. Jeff Bezos is well known for saying that this is only day one when it comes to Amazon. This means he can justify spending today at the cost of short-term profits to strengthen Amazon's relationship with its customers in the future. And this is a massive, massive competitive advantage for Amazon that Bezos has created. because he prioritized the business more than the stock, Amazon, has been able to make a string

Starting point is 00:29:31 of different investments in different areas. Most of them, admittedly, are failures, but some of them stuck very well, just like we mentioned with AWS. So if Amazon had constantly been searching for super quick fixes just to enhance its income statement as quickly as possible, innovation in that business would have looked much, much different. In fact, I doubt we'd probably have been talking about Amazon like we do today. if they'd taken that route. So when you are conducting business research, try to pay attention

Starting point is 00:29:59 to what management is really trying to do. Are they willing to take a hit to the stock to strengthen the business further in the long term? And lastly, as a long-term shareholder, you should be aware of the volatility that owning long-term-oriented businesses can offer. You will be required to wait while the market is wrong on a business that you own. Warren Buffett said this well in the Buffett Partnership letters. The course of a stock market will determine to a great degree when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen. So the next point I want to go over here is how will growth

Starting point is 00:30:41 in a business be funded? There are really three possible ways for a company to fund growth. internal financing, debt financing, and equity financing. So in internal financing, there's lots of attributes for me. It's most definitely my first preference. If all things being equal, one business could internally finance versus the other options. I would take internal financing in an instant. Why is that? So I think it's because internal financing really allows a business to stay open to optionality. If a business has debt or has to dilute shareholders, that optionality is obviously not the same versus if you are internally funded. Additionally, you know, if something bad were to happen to the business, but it has, you know, a large cash

Starting point is 00:31:27 position or it has the ability to, you know, a fortress balance sheet like Bursher Hathaway does, you don't have to rely on debtors to bail you out. Warren Buffett has a great line where he talks about not having to rely on the kindness of strangers for bailouts. And I think that really applies here. On top of that, you don't have to worry about debtors taking their share of business and leaving equity holders with little to nothing. I mean, I don't think this necessarily counts with investors who look for businesses that are growing. Obviously, you want businesses that are going to continue growing its income stream and profits. But, you know, if you are the type of investor looking at, you know, asset plays, this is obviously very important because if the assets,

Starting point is 00:32:11 If there's not enough asset value, then all asset value is going to go to bondholders and debtors before it goes to shareholders. And a lot of time, they're left with absolutely nothing. So the next method is going to be debt financing. So this would be my second preference. So while debt lowers the income of the business, because obviously there's a interest expense, this can actually be seen as a positive as it also reduces income taxes. Debt can also be refinanced in the future to further decrease.

Starting point is 00:32:41 interest expenses as interest rate fluctuate, which we've obviously seen a lot happening well, up up until kind of that 20, 22 period. So debt can also be seen as a positive in certain businesses that have, I guess you could call it a hidden moat where future investments will accrue small profits today, but big profits down the road. And you know, the thing that's really cool about that is obviously if they're making small profits today, maybe you're not going to see it on the income statement and it's not going to have that big of an impact, but years down the the road, it will obviously have a big impact. And then the other thing that's really interesting is that once they have that large amount of cash flows, they can sometimes just wipe that debt

Starting point is 00:33:20 off and forego a lot of interest payments. So at Berkshire, Buffett said, we would love to acquire businesses or invest in capital projects that produce no return for a year, but that could then be expected to earn 20% on growing equity. So this just kind of plays into the point that Warren Buffett, seeing as he's an owner of the business, he doesn't care about investing in a company where there's no profits, but will show up after a year, maybe even a couple years down the road. And that's kind of the type of management that I also would like to be aligned with. So the last type of financing here is equity financing. This is my least favored.

Starting point is 00:34:00 So it can destroy shareholder value when equity is issued, especially when it's issued on very cheap shares. many managers you see this method as free financing is there's no obligation to pay back anyone right but the fact is it's not free because you're financing the business essentially at the expense of your shareholders again if you are financing at cheap prices but unfortunately the fact is that even though there is a way to use equity financing that can be beneficial which I'll go over it's mainly abused and I think that the reason this is abuse and the reason that a lot of equity issuance happens is just that there's a lack of knowledge about capital allocation, just in business in general. Some companies have no choice but to look

Starting point is 00:34:47 at equity markets for financing when they can't internally fund growth and maybe they just don't have the financial health to justify having a bank lend the money. That's why you see this a lot. I like looking at smaller businesses. A lot of times they have to issue equity in order to grow simply because banks maybe don't know them, don't have a good enough relationship. Maybe some of them don't have a long history of profitability. So a lot of times they have to use that and that's kind of their only option. And then even bigger companies, right? And that's just their way of growing is to issue equity.

Starting point is 00:35:18 They just keep doing it and sometimes it can work. A lot of times it doesn't. And so I generally try to stay pretty far away from businesses where I know they're going to have to issue equity in order to continue growing. Now, as I was talking about earlier, there is a time where equity can be used to fund growth. And that is when shares are overpriced. So let's take a look at how this is possible. So a theoretical business, let's say, is worth a billion dollars and has 50 million shares outstanding.

Starting point is 00:35:48 So that comes out to about $20 a share. But let's just say right now it's trading at a steep discount to its intrinsic value and it's trading at only $10 a share. So this business then raises $200 million to fund some of its growth. initiatives, they issue 20 million shares to raise the needed funds. So now, I know it's a little bit harder to do on podcast form, but if you put all this in and look at the intrinsic value, because they're issuing shares that are cheap, the intrinsic value has actually dropped from the $20 per share to $17 per share. Obviously, that's not great, right? So, but now let's contrast that with a business when shares are trading at a premium. So let's take the exact same business.

Starting point is 00:36:26 And let's say that now instead of trading at $10, it's trading at $40, double its intrinsic value. And let's just say, for the sake of simplicity, they still need to raise $200 million. So now they only need to sell or issue $5 million shares. And in this case, intrinsic value actually increases from $20 to $22. So these equity issuances, you know, they can make some sense, but they have to be done at the right time. And it has to be done by a management team that has a very good understanding. of the intrinsic value of their business. And unfortunately, I just think that's, it's pretty rare. It does happen, but it's rare. So when considering a business future, I think you should

Starting point is 00:37:06 always consider how the future growth of that company is going to be funded. And you need to be obviously very realistic about it. Some businesses can still offer upside, even if shares become diluted. I wouldn't say that's very often, but opportunities do exist for people out there looking close enough. But, you know, if you have to give preference, I would say internal funding is going to be your best bet and then go, you know, bank funding after that. I didn't talk about here, but, you know, some businesses have really high returns on invest in capital. And those types of businesses are the types of businesses that probably do want funding past what's internally generated so that they can continue making more and more profits. So, you know, I like a lot of serial acquires. And part of the allure of serial choirs is that they, they get this larger growth. runway because they can purchase other companies. And, you know, sometimes they have more ideas to buy other companies than they have cash on their balance sheet and therefore they will borrow money from banks to help increase their returns. So the next point here is management open about mistakes and failures or do they try to sidestep them? So I absolutely love this point. It reminds me of a

Starting point is 00:38:14 passage from poor Charlie's Almanac. So Charlie says, I don't want to think we have any way of learning or behaving so you won't make a lot of mistakes. I'm just saying, saying that you can learn to make fewer mistakes than other people. And how you fix your mistakes faster when you do make them. But there's no way that you can live an adequate life without making many mistakes. Part of what you must learn is how to handle mistakes and new facts that change the odds. Life, in part, is like a poker game, wherein you have to learn to quit sometimes when holding a much loved hand. So you want management teams that are honest with themselves and the shareholders that we work for like Charlie was for Berkshire for so many years.

Starting point is 00:38:52 managers who constantly try to sugarcoat things are not what you should be searching for or settling with. I would prefer a manager who can admit past mistakes and openly discuss what they learned and how they will proceed going forward. It's a rare trait to find, but these managers definitely do exist. The main reason this is so important is that you want honest managers. If they're honest about the things that are hard to talk about, you can assume they'll also be honest about the things that are easy to talk about as well. And those are the types of managers that Philip Fisher wanted to be partnered with. And same with me. I think that's the same type of partners that Warren Buffett wanted as well.

Starting point is 00:39:28 So next section of the book here that I wanted to discuss is Fisher's points on conservative investing. He points out two aspects of conservatism. One is a conservative investment, which just means that an investment can maintain purchasing power at minimum risk. The second is the act of conservative. investing, which is just having a great understanding of a conservative investment and being able to systematically discern the degree of risk in conservative investments.

Starting point is 00:39:57 The interesting point here is that Fisher spends a large part of his book talking about growth type investments, then spends more time talking about conservatism. It seems at odds, but don't worry, he ties it in very nicely here. If the objective is conserving one's funds, the goal is safety. Why have we been talking about growth and the development of new and additional product? lines. Why isn't it enough to maintain a business at its existing size and level of profits without running all the risks that occur when new endeavors are started? When we come to a discussion of the influence of inflation on investments, other reasons for the importance of growth will present

Starting point is 00:40:32 themselves. But fundamentally, it should never be forgotten that in a world where change is occurring at a faster and faster pace, nothing long remains the same. It is impossible to stand still. A company will either grow or shrink. A strong offense. is the best defense. A conservative investment will have three vital aspects. One, the company must have a degree of paranoia towards advancing technologies and staying ahead of product offerings from competitors. Two, businesses must have a great working environment for all employees.

Starting point is 00:41:06 And three, management must be disciplined in sustaining their growth initiatives. So, his primary point is that you want a business managed by a team that displays tangible changes very, very well. You will not be making a conservative investment if a manager constantly touts the new initiatives they've implemented while showing nothing meaningful in the financial statements or in the business's fundamentals.

Starting point is 00:41:28 To me, this just screams of management with a high degree of ability to execute initiatives. You can analyze this by looking at annual reports from a few years ago and noting any initiatives that they've implemented. Fast forward a few years, I note if they still see the fruits of those same initiatives. Or have they completely swept them under the floor

Starting point is 00:41:46 because they were failures. The third dimension of a conservative investment is the presence of a moat, which I already covered in quite a bit of detail. A simple screening tool Fisher outlines is looking at a given industry's profit margins. You only really need to see a two, maybe three percent edge for one business to be ahead of the competition and have some sort of moat present. The fourth dimension of a conservative investment relates to the price you pay for that investment. Fisher echoes Benjamin Graham pretty well, saying that the price is a subjective appraisal. It's important to be a conservative investment. It's important to remember that the market as a whole can be incorrect in its appraisal of a business. Now, Fisher's advice to investors here is excellent. The conservative investor must be aware of the

Starting point is 00:42:26 nature of the current financial community appraisal of any industry in which he is interested. He should be constantly probing to see whether the appraisal is significantly more or less favorable than the fundamentals warrant. Now, if you've been listening to TIP episodes for a while, you know that we are all big fans of quality on the show. But quality is. a double-edged sword. Companies that are very clearly high-quality businesses tend to trade at a premium most of the time. Many value investors skip these investments entirely for fear that overpaying will lead to losses in an investment. But Fisher has a simple counter-argument, he talks about. The further out you can project earnings growth, the higher a multiple you can

Starting point is 00:43:05 pay and still make an acceptable return on your investment. The hard part of investing is nailing down a quality business and holding it for as long as that quality remains high. This has proven to be a very challenging pursuit for many investors. Another problem that can arise from high quality businesses is that investors can get excited about an idea and pile into the name further increasing the share price. There is always a possibility that the share price has a multiple that's very, very high. And when you buy it, that multiple goes down, never to reach that high again. So in that case, you know, buying even a quality business is probably a mistake unless you're

Starting point is 00:43:42 planning on holding it for a very, very long period of time. Now, one method to combat this is to look at historical multiples and use a baseline during non-ephoric times as your base rate. Sure, you may miss businesses like Costco, but you'll also avoid a lot of hidden risks. Fisher also notes that the true test of whether a stock is currently cheap or expensive is not based on its current stock price. What determines evaluation is whether the company's fundamentals are more or less favorable than the current financial community's appraisal of that stock. This concept is not very well understood by investors, but it definitely should be. If a company consistently improves its fundamentals year in and year out, you will observe that the stock price fluctuates more than the fundamentals do.

Starting point is 00:44:25 This means you must be prepared to focus on the right thing, the fundamentals, and most importantly, ignore the wrong thing, the stock price. So Poulat Prasad and his brilliant book, What I Learned About Investing from Darwin, did a wonderful job discussing this concept called punctuated equilibrium. This is a concept where businesses don't tend to change all that much and tend to spend most of their time being static. But the stock price is not static. One of the major mistakes investors make is to attribute stock price fluctuation to business fluctuation. Prasad pointed out that is not the right decision, as you'll end up selling many great businesses at high prices that can continue climbing for many years into the future.

Starting point is 00:45:04 The way to take advantage of business punctuation is when the market mistakes business punctuation and price fluctuation. This is where the price is being punished, but the business remains static or is even improving. In this case, buying is a correct decision. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together

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Starting point is 00:48:41 Back to the show. So the last part of this book that I like to discuss is Fisher's investing philosophy. I'd like to discuss its origin, lessons from his life experiences, and how it has matured. Fisher's first foray into creating his philosophy was in 1928. At this time, he was attending Stanford University's graduate school of business. One of his professors instilled some great rules into him during his education year. For instance, he was taught to never invest in a business where you could not speak to management. During Fisher's chats with management, he was taught to learn about the management team's strength and weaknesses.

Starting point is 00:49:15 Pilla Fisher had many back and forths with his professor as he drove him to many of these meetings with management. And he said that these conversations were one of the most valuable experiences that he ever had as an investor. Another important lesson he learned from his experience was the importance of sales to a business. So a healthy business must have the right sales to flourish as an investment. If a business has a brilliant inventor or an extremely efficient manufacturing process, but no ability to actually sell its products, then the business is not worth investing in. Returning to Fisher's 15-point checklist, you can see how he embedded that into it. He wanted to know that management could not only continue innovating and bringing new products

Starting point is 00:49:56 to the market, but also that they had the sales team set up properly so that the product would have exposure to the right market. Now, this seems pretty intuitive to me, but perhaps spending more time learning about the sales processes in businesses would be beneficial to the investor analysis process. After graduating, Fisher took a job at a local bank, but it wasn't not a good fit for him. Quote, the work I was assigned to do was extremely simple. In my opinion, it was also intellectually dishonest. The investment arm of the bank was chiefly engaged in selling high interest rate,

Starting point is 00:50:26 new issues of bonds on which they made quite sizable commissions as part of underwriters. writing syndicates. No attempt was made to evaluate the quality of these bonds or any stocks they sold, but rather in the day of a seller's market, they gratefully accepted any part of a syndicate offered them by their New York associates or by large investment banking houses, unquote. As you can see here, Fisher's opinion of security analysis was pretty low during this period of time. While he was at the bank, he realized how poorly done analysis really was. So he talked about how an analyst would just look up a company on Moody's or standard statistics than someone like Philip or in his position was zero knowledge of the business would then

Starting point is 00:51:06 paraphrase the wording of the information into their own report. Philip was never told to analyze the business any further than this very, very surface layer of work. This is pretty shocking to me, but I guess not really that surprising. The late 20s were a time of incredible speculation. So many of these banks were more interested in just collecting fat fees as efficient. as possible rather than actually enriching their clients. And the sad thing is, is that we still see the same thing today. So whether you invest yourself or have someone else to do it, ensure you don't

Starting point is 00:51:35 copy this blueprint above for investing. Do your work and come to your own conclusions. If someone else manages your money, you have every right to ask them about what they're investing your money into. If they can supply a coherent answer to why they have your money invested in a specific stock, then you probably don't want them managing your money in the first place. So back to Philip Fisher. As 1929 ruled around, Philip thought the market was overpriced and due for a major bear market. But the powers of greed set in, and Philip attempted to find cheap stocks that could still go up in price even in a bubble-like market. So what he did was he divided the money that he had saved from previous work into three stocks that he felt were undervalued. But as the depression deepened, Philip unfortunately paid a very steep price for an important lesson.

Starting point is 00:52:19 His initial investment shriveled to a tiny percentage of the original investment. realized that the shares had been cheap for a reason, and unfortunately the depression was not helping with any re-rating. So this was the basis for his emphasis on buying growing businesses. Pisher wrote, I began realizing that all the then current Wall Street opinion to the contrary, what really counts in determining whether a stock is cheaper overpriced, is not its ratio to the current year's earnings, but its ratio to the earnings a few years ahead. If I could build up in myself the ability to determine within fairly broad limits what those earnings might be in a few years from now, I would have unlocked the key both to avoiding losses and to making magnificent profits.

Starting point is 00:53:02 Now, this is a wonderful lesson that really fits with Charlie Munger's mantra of buying wonderful businesses at a fair price over a fair business at a wonderful price. I think it's a great mental model for thinking about business prices. Many cheap businesses are rightfully cheap and can always get cheaper in the future. And many expensive businesses are rightfully expensive and can get easy. even pricier in the future. The most important part of this, according to Fisher, was to nail down the likelihood of a business continuing to grow in the future. If you know the business will continue to grow, especially for multiple years in the future, you can justify paying a higher price.

Starting point is 00:53:36 But you must be certain that this will happen. I think this is why Warren Buffett places such a large emphasis on certainty during his analytical process. If he lacks the certainty required to understand whether profits will be higher in the future, he'll simply throw the business in the too hard pile and move on to something else. I think this is an intelligent way to invest and can definitely keep you away from making many risky investments. As Phillips continued to evolving, his focus started to increase on management quality rather than just the quality of the underlying business.

Starting point is 00:54:06 Fisher used the term business ability to discuss what made an excellent management team. He broke down business ability into two skill types. One, handling day-to-day operations above average efficiency, and two, the ability to look ahead and make long-range plans while managing risk. Fisher points out that many businesses have one of these qualities, but that it's very rare for a business to have both of them. He also points out that for real success, both of them are necessary. But just reading these two points makes me think a lot about Copart, which is a business that I mentioned previously. So Willis Johnson was always innovating and striving to increase efficiencies in Copart,

Starting point is 00:54:45 and he also implemented long-term goals to improve the business over the long-term. A great example of this was in the early days of the internet. So in 1996, Willis Johnson's son-in-law, the former CEO and current chairman of Copart Jay Adair, had a brilliant idea of improving Copart using the internet. So at this time, Copart had a master list of vehicles each day, and this list was often 8,000 pages long. So leveraging the internet would instantly increase efficiency by saving on paper and improving their ability to sort through their inventory at a much faster rate. But Jay went even further. He observed that there were reps for customers placing bids on cars that their clients wanted for $100.

Starting point is 00:55:23 They were clearing $2,000 plus per day using this strategy. So Jay realized he wanted a piece of this action. And so he helped create Copart's online bidding system. This system was value-creative to both Copart and its customers. So for only a $35 fee, you could bid on a car from the comfort of your own home. So after employing this strategy, Copart had a million dollars in sales in the first quarter after. So here you can see how Jade Air, increased copart's efficiency, which then reduced costs. Then he leveraged the internet to create

Starting point is 00:55:54 long-term advantages for copart at low risk. In a case you're wondering, the system has evolved since then and is still a big part of Copart's business model today in 2024. If you want to learn more about the business of Copart and its founder, my co-host Clay has discussed the stock of Copart on TIP 549, and he's discussed the autobiography of Copart's co-founder Willis Johnson on TIP 601. So back to Philip Fisher in management. Fisher points out that management integrity is vitally important. Quote, the owners and managers of a business are always closer to that business's affairs than are the stockholders.

Starting point is 00:56:29 If the managers do not have a genuine sense of trusteeship for the stockholders, sooner or later the stockholders may fail to receive a significant part of what is justly due to them. Managers preoccupied by their own personal interest are not likely to develop an enthusiastic team of loyal people around them. Something that is an absolute must if a business is to grow to a size. that one or two people can no longer control." Now, this is such a powerful point. And it's why it's important that management owns shares in a business and tangibly feel

Starting point is 00:57:00 both the upside and downside of their decision making. When insiders have no shares, their compensation is entirely tied to their salary and incentives. But if they own shares, then they are compensated to continue improving the fundamentals of the business, which will also increase their wealth as the share price increases. Fisher had some excellent insights in Motorola that remind me a lot of Bill Miller's concept of descriptions. So Bill Miller thinks you must use proper descriptions when looking at a business.

Starting point is 00:57:28 If you use the consensus description, you'll often miss out on a lot of potential. Amazon is Bill's greatest example, but let's look at Motorola and Philip Fisher a little more. So in 1955, Fisher purchased shares in Motorola. At that time, Motorola was seen as just another television and radio producer. However, through the scuttlebutt that Fisher had done, he realized that Motorola had some very intriguing products in development.

Starting point is 00:57:51 Since Motorola was so dominant mobile communications, it seemed likely that they could leverage that into additional growth levers into the future. So they started in the semiconductor industry by acquiring the services of a very intelligent person named Dr. Daniel Noble. Philip thought that Motorola could compete with giants in the industry like General Electric, RCA, and Westinghouse in the semiconductor industry. He was criticized for this move as a speculative play, and the immediate results didn't pan out as, shares were down 5% for 10% from his initial purchase price. But then something interesting happened. The semiconductor industry started gaining in popularity. Side note, it's funny how history doesn't repeat itself, but it often rhymes. Now, I couldn't find the stock price performance from 1955 to

Starting point is 00:58:33 1958, but Fisher said that there was an insurance company he worked with that also owned shares in Motorola. During that three-year time period, Motorola outperformed every stock in their portfolio, so I can only assume that it did reasonably well. Another excellent point of emphasis that I observed in my notes of this book is being self-aware of complacency or laxness. Fisher did very well with his picks from 1954 to 1969, and many of his positions beat the market as a whole. But he paid special attention to his mistakes regarding complacency and laxness. This lesson taught him not to place too much importance on the opinions of a few individuals. Let's go over an example. In the 1960s, Phillips wanted to gain exposure to the pharmaceuticals industry.

Starting point is 00:59:14 He spoke to a medical specialist as part of his scuttlebut. He learned this individual was very excited about a new family of drugs that were going to be manufactured by one specific business. Continuing with his due diligence, he spoke to a few other investment professionals and business officers. But his mistake was, unfortunately, I did not pursue my standard checks either with other drug companies or with other knowledgeable people in this particular specialty to see if they might have contrary evidence to offer. Regretfully, I subsequently learned none of the proponents had made a thorough investigation. either. So Fisher ended up making the investment and losing 50% on it. He said after the loss, he could have prevented himself from buying the business if he'd done a better job doing his due diligence. He found that management had some weaknesses he felt he could have identified with a more

Starting point is 00:59:58 thorough investigation of the business. So another point of complacency that Fisher makes is not keeping up with the events of a business at all levels of that business. So Fisher owned a business called Central California Electronics. Now, this business was going through a decline and Fisher thought the decline was just a temporary headwind. But he was blinded by the success that this investment had provided for him up until this headwind came up. And his main mistake that he admitted was spending too much time listening to top level management while not putting enough work in at lower levels and ultimately with customers. Luckily, he noticed this error early, was able to invest much of the winnings from this company into his investment into Motorola

Starting point is 01:00:39 of that I just discussed. So to conclude this book, Philip discusses eight key points that envelop his investing philosophy. Now, they're outstanding, so I want to briefly list them here. One, invest in businesses with discipline and profitable growth plans that have competitive advantages. Two, buy companies when they're undervalued due to weak market conditions or market misperception. Three, hold the stock until there are significant fundamental changes for the worse, or the business cannot outpace the economy. Also, self-of-management is unable to adapt to future growth initiatives. 4. Focus on capital gains over dividends.

Starting point is 01:01:16 The best opportunities rarely pay dividends. 5. Accept that you will make mistakes in your investing lifetime. But make sure you learn from them and avoid making them again. 6. There are very few outstanding companies and even fewer great investment opportunities. So concentration is an intelligent decision. Keep holdings in the 10 to 12 range.

Starting point is 01:01:35 7. You should form your own opinions about a business. whether they are contrary to popular belief or in line with popular belief, it does not matter if you are correct in your judgment. 8. Success in investing requires hard work, intelligence, and honesty. Now let's touch on how Phillips philosophy impacted Warren Buffett. The book was first released in 1957, and the Buffett partnership started in the same year. But Buffett was not following Fisher's tenants too closely at that time.

Starting point is 01:02:02 He was laser focused on the lessons he learned from Benjamin Graham. But as time went on, he met Charlie Munger. he began scaling up pretty fast, and Warren's philosophy changed toward the teachings of Philip Fisher. Robert Hagsman believes that today Warren Buffett is 50-50 between Benjamin Graham and Philip Fisher. I tend to agree with this notion, as you can see many of Buffett's investing philosophies are aligned with the teachings outlined in this book. Much has been said about how Warren Buffett had to evolve as investing philosophy away from cigar butts and towards quality. And I think this book was a perfect launching point for Warren to improve his already impressive investing strategy. To conclude this episode, I'd like to share some of my primary takeaways, which I know will continue

Starting point is 01:02:40 to evolve with my own investing philosophy. The majority of my lessons are on the points on Scuttlebutt. As I've read this book and interacted more and more with other fund managers and full-time personal investors, I've observed the great lengths that people go through to truly grasp and understand a business. While I think I was on the right path, I've learned more and more about how to amplify my knowledge base. This book does a beautiful job of explaining why and how to improve your Scuttlebutt techniques. While institutional investors, will always have an advantage in their network to acquire information, I think that the average investor can still take a lot of lessons from this book and apply them to their own investing

Starting point is 01:03:16 framework to improve their knowledge of a business, increase their circle of competence, and reveal any shortcomings in their investing thesis. So a couple of things that I'll start doubling down on include talking with lower level employees inside of a business. LinkedIn, as previously mentioned, seems to be the best way to do this. It can be hard to find people who will chat openly, but if you're persistent enough and ask nicely, people are generally open to chatting. So I also want to work on having more ongoing check-ins with upper-level management. I already have a few relationships with managers of some of the businesses that I own. I can use these to check in once or twice a year and get a better grasp of how the business is going from the C-suite level.

Starting point is 01:03:54 And then I also want to improve on my industry due diligence. This includes reaching out to customers and suppliers. So as some of the case studies that Fisher shares in this book highlight, these can be invaluable sources of information for identifying hidden upside and potential downsides inside of a business. This is the due diligence that might be the most important and is also accessible to anyone willing to put in the work. Here's a great case study that illustrates this point. So there was a trader named Jeffrey Newman, who was profiled in the latest edition of

Starting point is 01:04:23 Unknown Market Wizards. He was asked what some of his most profitable trades were in the last three years. Keep in mind, this question was posed in 2022. Quote, I watched the news for a living. It all began when I saw the initial reports of a coronavirus outbreak in China. I went to a CVS to buy some masks and I couldn't find any. When I asked for them, the clerk laughed at me and said, We don't have any and we're not going to get any.

Starting point is 01:04:45 Then I went to a Walgreens and they said, we might have them in a few months, but you can keep checking every day. I had traded through swine flu and bird flu and was familiar with a type of market plays these situations provided. I went home and bought a large stake in Alpha ProTech, a small cap mask maker. I smashed it. The stock went ballistic shooting up from $4 to $4 to $4.

Starting point is 01:05:02 to $40 in only 10 days. That trade started at all, unquote. I'm no trader. APT is now a $5.56 cents as of June 24th, 20204. But the point still stands that you can find wonderful opportunities in the market if you're curious and willing to ask questions to the right people, even if that just means asking a store clerk a question. If you find a product that you need or that you love flying off the shelves so fast that

Starting point is 01:05:27 you can't even buy it, that's an honest signal that's probably worth pursuing and seeing if there's an investment opportunity. But I think having ongoing touch points is very important. As Fisher mentioned, getting complacent with your winners can cause you to lose a lot of money. So whether your business is a winner or a loser or moving sideways, don't get lazy. Keep up with all your businesses, ask hard questions to people who can best answer them, and keep reassessing. That's it for today's show. Thanks for joining me.

Starting point is 01:05:53 Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

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