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Phil Fisher: When to Buy Stocks

- By Robert Abbott

In previous chapters of "Common Stocks and Uncommon Profits and Other Writings," Philip Fisher argued that investing successfully means finding stocks that are expected to post strong earnings per share growth in coming years.

Following up in chapter five, he asked if investors should buy those stocks when they are found. The answer was "Yes and no." For example, if investors bought superior companies in the summer of 1929, they would make money if they held those stocks for 25 years.

To maximize profits, though, investors need to have "made the small extra effort needed to understand a few simple principles about the timing of growth stocks." However, Fisher rejected what he calls the "conventional" method of timing, which is to collect a "vast mass" of economic data and use it to make buy and sell decisions. He noted that while it was not unreasonable in theory, the limits of human knowledge make it unworkable in practice.

Instead, he argued for a different type of timing: Buying when a company is improving its earnings, but before that increase has begun to push up its share price. As he wrote, "The answer lies in the very nature of growth stocks themselves."

With that, the author reviews the types of growth. companies he prefers: "These companies are usually working in one way or another on the very frontiers of scientific technology. They are developing various new products or processes from the laboratory through the pilot plant to the early stages of commercial production."

Fisher believed the best time for investors to begin buying is at the point where the first full-scale, commercial plant is ready to start production. Early in the production process, there will be a number of bugs, and they may last longer than anyone expects. At the same time, the company is pouring cash into it and not seeing much, if any, return from those costs.

It's during these dismal times investors should act. Eventually, the plant will get past its early-stage problems and as earnings begin to increase and word about production success gets out, buyers will start bidding up the price of its shares.

One of the examples Fisher used was American Cyanamid, a top 100 manufacturing company in the 1970s and 1980s, before being reorganized in the 1990s. Most of the company (pharmaceuticals) ended up with Pfizer (PFE), while the smaller, chemical operations were bought by several companies, including BASF (BAS) and Procter & Gamble (PG).

In the early 1950s, its stock was selling for a lower price-earnings ratio than other chemical companies because it was a conglomerate. In Fisher's words, it was a "hodge-podge of expensive and inefficient plants flung together in the typical 'stock market' merger period of the booming 1920's. These properties were generally considered anything but a desirable investment."

The market had not noticed a new management team had taken over and was cleaning up the mess, cutting costs, eliminating non-productive elements and streamlining the company. It was also "making a huge bet" on a giant new organic chemical plant. It was a highly complex build and months behind schedule, worsening the company's already poor reputation.

The turnaround worked, and the plant became profitable. Earnings jumped from $1.48 per share in 1954 to $2.10 in 1956. For 1959 (this book was published in 1958), the earnings were expected to hit $2.42. The market began to take notice; while the earnings power grew by some 70% over five years, the stock price jumped 163% in the same period.

A similar example was offered in the Food Machinery and Chemical Corp., now FMC Corp. (FMC). After decades of well-regarded machinery manufacturing, it decided it would try to stabilize cyclical earnings by investing in chemical plants and went on to buy four chemical companies. The chemical side of the business represented about half of sales volume in the mid-1950s.

While buying the chemical companies, it purchased some underperformers and the market lost interest in the new conglomerate. Management, though, was working to correct the problems and by 1958, its earnings hit an all-time peak. The market was again taking notice and bid up the share price by 102% in about one year.

Other phenomena can also lead to buying situations like these. Fisher cited the case of an electronic company that had an excellent reputation for "unusual and excellent labor relations." However, its growth led the company to change its labor relations practices, resulting in slowdown strikes and lower productivity. At the same time, it also misjudged the market for a new product. Earnings fell off, as did the share price.

What Fisher called "unusually able and ingenious management" acknowledged the problems and set about correcting them. While they developed their plans quickly, execution took much longer and earnings and the share price languished. Matters were made worse by two strikes during the correction period and the financial community thought the company was going from bad to worse. Astute observers, however, saw an opportunity emerging. Fisher wrote, "Those who looked beneath the surface and saw what was really happening were able to buy, at bargain prices, a stock that may well grow for them for many years."

Thus, investors should be looking for "exceptionally able management." When problems occur, as they are so likely to, a good management team will turn their circumstances around; that provides an opportunity for investors to get into a quality company at a bargain price, and watch it outperform for years to come.

Another exceptional opportunity arises when a company finds new efficiencies; Fisher's example was of a company that invests 15% more in existing facilities and sees output increase by 40%.

Fisher may call his favored securities growth stocks, but in today's terms they look quite a bit like value stocks, where investors put their capital in temporarily troubled stocks. If investors can catch those rebounding companies before the rest of the market, they should enjoy many years of above-average results.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.