Common Stocks and Uncommon Profits – Book Review

When Warren Buffet was asked for his top book recommendations, his list included the following four books (in no particular order of importance):

  1. The Wealth of Nations by Adam Smith
  2. The Intelligent Investor by Benjamin Graham
  3. Security Analysis by Benjamin Graham & David Dodd
  4. Common Stocks and Uncommon Profits by Philip Fisher

Buffet has admitted that his own investing style is a mix of teachings from Ben Graham and Philip Fisher. I have already read the Intelligent Investor and Security Analysis multiple times and I am sure to read these several more times in my investing journey. However, I have never read Philip Fisher. The book was first published in the 1950s, so before even picking up this book, I had a sense that some of the observations may be dated. But I wanted to take a look anyway.

Before we get into the book itself, I wanted to first explore a little more about Philip Fisher, the person behind the book.

Who is Philip Fisher?

Fisher made his humble beginnings as a dropout of the then newly created program/school Stanford School of Business Administration in 1928, to start working as a security analyst. He started his own investment firm called Fisher and Co. in 1931 and remained at the helm till his retirement in 1999. Immediately after starting his firm, due to the advent of World War II, he was forced to take up several desk jobs at the US Army Air Force. He used this opportunity to research and refine his own investment philosophy which he later put into practice after the end of the war.

I could not find a whole lot more information about him through the interweb beyond what he mentioned in his book and also what his son, Kenneth Fisher, has mentioned in the preface. He was known to a very private person, not known to give a lot of interviews. However, after publishing this book, he rose to prominence. Per what I have gathered reading around the internet, Fisher and Co. had a very small number of selected clients who were able to secure attractive returns using Phil Fisher’s approach. Today, he is widely regarded as a pioneer of growth investing and recognized by Morningstar as one of the greatest investors of all time.

Phil Fisher was one of the early proponents of the “buy and hold” strategy. To stress this point further, one of his most successful investments was a purchase of Motorola, which he bought in 1955 and held until his death in 2004. His other investments were Texas Instruments, a stock that I currently hold in my dividend portfolio, Dow Chemicals and so on.

During the later half of his life, he began suffering from dementia and/or Alzheimer’s disease and he ended up selling all of his holdings except for Motorola. Per his son Kenneth Fisher, he would never have sold his investments had he been of sound mind or his younger self and his investment returns would have looked much much better as a result. Fisher was known as a strong supporter of companies that would invest in research and development and a master at evaluating companies in the tech sector. This was a good 50 years before the advent of Silicon Valley.

Lets get into the book itself.

Book Dedication

The book starts of with a rather interesting dedication. Let me quote it here:

This book is dedicated to all investors, large and small, who do NOT adhere to the philosophy: “I have already made up my mind, don’t confuse me with facts.”

I paused after reading that statement because there is an interesting paradox. At times, as investors (and perhaps as individuals) we can be very closed-minded and not as receptive to opposing viewpoints. Maybe it is with the understanding that having a conflicted mind can impact our investing philosophy and mess with our heads. This trait can be good but it can also be bad as it stunts our learning process. It takes a strong mind to be open to counter viewpoints and somehow let that organically grow one’s own investing mindset.

Scuttlebutt technique

One of the strategies that Fisher repeatedly uses to evaluate businesses before deciding to buy them is coined as “scuttlebutt”. What does this mean?

Fisher recommends that in addition to studying a company’s financial statements, a wise investor can learn a lot more about any given company through the following avenues:

  1. By going to five companies that are competitors and asking them intelligent questions about the strengths & weaknesses of the other four. Fisher claims that, more often than not, this approach will give the investor a surprisingly detailed and accurate picture of the overall landscape of the sector and the business itself.
  2. By questioning vendors and customers that directly interact with the company.
  3. By questioning research scientists who rely on products manufactured by this said company.
  4. By questioning former employees of the company. Although, Fisher cautions about using this input with a pinch of salt as there could be bias in opinions here.

Fisher admits that while a typical retail investor may not (or cannot) have the leverage to go on such fact-finding missions, he/she can use these as a yardstick when choosing a professional advisor that can help them with such analysis.

With the scuttlebutt technique as the baseline, Fisher recommends the following 15 principles to look for in a stock before investing in them:

  1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for atleast several years?
  2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials 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?
  4. Does the company have an above average sales organization?
  5. Does the company have a worthwhile profit margin?
  6. What is the company doing to maintain or improve profit margin?
  7. Does the company have outstanding labor and personnel relations?
  8. Does the company have outstanding executive relations?
  9. Does the company have depth in its management?
  10. How good are the company’s cost analysis and accounting controls?
  11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will given the investor important clues as to how outstanding the company may be in relation to its competition?
  12. Does the company have a short-range or long-range outlook in regard to profits?
  13. In the foreseeable future will the growth of the company require sufficient equity financing so that the large number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
  14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
  15. Does the company have management of unquestionable integrity?

For a book that was published more than 60 years ago, I am amazed to see that so many of these principles are timeless and very much applicable even today. Fisher admits that it is unlikely that one would find a company that would meet all 15 of these principles, but he recommends to avoid companies that do not pass several of the above.

Selling Out of Positions

After going through all the research and investigation on what to buy and when to buy, an investor would naturally be curious about when to sell to gather profits. For this, Fisher states the following:

If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.

Evidently, Fisher is a supporter of the philosophy or buying and holding. He goes into several reasons why investors choose to incorrectly sell out of their positions. I particularly liked the discussion on selling out when the investor believes a stock is overvalued/overpriced:

This brings us to another line of reasoning so often used to cause well-intentioned but unsophisticated investors to miss huge future profits. This is the argument that an outstanding stock has become overpriced and therefore should be sold….Before reaching hasty conclusions, let us look a little below the surface. Just what is overpriced? What are we trying to accomplish? Any good stock will sell and should sell at a higher ratio to current earnings than a stock with a stable rather than an expanding earnings power…All of this is trying to measure something with a greater degree of preciseness than is possible. The investor cannot pinpoint just how much per share a particular company will earn two years from now…As a matter of fact, the company’s top management cannot come a great deal closer to this .. Under these circumstances, how can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate?

I found this discussion particularly interesting and revealing. Valuing growth stocks, especially the ones that are early in their growth trajectories, is incredibly hard. Even top-investors like Warren Buffet, Mohnish Pabrai and the likes in various interviews have stated how they have tossed such opportunities in the “too hard” basket.

Dont’s for investors

Fisher goes into several dont’s for investors. I will cover some of the ones that I thought were interesting:

  1. Don’t buy into promotional companies.
  2. Don’t overstress diversification.
  3. Don’t be afraid of buying on a war scare.
  4. Don’t fail to consider time as well as price when buying a true growth stock.
  5. Don’t follow the crowd.

Again, several of these dont’s are just as applicable today as they were when this book first came out. I wanted to expand on the second point regarding diversification here. Fisher states the following:

The horrors of what can happen to those who “put all their eggs in one basket” are too constantly being expounded. Too few people, however, give sufficient thought to the evils of the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after all eggs get put into them.

So clearly, Fisher believed in having a concentrated portfolio rather than diversifying among several sectors/industries. I have previously written about this subject stating why I disagree with this philosophy. There is a sea difference between the business acumen that the likes of Fischer, Buffet and Munger possess in comparison to an average retail investor such as myself. Diversification is a protection against this shortcoming and if performed as a part of a specific strategy, also provides a great defense in a various economic environments. A risk-averse investor would want to safeguard his invested capital and diversification is one way to achieve this.

Other writings

Part 1 of this book covers the subject of Common Stocks and Uncommon Profits. Parts 2 and 3 cover some of Philip Fisher’s other writings dealing with subjects regarding “Conservative Investment” and details on how Fisher went about developing his investment philosophy over the course of his life. I will cover the other two parts in greater detail in a future post on this blog as they are very important topics by themselves.

Overall thoughts regarding this book

Peter Lynch, another investing legend, once stated that investing needs to be a fine mix between science and art and that an astute investor will ensure that there is a proper balance maintained between both facets. If this balance is lop-sided in either direction, it could lead to a bad decision. I get a sense that while Buffet relies on Graham’s teachings for the “science” side of his investment philosophy, he chooses to rely on Fisher’s teaching for the “art” aspect of his investments.

In comparison to Graham’s books, I found the writing style in this book was very easy to follow. In that regard, I found the book to be more amenable to a beginner investor. Although the subject is mostly focused around picking growth stocks, I could see the same principles being used for evaluating dividend growth stocks and/or value stocks as well.

Some of the techniques mentioned in the book are just as well applicable to this day and age. I use an “indirect scuttlebutt” strategy in my analysis, where I look at the interviews of the CEOs (or other members of the board/management) for companies that I am interested in. If I can see consistency in responses and clarity of thought, that is usually a good sign. But if I detect BS in the responses, that is a massive red flag. I also read through forums, talk to technicians/consumers to see what they think of the products coming from a company which I am considering to invest in.

My only critic is that the writing at times appeared to be very dry. I could see some interesting parallels with the ideas discussed in Peter Lynch’s books, but in comparison Peter Lynch has a knack of keeping the reader engaged with his humor. I would have also liked to see more examples, potentially with graphs to accompany the discussion surrounding profit margins, cost of research vs size of the company etc. But some of these are very minor critics.

Overall, this is a great book and something I will re-read in the future.

Have you read this book? What were your takeaways? Please drop a comment below.

The Dhandho Investor – Book Review

I have decided to launch a new category on this blog where I will discuss my insights gained from reading investing books written by famous investors. It is widely acknowledged in the investing community that the knowledge gained from reading such gems will be lot more fruitful for the average investor. So it seems like a good idea to (re)read them and also discuss the learnings within the community.

For my first book in this series, I decided to pick a book written by an investor whose name has come up so many times in the recent past in my readings on value investing: Mohnish Pabrai.

Who is Mohnish Pabrai?

Mohnish has an interesting history. Born in Mumbai, India, Mohnish first came to the US to pursue a degree in Computer Engineering at the Clemson university. After graduating, he worked at Tellabs as an engineer first and then in the marketing division. In 1991, he quit Tellabs to start his own IT consulting firm called TransTech. He did so by cashing out his 401(k) retirement account, which yielded about $30,000, along with a credit card debt of $70,000, giving him the capital to start his company. He eventually sold his company for about $20 million in 2000. Mohnish founded the Pabrai Investment Funds in 1999 and continues to run that to this day. Interestingly, he was motivated to get into investing after reading another classic investment book (and something I hope to cover in the near future) called “One Up on Wall Street” by Peter Lynch.

Pabrai Investment Funds started out with a sum of $1 million, which as of 2020 has mushroomed into almost $469 million. Compared to the NASDAQ-100 index (ticker: QQQ) which offers a CAGR of about 8% in the same time frame, Pabrai Investment Funds offers a CAGR of around 12%.

Mohnish proudly states that he is a student of the Charlie Munger/Warren Buffett school of investing. In fact, he even goes on to state that the Pabrai Investment Funds was setup by copying ideas that he learned by studying The Buffett Partnerships. This includes ideas such as fee structure, portfolio management and other operations.

Dhandho?

So what does the word “Dhandho” mean? Dhandho is a word from a regional Indian language called Gujarati (from the Indian state of Gujarat). It literally means “business”. People from Gujarat in India are especially known to have an acumen for entrepreneurship. It comes as no surprise that one of the richest men in the world, Mukesh Ambani, who inherited his wealth from his father Dhirubhai Ambani, hails from this same state in India.

Mohnish begins his book by a discussion of a community from this state called “Patels” and how they have staked ownership for a sizeable percentage of motels in the USA. The book goes on to present several such case studies discussing more well-known names such as Richard Branson and how he launched Virgin Atlantic, Lakshmi Mittal and how he became a steel baron, and finally himself and how he launched Pabrai Funds.

All of the case studies are based on the one fundamental principle of a low-risk high-return bet i.e. a coin toss that is based on the following premise: “Heads: I win, Tails: I don’t lose much!“.

The Dhandho Framework

So Mohnish distills all his learnings from the case studies presented into the following core principles:

  1. Invest in existing businesses.
  2. Invest in simple businesses.
  3. Invest in distressed businesses in distressed industries.
  4. Invest in businesses with durable moats.
  5. Few bets, big bets and infrequent bets.
  6. Fixate on arbitrage.
  7. Margin of safety – always.
  8. Invest in low-risk, high-uncertainty businesses.
  9. Invest in copycats rather than innovators.

The first two are pretty simple and straightforward to understand. Mohnish suggests to invest your money in publicly traded companies i.e. the stock market, and to treat that as owning a piece of that business. This is far more convenient and easier to manage than starting a new business venture, has a better chance of generating a return than the other investment vehicles available. In a similar vein, businesses that are simpler to understand are easier to reason about. And why is this important? It is easier to estimate the intrinsic value of a business if it is simple to understand, because you want to know if the price you are paying for a share of a business is worth its value. Mohnish suggests using the Discounted Cash Flow (DCF) analysis to estimate the intrinsic value of a business.

The suggestion to invest in distressed businesses relies on the understanding that the markets aren’t efficient always. There are always some businesses whose current stock price have deviated from the actual health of the business itself. The suggestion here is to look past the negative headlines and to dive into the fundamentals of such businesses, while ensuring still that the business is simple to understand and within one’s circle of competence.

The suggestion to invest in businesses with durable moats is also self-explanatory. Businesses that have a competitive advantage in their domain will last for a longer time. And for the compounding of wealth to work its magic, you need business that will last decades and not a few years.

The next five suggestions in the framework are when things start to get interesting. Each of these deserve further elaboration.

Kelly’s Formula

Here Mohnish introduces us to this rather simple formula to determine how much money should you be investing in a particular business depending on the probability of winning, probability of losing and the payoff if you win.

The formula can be simply put as follows:

(P* W – L)/P = percentage of your money you should be betting

where P = payoff if you win.

W = Probability of Winning

L = Probability of Losing

So to illustrate this with a simple example: Let us consider a simple coin toss, where on Heads you win $1, on Tails you lose $1. The probability of winning and losing here is 0.5. Therefore, applying Kelly’s formula, you get (0.5 * $1 – 0.5) / 1 i.e. percentage of your money you should be betting on such a bet is 0. And that is not surprising since there is a equal probability of you winning or losing this bet. However, if you were to take the same coin toss example with a mispriced bet, where on Heads you win $2, on Tails you lose $1. In this example, Kelly’s formula suggest that you invest (0.5 * $2 – 0.5)/ 2 i.e. you should be betting 25% of your money on this bet.

Obviously, it is not as simple to estimate probabilities, but the general idea with this formula is that it will steer investors away from business bets that have a low payoff and high-risk (or high probability of losing). And with reasonable estimates, it should allow investors to determine how much percentage of their portfolio should be invested in what businesses.

The crux of this principle is: Bet big when the odds of winning are overwhelmingly in your favor.

Arbitrage opportunities

This is the Dhandho principle on steroids, where the outcome of a coin toss could lead to the following results: “Heads: I win; Tails: I break even or even win!“i.e. the investor gets decent returns at virtually no risk. Mohnish provides several examples to illustrate this point. One such example is comparing GEICO’s insurance business to that of AllState or StateFarm. Given GEICO’s business model of directly underwriting insurance policies out of call-centers of through geico.com, they have a 15% cost advantage over StateFarm and AllState, who operate through brick and mortar stores independently owned by a commissioned agent. Mohnish states that while this arbitrage spread will eventually disappear, if the savvy investor can find such an opportunity and determine that the spread will last for a while, the investor can make decent returns with very limited risk.

Margin of Safety

This is perhaps one of the core founding principles of any investor, but especially true for a value investor.

One of the best books on investing titled “The Intelligent Investor” was written several years back by the godfather of value investing, Benjamin Graham. This book has a chapter dedicated to this subject of “Margin of Safety”. Graham states the following at the start of the chapter:

Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

At the heart of it, the principle is simply the following: When buying a business, ensure that the price you are paying is way less that what you think it is worth. Thus, when attempting to estimate the intrinsic value of a business, after you have arrived at a figure, you pad that with some extra percentage for uncertainty in your calculations, similar to how a structural engineer would add a “margin of safety” to his/her specifications for a building/design project.

Investing in low-risk and high-uncertainty businesses

Mohnish draws a distinction between businesses where the range of possible outcomes of investing are very large versus the odds of permanent loss of capital. He states that Wall Street confuses the aspects of uncertainty and risk and this confusion can result in an opportunity for the watchful investor. Mohnish argues that Wall Street prefers the low-risk low-uncertainty businesses and these, therefore, typically trade at very high multiples. He gives examples of ADP (ticker: ADP), Paychex (ticker: PAYX), Procter and Gamble (ticker: PG), Costco (ticker: COST) as low-uncertainty businesses and suggests to avoid such businesses since they rarely trade at a discount.

I can see where Mohnish is coming from in this context when viewing these as value investing opportunities. However, as a dividend growth investor, my perspective is slightly different here. PG and ADP are fantastic companies from a dividend growth investor perspective, they are dividend aristocrats. They have been around for decades, have a stable cash flow and, in my opinion, should find their place as a core/foundation stock in a dividend growth investor’s portfolio.

Investing in copycats rather than innovators

Mohnish states the following:

Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.

Mohnish provides several examples to emphasize his point. One such example was regarding Microsoft (ticker: MSFT). Mohnish argues that the origins of the MS-DOS operating system can be traced back to the QDOS (Quick and Dirty Operating System) developed by Seattle Computer. MSFT went out and bought the rights for this and scaled it.

In relation to MSFT, Mohnish also contends the following:

  • the original idea for mouse and GUI for the PCs were inspired from Apple’s (ticker: AAPL) Macintosh computers.
  • Excel’s features were lifted from Lotus 1-2-3 and VisiCalc. Word inspired from WordPerfect.
  • Xbox was inspired from Nintendo and Sony’s PlayStatation.
  • …and so on

While I can see where Mohnish is going with this, I have to disagree with this principle slightly. I certainly do not see innovation as a crapshoot and a copycat as a homerun in all cases. Take MSFT’s Bing search engine versus Google’s search engine. Google dominates the search space in comparison to Bing. MSFT’s Internet explorer browser, which has been around for a lot more longer, is a joke in comparison to Google’s Chrome browser. The Internet Explorer was created to trounce Netscape Navigator, and MSFT tried everything in their might to achieve that, but Netscape lives on today in the form of Firefox which is an awesome internet browser. There are several other such examples: Zune Portable media player vs Apple’s iPod, Windows Phones vs Android etc.

When to Sell?

In this regard, Mohnish states the following:

any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.

In other words, Mohnish recommends holding a stock for two-three years at a minimum. Why two-three years? Why not a few months? This is because any meaningful change in a business takes some time to play out. Why not five years or more? Because the cost of waiting is appreciable and there is the associated opportunity cost wherein the same capital could have been invested in some other business.

What about after three years and if the stock price as crossed our estimated intrinsic value? Mohnish recommends selling if we are convinced that the stock is overvalued while also considering the capital tax implications of such a sale.

As a dividend growth investor, I will only sell a stock if the underlying fundamentals of the business have changed with respect to my original investment thesis and reasons for investing in the business. I am a buy-and-hold investor and the compounding effect of the dividend snowball can only be realized if I can hold onto a stock for not three years, but several years. Selling a stock would kill that compounding growth machine, and that is something I cannot afford in my strategy.

Final Remarks and Summary

So there you go! Those were my takeaways from this book. It is nicely written in a very easy-to-read language. I am pretty confident that I would have been able to breeze through this book in a single sitting. Some of the ideas discussed are in sync with what I have read in other investing books. And while I did not necessarily agree with some of the principles, I enjoyed the slightly different perspective of approaching the same underlying philosophies. There is a LOT of reference to Charlie Munger and Warren Buffett’s letters and quotes, not at all surprising in a book authored by Mohnish Pabrai.

I will re-read this in a few years from now, just to see if the ideas presented in this book provide a renewed perspective to my outlook on investing.

Have you read this book? If yes, what are your takeaways? What are your favorite books on investing? Please share in the comments below.

Thank you for reading thus far.

Disclosure: Long MSFT, AAPL, PG, COST